## _wp12222

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---

### Introduction
- During the run-up to the global financial crisis in 2008, emerging Europe experienced an exceptionally large capital inflow surge.
- Net private capital flows averaged about 15 percent of the region’s GDP when the surge crested in 2007.
- The 2007 capital inflows to emerging Europe were threefold of the size of the 2007 capital inflows to all emerging economies combined.
- Cross-country diversity in inflows (average 2003–07) ranged from 3 percent of GDP for Russia to 27 percent of GDP for Bulgaria.
- Literature and interpretations cited:
  - Large inflows pose policy dilemmas but can be intrinsic to convergence (Lipschitz et.al., 2002).
  - Rapid financial deepening seen as capital flowing “downhill” (Dell’Ariccia et.al., 2008; Abiad et.al., 2009).
  - Critical perspectives stress internal and external imbalances and call for policies to slow inflows (IMF, Regional Economic Outlook for Europe, November 2007).
  - Global (push) factors may trigger surges while domestic (pull) factors determine surge size (Ghosh et.al., 2012).
- Emerging consensus on policy toolkit: mix of macroeconomic policies (fiscal, monetary, exchange rate, FX intervention), prudential regulations, and capital controls; appropriate mix depends on reserves, regulatory quality, exchange rate flexibility, and persistence of inflows (Ostry et.al., 2010).
- Focus of paper: role of fiscal policy during pre-crisis surge in emerging Europe using a push-pull-brake model and cross-country variation in inflows and fiscal stances.

### Main findings (from the Introduction)
- Push vs pull:
  - Push factors (low returns in originating countries) drove most private capital flows to emerging Europe.
  - Local pull factors also played an important role in some countries.
- Fiscal policy effectiveness:
  - Forceful countercyclical fiscal policies could have slowed down capital inflows, but would not have been effective in countering inflows of the magnitude faced by some countries.
  - Implication: other policy tools need to support countercyclical fiscal policy during surges.

### The Push-Pull-Brake Model (Section B)
- Core components and equations:
  - Nonarbitrage condition: D_t / C_t = R_t.  (Equation (1))
  - Domestic returns: D_t = D(A_t, I_t, K_t), D_A >0, D_I <>0, D_K <0.  (Equation (2))
  - Creditworthiness depends on structural fiscal balance: C_t = C(F_S_t), C_F >0.  (Equation (3))
  - Reduced-form for net private capital flows: K_t = b_1 A_t + b_2 F_S_t + b_3 I_t + b_4 R_t, with b_1 >0, b_2 >0, b_4 <0.  (Equation (5))
  - Domestic absorption responds: A_t = a_1 K_t + a_2 F_S_t, with a_1 >0, a_2 <0.  (Equation (6))
  - Solved reduced-form: K_t = [(b_2 + a_2 b_1) F_S_t + b_3 I_t + b_4 R_t] / (1 - a_1 b_1).  (Equation (7))
- Interpretation of fiscal tightening:
  - If (b_2 + a_2 b_1) < 0: fiscal tightening discourages capital inflows (contractionary absorption effect stronger than confidence effect).
  - If (b_2 + a_2 b_1) > 0: fiscal tightening attracts additional capital inflows (confidence effect dominates absorption effect).
- Identification limitation: model cannot separately identify confidence effect b_2 from absorption effect a_2 b_1 given limited observables.

### Measuring the Fiscal Stance During Absorption Booms (Section C)
- Observed fiscal deficits correlate with inflows but headline fiscal balance is a poor measure of fiscal stance due to automatic budget responses.
- Conventional structural balance: F_S = F - α Y_GAP.  (Equation (9))
- Absorption gap decomposition: A_GAP ≈ Y_GAP + CAD_GAP.  (Equation (8))
- Structural balance accounting for external gap: F_S = F - α Y_GAP - β CAD_GAP.  (Equation (10))
- Implication: omitting CAD_GAP leads to mis-measurement of fiscal stance during absorption booms.

