Capital Flows to Central and Eastern Europe and the Former Soviet Union

This PDF is a selection from an out-of-print volume from the National Bureau of Economic Research Volume Title: Capital Flows and the Emerging Economies: Theory, Evidence, and Controversies Volume Author/Editor: Sebastian Edwards, editor Volume Publisher: University of Chicago Press Volume ISBN: 0-226-18470-6 Volume URL: http://www.nber.org/books/edwa00-1 Conference Date: February 20-21, 1998 Publication Date: January 2000 Chapter Title: Capital Flows to Central and Eastern Europe and the Former Soviet Union Chapter Authors: Stijn Claessens, Daniel Oks, Rossana Polastri Chapter URL: http://www.nber.org/chapters/c6171 Chapter pages in book: (p. 299 - 339) ~ Capital Flows to Central and Eastern Europe and the Former Soviet Union Stijn Claessens, Daniel Oks, and Rossana Polastri 9.1 Introduction and Background Capital flows to Central and Eastern Europe (CEE) and the former Soviet Union (FSU) represent a relatively small, albeit growing, share of capital flows to developing countries. Taking all flows together, total net flows to these twenty-five countries were about $44 billion in 1996 (and a preliminary figure of $57 billion for 1997),’ or about one-eighth of aggre- gate net flows to all developing countries. These countries accounted, however, for about 20 and 22 percent, respectively, of all developing countries’ gross domestic product (GDP) and exports in 1996. As a fraction of their GDP, total inflows were consequently smaller than for many other developing countries, and averaged about 5.4 percent over the 1990-96 period. Taking debt service and capital flight into account, resource inflows were much lower and even negative to some countries (capital flight from Rus- sia alone has been estimated at some $50 billion for 1992-96). The lower level of capital flows to these countries occurred during a period when global capital flows were very buoyant. Private capital flows to developing countries increased dramatically during the 1990s, especially foreign direct investment (FDI) and portfolio equity investment. Stijn Claessens is a lead economist in the Financial Sector Strategy and Policy Group at the World Bank. Daniel Oks is manager of the economic analysis department of the Central Bank of Argentina. Rossana Polastri is an economist in the Europe and Central Asia Region at the World Bank. The authors thank their discussant, Michael Dooley, other participants in the preconfer- ence and conference, Ricardo Martin, Frank Lysy, Marcelo Selowsky, and participants in a World Bank workshop for useful comments. The views expressed in this paper are those of the authors and do not necessarily represent those of the World Bank. 1. Excluding grants, the total amount of net flows amounted to US$41 billion in 1996. 299 300 Stijn Claessens, Daniel Oks, and Rossana Polastri While flows to CEE and FSU have also been growing fast-for example, portfolio and FDI flows increased from $1.4 billion in 1990 to $23.5 billion in 1996-between them they still attracted only about 15 percent of total private capital flows to all developing countries in 1996.2In 1996, FDI to CEE and FSU, for example, was only $14 billion, equivalent to the total amount received by Malaysia and Mexico in that year. The distribution of FDI flows has also been highly uneven. Over the 1992-96 period, Rus- sia and the Visegrad countries (the Czech Republic, the Slovak Republic, Poland, and Hungary) received the bulk of FDI flows, while many other countries in the region are still a11 but untouched by FDI. The still relatively low level of capital flows, especially of private capital, reflects the special nature of the economic development processes in these countries. Several factors are important. First, CEE and FSU are all transition economies. This means, for one thing, that market reforms did not get underway until the end of the 1980s for most of CEE-with the no- table exceptions of Hungary and Poland-and until 1991 for the FSU. The transition process also influenced the nature and composition of the capital flows. In particular, early on in the transition the capital flows were mainly fiscally driven and often from official sources. Annual net flows of official development finance-including official development assis- tance (grants and official concessional loans) and official nonconcessional loans-represented about 40 percent of total net flows in 1990-96 and over 100 percent in 1990-91 (as private net flows were negative in those years). This reflected the sharp deterioration of fiscal revenues at the onset of the transition process and the lack of credit worthiness of some countries. Associated with this process were low private capital inflows, and, as mentioned, for some countries substantial amounts of capital flight. The low level of private inflows was due to a variety of factors, including partial and incomplete reforms or an uncertain commitment to reform in most countries, high political and social costs of the transition process