The substantial rise in private capital flows to many developing countries in recent years has helped the developing world to sustain relatively rapid growth during a period of protracted weakness in the industrial countries. The capital inflows can be attributed in part to the successful adjustment and stabilization efforts of a large number of developing countries, but they are also likely to have been boosted by the sluggishness of activity, and hence of the demand for funds, and the associated decline in interest rates in the industrial countries. The moderation of such flows in the first half of 1994 seems mainly to reflect the rise in interest rates worldwide, although concern about the emergence of financial imbalances in some developing countries may also have contributed.

The substantial rise in private capital flows to many developing countries in recent years has helped the developing world to sustain relatively rapid growth during a period of protracted weakness in the industrial countries. The capital inflows can be attributed in part to the successful adjustment and stabilization efforts of a large number of developing countries, but they are also likely to have been boosted by the sluggishness of activity, and hence of the demand for funds, and the associated decline in interest rates in the industrial countries. The moderation of such flows in the first half of 1994 seems mainly to reflect the rise in interest rates worldwide, although concern about the emergence of financial imbalances in some developing countries may also have contributed.

The surges in capital inflows have important implications for policies in the recipient countries. The primary considerations are to ensure that the capital inflows are invested productively, that they enhance longer-term prospects, that they do not primarily finance consumption, and that financial stability is preserved in order to reduce the risk of disruptive changes in financial market sentiment. Future growth trends in the developing countries will depend to some degree on the strength and sustainability of net capital inflows. However, the factors that affect the level of capital flows are generally much more important determinants of growth than the capital flows themselves. The external environment plays some role in influencing capital flows, and the degree of success of the industrial countries in eliminating structural budget imbalances and alleviating pressures on real interest rates seems particularly important. For the developing countries, the key lesson from earlier episodes of capital inflows is that foreign capital can complement domestic resources but cannot substitute for sustained efforts at mobilizing and efficiently investing domestic savings.

Recent issues of the World Economic Outlook have focused on various aspects of the strong growth performance of the developing countries as a group and on the marked divergences in performance across the developing countries. Among the factors that have contributed to the successful performance of many developing countries, the roles of domestic and foreign saving, structural reform policies, and macroeconomic stability have been extensively discussed. This issue of the World Economic Outlook focuses on the recent surges of capital flows to many developing countries.

Trends in Capital Flows

The recent surge in capital flows to developing countries contrasts sharply with the experience of the mid-1980s, when most developing countries attracted very little foreign capital. It also contrasts with the experience of the 1970s and the early 1980s in that a substantial part of total flows is now private, non-debt-creating capital. Annual average net flows to developing countries, excluding exceptional financing, fell from over $30 billion during the 1977–82 period to under $9 billion during 1983–89, but they have subsequently risen significantly to an average of almost $92 billion during the 1990–93 period (Table 7). These figures, however, mask considerable variations within each period: the net inflow in 1981 was just under $52 billion; in 1989 it was negative $14 billion; and in 1993 it exceeded $130 billion. Foreign direct investment has increased steadily over the past two decades and now constitutes one of the largest components of aggregate flows to developing countries (see Chart 3 in Chapter I). But short-term inflows and long-term portfolio investments in emerging stock markets have also increased sharply. By contrast, net long-term capital flows, including long-term borrowing (notably by governments or public enterprises), which constituted the bulk of capital inflows in the 1970s and early 1980s, have been negative in recent years, reflecting in part the repayment of debt accumulated in the earlier periods. Countries in Asia and in the Western Hemisphere have been the main recipients of the recent surge in capital flows (Chart 16).

Table 7.

Developing Countries: Capital Flows1

(Annual averages; in billions of U.S. dollars)

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Source: IMF Balance of Payments Statistics data base and staff estimates. A number of countries do not report assets and liabilities separately. For these countries it is assumed that there is no outflow, so that liabilities are set equal to the net value. To the extent that this assumption is not valid, the data underestimate the gross values.

Excludes exceptional financing. Other long-term capital inflows and short-term capital inflows consist of investment by three sectors: resident official sector, deposit money banks, and other sectors.

A minus sign indicates an increase.

Chart 16.
Chart 16.

Developing Countries: Net Capital Flows by Region

(In billions of U.S. dollars)

Sources: IMF, Balance of Payments Statistics Yearbook; and IMF staff estimates.

The recent trend shows a marked increase in gross flows—particularly in the case of portfolio investment, where gross inflows have grown by a factor of seven since the mid-1980s, while net flows have only doubled. This increase in gross flows across countries, which far outweighs the growth in world trade, constitutes a marked increase in the international diversification of portfolios. Some of the increase in gross flows, particularly in Asia, reflects the growing role of some developing countries as suppliers of capital to other developing countries. Several developments have contributed to the changing patterns in capital flows. These include trade and domestic financial liberalization in many developing countries; fewer restrictions on acquisition of assets by foreigners; and considerable progress in reducing external debt burdens, which inhibited access to international capital markets for many developing countries through much of the 1980s. Repatriation of flight capital has also been important, in particular in Latin America, but more recently the investor base has been broadened to include large institutional investors from the industrial countries.

A particularly encouraging aspect is the rising share of foreign direct investment, giving host countries greater access to state-of-the-art technology, increasing the scope for rapid growth of exports, and promoting competition in developing country markets. Foreign direct investment is likely to be determined by long-term profitability considerations and, as a result, is probably less subject to sudden shifts in market sentiment. The sharp increase in equity portfolio flows that has accompanied the surge in foreign direct investment has been facilitated by a shift in the channels of equity investment. Whereas in the late 1980s equity flows to developing countries were mainly through country-specific and multicountry investment funds, the primary source of the recent flows has been equity offerings by developing country corporations on industrial country stock markets or direct investment by institutional investors, especially in emerging markets.21 Asian and Latin American countries have accounted for the bulk of international equity issues.