### Box 1. Absorption Gaps and Automatic Fiscal Stabilizers
- National accounts identity (levels): Y + YF = A – CAD, where Y = real GDP; YF = real net foreign incomes and transfers; A = real absorption; CAD = real current account deficit.
- Gap representation: (Y – YPOT) + (YF – YF,POT) = (A – APOT) – (CAD – CADPOT). With (YF – YF,POT) neglected, (A – APOT) ≈ (Y – YPOT) + (CAD – CADPOT).
- Fiscal decomposition (ratios to potential GDP): F = FS + α YGAP + β CADGAP.
  - α set equal to the average ratio of general government expenditure as a percent of GDP during 2000–07.
  - β set equal to 0.20 for all countries.
- Regional experiences (2000–07):
  - Baltics and Bulgaria: large output gaps and large external imbalances; amplified by procyclical effect of EU funds.
  - Bosnia and Herzegovina, Hungary, Romania, Serbia: similar but to a lesser extent.
  - Albania, Czech Republic, Poland, Slovakia: absorption booms largely contained.
  - Russia and Ukraine: output gaps driven partly by international commodity prices; current account stronger than expected.
- Fiscal positions (2000–07):
  - Headline fiscal balances improved in most countries; pre-crisis headline balances around zero in many cases.
  - Several countries ran large fiscal surpluses by 2007: Bosnia and Herzegovina, Bulgaria, Estonia, Montenegro, Russia.
  - Headline fiscal balances deteriorated only in Hungary and Romania.
  - Cyclically-adjusted balances painted a less healthy picture: revenue booms were often cyclical and policymakers allowed significant government expenditure growth.
  - Pre-crisis fiscal stance particularly procyclical in Baltic countries, Bulgaria, Hungary, Romania, Serbia, and Ukraine.
  - Pronounced improvements in cyclically-adjusted balances in Turkey, Albania, Bosnia and Herzegovina, Czech Republic, Macedonia, and Russia.
- Notes on measurement:
  - Output gaps for 2000–07 estimated using Hodrick–Prescott filter over 1995–2014.
  - Current account gaps for 2000–07 estimated as deviation from average current account balance during 1995–2014.

### Empirical findings: determinants of capital inflows (panel, 19 countries, annual 2000–07)
- Data and specification highlights:
  - Capital inflows measured in real U.S. dollar terms (deflated by U.S. CPI), expressed as fraction of 2000 GDP.
  - External returns proxied by annualized 10-year German government bond nominal yields.
  - Structural fiscal balance excludes automatic effects of internal and external imbalances.
  - Model includes interaction between fiscal stance and hard-peg exchange rate dummy; country fixed effects included.
- Key quantitative results (preferred specifications, regressions 1–4, Table 1):
  - International returns (yield on GR Bond):
    - 100 basis points drop in international returns associated with about 8–15 percent of GDP higher capital inflows.
  - Cyclically-adjusted fiscal balance:
    - An improvement of the cyclically-adjusted fiscal balance of 1 percent of GDP is associated with 2–4 percent of GDP less capital inflows.
    - Interaction with hard-peg dummy negative (reinforcing dampening effect) but not statistically significant.
  - Measurement matters:
    - Using headline fiscal balances can produce misleading positive correlation between fiscal improvements and capital inflows.
    - Cyclical adjustment that omits external gap revenues understates the dampening effect of fiscal consolidation relative to absorption-gap adjusted fiscal balances.
- Robustness:
  - Adding VIX reduces explanatory power of international returns (co-linearity).
  - Results robust to using U.S. government bond yields (push story marginally weaker).
  - Dickey-Fuller cointegration test rejects inconsistency due to nonstationarity.
  - Durbin-Watson statistic indicates serial autocorrelation not a problem.
  - Results robust to interactions with capital account restrictions, initial per capita income, expanding sample to 2008, or restricting to noncommodity exporters.

### Decomposition of capital inflows into proximate causes (country-specific)
- Method: use preferred model coefficients (regression 4) and average changes in explanatory variables (since 2000) to decompose increase in total capital flows.
- Aggregate and sectoral decomposition highlights:
  - Falling international returns explain the lion’s share of the surge in capital inflows.
    - For an average country: capture 134 percent of the increase in foreign direct investment and 100 percent of the increase in other investment.
    - Very little bearing on private portfolio inflows.
  - Country-specific fixed effects are critical for cross-country differences:
    - Positive and large fixed effects in Bulgaria, Bosnia and Herzegovina, Serbia; positive also in Estonia, Romania, Slovak Republic, Turkey.
    - Negative fixed effects in Belarus, Russia, Ukraine, and Czech Republic, Hungary, Poland.
  - Fiscal policy effects:
    - Average fiscal policy effect for the region is about 7 percent of total capital inflows (regionally small but heterogeneous).
    - Procyclical fiscal policy pulled in inflows in Hungary, Serbia, Latvia, Macedonia, Ukraine (reinforced by fixed exchange rate regimes).
    - Prudent fiscal stance mitigated inflows in Albania, Bosnia and Herzegovina, Slovak Republic, Turkey.
- Table excerpts (Total Private Capital Inflows, Percent of GDP) — selected country rows preserved exactly:
  - Albania: 4.3 -2.60 -9.20 0.0 16.0
  - Belarus: 8.2 -7.3 -1.1 -0.4 16.0
  - Bosnia and Herzegovina: 22.4 33.05 -17.1 -9.6 16.0
  - Bulgaria: 38.1 22.6 -0.4 -0.2 16.0
  - Hungary: 5.9 -24.4 14.2 0.0 16.0
  - Serbia, Republic of: 41.1 12.4 12.6 0.0 16.0
  - Average: 15.1 -2.00 0.8 0.4 16.0
  - Bottom line row (aggregate shares): 100% -13% 5% 2% 106%

