In contrast with the previous decade, capital has flowed in abundance from industrial to developing countries in the early 1990s, most prominently in Latin America and Asia, and with a lag in Central and Eastern Europe. This paper examines emerging trends in capital flows in selected countries in Central and Eastern Europe and analyzes policy options for these countries.
The paper documents the pattern and composition of capital flows in the region during 1987-93 and finds that, in many ways, 1992-93 was a common turning point. In a remarkable turnaround, the capital account of the region improved by about $20 billion in 1992-93, mostly reflecting a reversal in external borrowing. The capital inflows have increasingly been used to finance widening current account deficits. These large current account deficits mainly mirror increases in consumption (predominantly private consumption) rather than investment. Another common phenomenon has been the appreciation of the real exchange rate during the capital inflows episode.
It is argued that the rise in consumption and the real exchange rate appreciation may not necessarily be a cause for concern on several grounds. The higher consumption may reflect a move toward an equilibrium level from artificially depressed levels rather than a temporary binge in consumption. The real exchange rate appreciation may be a temporary phenomenon, reflecting the relative inelasticity of the supply of nontraded goods, as consumption and direct foreign investment rise. However, the real exchange rate appreciation may have a permanent component if the productivity of labor is rising as a result of qualitative changes in capital stock.
To the extent that capital inflows are financing temporary rises in consumption and causing real wages to overshoot, the inflows may need to be discouraged. In laying out the options facing policymakers, the paper points to the inherent problems of pursuing second-best policies like imposing capital controls, levying taxes, and raising interest rates on government debt to attract capital away from the private sector. The advantages and disadvantages of sterilized versus nonsterilized intervention are also examined.