Determinants of capital flows to the new EU member states before and during the financial crisis : economic papers 425, september 2010

This paper looks at capital flows to the new EU Member States from Central and Eastern Europe (NMS10) during the last decade. Firstly, it analyses the role of various types of foreign capital flows - direct investment, portfolio investment, financial derivatives and other types of flows (mainly bank loans) - over time and across countries. Secondly, it explores the determinants of capital flows to the NMS10, distinguishing between factors relating to the external economic and financial environment ("push factors") and factors specific to the recipient NMS ("pull factors"). The econometric analysis shows that external determinants have been important in explaining capital flows to the NMS10. In particular, we find a strong role for euro area interest rates, business cycle, and risk sentiment. At the same time, the ability of the NMS10 to attract foreign capital has been also influenced by domestic economic and financial conditions and policies. Risk sentiment appears to be a robust driver for both the common component of aggregate capital flows to NMS10 and flows to individual countries. Overall, these results suggest a need for caution on the part of NMS in borrowing too heavily during periods of favourable external financial conditions. As the financial crisis has shown, this increases their vulnerability to a sudden reversal in the availability of financing, which can be largely driven by factors beyond their control.