### Counterfactual simulations (preserving cyclically-adjusted fiscal balance at 2000 level)
- Simulation design:
  - Use regression 4 coefficients and historical explanatory variables, but hold cyclically-adjusted fiscal balance constant at 2000 level to predict 2001–07 inflows.
- Main simulation outcomes:
  - Bulgaria and Romania: preserving cyclically-adjusted fiscal balance at 2000 levels would have had very little effect on capital inflows (other factors dominate).
  - Estonia, Latvia, Serbia: avoiding fiscal expansions of 2005–07 would have significantly reduced capital inflows, though other factors remain important.
  - Hungary: large fiscal expansion in 2005–07 appears to be the main driving force of capital inflows during boom years.
- Practical constraints on countercyclical fiscal tightening:
  - Difficulty tracking capital inflows and absorption booms in real time (IMF forecasts missed the surge).
  - Political economy: electorates unlikely to accept fiscal austerity as growth begins.
  - Implementation lags and potential adverse growth implications from fiscal tightening.
  - Nonetheless, countercyclical fiscal policy that accumulated surpluses/reserves helped create fiscal space and reduced vulnerability.

### Historical vs. Real-time interpretation of policy
- Historical estimation vs real-time perception:
  - Historical HP filter over 1995–2014 produces large pre-crisis positive output gaps because of the crisis-induced drop in estimated potential output.
  - Real-time estimates (Spring 2008 WEO vintage) omit crisis effects and yield more modest overheating estimates.
- Empirical differences:
  - Dampening effect of countercyclical fiscal policy on inflows confirmed across both historical and real-time samples (coefficients uniformly negative).
  - Statistical significance in real-time sample arises only when cyclically-adjusted fiscal balance accounts for both output and current account gaps.
  - Magnitude:
    - Historical sample: a 1 percent improvement in cyclically-adjusted fiscal balance associated with up to 4 percent of GDP reduction in capital inflows.
    - Real-time sample: a 1 percent improvement associated with about 2½ percent of GDP reduction in capital inflows.

### Conclusions and policy implications
- Main lessons:
  - Push factors (global liquidity / falling international returns) largely explain the surge in flows to emerging Europe pre-crisis, though local pull factors mattered in some countries.
  - Countercyclical fiscal policy dampens capital inflows, but effectiveness depends on measuring fiscal consolidation net of both output gap and cyclical external current account movements.
  - Even pronounced countercyclical fiscal policy would have been difficult politically and may not have fully offset the magnitude of inflows in many countries, though it would have created fiscal space to mitigate crisis impacts.
  - Effective management of inflow surges requires a mix of:
    - Countercyclical fiscal policy,
    - Monetary and exchange rate policy options,
    - FX intervention,
    - Prudential regulation and capital controls.
  - Choice of policy mix depends on reserves, quality of prudential regulation, scope for currency appreciation, and expected persistence of inflows.

*Source: _wp12222 - References .............................................................................................................*

### References .............................................................................................................

### _wp12222 - References .............................................................................................................