Among the developing countries, those in Asia have been by far the main recipients of capital inflows in the form of portfolio and foreign direct investment (see Table 7). Foreign direct investment in Asia, and notably in China (Box 6), has grown particularly rapidly in recent years, with the region receiving gross inflows of over $27 billion a year during the 1990–93 period. Intraregional foreign direct investment, notably by residents of Hong Kong and Taiwan Province of China, has also grown significantly. Portfolio investments have been substantial as well, with inflows averaging over $10 billion a year and outflows averaging over $3 billion a year during the same period.

Countries in the Western Hemisphere, especially Mexico, Argentina, and Chile, have also benefited considerably from foreign direct investment, which has amounted to over $12 billion annually in the recent period. But inflows in the form of private bond and equity financing have played an increasingly important role, reflecting the changing structure of capital markets in these countries. Portfolio investment inflows in the region have averaged $25 billion a year, partially offset by an average outflow of over $7 billion a year over the period 1990–93.

An interesting feature of recent capital flows is that they have been directed mainly to successful middle-income countries, and to some low-income countries with promising growth prospects such as China and India. Many of the recipient countries, especially China and India, represent some of the largest markets in the developing world. In many recipient countries, policies and attitudes toward foreign participation in domestic economic activities have changed significantly in recent years. However, most African countries continue to attract very little private capital. Although there has been a gradual increase in foreign direct investment in nominal terms, it still remains small by comparison with other regions. This has reflected low growth prospects and political and macroeconomic instability, which make returns on investments in these countries highly uncertain. Nigeria and north African countries such as Tunisia and Morocco have been the main recipients of the increased direct investment. Net flows to Africa of short-term and other long-term capital, however, have been negative in recent years, primarily reflecting flows out of Nigeria and South Africa. As a result, total net capital flows to the region, excluding exceptional financing, have also been negative.22

Capital flows to the Middle East have been dominated by short-term flows. The large outflows of the 1970s and early 1980s reflected primarily the sharp increases in oil prices and the resulting current account surpluses. Similarly, the massive inflows in the recent period followed a period of low oil prices and large current account deficits, in particular in Saudi Arabia, and reconstruction activities following the regional conflicts. The bulk of recent inflows has been reflows of assets that had been accumulated abroad by domestic residents and governments during the surplus years. Countries such as Egypt and Turkey have, however, received large private capital inflows in the recent period. In Egypt, a substantial proportion of these capital flows has been in the form of foreign direct investment, whereas in Turkey the inflows have been largely portfolio investments.

Foreign Direct Investment in China

With the promulgation of the Chinese-Foreign Joint Venture Law in July 1979, China provided a clear signal that it was departing from the essentially “closed-door” investment policy that had been in effect since 1949. The initial response was somewhat muted because of continuing legal ambiguity and uncertainty, remaining restrictions on foreign investment in a number of sectors and regions, and a perception of a high level of political risk. A new phase in the reform process and the opening up of the Chinese economy began in 1992, when foreign investment was allowed in all the major inland cities.1 The “open-door” policy eventually led to a surge in foreign direct investment (FDI) of over $20 billion in 1993, making China the largest single recipient of FDI in the developing world (see chart).

Three distinctive features have characterized the FDI inflow to China.2 First, it was initially dominated by investors from Hong Kong and Macao, with some of the funds undoubtedly coming from investors residing in Taiwan Province of China, where there are restrictions on such investments. More than half of the value of FDI in China from 1979 to 1990 was undertaken by these “overseas Chinese” investors. China’s ability to attract these flows was due mostly to geographic proximity and cultural affinity. Other foreign investors, such as those from the United States and Japan, undertook projects indirectly through Hong Kong, by establishing wholly owned subsidiaries of transnational corporations or by setting up joint ventures. Many of these investors took a wait-and-see attitude, postponing investment decisions until market conditions became more certain and favorable.


Foreign Direct Investment in China

(In billions of U.S. dollars)

Sources: IMF, Balance of Payments Statistics Yearbook; and IMF staff estimates.

The second distinctive feature is that the FDI inflow was concentrated in coastal areas such as Guangdong and Fujian Provinces, and Shanghai. To promote development of these areas, the authorities established Special Economic Zones in 1980 and designated some cities as open economic development zones. To introduce advanced technology, capital, and managerial skills from abroad to these areas, China established supporting infrastructure, provided preferential tax and duty treatment, and granted autonomy to local authorities in their dealings with foreign investors. Although Guangdong and Fujian Provinces were relatively underdeveloped, the “overseas Chinese” investors invested intensively in these areas because of close geographic and historical links. Shanghai was also designated as an “open coastal city,” but its development lagged behind other coastal areas until 1990 when the Pudong district of Shanghai was designated as a Special Development Zone endowed with all the preferential treatments given to other Special Economic Zones. However, the inadequacy of infrastructure, particularly the shortage of transportation and communication facilities, limited FDI inflows not only in these coastal areas but also in less advantaged inland areas.

