The Composition of Capital In ows When Emerging Market Firms Face Financing Constraints∗

The composition of capital in ows to emerging market economies tends to follow a predictable dynamic pattern across the business cycle. In most emerging market economies, total in ows are pro-cyclical, with debt and portfolio equity owing in rst, followed later in the expansion by foreign direct investment (FDI). To understand the dynamic composition of these ows, we use a small open economy (SOE) framework to model the composition of capital in ows as the equilibrium outcome of emerging market rms' nancing decisions. We show how costly external nancing and FDI search costs generate a state contingent cost of nancing such that the cheapest source of nancing depends on the phase of the business cycle. In this manner, the nancial frictions are able to explain the interaction between the types of ows and deliver a time-varying composition of ows, as well as other standard features of emerging market business cycles. If, as this work suggests, ows are an equilibrium outcome of rms' nancing decisions, then volatility of capital in ows is not necessarily bad for an economy. Furthermore, using capital controls to shut down one type of ow and encourage another is certain to have both shortand long-run welfare implications. JEL Codes: F32, F34, F41, G15