FRBSF Economic Letter
2000-22; July 21, 2000
 Economic
Letter Index
What explains capital flows?
Capital flows between countries can yield significant benefits. They
allow investors to diversify their risks and increase returns, and they
allow residents of recipient countries to finance rapid rates of investment
and economic growth, as well as to increase consumption. However, sudden
shifts in capital flows can be devastating for recipient countries. For
example, the boom and bust observed in South Korea in the 1990s where
the economy grew 5% in 1997, contracted nearly 7% in 1998, and grew nearly
11% in 1999 is partly attributable to the abrupt reversals of capital
flows. This experience, shared to varying degrees by a number of other
developing countries in the 1990s, illustrates the importance of understanding
the factors that explain capital flows to developing countries. This Economic
Letter reviews some of the stylized facts of capital flows in the
1990s and discusses factors that may account for their behavior.
Capital flows to developing countries
As the figure illustrates,
there has been a strong upward trend in capital flows since the 1970s,
despite recent reversals. The dollar value of inflows quadrupled between
the early 1980s and early 1990s, peaking at close to $200 billion in 1996.
At the same time, the figure shows that capital flows are distinctly cyclical:
A boom in capital flows to developing countries in the 1970s was followed
by a sharp reversal in the 1980s. Another much larger boom and reversal
occurred in the 1990s.
Finally, the figure reveals dramatic changes in the composition of capital
flows. Bank lending and other flows (which largely reflect bank loans)
dominated capital flows to developing countries in the 1970s, while foreign
direct investment and portfolio investment dominated such flows in the
1990s. However, it is apparent from the figure that even in the 1990s,
capital flow reversals largely reflected the sudden interruptions in bank
lending associated with the Mexican crisis of 1994-1995 and the East Asian
crises of 1997-1998.
Trend factors
The dramatic increase in international capital flows in the 1990s reflects
the opening of two major pathways to international portfolio diversification.
First, developing countries have encouraged globalization by liberalizing
their domestic financial markets and opening them to foreigners. For example,
according to the World Bank (1997), the proportion of emerging stock markets
allowing free entry to foreign investors roughly doubled to nearly 60%
between 1991 and 1994. Developing countries also have expanded investment
opportunities by privatizing government enterprises and encouraging the
development of deeper and more liquid financial markets.
Second, advances in information and communications technology have made
it much easier to evaluate and monitor investments around the globe. Lack
of information about the quality of investment projects has traditionally
discouraged cross-border lending by creating greater incentives for borrowers
with very risky projects to apply for financing (a phenomenon known as
adverse selection). This problem is particularly severe in developing
countries, where reporting and accounting practices are generally less
transparent. Lending also may be limited because borrowers can shift part
of the risk of their projects to lenders, creating an incentive for borrowers
to engage in riskier activities once they have received credit (this is
known as moral hazard). In addition to attenuating these effects, technological
advances also have contributed to the development of financial instruments
that more effectively manage risk, and also make it easier to circumvent
remaining barriers to foreign investment. Such advances also may have
reduced the comparative advantage of banks in obtaining information about
the quality of borrowers, contributing to the observed decline in the
importance of bank lending in international capital flows.
Even with the sharp increases in capital flows in the 1990s, international
portfolio diversification is far from complete. Standard models of capital
asset pricing imply that investors seeking to diversify their portfolios
should hold equities in different markets roughly in proportion to the
share of these markets in total market capitalization. The shares of foreign
assets in investment portfolios are still much lower than indicated by
this rule, a phenomenon known as "home bias." For example, according
to Tesar and Werner (1998), in 1996, U.S. investors held nearly $880 billion,
or about 10% of their total stock portfolios, abroad. This was up from
4% in 1987, but still well below the 55% share they would have held in
foreign stocks if they had had fully diversified portfolios. The home
bias in bond markets is even greater: U.S. investors held $398 billion,
or 3.4% of their total bond holdings, in foreign bonds, well below the
approximately 60% share of foreign bond markets in global bond market
capitalization. Similar home bias in investment occurs in other countries.
In addition to home bias, a general reluctance towards geographic diversification
is indicated by the fact that capital flows to developing countries are
concentrated in a small group of "emerging markets." Between
1990 and 1997, about 75% of private capital flows went to a dozen countries,
of which 60% went to six countries: China, Brazil, Mexico, Thailand, Indonesia,
and South Korea.
The reasons for "home bias" or lack of geographic diversification
are not fully understood. However, apart from impediments to market access
and difficulties in assessing and monitoring investments cited earlier,
exchange rate uncertainty is likely to have played an important role.
This is suggested by the wave of cross-border mergers and acquisitions
observed in Europe since the introduction of its common currency, the
euro, which eliminated currency risk in that region.
Boom and bust cycles
While it is generally agreed that financial liberalization and technological
innovations have contributed to the strong trend increase in capital flows
to developing countries, there is much less agreement on the causes of
the "boom and bust" cycles in capital flows. One possibility
is that fluctuations in capital flows reflect external, or "push,"
factors, such as movements in U.S. interest rates, which alter the relative
attractiveness of investments in developing countries. Domestic "pull"
factors also may be important. For example, better macroeconomic policies
encouraged capital flows into developing countries in the 1990s, contributing
to economic booms. However, the perception that governments in recipient
countries would prop up the financial sector in case of adverse outcomes
encouraged excessive risk-taking as reflected in declining foreign reserve
cover for the short-term liabilities of the financial system and in lending
to highly volatile and ultimately unproductive sectors. The resulting
financial fragility made these economies vulnerable to sudden changes
in investor sentiment and capital flow reversals.