Third, despite the policy emphasis on FDI as a source of technology transfer and as a complement to export-oriented manufacturing, inflows were initially concentrated in the real estate and natural resource sectors.3 Projects in the real estate sector focused on the construction of industrial sites, residential buildings, and recreational facilities. In the initial period after passage of the 1979 legislation, these sectors accounted for 70 percent of FDI coming from Hong Kong and Macao and 60 percent of that from Japan. Real estate ventures and hotel development were popular because of short payback periods and ease of repatriating profits from foreign exchange earnings. In addition, growing interest in China after 1979 attracted many foreign visitors, raising the profitability of real estate projects, and access to China’s resource base spurred foreign interest in oil and gas development. Foreign investment in the service sector, except for hotels and foreign exchange dealings, was largely restricted until 1992, when the authorities began to allow investment in wholesale and retail trade, professional services, and other services.

Foreign investors were initially reluctant to initiate projects in the manufacturing sector. There was a perception that it would take longer to recover initial costs and earn reasonable profits because it would be necessary to train local workers, find reliable sources of raw materials and intermediate goods, and establish sales-distribution systems and communication networks. As a result, FDI in manufacturing was initially concentrated in export processing and assembling activities that were relatively easy to operate and monitor. After 1987, however, the FDI inflow began gradually to shift toward manufacturing as investors diversified into fields such as electrical equipment, electronics, precision machinery, and transportation equipment. China’s attraction as a low-cost manufacturing base has also resulted in much of the manufacturing sector in Hong Kong being relocated across the border.

China’s efforts to clarify regulations, establish property rights, and simplify the approval process promoted the shift of FDI inflows to manufacturing. The subdued pace of FDI in the mid-1980s, and an increasing awareness of competition between developing countries for FDI, led the Chinese government to enact fresh legislation in late 1986 that contained several provisions addressing concerns that had been raised by foreign investors4. The 1986 legislation not only helped to clarify the legal position of joint ventures, it also contained measures to create a more liberal investment environment. The provisions attempted to further guarantee the autonomy of joint ventures from bureaucratic interference and to eliminate many local costs or charges that foreign investors considered to be unreasonable.

Several factors may act to sustain the level of FDI inflows into China experienced during the past two years. Although there have been statutory changes to reduce preferential tax treatment, and tougher competition for FDI from neighboring Asian countries such as Vietnam, China represents an enormous potential market still to be exploited. The possibility of considerable productivity gains from external trade and structural reform and the substantial investments that are needed in infrastructure contribute to the attractiveness for foreign investors. Indeed, China is already the largest market for certain industries, such as telecommunications and aerospace. Access to China’s large domestic market, rather than a low-cost production base, now appears to be the primary attraction for FDI.

Although China has begun to rely more heavily on FDI, the share of FDI in total investment was less than 7 percent on average until the early 1990s; in 1993 the value of FDI amounted to about 11 percent of total investment. Despite the fact that FDI has constituted a relatively small part of total investment, China has nevertheless reaped important benefits from FDI in several areas. First, because FDI was concentrated initially in the services or tertiary sector, it helped to broaden the structure of Chinese output. Second, FDI in the manufacturing sector helped China to advance technologically and to raise productivity. The further growth of FDI in manufacturing in the early 1990s has been an important factor behind the recent high rates of economic growth. Third, FDI generated external demand for Chinese products by enhancing export competitiveness. Finally, in the context of a transition economy, the most important benefit of FDI has been its educational value in providing the Chinese authorities with concrete models of market mechanisms.

1 See Michael W. Bell, Hoe Ee Khor, and Kalpana Kochar, China at the Threshold of a Market Economy, IMF Occasional Paper No. 107 (September 1993).2 See Dongpei Huang and Sayuri Shirai, “Information Externalities Affecting the Dynamic Pattern of Foreign Direct Investment: The Case of China.” IMF Working Paper 94/44 (April 1994).3 A sectoral breakdown of FDI projects during the mid- to late 1980s is given in Phillip Donald Grub and Jian Hai Lin, Foreign Direct Investment in China (New York: Quorum Books, 1991).4 See Margaret Pearson, Joint Ventures in the People’s Republic of China: The Control of Foreign Direct Investment Under Socialism (New Jersey: Princeton University Press, 1991).

External and Domestic Influences

External factors—in particular, the cyclical downturn in activity and the decline in interest rates in the large industrial countries during the recent recessions—have played an important role in the recent surges in capital flows to developing countries.23 The downturn in the industrial countries generally preceded the surges of capital flows, and there appears to be a strong inverse relationship between developments in long-term interest rates in the major countries and stock prices in emerging markets (Chart 17).24 A number of recent empirical studies have attempted to distinguish between domestic and external factors.25 These studies suggest that external factors may have accounted for some 30 to 50 percent of the variation in capital flows to developing countries. External factors appear to have played a greater role in Latin America than in Asia. For some countries in Latin America, such as Bolivia, Chile, Colombia, and Peru, external factors typically explained about 50 percent, while in Asia, particularly in China, India, Indonesia, and the Philippines, external factors typically contributed about 30 percent.26

Chart 17.
Chart 17.

Stock Prices in Emerging Markets and Long-Term Interest Rates in Industrial Countries

1 Weighted aggregate of ten-year government bond rates in the major industrial countries, using 1987 GDP weights.2Index of equity prices in 15 emerging slock markets.

Notwithstanding the role of cyclical factors, the recent pattern of capital flows seems to reflect a longer-term trend toward globalization and international diversification of industrial country investments that appears likely to continue, for two reasons. First, if current growth trends continue—with underlying growth of about 2½ percent in the industrial countries and of 5 to 6 percent in the developing countries—the share of the developing countries in world output and trade will continue to rise sharply (Table 8). This changing pattern of global production (and income) should provide strong incentives to investors in the industrial countries to diversify their portfolios. At present most institutional investments appear to be significantly underweighted in developing country investments relative to the size of the emerging stock markets. These markets not only have offered attractive returns, but because of their low correlation with financial markets in industrial countries they also provide significant scope for portfolio diversification. Recent calculations suggest that investors who placed 20 percent of their portfolio in an emerging market index fund would have reduced portfolio risk by about 1½ percent, while increasing returns by 2 percent.27

Table 8.