### Introduction
- During the run-up to the global financial crisis in 2008, emerging Europe experienced an exceptionally large capital inflow surge.
- Net private capital flows averaged about 15 percent of the region’s GDP when the surge crested in 2007.
- The 2007 capital inflows to emerging Europe were threefold of the size of the 2007 capital inflows to all emerging economies combined.
- Cross-country diversity in inflows (average 2003–07) ranged from 3 percent of GDP for Russia to 27 percent of GDP for Bulgaria.
- Literature and interpretations cited in the chapter:
  - Large inflows pose policy dilemmas but can be intrinsic to convergence (Lipschitz et.al., 2002).
  - Rapid financial deepening seen as capital flowing “downhill” (Dell’Ariccia et.al., 2008; Abiad et.al., 2009).
  - Critical perspectives stress internal and external imbalances and call for policies to slow inflows (IMF, Regional Economic Outlook for Europe, November 2007).
  - Global (push) factors may trigger surges while domestic (pull) factors determine surge size (Ghosh et.al., 2012).
- Emerging consensus: policy toolkit should include macroeconomic policies (fiscal, monetary, exchange rate, FX intervention) and prudential regulations and capital controls. Appropriate mix depends on reserves, regulatory quality, exchange rate flexibility, and persistence of inflows (Ostry et.al., 2010).
- Focus of paper: role of fiscal policy during pre-crisis surge in emerging Europe; uses a push-pull-brake model; exploits large cross-country variations in inflows and fiscal stances.

### Main findings (from the Introduction)
- First main finding:
  - For the region as a whole, push factors (low returns in originating countries) drove most private capital flows to emerging Europe.
  - Local pull factors also played an important role in some countries.
- Second main finding:
  - Forceful countercyclical fiscal policies could have slowed down capital inflows, but would not have been effective in countering inflows of the magnitude faced by some countries.
  - Implication: other policy tools need to support countercyclical fiscal policy during surges.

### The Push-Pull-Brake Model (Section B)
- Model captures interplay among:
  - Push factors: abundant global liquidity and low risk aversion led to falling long-term interest rates in the euro area and the U.S.
  - Pull factors: prospects of high returns in emerging Europe due to relatively low wages and capital-labor ratios, privatization, improving risk perceptions, and EU accession prospects.
  - Macroeconomic policy regimes: variety of monetary/exchange rate regimes, fiscal responses, prudential regimes.
- Starting point: Fernandez-Arias (1996) framework; nonarbitrage condition equating expected return in an emerging European country (contractual return D_t adjusted for creditworthiness C_t) to international return R_t:
  - D_t / C_t = R_t.  (Equation (1) in text)
- Domestic returns assumed to depend on absorption A_t (positive), country-specific factors I_t (sign unrestricted), and net foreign capital inflows K_t (negative):
  - D_t = D(A_t, I_t, K_t), D_A >0, D_I <>0, D_K <0.  (Equation (2))
- Creditworthiness depends on structural fiscal balance F_S_t, with C_F >0.  (Equation (3))
- Reduced-form comparative statics for net private capital flows:
  - K_t = b_1 A_t + b_2 F_S_t + b_3 I_t + b_4 R_t, with b_1 >0, b_2 >0, b_4 <0.  (Equation (5))
- Domestic absorption responds to capital inflows (a_1 >0) and tighter fiscal stance (a_2 <0):
  - A_t = a_1 K_t + a_2 F_S_t.  (Equation (6))
- Solving yields the reduced-form for capital inflows:
  - K_t = [(b_2 + a_2 b_1) F_S_t + b_3 I_t + b_4 R_t] / (1 - a_1 b_1).  (Equation (7))
- Interpretation of fiscal tightening on capital inflows depends on sign and magnitude of (b_2 + a_2 b_1):
  - If (b_2 + a_2 b_1) < 0, fiscal tightening discourages capital inflows (contractionary absorption effect stronger than confidence effect).
  - If (b_2 + a_2 b_1) > 0, fiscal tightening attracts additional capital inflows (confidence effect dominates absorption effect).
- Note: The model specification cannot separately identify the confidence effect b_2 from the absorption effect a_2 b_1 given limited observables (identification limitation noted in footnote).

### Measuring the Fiscal Stance During Absorption Booms (Section C)
- Observed scatter plots show lower fiscal deficits associated with higher capital inflows, but actual fiscal balance is not a good measure of fiscal stance because it includes automatic budget responses.
- Conventional measurement strips out automatic responses to the output gap (Y_GAP) to estimate structural balance as percent of potential GDP:
  - F_S = F - α Y_GAP.  (Equation (9))
- In absorption booms, output gap alone may not capture all automatic fiscal fluctuations because absorption gap (A_GAP) comprises internal and external components:
  - A_GAP ≈ Y_GAP + CAD_GAP.  (Equation (8))
  - Where CAD_GAP is the gap between actual and sustainable current account deficit.
- When absorption boom spills into current account deficits, structural balance should account for both output and current account gaps:
  - F_S = F - α Y_GAP - β CAD_GAP.  (Equation (10))
- Implication: conventional structural balance measures that ignore CAD_GAP can mis-measure the fiscal stance during absorption booms.

