TWN Info Service on Finance and Development (May11/11)
31 May 2011
Third World Network

Capital Flows to Developing Countries in a Historical Perspective:  Will the Current Boom End With a Bust? 
(South Centre Research Paper 37)

This South Centre research paper, authored by its Chief Economist, Yilmaz Akyüz, addresses a topical issue that is affecting many developing countries as well as the global economy: the surge in capital flows to some developing countries arising from financial institutions in developed countries.  There is also a significant expansion of investment in commodity markets which is generating commodity price increases.

This South Centre research paper argues that the policy of quantitative easing and close-to-zero interest rates in advanced economies, notably the US, is generating a surge in speculative capital flows to developing countries.  These speculative capital flows are in search for high yields, and are creating bubbles in foreign exchange, asset, credit and commodity markets.

This latest generalized surge constitutes the fourth post-war boom in capital flows to developing countries. All the previous phases of capital flows ended with busts, causing serious damages to recipient countries.  The conditions driving the current boom in capital flows and commodity prices are not sustainable and they are likely to be followed by a sharp downturn.

Various scenarios that can bring them to an abrupt end are discussed in the paper.  Examining the policy responses and financial and macroeconomic developments in major emerging economies, the paper concludes that deficit commodity-rich economies that have been enjoying the dual benefits of global liquidity expansion - that is, the boom in capital flows and commodity markets - are most vulnerable to a possible reversal.  The paper urges these countries to manage capital flows more effectively.

Below is an opinion article based on the Research Paper by Yilmaz Akyuz.  The paper can be found on the South Centre website:



An unhealthy boom in capital flows to developing countries


An unusual feature of the global financial crisis is that for developing countries (DCs) the financial band seems to have picked up the pace of the music. While many advanced economies (AEs) continue to encounter debt deflation, financial stringency and risks of insolvency, the financial problem for most DCs is asset inflation, credit expansion and currency appreciations. Except for a brief interruption in 2008, DCs have continued to receive large capital inflows as AEs have responded to the crisis caused by excessive liquidity and debt by creating still larger amounts of liquidity to bail out banks and governments, lift asset prices and lower interest rates.

Quantitative easing and close-to-zero interest rates are now generating a surge in speculative capital flows to DCs with higher interest rates and better growth prospects, creating bubbles in foreign exchange, asset, credit and commodity markets.

This is the fourth post-war boom in capital flows to DCs. All previous booms also started under conditions of rapid liquidity expansion and exceptionally low interest rates in the US, and all ended with busts. The first boom ended with a debt crisis in Latin America in the 1980s when US monetary policy was tightened.

The second ended with a sudden shift in the willingness of lenders to maintain exposure in East Asia as financial conditions tightened in the US and macroeconomic and external positions of recipient countries deteriorated due to the effects of capital inflows. The third boom developed alongside the subprime bubble and ended with the collapse of Lehman Brothers and flight to safety in late 2008, but was followed by a rapid recovery in 2009.

Credit and asset bubbles

Like these past episodes, the current surge in capital inflows is creating fragility in DCs.  Deficit countries including Brazil, India, South Africa and Turkey are experiencing currency appreciations faster than surplus economies and relying on capital flows to meet growing external shortfalls. Many of those that have been successful in maintaining strong payments positions are facing credit and asset bubbles. Both categories are now exposed to the risk of instability to a greater extent than during the subprime debacle, though in different ways.

It is almost impossible to predict the timing of capital reversals or their trigger, even when the conditions driving the boom are clearly unsustainable. Still, it is safe to assume that the historically low interest rates in AEs cannot be maintained indefinitely and the current boom can be expected to end as interest rates start to edge up.

The US is now under deflation-like conditions and the Fed is aiming at creating inflation in goods and asset markets.  But its policies are adding more to the commodity boom and credit expansion and asset price rises in DCs.

If commodity prices are kept up by strong growth in China, the continued policy of easy money in the US, along with speculation and political unrest in Arab countries, the Fed may end up facing inflation, but not the kind it wants. In such a case, capital and commodity booms may end in much the same way as the first post-war boom ended in the early 1980s — that is, by a rapid monetary tightening in the US even before the economy fully recovers from the subprime crisis.

The boom may also be ended by a sharp slowdown in China. As a result of a massive stimulus programme financed by cheap credits, large capital inflows and rising commodity prices, the Chinese economy is overheating. Monetary breaks now applied to control inflation could reduce growth considerably, particularly if it pricks the property bubble. The consequent fall in commodity prices could be aggravated by the exit of large sums from commodity futures, creating payments difficulties in commodity-rich economies and leading to extreme risk aversion and flight to safety.

Regardless of how the current surge in capital flows may end, it is likely to coincide with a reversal of commodity prices. The most vulnerable countries are those which have been enjoying the dual benefits of global liquidity expansion. Most of these are in Latin America and Africa and some are running growing deficits despite the commodity bonanza.

When policies falter in managing capital flows, there is no limit to the damage that international finance can inflict on an economy. Multilateral arrangements lack effective mechanisms that restrict beggar-my-neighbour policies by reserve issuers or enforce control on outflows at the source.

The task falls on recipient countries. But many developing countries still adopt a hands-off approach to capital inflows while others have been making half-hearted attempts to control them through taxes that are too low to match large arbitrage profits promised by interest rate differentials and currency appreciations. In either case taking capital controls much more seriously is now the order of the day.

(This article was published as a Column in the Inter Press Service)

For more information, please contact Vicente Paolo Yu of the South Centre: Email, or telephone +41 22 791 80 50