Global Trends in Output and Stock Market Capitalization

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Sources: International Finance Corporation (IFC); and World Economic Outlook.

Consists of the 43 developing country emerging markets for which data are available from the IFC.

Consists of 21 of the 25 countries included in the IFC composite index. Greece, Hungary, Poland, and Portugal are excluded from this classification.

A second factor that is contributing to reinforce the trend toward globalization and international diversification is the extent of financial deregulation in industrial and developing countries, which has resulted in greater competition in financial markets and has increased international capital mobility. Some of these changes have also resulted in lower transaction costs for developing countries accessing capital markets in the industrial countries. At the same time, a wider range of financial instruments has become available to investors who seek to invest in developing countries.

Although external developments have contributed to the international diversification of both portfolio and direct investments, domestic factors have also played a key role in attracting capital flows to many developing countries.28 In recent years a number of countries, particularly in Latin America and Asia, have made substantial progress in fostering macroeconomic stability, implementing structural reforms, and pursuing outward-oriented trade policies. These policy changes have helped to raise growth expectations and have helped to reduce uncertainty and to increase the scope for profitable investment. Improved relations with external creditors, together with debt-restructuring and debt-reduction agreements, have also allowed many countries to regain access to international capital markets.

For some countries, including Argentina, Thailand, Mexico, and Chile, significant reductions in fiscal deficits preceded the surge in capital inflows and were associated with important changes in public expenditure policies, reductions in government subsidies, and tax reform. The improvements in the fiscal positions helped to lower expectations of inflation and to underscore the commitment of the authorities to achieve and safeguard macroeconomic stability. Nevertheless, many other countries that have made much less progress toward fiscal sustainability, such as Brazil, India, and Turkey, have also attracted relatively large inflows. In these countries, where large fiscal deficits have exerted upward pressure on domestic interest rates, capital inflows—primarily short-term inflows—have been attracted by the resulting favorable interest rate differentials with respect to both industrial and neighboring countries. In countries where fiscal adjustment has been inadequate, monetary and credit policies have borne a heavier burden in restraining domestic demand in order to curtail inflation, often putting additional pressure on interest rates.

In addition to macroeconomic stability, structural reforms and the outward orientation of trade policies—since the mid-1980s in many Asian countries and more recently in Latin American countries—have played a key part in attracting foreign direct investment. Financial deregulation, privatization, and tax reforms have reduced distortions and generally led to improved supply conditions, thereby enhancing the potential returns on long-term investments. In many cases, including Argentina, Chile, Mexico, Indonesia, Malaysia, and the Philippines, privatization programs have helped to attract capital flows.

Many developing countries that have liberalized trade policies have benefited from large flows of foreign direct investment. The ability to import both capital goods and intermediate inputs has influenced the willingness of foreign investors to engage in long-term investments. Regional trade arrangements have also been helpful in reducing trade barriers and providing foreign investors with assurances of countries’ longer-term commitment to stable trading conditions. For example, capital flows to Mexico in the early 1990s were undoubtedly stimulated by the initiation of negotiations for the North American Free Trade Agreement (NAFTA), which was eventually signed in 1993. The trend toward free trade has increased the attractiveness of some developing countries as low-cost locations for labor-intensive products: Indonesia, Malaysia, Thailand, and China have all benefited from the relocation of labor-intensive industries away from Japan, Korea, and Taiwan Province of China. The maintenance of competitive exchange rates has contributed to the attractiveness of these countries for foreign investors.

Extensive deregulation and liberalization of domestic financial markets not only have improved the allocation of saving in many developing countries but also have greatly encouraged inflows of foreign capital. A number of countries have also made considerable progress in relaxing barriers on capital account transactions (Box 7). In an effort to encourage foreign inflows, countries such as Egypt, Malaysia, and Thailand eased rules for repatriation of profits and for portfolio investments and capital transfers. In India a large proportion of recent inflows is accounted for by domestic enterprises accessing international capital markets, often significantly lowering their cost of capital.29 More generally, financial sector reforms have lowered both explicit and implicit taxation on investment and have raised rates of return. These reforms have also supported the growth and development of stock markets, which has contributed to the mobilization of domestic saving and helped to provide investment capital at a relatively low cost.30

Although favorable domestic conditions have played a key role in most cases, there are also some countries that have benefited from the general optimism about developing country growth prospects, but where the underlying fundamentals do not seem to warrant the confidence that large capital inflows may suggest. For such countries there is reason for concern about the sustainability of the capital inflows and about the risk of sudden changes in market sentiment.

Currency Convertibility

Currency convertibility is generally understood as the freedom to convert one currency into other internationally accepted currencies. The most important and most often distinguished forms are convertibility for current international transactions and convertibility for international capital movements. Currency convertibility implies the absence of restrictions on foreign exchange transactions or of exchange controls—but not necessarily the absence of other forms of restrictions on international transactions in goods, services, or capital.

The convertibility of currencies is an essential part of the system of multilateral trade and payments. Recently, there has been an acceleration in the number of IMF members eliminating restrictions on both current and capital account transactions. The elimination of controls on capital movements has tended to lag the liberalization of current transactions in a number of countries.