itself, and high levels of corruption and political instability (several countries in the FSU have been affected by civil wars). Many countries in CEE also lost financing and aid from the Soviet Union-they had received a large amount of aid, including above-market export prices and below-market import (especially energy) prices, from the Soviet Union (World Bank 1992), but these flows essentially ceased in 1989-implying a larger financing need for their governments. In more recent years, there has been a more rapid inflow of private capital, as reform efforts have consolidated and economic prospects im- proved and, for some countries, as European Union (EU) integration be- came a possibility for the near future. For some countries, short-term capital has recently become an important source of external financing. Since 2. Portfolio and FDI flows to all developing countries in 1996 were $155 billion. Flows to Central and Eastern Europe and the Former Soviet Union 301 most countries have been “latecomers” to the phenomenon of large private capital inflows, they have not experienced much of the overheating phenomena that have affected other developing countries in the past (Latin America) and recently (East Asia). The main exceptions, indeed, were precisely some of the earlier and faster reformers like Hungary, Po- land, the Czech Republic, and Estonia. At the same time, the transition to a market economy is far from com- plete for most of the economies in the region. Distortions in factor mar- kets are still prevalent and the institutional development in areas crucial to beneficial financial integration-particularly the legal system and financial sector-is still limited, especially in many of countries of the FSU. Deficiencies, which in other developing countries have been associated with subsequent problems, including poor resource allocation and financial crises, are thus still prevalent in many transition economies. By tack- ling these issues now, these countries could presumably stand to gain more of the benefits and to run less of the risks associated with more financial integration and large private capital flows. This paper investigates the amounts, types and sources of capital flows to these countries. It tries to determine the motivation of the various sources of capital flows, distinguishing global and country-specific factors. The paper provides estimates of the (econometric) relationships between, on one hand, the different kinds of capital flows and, on the other hand, the reform process, macroeconomic fundamentals and performance, and external factors. Because the history of capital flows to CEE and FSU is short, historical analysis has significant limitations and econometric esti- mation is difficult. Lessons from experiences of other countries with private capital flows may, however, be applied to these countries, when taking into account their special characteristics. The paper is organized as follows. Section 9.2 briefly describes the facts about capital flows to these countries. Section 9.3 discusses important links and relationships between macroeconomic variables and the capital flows, including some of the basic motivations and causes for capital flows. Section 9.4 describes and analyzes the policy framework and policy re- sponses in those countries that received the bulk of capital flows. Econo- metric tests are presented in section 9.5, while section 9.6 discusses the issues surrounding capital flows that may in the future arise in these countries, and provides some conclusions. 9.2 Facts about Capital Flows to Central and Eastern Europe and the Former Soviet Union We start by providing some simple raw statistics for the various capital flows. In principle, one can distinguish capital flows by destination (e.g., public versus private); by type (e.g., long-term and short-term debt, FDI, 302 Stijn Claessens, Daniel Oks, and Rossana Polastri bonds and equity portfolios); and by origin (e.g., commercial, that is private, versus official creditors). One can also combine the three distinctions, for example, by splitting debt-type flows into public and private debt, with the latter further into long and short, and by origin, for example, commercial versus official. For our purposes, and given the data we have at hand and the patterns in capital flows we observe, we create five categories of capital flows: public debt (official) flows; commercial long-term (LT) debt flows; commercial short-term (ST) debt flows; FDI flows; and portfolio (bond and equity) flows. For some purposes, it would be useful to further split commercial debt flows into those going to the banking system and those going to other sectors of the economy, but it turns out that this cannot be done for most of the countries given the data available. Our focus is on net flows; however, while we occasionally also discuss “capital flight” (other than that captured through short-term flows), we do not net out capital flight from our net flow measures.

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