The Prizes and Pitfalls of Large Capital Inflows in a Small Integrated Economy — Case of Croatia

Abstract

This paper studies the macroeconomic and financial implications of large capital inflows in a small integrated economy by examining the case of Croatia and other EU new member states. Croatia was one of the countries that have experienced very large, dominantly debt inflows in the pre-crisis period. The question of implications of capital inflows is an important one, due to the fact that they have created dangerous macroeconomic imbalances, along with policy and prudential challenges for the policy holders. The analysis has shown that capital inflows positively impacted economic growth in the pre-crisis period and accelerated the development of the financial system in Croatia and EU NMS as well, but also fueled higher inflation rates, worsened current account balances, increased the indebtedness of countries and appreciated real exchange rates, which created severe policy challenges when the crisis hit. The contribution of the paper is reflected in emphasizing the importance of differentiating between types of foreign financing, given that short-term debt flows provide more exposure to potentially harmful macroeconomic and financial imbalances than long-term equity financing.