### Empirical approach and simulations (referenced in organization)
- Paper uses empirical decomposition of inflows into push, pull, and brake factors (Section D).
- Simulations produce counterfactual outcomes for selected countries under alternative fiscal stances (Section E).
- Robustness checks include comparing historical vs. real-time measures of cyclical gaps (Section F).

### Policy implications (from Introduction and model discussion)
- The fiscal tool can act both as a brake (via reducing absorption) and as a pull (via improving confidence/creditworthiness).
- Forceful countercyclical fiscal policy can help slow inflows but may be insufficient for very large surges.
- Effective management of inflow surges likely requires a mix of:
  - Countercyclical fiscal policy,
  - Monetary and exchange rate policy options,
  - FX intervention,
  - Prudential regulation and capital controls.
- Choice of mix depends on state of economy, reserves, quality of prudential regulation, scope for currency appreciation, and expected persistence of inflows.

*Source: _wp12222 - References .............................................................................................................*

### Box 1. Absorption Gaps and Automatic Fiscal Stabilizers

### Box 1. Absorption Gaps and Automatic Fiscal Stabilizers

### Framework and definitions
- National account identity (levels): Y + YF = A – CAD, where:
  - Y = real GDP
  - YF = real net foreign incomes and transfers
  - A = real absorption
  - CAD = real current account deficit
- Gap representation (deviations from equilibrium, superscript “POT”):  
  (Y – YPOT) + (YF – YF,POT) = (A – APOT) – (CAD – CADPOT)
- With (YF – YF,POT) assumed small and neglected, absorption gap approximates:  
  (A – APOT) ≈ (Y – YPOT) + (CAD – CADPOT)
  - Interpretation: An absorption gap is reflected in either an output gap (internal imbalance) or a current account gap (external imbalance).
- Fiscal decomposition (ratios to potential GDP):  
  F = FS + α YGAP + β CADGAP
  - F = actual fiscal balance (ratio to actual GDP)
  - FS = underlying (structural) fiscal balance (ratio to potential GDP)
  - YGAP = output gap (ratio to potential GDP)
  - CADGAP = current account gap (ratio to potential GDP)
  - α and β = automatic response coefficients of the actual fiscal balance to the two gaps
  - In the analysis: α set equal to the average ratio of general government expenditure as a percent of GDP during 2000–07; β set equal to 0.20 for all countries.

### Regional absorption and output experiences (2000–07)
- Absorption booms financed by capital inflows:
  - Baltics and Bulgaria: large output gaps and large external imbalances; process amplified by procyclical effect of EU funds.
  - Bosnia and Herzegovina, Hungary, Romania, Serbia: similar but to a lesser extent.
  - Albania, Czech Republic, Poland, Slovakia: absorption booms largely contained (internal and external imbalances contained).
  - Russia and Ukraine: output gaps driven in part by international commodity prices; current account position stronger than expected given output gap.

### Fiscal positions and cyclically-adjusted balances (2000–07)
- Headline fiscal balances:
  - Actual fiscal positions improved in most countries during 2000–07; pre-crisis headline balances were around zero in many countries.
  - By 2007 several countries ran large fiscal surpluses (examples listed): Bosnia and Herzegovina, Bulgaria, Estonia, Montenegro, Russia.
  - Headline fiscal balances deteriorated only in Hungary and Romania.
- Once adjusted for cyclical factors:
  - Underlying fiscal positions looked much less healthy.
  - Revenue booms (tax buoyancy) drove fiscal improvements where growth was led by capital inflow-driven absorption booms.
  - Policymakers often failed to fully appreciate cyclical nature of revenue buoyancy or faced political constraints on accumulating surpluses, allowing significant government expenditure growth.
  - Result: pre-crisis fiscal policy stance was particularly procyclical in Baltic countries, Bulgaria, Hungary, Romania, Serbia, and Ukraine.
  - Pronounced improvements in cyclically-adjusted fiscal balances occurred in Turkey and in Albania, Bosnia and Herzegovina, Czech Republic, Macedonia, and Russia.
- Notes on measurement:
  - Output gaps for 2000–07 estimated using Hodrick–Prescott filter over 1995–2014.
  - Current account gaps for 2000–07 estimated as deviation from average current account balance during 1995–2014.

