Portfolio and short-term capital inflows to the new and potential EU countries: Patterns, determinants and policy responses

In this paper we estimate a dynamic panel model (Arellano-Bond GMM) explaining the volume of portfolio and short-term capital inflows (predominantly bank loans) in the new and potential EU member States as a function of a set of variables representing macroeconomic fundamentals (both domestic and foreign), macroeconomic policies and development of the financial sector. We find that while inflows of short-term bank loans are significantly explained by macroeconomic factors, exchange rate regime and liquidity of the banking sector, portfolio inflows seem to be meaningfully influenced only by the level of foreign GDP. We suggest two explanations for the latter result. First, the inability of aggregate data to capture the risk and expected profitability dimensions that typically underlie portfolio decisions. Second, portfolio capital in the form of bonds might react to interest rates other than the domestic and the European ones. During the last decade, the volume of short-term capital in the form of bank loans to the New and potential member States increased (with some heterogeneity across countries). In light of the econometric results, their vulnerability to reversals could be mitigated by adequate macroeconomic policies and further improvement of their financial sector.