A primary purpose of the IMF, as stated in its Articles of Agreement, is “to assist in the establishment of a multilateral system of payments in respect of current transactions between members and in the elimination of foreign exchange restrictions which hamper the growth of world trade” (emphasis added).1 Article VIII of the Articles enjoins members from imposing restrictions on the making of payments and transfers for current international transactions or from engaging in discriminatory currency arrangements or multiple currency practices unless the measure is authorized under the Articles or approved by the IMF. Members are permitted, as a transitional measure under Article XIV, to maintain (and to adapt to changing circumstances) exchange restrictions that were in effect on the date when they joined the IMF but not to reimpose pre-existing exchange restrictions once these have been eliminated or to introduce new ones. Members are expected to withdraw restrictions as soon as their balance of payments positions permit. Current international transactions for the purposes of IMF jurisdiction include, in addition to trade and invisible payments, short-term banking and credit facilities and moderate amounts of loan amortization.

Members may accept the obligations of Article VIII at any time; however, members would normally be expected to eliminate exchange restrictions before acceptance and also satisfy themselves that they are not likely to need recourse to such measures in the foreseeable future. Thus, when a member is contemplating acceptance of the obligations of Article VIII, the IMF staff will examine the member’s exchange system in order to ascertain whether the restrictive exchange measures maintained under Article XIV have been eliminated, and also whether there are any exchange measures subject to IMF jurisdiction under Article VIII.

As of mid-July 1994, 93 members (or 52 percent of IMF membership at the time) had accepted the obligations of Article VIII. Virtually all industrial countries have for some time been free of exchange restrictions on current international transactions. The number of developing countries accepting Article VIII has recently increased sharply, with 19 new acceptances since the beginning of 1993. Other members that have not yet accepted the obligations of Article VIII maintain exchange systems that are almost or completely free of exchange restrictions on current account and would be candidates for early Article VIII acceptance. Acceptance of Article VIII can provide a signal to the international community that the country intends to manage its affairs without the reintroduction of exchange restrictions, and thus can enhance international confidence in the country’s policies.

In a number of countries, the elimination of exchange controls for capital movements has been slower than for current international transactions. However, the pace of reform among industrial countries quickened during the 1980s, and by 1994 industrial countries had eliminated virtually all exchange restrictions with respect to international capital movements, thus making their currencies fully convertible. Nevertheless, in most countries regulations continue to be applied to the underlying capital transactions. For example, direct investment inflows may be screened outside the exchange system as regards ownership of assets and industrial structure.

Although some developing countries have traditionally maintained liberal capital accounts, most have applied extensive exchange restrictions on capital movements—including restrictions on genuine current international payments and repatriation requirements on foreign earnings—in part reflecting concerns about capital flight. Recently, an increasing number of developing countries have liberalized exchange controls on capital movements. During 1991–93, 11 developing countries undertook full or extensive liberalizations of their exchange controls on capital movements, and another 5 eased or eliminated controls on portfolio outflows. Twenty-three developing countries liberalized controls on foreign direct investment, and 15 eased restrictions on portfolio inflows.

A growing number of developing countries have eliminated all exchange restrictions and have experienced a rapid turnaround in capital inflows. These experiences with successful capital account liberalization suggest some common features:

  • the liberalizations were undertaken as part of programs of macroeconomic stabilization or structural adjustment, in many cases supported by an IMF arrangement and debt rescheduling;

  • they have often been undertaken in conjunction with the adoption of floating or managed-floating exchange rates, although some have been initiated under fixed exchange rate regimes;

  • liberalizations of domestic interest rates and controls on domestic financial systems have been undertaken either in advance of, or concurrently with, the liberalization of capital controls; and

  • liberalizations of exchange controls on current account transactions have been undertaken in advance of, or concurrently with, the liberalization of exchange controls on capital movements.

More generally, the trend toward liberalization of countries’ capital accounts and international payments and transfer systems has reflected several factors. First, there is a growing recognition that exchange restrictions are an inefficient and largely ineffective way to protect the balance of payments. Second, greater flexibility and realism in exchange rate policies, and sounder macroeconomic policies, have enabled countries to restore viability in their balance of payments without incurring the inefficiencies of exchange restrictions. Third, there is evidence that eliminating exchange restrictions can increase capital inflows in the short run, and promote efficiency in the allocation of these inflows, if the liberalization is carried out in the context of a comprehensive adjustment strategy.

1 Article I(iv) in Articles of Agreement of the International Monetary Fund (IMF, reprinted April 1993), p. 2.

A large number of countries, particularly in sub-Saharan Africa, and also some countries in Latin America and Asia, have not experienced increased private inflows. In many of these countries, although growth prospects may be improving, domestic policies have not been sufficiently strong to attract private capital flows. In some cases, there may be obstacles to foreign ownership of domestic enterprises while significant barriers to trade and capital mobility remain. However, private capital flows do appear to have resumed in the countries of the CFA franc zone following the recent devaluation, and also in Kenya and Uganda, where recent adjustment efforts have been relatively successful.

Capital Inflows, Economic Performance, and Policy Responses

The recent pattern of capital flows to developing countries shows some similarities with the 1977–82 period, which also saw large capital flows to many of the non-oil developing countries. In the recent period, however, a much larger proportion of the capital flows has been in the form of non-debt-creating flows, such as foreign direct investment and acquisitions of equity in emerging stock markets. Notwithstanding this important difference, policymakers need to monitor developments carefully. Potential concerns include the impact on domestic monetary conditions, the possibility of an intensification of inflationary pressures, and an excessive appreciation of the real exchange rate, which would reduce external competitiveness and exacerbate the deterioration of the current account that tends to be associated with large capital inflows. Moreover, any sudden reversal of capital inflows would pose significant risks both for external viability and for the stability of domestic financial markets. These risks are likely to be most serious where the capital inflows are of a relatively short-term nature and where the fundamentals may not warrant large inflows on a sustained basis. In contrast, when the inflows are invested profitably in countries with a solid economic performance and strong longer-term prospects, there would seem to be less cause for concern.