The relative importance of external or domestic factors in driving capital
flows has important implications for policy. If capital flows are driven
largely by domestic factors, developing countries can attract a steady
and predictable flow of foreign capital and minimize cycles by adopting
sound macroeconomic and financial policies. However, if capital flows
are driven largely by external factors, developing countries are vulnerable
to unexpected external shocks even if they maintain prudent policies,
and they must take measures to insulate themselves. Research suggests
that both external and domestic factors contribute to capital flows, but
their relative importance appears to vary over time. Calvo, Leiderman,
and Reinhart (1993) found that declines in U.S. interest rates were correlated
with increases in proxies for capital inflows (foreign reserve accumulation
and real exchange rate appreciation) to Latin America in the early 1990s,
suggesting that external factors were the primary determinant of capital
inflows to developing countries in that period. Fernandez-Arias (1996)
studied a broader sample of developing countries (mainly so-called emerging
markets) and estimated that global interest rates accounted for nearly
90% of the increase in portfolio investment flows for the "average"
emerging market in 1989-1993. However, domestic factors apparently became
more important determinants of capital flows in 1993-1995 (World Bank
1997), as rising U.S. interest rates did not interrupt continued flows
to developing countries. Indeed, the negative correlation between capital
flows and U.S. interest rates originally identified by Calvo, Leiderman,
and Reinhart, turned positive over this period.
Taking a longer perspective, Milesi-Ferretti and Razin (1998) studied
sudden reversals in capital inflows in 86 countries from 1971-1992 and
found that both external and domestic factors, particularly those affecting
the sustainability of external borrowing, play a role in explaining sudden
reversals of capital inflows (as measured by an increase in the current
account of a recipient country). External factors that increase the likelihood
of capital flow reversals include worsening terms of trade (the ratio
of export to import prices), high U.S. interest rates, and low official
transfers to the developing country. Among the domestic factors likely
to be associated with a reversal in capital inflows are larger current
account deficits or foreign borrowing, a smaller ratio of exports plus
imports to GDP, lower foreign reserves, and a smaller proportion of concessional
debt. Additional perspectives on the causes of sudden capital inflow reversals
are provided by the literature on currency crises. Moreno and Trehan (2000)
found that global and regional shocks explain a large proportion of the
global incidence of sharp depreciation episodes over the period 1974-1998.
However, a study by Berg and Pattillo (1998) suggests that domestic factors
may have played a larger role in the most recent East Asian currency crises
that began in 1997. Their study of the ability of existing "early
warning" crisis models to predict these crises identifies the following
predictors: external competitiveness (as measured by the real exchange
rate), the sustainability of external borrowing (as measured by the current
account deficit), the liquidity of the external sector (as measured by
the ratio of M2/foreign reserves or short-term debt/foreign reserves),
and the fragility of the financial sector (as measured by the rate of
domestic credit growth).
Conclusions
International capital flows appear to be driven in part by growing international
portfolio diversification, which is still at an early stage. This implies
a continued underlying trend towards global financial market integration,
or equivalently, a reduction in the observed "home bias" in
investment portfolios. Capital flows also are influenced by global and
domestic factors whose relative importance tends to vary over time. While
capital flows provide significant benefits to investors and recipients,
their sensitivity to economic conditions makes recipient countries vulnerable
to sudden reversals.
Developing countries thus face the challenge of designing economic policies
that secure the most benefits from capital inflows while reducing their
vulnerability to sudden reversals. Countries have sought to reduce vulnerability
in several ways. Some have adopted more flexible exchange rates, which
tend to dampen boom and bust cycles by regulating the volume of capital
flows. Others have strengthened their domestic financial systems to improve
the intermediation of sudden capital inflows or to cope with sudden capital
outflows. In a number of cases, countries have restricted capital inflows
or outflows.
Ramon Moreno
Senior Economist
References
Berg, Andrew, and Catherine Pattillo. 1998. "Are
Currency Crises Predictable? A Test." International Monetary
Fund Working Paper WP/98/154. <http://www.imf.org/external/pubs/ft/wp/wp98154.pdf>
accessed July 2000.
Calvo, Guillermo, Leonardo Leiderman, and Carmen Reinhart. 1993. "Capital
Inflows and Real Exchange Rate Appreciation in Latin America." IMF
Staff Papers 40(1) pp. 108-151.
Fernandez-Arias, Eduardo. 1996. "The New Wave of Private Capital
Inflows: Push or Pull?" Journal of Development Economics 48
(March) pp. 389-418.
Milesi-Ferretti, Gian Maria, and Assaf Razin. 1998. "Current Account
Reversals and Currency Crises: Empirical Regularities." NBER Working
Paper 6620.
Moreno, Ramon, and Bharat Trehan. 2000. "Common
Shocks and Currency Crises." Federal Reserve Bank of San Francisco
Working Paper 2000-05. <http://www.sf.frb.org/econrsrch/workingp/index.html>.
Tesar, Linda, and Ingrid M. Werner. 1998. "The Internationalization
of Securities Markets since the 1987 Crash." In Brookings-Wharton
Papers on Financial Services, 1998, eds. R.E. Litan and A.M. Santomero,
pp. 281-372. Washington, DC: The Brookings Institution.
World Bank. 1997. Private Capital Flows to Developing Countries. The
Road to Financial Integration. Washington, DC: The World Bank and
Oxford University Press.
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