Financial integration, push factors and volatility of capital flows: evidence from EU new member states

Due to the recent financial crisis and ensuing sudden stop episodes, the question whether capital inflows are dominated by push or pull factors has become an extremely important policy question in small, open and integrated economies. The aim of this paper is to empirically measure, in a methodologically innovative manner, the extent to which the movement of capital inflows in the non-euro area new EU member countries has been determined by domestic and external factors and discuss potential consequences of such trends, thereby filling the existing literature gap, i.e., the lack of empirical papers that systematically model the temporal dynamics of capital flow determinants. The paper uses econometric methods, i.e., historical decomposition from a structural vector autoregression model, to examine the temporal dynamics of capital flow determinants and extract components of capital inflows in non-euro area new EU member countries that are influenced by domestic and foreign shocks separately. Econometric analysis confirmed the hypothesis that macroeconomic factors in the euro area are becoming increasingly dominant determinants of capital inflows in new EU member countries, especially after the EU accession, and proved that these trends can be connected to rising financial integration levels of analysed countries. Furthermore, results suggest that the rising influence of push factors can be connected with the higher volatility of capital inflows, thus making host countries more prone to sudden stop episodes. The paper uncovers several non-negligible macroeconomic risks of large capital inflows determined by push factors for domestic economic authorities in small integrated economies and points out the need to make efforts to strengthen the domestic financial and regulatory system to ensure the capability of these economies in efficiently managing capital inflows.