### Empirical findings: determinants of capital inflows (panel, 19 emerging European countries, annual 2000–07)
- Data and specification:
  - Capital inflows measured in real U.S. dollar terms (deflated by U.S. CPI), expressed as fraction of 2000 GDP.
  - External returns proxied by annualized 10-year German government bond nominal yields.
  - Structural fiscal balance measured by excluding automatic effects of internal and external imbalances.
  - Model includes interaction term between fiscal stance and dummy for hard peg exchange rate regimes.
  - Country-specific effects treated as unobservable intercepts; all variables expressed as deviations from 2000 levels.
- Key quantitative results (preferred specifications, regressions 1–4, Table 1):
  - International returns (yield on GR Bond):
    - 100 basis points drop in international returns associated with about 8–15 percent of GDP higher capital inflows.
  - Cyclically-adjusted fiscal balance:
    - Coefficient negative and significant: an improvement of the cyclically-adjusted fiscal balance of 1 percent of GDP is associated with 2–4 percent of GDP less capital inflows.
    - Interaction term with hard-peg dummy negative (reinforcing dampening effect) but not statistically significant.
  - Measurement matters:
    - Using headline fiscal balances (no cyclical adjustment) can produce a misleading positive correlation between fiscal improvements and capital inflows.
    - Cyclical adjustment that omits external gap revenues understates the dampening effect of fiscal consolidation relative to absorption-gap adjusted fiscal balances.
- Robustness and diagnostics:
  - Alternative specifications qualitatively similar.
  - Adding VIX reduces explanatory power of international returns (co-linearity).
  - Findings robust to using U.S. government bond yields (qualitative results unchanged; push story marginally weaker).
  - Dickey-Fuller cointegration test rejects inconsistency due to nonstationarity.
  - Durbin-Watson statistic indicates serial autocorrelation not a problem.
  - Results robust to interaction tests with capital account restrictions (not significant), initial per capita income (evidence for downhill flows), expanding sample to 2008 or restricting to noncommodity exporters.

### Decomposition of capital inflows into proximate causes (country-specific)
- Method: use preferred model coefficients (regression 4) and average changes in explanatory variables (since 2000) to decompose increase in total capital flows.
- Aggregate and sectoral decomposition highlights:
  - Falling international returns:
    - Explain the lion’s share of the surge in capital inflows.
    - For an average country: capture 134 percent of the increase in foreign direct investment and 100 percent of the increase in other investment.
    - Very little bearing on private portfolio inflows.
  - Country-specific fixed effects:
    - Critical for cross-country differences.
    - Positive and large in Bulgaria, Bosnia and Herzegovina, Serbia (improvements in investment climate, privatization, financial integration, post-conflict normalization).
    - Positive also in Estonia, Romania, Slovak Republic, Turkey.
    - Negative fixed effects in Belarus, Russia, Ukraine, and surprisingly Czech Republic, Hungary, Poland (reflecting frontloaded reforms, higher initial capital-labor ratios, tilt toward portfolio flows).
  - Fiscal policy:
    - Average fiscal policy effect for the region is relatively small (about 7 percent of total capital inflows) but heterogeneous across countries.
    - Procyclical fiscal policy (deteriorating cyclically-adjusted stance) pulled in capital inflows in Hungary and Serbia and in Latvia, Macedonia, Ukraine (effect reinforced by fixed exchange rate regimes).
    - Prudent fiscal stance mitigated inflows in Albania, Bosnia and Herzegovina, Slovak Republic, Turkey.

- Empirical decomposition table excerpts (Table 2, Total Private Capital Inflows, Percent of GDP):
  - Country examples (increase in inflows; country-specific effects; fiscal tightening 1/; fiscal tightening in hard pegs 1/; reduction in international returns):
    - Albania: 4.3 -2.60 -9.20 0.0 16.0
    - Belarus: 8.2 -7.3 -1.1 -0.4 16.0
    - Bosnia and Herzegovina: 22.4 33.05 -17.1 -9.6 16.0
    - Bulgaria: 38.1 22.6 -0.4 -0.2 16.0
    - Hungary: 5.9 -24.4 14.2 0.0 16.0
    - Serbia, Republic of: 41.1 12.4 12.6 0.0 16.0
    - Average: 15.1 -2.00 0.8 0.4 16.0
  - Bottom line row (aggregate shares): 100% -13% 5% 2% 106% (as in table footnote presentation)

