Some Perspective on Capital Flows to Emerging Market Economies (2005)

From Hume's discussion of the specie-flow mechanism under the gold standard to the Keynes-Ohlin debate on the transfer problem associated with German reparations after the WWI, understanding the flow of capital across national borders has been central to international economics. My work on the topic has focused mainly on the flow of funds between rich and poor countries. Theory tells us that, for the recipient, foreign capital put to good use can finance investment and stimulate economic growth. For the investor, capital flows can increase welfare by enabling a smoother path of consumption over time and, through better risk sharing as a result of international diversification, a higher level of consumption. The reality is that the effects of such flows--as seen from either recent experience or the longer sweep of history--do not fit neatly into those theoretical presumptions. As a result, my research has mostly been directed at shedding light on four questions: 1. What motivates rich-to-poor capital flows? 2. Why doesn't capital flow more from rich to poor countries? 3. What are the consequences of a surge of capital inflows for an emerging market economy? 4. How do policymakers typically respond to an incipient inflow of capital? The Causes of Capital Inflows The surge in capital inflows to emerging market economies in the early part of each of the past two decades was attributed initially to domestic developments, such as sound policies and stronger economic performance, implying both the good use of such funds in the recipient country and the informed judgment of investors in the developed world. (1) The widespread nature of the phenomenon became clearer over time, though, as most developing countries--whether they had improved, unchanged, or impaired macroeconomic fundamentals--found themselves the destination of capital from global financial centers. The single factor encouraging those flows was the sustained decline in interest rates in the industrial world. (2) For example, short-term interest rates in the United States declined steadily in the early 1990s and by late 1992 were a their lowest level since the early 1960s. Lower interest rates in developed nations attracted investors to the high yields offered by economies in Asia and Latin America. Given the high external debt burden of many of these countries, low world interest rates also appeared to improve their credit-worthiness and to reduce their default risk. Those improvements were reflected in a marked rise in secondary market prices of bank claims on most of the heavily indebted countries and pronounced gains in equity values. Thus, the tightening of monetary policy in the United States and the resulting rise in interest rates made investment in Asia and Latin America relatively less attractive, triggering market corrections in several emerging stock markets and a decline in the prices of emerging market debt. This experience strongly suggests multiple forms of investor myopia: The initial decision to invest seemed more motivated by reaching for yield without an appropriate appreciation of risk, and the sudden withdrawal similarly looked more like a quick dash for the exit door than a reasoned assessment of fundamentals. Looking back, one is struck by an overwhelming sense of deja vu. It certainly seems a mystery why these wide swings in capital flows recur, in spite of the major costs associated with them. The common theme is that investors enter each episode of upsurge in capital flows confident in the belief that this time it is different and look to international financial institutions to make them whole when they later learn that it really wasn't different. Rich-to-Poor Capital Flows To some, the mystery of cross-border flows is not these recurrent cycles unanchored from country conditions but rather the restricted volume of these flows overall. Most famously, Robert Lucas argued that it was a puzzle that more capital does not flow from rich countries to poor countries, given back-of-the envelope calculations suggesting massive differences in physical rates of return in favor of capital poor countries. …