Comparing countries in Asia and Latin America that have attracted large capital inflows with those that have received relatively small inflows helps to illustrate some key differences in macroeconomic performance (Table 9). In the group of high-capital-inflow countries in Asia, the ratio of private investment to GDP, which was already relatively high during the 1980s at over 30 percent, has risen by a further 2 percentage points in the recent period compared with the mid-1980s. Investment has also increased in the group of low-capital-inflow countries, albeit significantly less. At the same time, high-capital-inflow countries have experienced further reductions in fiscal deficits. Growth, which has been remarkably high for most of the 1980s in Asia, has been sustained at over 7 percent during the recent period in the high-capital-in flow countries. By contrast, in the group of high-capital-inflow countries in Latin America, investment-to-GDP ratios have remained broadly constant, indicating that higher capital inflows have been associated with declining domestic saving and can therefore be said to have largely financed higher consumption—private consumption as a ratio to GDP has risen by over 2½ percentage points in this group. Growth in these countries has moderated somewhat relative to the 1980s, from 2.4 percent during 1983–89 to 2.1 percent in the recent period. There are, however, marked differences across Latin American countries; investment ratios in Argentina, Chile, and Mexico have risen consistently over the recent period. Other countries in the region, such as Colombia and Peru, have experienced some increases in investment more recently.

Table 9.

Developing Countries: Macroeconomic Indicators

(Annual averages; in percent of GDP unless otherwise noted)

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Annual percent change. Figures for 1973–76 correspond to 1974–76.

Data for real effective exchange rates are available only from 1979 onward. The data reported for the period 1977–82 are for the period 1980–82.

In defining the high- and low-inflow groups, countries within each region were ranked on the basis of the average net capital inflow during the period 1990–93. Small countries with purchasing-power-parity (PPP) shares less than 0.1 percent in each region were excluded.

In many of the recipient countries, although there has been a natural tendency for the capital inflows to raise trade and current account deficits, capital account surpluses have far outweighed deficits on current transactions. In Thailand in 1993, for example, the current account deficit stood at just over 5 percent of GDP, whereas the capital account surplus was about 8½ percent of GDP. For most countries capital inflows have thus been associated with sharp increases in international reserves because monetary authorities have been reluctant to let currencies appreciate. The Asian countries have been comparatively more successful in sterilizing a larger proportion of the increase in foreign exchange reserves, and as a result have managed to limit the expansion of money and credit, thereby restraining inflationary pressures. In contrast, many of the Latin American countries have allowed their real exchange rates to rise.

Although many other factors may be at work, there appear to be marked differences in macroeconomic performance not only between countries that have experienced large as opposed to smaller inflows, but also across the countries that have experienced relatively large inflows. Macroeconomic performance clearly has been a key factor in attracting the inflows, but these divergences also seem to suggest marked differences in policy responses to the capital inflows. These different responses, in turn, reflect different solutions to what in many countries has become a difficult policy dilemma.

Governments in the recipient countries are often concerned about the sustainability of real exchange rate appreciations and widening current account deficits. Where capital inflows are primarily the result of policy changes, such as structural reform and fiscal adjustment, a tendency for the real exchange rate to appreciate is more likely to be an equilibrating response to improvements in productivity and profitability, especially in traded-goods sectors. In contrast, where capital inflows are caused by restrictive credit policies that raise short-term interest rates and are not supported by sustainable fiscal policies, an exchange rate appreciation may be more disruptive, and these countries will be more vulnerable to sudden reversals. In this respect, performance of export sectors is often an important guide to the underlying reasons for the inflows and their sustainability.31 For most countries, large capital inflows may provide an opportunity to increase the pace of liberalization of trade and payments. This should help to alleviate some of the upward pressure on real exchange rates as import demand increases and the current account weakens. In the longer run, however, in countries such as India, where tariffs have restricted imports of intermediate inputs, a lowering of tariffs would probably help to strengthen competitiveness, improve resource allocation, and ultimately reduce the current account deficit.

Restrictive fiscal policies—especially lower government expenditure on nontraded goods and services that act to lower aggregate demand and therefore reduce the inflationary pressures arising from increases in capital inflows—can help to limit the extent of real exchange rate appreciation. A sharp fiscal contraction during 1988–91 helped Thailand to avoid upward pressure on the exchange rate for much of the recent period. Indeed, efforts to reduce fiscal deficits have been a key characteristic of many Asian countries that have experienced large capital inflows. For countries that do not exercise sufficient control over fiscal deficits, the resulting upward pressure on domestic interest rates may increase the proportion of shorter-term inflows and increase the vulnerability to changes in market sentiment. Countries such as India and Turkey, where fiscal positions remain weak, are already facing some of these pressures. For many countries, the inflationary consequences of capital inflows further strengthen the case for fiscal consolidation. However, in most cases fiscal policy is not sufficiently flexible to deal with short-term fluctuations in international capital flows, and it may often be difficult to reduce government expenditures in countries where significant fiscal adjustments have already taken place.

Much of the task of managing capital inflows has therefore fallen on monetary policy. The monetary authorities in most of the recipient countries have intervened in foreign exchange markets to prevent the nominal exchange rate from appreciating. In most cases, central banks have engaged in sterilized intervention to contain the monetary effect of the increase in foreign exchange reserves. Sterilization can be implemented relatively quickly and can allow policymakers some time in which to assess whether inflows are likely to be transitory or not. Moreover, the accumulation of reserves can provide some degree of protection against a reversal of the inflows. Sterilization can also help reduce the vulnerability of the domestic banking system to sudden reversals, especially in countries where the authorities may not have adequate prudential controls to maintain the quality of banks’ asset portfolios.

