RDP 2002-03: International Financial Liberalisation and Economic Growth 2. Capital Flows to Developing Countries: Trends During the Past Three Decades

The developing country experience with capital flows has been characterised by cycles of booms and busts. After more than two decades of limited capital flows, capital flows to developing countries surged in the 1970s. With the onset of the debt crisis in 1982, capital inflows to developing countries declined dramatically and remained small during most of the 1980s. This trend was reversed in the late 1980s, and capital flows to Asia and Latin America increased substantially in the first half of the 1990s. The setback from the 1994 Mexican crisis was relatively short-lived, with capital flows to emerging markets, including Mexico, resuming soon after the crisis. Capital flows, especially to Asia, slowed down considerably in the wake of the Asian crisis in 1997. Capital flows to developing countries remained subdued in the second half of the 1990s, reflecting the effects of the Asian crisis as well as the Russian and Brazilian crises of 1998 and 1999.

Capital flows to developing countries in the 1970s were associated with the recycling of oil revenues – the so-called petrodollars – by oil producing countries. As the petrodollars were intermediated through international commercial banks, capital flows to developing countries were primarily in the form of syndicated bank loans. Capital inflows to developing countries during 1978–1981 averaged US$68 billion, and were comprised mainly of bank loans (Table 1).

This trend came to an abrupt halt in 1982 when Mexico declared a moratorium on its debt-service payments in August of that year. This, combined with the debt service difficulties of other Latin American countries including Argentina and Brazil, led to a rapid decline in capital flows to the region. The decline in total capital flows to developing countries was fully accounted for by the decline in capital flows to Latin America, which as a whole experienced a net outflow during 1983–1989. In contrast, capital flows to Asia and developing countries in other regions increased modestly during this period.

A combination of domestic and external factors contributed to the resurgence of capital flows to developing countries in the late 1980s. The main domestic factors were the initiation of the Brady plan for debt restructuring in 1989, and the successful implementation of other structural reform programs in many Latin American countries. The decline in US interest rates and the growth of institutional investors worldwide in the early 1990s were the primary external factors. In addition to the surge in magnitude, there were also important changes in composition of capital flows. While bank flows were dominant during the 1970s, capital flows in this episode consisted mainly of foreign direct investment and portfolio flows. Capital flows to Asia were primarily in the form of FDI, whereas portfolio flows were more important in Latin America, accounting for over 60 per cent of total inflows. Further, much of the foreign borrowing during the 1970s was done by the public sector, while capital flows in the early 1990s were primarily directed at the private sector.

This new wave of capital flows was perceived as a positive global development. It provided increased diversification opportunities to investors in developed countries. Capital inflows also held the potential of augmenting domestic investment, and hence economic growth in emerging economies that had until then experienced years of tight external financing constraints. For Latin America, in particular, the renewed access to international capital markets seemed to signal an end to the ‘lost decade’ of the 1980s. At the same time, given the experience of the early 1980s, many voiced concerns about the potential risks of capital flows, especially short-term capital flows. Of particular concern was that, as in the previous episode, capital flows could reverse abruptly and lead to balance-of-payments crises. The Mexican peso crisis of 1994 validated some of these concerns.

Mexico's adoption of a strong adjustment program, aided by the large-scale international financial support, helped restore financial stability in the country relatively quickly.^[4] Indeed, Mexico returned to international capital markets more rapidly than most observers had anticipated. Other countries affected by the crisis included Argentina and Brazil, and to a lesser extent, Thailand and Hong Kong. The contagion from the Mexican crisis was short-lived and capital flows to developing countries reached a record level of US$212 billion in 1996.

In contrast, the impact of the Asian crisis that followed Thailand's devaluation of the baht in 1997 was more widespread and longer lasting. While FDI and portfolio flows to the five Asian countries most affected by the crisis recovered fairly quickly, these countries continued to experience net outflows as international banks reduced their exposure to the region. The Asian crisis, combined with the Russian and the Brazilian crises in 1998 and 1999, led to a significant decline in capital flows to most developing countries. Overall, net private inflows to emerging markets in 1999 were equivalent to approximately 1.1 per cent of aggregate emerging market GDP, down from 3 per cent in 1995.

Footnote

The IMF arrangement with Mexico was the largest ever approved for a member country, both in absolute amount and in relation to the country's quota in the Fund. [4]