The Composition Matters: Capital Inflows and Liquidity Crunch During a Global Economic Crisis

IMF Working Papers, August 1, 2009

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Research question: Do capital flows affect the degree of credit crunch faced by a country's manufacturing firms during the 2007-09 crisis?
Sample and period:
- 3823 firms
- 24 emerging countries
- 2007-09 crisis (also examines surrounding the Lehman Brothers bankruptcy)
Authors: Hui Tong, Shang-Jin Wei
Date: August 1, 2009

Firm-level exposure:
- The decline in stock prices was more severe for firms that are intrinsically more dependent on external finance for working capital.
Aggregate capital flows:
- The volume of capital flows has no significant effect on the severity of the credit crunch.
Composition of capital flows:
- Pre-crisis exposure to non-FDI capital inflows worsens the credit crunch.
- Exposure to FDI alleviates the liquidity constraint.
Robustness:
- Similar results also hold surrounding the Lehman Brothers bankruptcy.

Composition matters more than volume: policy analysis should focus on the types of inflows (FDI versus non-FDI) when assessing vulnerability to liquidity shocks.
Firms reliant on external finance for working capital are particularly vulnerable to equity-price declines during global crises, suggesting targeted liquidity support or financing alternatives could mitigate firm-level distress.
FDI appears to provide a stabilizing role in liquidity provision during crises, whereas non-FDI inflows can amplify funding stress.

Subject: Asset prices, Capital flows, Capital inflows, External debt, Financial crises
Keywords: capital flow, credit crunch, crisis exposure, FDI openness, market index, portfolio inflow, WP