There are a number of problems that may limit the degree to which in practice capital inflows can be sterilized. In countries where domestic markets in government securities are relatively thin and illiquid, such as in Korea in the mid-1980s, the sterilization capacity of the central bank may be limited.32 Moreover, sterilization can also be costly for the authorities. Sterilization that takes the form of open market operations will typically require domestic interest rates to be higher than they otherwise would be. To the extent that domestic interest rates are higher than the return on foreign reserves, this will increase net costs to the central bank. In Chile and Colombia, these costs were estimated to be around 0.8 percent of GDP in 1991.33 Higher domestic interest rates may also give added impetus to capital inflows, as occurred in Brazil since 1991, in Colombia in 1991, and in Malaysia during the period 1991–93.

When it became apparent that the surge in inflows was not a transitory phenomenon, many countries recognized that sterilization on the scale required to limit money growth and inflation to targeted levels was not feasible. In Chile, and more recently in Taiwan Province of China, the authorities have allowed their exchange rates to appreciate somewhat by widening the bands within which the exchange rates were targeted. A number of other countries are facing similar pressures. In Malaysia, the exchange rate has appreciated recently, and in Singapore the long-term upward trend of the exchange rate has resumed over the past year. In countries where interest rates are high and there is a market perception that the currency may be undervalued, it might help to permit greater exchange rate flexibility and thereby increase the perceived exchange risks and deter short-term speculative inflows.

The capacity of financial markets, particularly of banking systems, to intermediate large volumes of capital inflows effectively may also be limited in many developing countries. Long-standing distortions in the financial sector and inadequate banking supervision and prudential standards could lead banks to engage in excessively risky lending behavior. This problem can be particularly acute where explicit deposit insurance schemes and inadequate capital requirements effectively shield banks from the true opportunity costs of their increased liabilities. Banking crises have been experienced in countries such as Venezuela, where a number of banks that had been receiving assistance from deposit guarantee schemes have recently been closed. An important concern of policymakers is the exposure of domestic banks to foreign exchange risk. Some countries, such as Egypt and Mexico, tightened measures to limit banks’ open foreign exchange positions during the period of large inflows.

Many developing countries have recently attempted to slow the inflows by resorting to a variety of restrictions, such as ceilings on foreign borrowing, minimum reserve requirements on foreign loans, and interest rate equalization taxes. Such impediments to capital inflows can be imposed relatively quickly and easily. Reserve requirements of 30 percent on all foreign credits were imposed in Chile in 1992, and reserve requirements on domestic and foreign deposits were raised in Argentina in August 1993 in order to sterilize part of the inflows from the sale of the state oil company. In April 1992, Mexico restricted foreign currency liabilities of commercial banks to 10 percent of their total liabilities, but these restrictions were eased somewhat later in that year. In January 1994, Malaysia introduced a variety of measures designed to discourage short-term capital inflows, including prohibiting residents from selling short-term monetary instruments to nonresidents, and requiring banks to place with the central bank the domestic currency funds of foreign banking institutions held in non-interest-bearing accounts. In Brazil, the government has introduced measures to restrict external investors’ access to its domestic private bond market and has introduced interest equalization taxes at rates of 5 and 3 percent, respectively, for foreign investment in fixed-income instruments and for domestic enterprises issuing bonds abroad, and pre-export financing—an important channel for capital inflows—also was curtailed.34

Capital controls are often introduced with the justification that they allow the authorities to pursue an independent monetary policy. The authorities may also regard capital controls as helpful in preventing capital flows from destabilizing the domestic economy, particularly during the early stages of a structural reform program, as might happen if there were large swings in equity prices or real exchange rates. Moreover, policymakers are often concerned about sudden reversals of capital inflows and the potential complications for macroeconomic management and the stability of the financial system that capital outflows would cause. Although the use of capital controls has been extensive and some measures such as higher reserve requirements on foreign liabilities and restrictions on foreign borrowing may help to discourage short-term flows, evidence from many countries, especially during the 1980s, suggests that capital controls may not be particularly effective in restricting capital movements.35 Moreover, restricting capital inflows will limit potentially significant longer-term benefits for investment and growth.

Countries that experience large capital inflows, in particular short-term inflows, may need to tighten restrictions until their economies are better able to cope with pressures on financial and exchange markets. It would, however, be inappropriate to use capital controls as a substitute for measures to address underlying macroeconomic imbalances. The introduction of new controls may also damage the credibility of the authorities’ commitment toward greater reliance on market forces, thereby harming the investment climate. When short-term portfolio inflows result from high interest rates associated with large budget deficits, the emphasis needs to be on corrective fiscal measures rather than capital controls. Even when there are no policy imbalances prior to the capital inflows, and the inflows themselves lead to imbalances, restrictions may not be appropriate unless the inflows are primarily of a short-term and speculative nature. When the inflows are less volatile and expected to augment domestic investment, a combination of exchange rate appreciation and fiscal tightening would generally appear to be the best policy response to safeguard macroeconomic stability.