### Counterfactual simulations (preserving cyclically-adjusted fiscal balance at 2000 level)
- Simulation setup:
  - Use regression 4 coefficients and historical values for explanatory variables, but hold cyclically-adjusted fiscal balance constant at 2000 level to predict total capital inflows in 2001–07.
- Main simulation observations:
  - Bulgaria and Romania: preserving cyclically-adjusted fiscal balance at 2000 levels would have had very little effect on capital inflows (driven by other factors).
  - Estonia, Latvia, Serbia: avoiding fiscal expansions of 2005–07 would have significantly reduced capital inflows, though other factors remain important.
  - Hungary: large fiscal expansion in 2005–07 appears to be the main driving force of capital inflows during boom years.
- Practical considerations and constraints on implementing countercyclical fiscal tightening:
  - Difficulty in tracking capital inflows and absorption booms in real time (misses in IMF forecasts during surge period).
  - Political economy: electorates unlikely to accept fiscal austerity “just as things start to get a bit better.”
  - Implementation lags and potential quality concerns of fiscal tightening (possible adverse growth implications).
  - Nonetheless, countercyclical fiscal policy, even if imperfect, helped countries that accumulated surpluses/reserves in the boom phase to have more fiscal space and be less vulnerable.

### Historical vs. Real-time interpretation of policy
- Real-time vs retrospective gap measurement:
  - Historical estimation uses full sample (including 2008–09 crisis) with HP filter over 1995–2014, which mechanically produces a large drop in estimated potential output before crisis and hence large positive output gaps pre-crisis.
  - Real-time perceptions likely differed; real-time estimates of gaps can be materially different from estimates that use later revisions and crisis information.
- Real-time proxy analysis:
  - Replicate empirical analysis using Spring 2008 WEO vintage (last pre-Lehman) to proxy real-time data; omits crisis effect and yields more modest overheating estimates.
- Differences in empirical findings (historical vs real-time samples, Table 3):
  - Dampening effect of countercyclical fiscal policy on capital inflows confirmed across samples (coefficients on cyclically-adjusted fiscal balance uniformly negative).
  - Statistical significance in real-time sample arises only when cyclically-adjusted fiscal balance accounts for both output and current account gaps.
  - Magnitude differences:
    - Historical sample: a 1 percent improvement in cyclically-adjusted fiscal balance associated with up to 4 percent of GDP reduction in capital inflows.
    - Real-time sample: a 1 percent improvement associated with about 2½ percent of GDP reduction in capital inflows.

### Conclusions and policy implications
- Main lessons:
  - Push factors (global liquidity / falling international returns) largely explain the surge in flows to emerging Europe pre-crisis, though local pull factors mattered in some countries.
  - Countercyclical fiscal policy dampens capital inflows, but only when fiscal consolidation accounts for both output gap and cyclical movements in the external current account position.
  - Even pronounced countercyclical fiscal policy would have been difficult to implement politically and may not have fully countered the magnitude of inflows observed in many countries, though it would have created fiscal space to mitigate crisis impacts.
  - Other policy tools (complementary to fiscal policy) will need to play a role in future capital inflow surges.

*Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2012/_wp12222.pdf*

### References

### _wp12222 - References

### Capital flows, financial globalization, and capital inflows management
- Abiad, Abdul, Daniel Leigh and Ashoka Mody, 2009, “Financial Integration, Capital Mobility, and Income Convergence,” Economic Policy, Vol. 24 (April).
- Cardarelli, Roberto, Selim Elekdag, and Ayhan Kose, 2007, “Managing Large Capital Inflows,” Chapter 3, World Economic Outlook, October (Washington: International Monetary Fund).
- Cardarelli, Roberto, Selim Elekdag, and Ayhan Kose, 2009, “Capital Inflows: Macroeconomic Implications and Policy Responses” IMF Working Paper 09/40 (Washington: International Monetary Fund).
- Dell’Ariccia, Giovanni, Julian di Giovanni, André Faria, Ayhan Kose, Paulo Mauro, Jonathan D. Ostry, Martin Schindler, and Marco Terrones, 2008, “Reaping the Benefits of Financial Globalization,” IMF Occasional Paper No. 264 (Washington: International Monetary Fund).
- Fernandez-Arias, Eduardo, 1996, “The New Wave of Private Capital Inflows: Push or Pull?” Journal of Development Economics, Vol. 48, pp. 389–418.
- Ghosh, Atish R., Jun Kim, Mahvash S. Qureshi, and Juan Zalduendo, 2012, “Surges” IMF Working Paper 12/22 (Washington: International Monetary Fund).
- Lipschitz, Leslie, Timothy Lane, and Alex Mourmouras, 2002, “Capital Flows to Transition Economies: Master or Servant?” IMF Working Paper 02/11 (Washington: International Monetary Fund).
- Ostry, Jonathan D., Atish Ghosh, Karl Habermeier, Marcos Chamon, Mahvash S. Qureshi, and Dennis B.S. Reinhardt, 2010, “Capital Inflows: The Role of Controls,” IMF Staff Position Note 10/04 (Washington: International Monetary Fund).
- Ötker-Robe, Inci, Zbigniew Polanski, Barry Topf, and David Vávra, 2007, “Coping with Capital Inflows: Experience of Selected European Countries,” IMF Working Paper 07/190 (Washington: International Monetary Fund).
- Peiris Shanaka, 2010, “Foreign Participation in Emerging Markets’ Local Currency Bond Markets,” IMF Working Paper 10/88 (Washington: International Monetary Fund).
- Pradhan, Mahmood, Ravi Balakrishnan, Reza Baqir, Geoffrey Heenan, Sylwia Nowak, Ceyda Oner, and Sanjaya Panth, 2011, “Policy Responses to Capital Flows to Emerging Markets,” IMF Staff Discussion Note 11/10 (Washington: International Monetary Fund).
- Mathisen, Johan, and Srobona Mitra, 2010, “Managing Capital Flows,” Chapter 2, Regional Economic Outlook for Europe, May (Washington: International Monetary Fund).
- Ghosh, Atish R., Jun Kim, Mahvash S. Qureshi, and Juan Zalduendo, 2012, “Surges” IMF Working Paper 12/22 (Washington: International Monetary Fund).

