Testing the ‘trilemma’ in post-transition Europe – a new empirical measure of capital mobility

Abstract

This article develops a new empirical measure of capital mobility. It tests the hypothesis that the degree of capital mobility can be estimated by measuring the reaction intensity of capital flows to shocks in interest rates on a sample of eight European post-transition economies. This hypothesis can be derived from the Mundell–Fleming open economy model, the implications of which are essentially based on the assumption of a close link between the degree of capital mobility in a country and the reaction of its capital flows to changes in domestic and external interest rates. Precisely because of this interrelationship, policy makers, in theory, face the policy ‘trilemma’ or the ‘impossible trinity’, i.e. the inability to achieve the following three objectives simultaneously – a stable exchange rate, financial openness and an independent monetary policy. Using impulse response and historical decomposition analysis in a VAR framework, the results show a significant increase in the explanatory power of interest rates for the movement of capital flows shortly before and after the accession of post-transition economies to the European Union. On the other hand, the recent financial crisis made capital flows less sensitive to interest rates owing to increased risk aversion on international capital markets. Results suggest that the degree of capital mobility, i.e. the level of financial integration with EU-15, is highest in Bulgaria, Latvia and Lithuania and least pronounced in Poland and Croatia. Results are verified by a number of robustness checks, with three separate alternative measures of capital mobility confirming the results obtained from the econometric model.