Alternative Medium-Term Scenarios

Improved economic prospects and financial reform in Asia and the Western Hemisphere have attracted large inflows of portfolio and foreign direct investment. The outlook for developing countries in the medium term will depend both on policies in the developing countries to cope with some of the potentially destabilizing effects of large capital flows, and on developments in the external environment facing developing countries. Unfavorable external developments are, however, more likely to have significant adverse effects on countries suffering from policy imbalances and distorted markets. The baseline projections assume that policy reforms under way in a number of countries will stay on track and that recent trends in capital inflows will, for the most part, be sustained at levels close to those in recent years, although the total outflows from industrial to developing countries may decline somewhat with the projected strengthening of economic conditions in Europe and Japan.

Policy slippages and a reversal of capital flows would pose significant downside risks to the medium-term projections. A reversal, which would be expected to lower growth in the developing countries by reducing external financing, constraining imports, and lowering investment, could be triggered either by domestic developments or by external factors such as an increase in interest rates in industrial countries. Conversely, some increase in capital flows to developing countries could result from increased saving in industrial countries if fiscal consolidation efforts were stepped up over the medium term (see Chapter III). Moreover, improved policy reform efforts in many countries in Africa, the Middle East and Europe region, and the Western Hemisphere would help to boost growth among developing countries and increase the attractiveness of these markets for international investors.

To illustrate the potential consequences if any of these risks were to materialize, two alternative scenarios have been constructed using the IMF’s developing country model (Table 10). The scenarios include different assumptions about capital inflows and policy reforms as well as the external environment.36 The first scenario, which illustrates the downside risks, assumes a sharp reversal of capital inflows in response to policy slippages in the developing countries in the form of higher fiscal deficits from increased public spending, and an external environment that is characterized by lower growth, higher inflation, and higher interest rates in industrial countries.37 The scenario suggests that output growth in the developing countries would be reduced by almost 3 percent by the third year of the simulations, most of which would not be recouped in the medium term. Initially, increased public spending offsets the effects of the deterioration in the external environment, but higher import prices and inflation lower output over time. The reversal of capital inflows has an adverse effect on output in Asia and the Western Hemisphere by reducing external financing and thereby lowering imports and investment. The less favorable policy assumptions for industrial countries would tighten financing constraints further because of lower exports and increased debt service.

Table 10.

Developing Countries: Alternative Medium-Term Scenarios1

(Percent deviation from baseline unless otherwise noted)

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The simulation results are based on the IMF’s developing country model, which includes 87 developing countries.

Baseline values (indices, 1993 = 100, unless otherwise noted).

Scenario A assumes a significant reversal of capital inflows beginning in 1995 and sustained through 1999, policy slippages in developing countries in the form of higher fiscal deficits, and a “pessimistic” scenario for industrial countries (see Annex II for further details).

Scenario B assumes fiscal policy reforms in countries in Africa, the Western Hemisphere, and the Middle East and Europe region, marginal increase in capital flows, and “good policies” scenario for industrial countries (see Annex II for further details).

Projections are expressed as deviations in billions of U.S. dollars.

The second scenario assumes a continued deepening and broadening of policy reforms in the developing countries and improvements in the external environment. Reductions in fiscal deficits are assumed in Africa, the Western Hemisphere, and in the Middle East and Europe region (through lower public spending) in combination with stronger fiscal consolidation efforts in the industrial countries and some increase in capital flows to developing countries.38 On the basis of these assumptions, growth in the developing countries would rise by about of 1 percent a year over the next three years (see Table 10). Initially, output contracts as a result of fiscal consolidation measures, but it is higher in the medium term because of the lowering of world interest rates and higher rates of saving and investment. Inflation is also lower. The increase in capital inflows Contributes to somewhat higher investment in Asia and the Western Hemisphere. However, the deviations of output from the baseline projections are smaller in this scenario than in the first scenario, reflecting the relatively favorable assumptions embodied in the baseline scenario (Chart 18).

Chart 18.
Chart 18.

Developing Countries: Alternative Medium-Term Scenarios1

Real GDP (index, 1993 = 100)

1Based on simulations using the IMF’s developing country model.

* * *

Developing countries that have been recipients of large capital flows have for the most part utilized these resources to improve their longer-term growth prospects. The recent trends are therefore clearly more sustainable than in the 1970s and early 1980s. Indeed, compared with the latter part of the 1980s, when net capital flows to developing countries were negative, the current episode of large private capital inflows represents an important market recognition of sustained reform efforts and of the growth potential in many countries. Although the recipient countries have faced a number of short-term macroeconomic challenges as a result of these inflows, most of them have managed to limit the potentially adverse effects on their real exchange rates, domestic monetary conditions, and financial markets. Many have succeeded remarkably well in accumulating foreign exchange reserves. Significant changes in the composition of the inflows compared with the 1970s, with a much larger share of foreign direct investment, are particularly encouraging.

Despite the generally positive character of the large capital inflows, there are a number of countries where the confidence of foreign investors may not be warranted on a sustained basis—either because of insufficient attention to macroeconomic adjustment and reform in the past that cast doubt on the medium-term outlook for these countries, or because the capital inflows may be contributing to an unsustainable buildup of inflationary pressures and deteriorations in external current account positions that may not be viable over the medium term. Some countries may therefore experience changes in market sentiment, as already witnessed in a few cases. To reduce the risk of sudden reversals of capital flows, policymakers will need to strengthen domestic saving as well as reform and stabilization efforts in order to ensure that the foreign capital is invested efficiently and is used to improve longer-term growth prospects.

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    Developing Countries: Net Capital Flows by Region

    (In billions of U.S. dollars)

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    Foreign Direct Investment in China

    (In billions of U.S. dollars)

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    Stock Prices in Emerging Markets and Long-Term Interest Rates in Industrial Countries

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    Developing Countries: Alternative Medium-Term Scenarios1

    Real GDP (index, 1993 = 100)