### EU new member states, absorption booms, and regional experience
- Bakker, Bas B., and Anne-Marie Gulde, 2010, “The Credit Boom in the EU New Member States: Bad Luck or Bad Policies?” IMF Working Paper 10/130 (Washington: International Monetary Fund).
- Jaeger, Albert, and Alexander Klemm, 2007, Assessing the Fiscal Stance During Absorption Booms, Bulgaria: Selected Issues, IMF Country Report 07/390.
- Rahman, Jesmin, 2010, “Absorption Boom and Fiscal Stance: What Lies Ahead in Eastern Europe?” IMF Working Paper 10/97 (Washington: International Monetary Fund).
- Rosenberg, Christoph B. and Robert Sierhej, 2007, “Interpreting EU Funds Data for Macroeconomic Analysis in the New Member States,” IMF Working Paper 07/77 (Washington: International Monetary Fund).
- Ötker-Robe, Inci, Zbigniew Polanski, Barry Topf, and David Vávra, 2007, “Coping with Capital Inflows: Experience of Selected European Countries,” IMF Working Paper 07/190 (Washington: International Monetary Fund).

### Fiscal policy, sovereign yields, and public debt
- Baldacci, Emanuele and Manmohan S. Kumar, 2010, “Fiscal Deficits, Public Debt, and Sovereign Bond Yields,” IMF Working Paper 10/184 (Washington: International Monetary Fund).
- Jaeger, Albert, and Alexander Klemm, 2007, Assessing the Fiscal Stance During Absorption Booms, Bulgaria: Selected Issues, IMF Country Report 07/390.
- Rahman, Jesmin, 2010, “Absorption Boom and Fiscal Stance: What Lies Ahead in Eastern Europe?” IMF Working Paper 10/97 (Washington: International Monetary Fund).

### Monetary policy, output gap measurement, and real-time data issues
- Nelson, E. and K. Nikolov, 2011, “UK Inflation in the 1970s and 1980s: the Role of Output Gap Mismeasurement,” Bank of England Working Paper Series 148.
- Orphanides, A., 2001, “Monetary Policy Rules Based on Real-Time Data,” American Economic Review 91(4), 964-85.
- Orphanides, A. and S. van Norden, 1999, “The Reliability of Output Gap Estimates in Real Time,” Board of Governors of the Federal Reserve System, Finance and Economics Discussion Series: 99/38.
- Orphanides, A. and S. van Norden, 2001, “The Unreliability of Output Gap Estimates in Real Time,” CIRANO, Scientific Series 2001s-75, Montreal.

### Other methodological and interpretive studies
- Peiris Shanaka, 2010, “Foreign Participation in Emerging Markets’ Local Currency Bond Markets,” IMF Working Paper 10/88 (Washington: International Monetary Fund).
- Rosenberg, Christoph B. and Robert Sierhej, 2007, “Interpreting EU Funds Data for Macroeconomic Analysis in the New Member States,” IMF Working Paper 07/77 (Washington: International Monetary Fund).

*References as listed in _wp12222 - References (source PDF).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2012/_wp12222.pdf_