The Boom in Capital Flows to Developing Countries in Historical Perspective: Going for a Bust– Again?

Yılmaz Akyüz, Guest Blogger

The post-war period has seen three generalized boom-bust cycles in private capital flows to developing countries (DCs) and we now appear to be in the boom phase of the fourth cycle.  All these booms started under conditions of global liquidity expansion and low US interest rates, and all previous ones ended with busts.  The first one ended with a debt crisis in the 1980s when US monetary policy was tightened, and the second one with a sudden shift in the willingness of lenders to maintain exposure in East Asia as financial conditions tightened in the US and macroeconomic conditions of recipient countries deteriorated because of 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.

Unlike previous episodes, the Lehman reversal did not cause serious and widespread dislocations in DCs because of generally strong payments and reserve positions, reduced mismatches in balance sheets and, above all, the short-duration of the downturn.  Indeed, it was soon followed by a rapid recovery in 2009 as major advanced economies (AEs) responded to the crisis caused by excessive liquidity and debt by creating still larger amounts of liquidity to bail out troubled banks and governments, lift asset prices and lower interest rates.

Quantitative easing and close-to-zero interest rates are generating a surge in speculative capital flows to DCs with higher interest rates and better growth prospects, creating bubbles in commodity, currency, asset and credit markets.  Deficit countries including Brazil, India, South Africa and Turkey are now experiencing currency appreciations faster than surplus ones and relying on foreign capital to meet growing external shortfalls.  Many of those that have been successful in maintaining strong payments positions are facing credit and asset bubbles.  They are now all exposed to greater risk of instability 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.  There can be little doubt that the historically low interest rates in AEs cannot be maintained indefinitely and the current boom can be expected to end as interest rates in the US start to edge up.  It can also end as a result of a balance-of-payments and/or a financial crisis in a major emerging economy, producing contagion across the developing world, even without tightened monetary conditions in the US.

The US is now under deflation-like conditions and the Fed is trying to create inflation in goods and asset markets.  But its policies are adding more to the commodity boom, credit expansion and asset price rises in DCs.  If commodity prices are kept up by strong growth in China, the policy of easy money in the US continues 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 end because of a sharp slowdown in China.  Due to a massive stimulus program 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 that have been enjoying the dual benefits of global liquidity expansion – the boom in commodity prices and capital inflows.  Most of these are in Latin America and Africa and some are running growing deficits despite the commodity bonanza.  The current situation thus invokes the memories of the 1980s when Mexico– a country that had enjoyed the twin booms in the preceding period, both the hike in oil prices and expansion of international bank lending – was the first one to fall into crisis.

When policies falter in managing capital flows, there is no limit to the damage that international finance can inflict on an economy.  There are no effective multilateral arrangements to restrict beggar-thy-neighbour policies by reserve issuers or enforce control on outflows at the source.  The task falls on recipient countries.  But many DCs 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.

Yılmaz Akyüz is a Chief economist at the South Centre in Geneva.  This post is based on “Capital Flows to Developing Countries in a Historical Perspective:  Will the Current Boom End with a Bust?,” South Centre Research Paper 37, 14 March 2011.

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