Large Capital Flows Causes, Consequences, and Policy Responses

• Author: Alejandro López-Mejía
• Position: Economist in the IMF Institute's Western Hemisphere Division

Large capital inflows can bring considerable economic benefits to developing countries but, if not properly managed, can also cause economies to overheat, increase exchange rate volatility, and lead eventually to large outflows. How can governments maximize the benefits from capital inflows while minimizing the risks?

During the 1990s, net capital flows to developing countries increased markedly. In 1996, net private capital flows were $190 billion, almost four times larger than in 1990. During 1990-97, annual net private capital inflows were also larger than those preceding the 1982 debt crisis, and more heavily concentrated. Five countries accounted for more than 50 percent, and a dozen countries accounted for 75 percent, of total inflows (Chart 1). Most of the surge was concentrated in Asia and Latin America. Consequently, 140 of 166 developing nations collectively accounted for less than 5 percent of total inflows.

The composition and sectoral destinations of capital flows during the recent surge were different from those during the surge that preceded the 1982 debt crisis. In the 1970s, bank lending was the larger component of capital flows, the most important recipient of which was the public sector. In the 1990s, by contrast, the surge was dominated by bonds, foreign direct investment, and portfolio investment, and the private sector did most of the external borrowing.

The heightened interest of foreign investors in some developing countries has led to their increased integration into the global financial system, with benefits for those countries and for the global economy. However, large capital inflows can be a mixed blessing. They can lead to overheating, greater exchange rate volatility, and-eventually-to large outflows because of changes in expected returns on assets, investor herding, and contagion effects. To address these problems, policymakers have used a combination of countercyclical and structural policies, as well as other measures designed to reduce net capital inflows or change their composition or maturity and decrease their volatility.

Causes of capital flows

What were the reasons behind the capital inflows into various countries in the 1990s and the causes of major reversals? And what can explain the contagion effects recently observed in capital flows?

Causes of capital inflows. The responsiveness of private capital to opportunities in emerging markets started to improve in the 1990s because of both internal and external factors. Internal factors improved private risk-return characteristics for foreign investors through three main channels. First, creditworthiness improved as a result of external debt restructuring in a wide range of countries. Second, productivity gains were obtained from structural reform and the establishment of confidence in macroeconomic management in several developing countries that had undertaken successful stabilization programs. Third, countries adopting fixed exchange rate regimes became increasingly attractive to investors owing to the transfer of the risk of exchange rate volatility-at least in the short run-from investors to the government.

In addition, because of both cyclical and structural forces, external influences played a significant role in the capital inflow surge of the 1990s. Cyclical forces were the dominant explanation in the early 1990s, when the decline in world real interest rates "pushed" investors to emerging markets. The persistence of private capital flows after the increase in world interest rates in 1994 and the Mexican crisis of 1994-95 suggests, however, that...