III. Causes of Surges in Capital Inflows

Robert Kahn, Adam Bennett, María Carkovic S., and Susan Schadler
Published Date:
September 1993
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Two sources of information on the causes of capital inflows are the characteristics of the actual inflows and the domestic and external economic developments leading up to and during the inflow period. This section starts by reviewing characteristics of the inflows to set the stage for a discussion of domestic and external influences driving the inflows.

Characteristics of the Inflows

The timing, persistence, and size of the net inflows differed considerably among the six countries under review (Table 1). In most, there was a rather clear break in the size of net inflows: for three, it occurred in the late 1980s; for two, it occurred in the early 1990s; only in Chile did inflows rise gradually before jumping in 1990. The surge relative to GDP was largest in Mexico and Thailand, where it peaked at about 10 percentage points. In the other countries it peaked at 5–6 percentage points. Of course, to the extent that policy changes such as the imposition of capital controls or currency appreciation contained incipient inflows, pressures from surges in capital inflows cannot be calibrated solely in terms of the size of net inflows.

Table 1.Capital Inflows1(In billions of U.S. dollars, unless otherwise indicated)
Average of

Three Years

Prior to

Inflow Episode
Year 1Year 2Year 3Year 4
Chile (1990)
In percent of GDP4.510.63.58.1
Colombia (1991)
In percent of GDP0.94.82.7
Egypt (1991/92, July–June)0.93.3
In percent of GDP2.79.3
Mexico (1989)–0.44.911.020.824.7
In percent of GDP–
Spain (1987)–1.810.99.214.614.5
In percent of GDP–
Thailand (1988)
In percent of GDP3.35.29.711.412.6
Source: IMF staff reports and estimates.

First year of the surge in inflows noted in parentheses after country name.

Overall balance of payments surplus.

Source: IMF staff reports and estimates.

First year of the surge in inflows noted in parentheses after country name.

Overall balance of payments surplus.

Data on the nature of these inflows (Table A1) vary in quality and disaggregation, and definitions are not comparable across countries. Nevertheless, several generalizations can be drawn.

  • Almost all the increase in inflows was on account of flows to the private sector. Inflows to the public sector rose only in Egypt and Spain. In Spain, this largely resulted from changes in regulations and the Government’s financing strategy, which improved incentives for foreign investors to hold government bonds. Egypt also changed financing practices by introducing treasury bills that proved attractive to foreign and flight capital. Most of these inflows, however, were channeled through banks and not reflected in public external borrowing.
  • Short-, medium-, and long-term inflows claimed roughly comparable shares of the increase in total inflows to the private sector, except in Egypt (where increases in short-term inflows predominated) and Spain (where increases in medium- and long-term inflows were largest).
  • In Colombia and, to a lesser extent, Egypt, surges in “capital-like” inflows were recorded in the current account either because of problems with data recordation or because the inflows stemmed from shifts in workers’ remittances motivated by influences similar to those affecting conventionally defined capital flows. The assets in which these were invested are not recorded.
  • Portfolio investment (usually not recorded separately) is seen to have been important in Mexico and Spain.
  • Direct foreign investment constituted about 15–20 percent of the increase in inflows, except in Colombia where the change was small. Distinctions between long-term commercial credit, portfolio investment, and direct foreign investment, however, are not uniform across countries.

Domestic and External Influences

This section focuses on two main issues: the importance of external versus domestic causes of the surges in capital inflows and which domestic influences were most important. On the first issue, it is concluded that developments in foreign interest rates and growth, while important, cannot be seen as dominant causes of the inflows for two reasons. First, the timing of the changes in external factors did not coincide precisely with, and for several countries postdated, the surges in capital inflows. Second, the timing of the surges as well as their persistence and intensity varied considerably among the countries reviewed.4 Other external developments, such as those in regional trade, however, appear to have played critical roles, especially in Mexico, Spain, and Thailand.

As for the domestic influences, this section suggests that inflows to most of the six countries were attracted by a mix of real economic policy changes and a tightening of domestic credit market conditions. There were differences, however, in the relative importance of these domestic causes: at one end of the spectrum was Thailand, where sustained fiscal and structural policy changes were implemented, while credit policies were broadly unchanged; at the other end were Colombia and Egypt, where, notwithstanding important fiscal and structural policy changes, a tightening of credit conditions was a major impetus to the inflows. The importance of bandwagon effects was and remains highly uncertain.

External Developments

Changing conditions in the major industrial countries during the late 1980s and early 1990s—particularly falling interest rates and reductions in output growth—sent capital looking for more profitable investments. These developments, however, were not uniform across countries nor precisely coincident with the surges in capital flows. Using Germany, Japan, and the United States as references, output growth peaked in 1988 in Japan and the United States but only in 1990 in Germany (Chart 1). The timing of the drop in interest rates also varied: interest rates began to fall in the United States in early 1989 and in Japan in mid-1990, but in Germany short-term rates rose continuously while long-term rates fell only slightly in 1991–92.

Chart 1.Interest Rates, Growth, and Capital Flows

Source: IMF’s World Economic Outlook data base.

1 Long-term interest rates are rates on 9–10 year government bonds. Short-term interest rates are 3-month rates on treasury bills (United States), interbank deposit rate (Germany), or 3-month certificates of deposit (Japan).

2 GNP for Japan.

Even more important than these macroeconomic changes were other less easily quantifiable developments. The most important of these were actual or prospective changes in regional trade arrangements and conditions. These appear to have been the most important influence in Spain, where accession to the European Community (EC) in 1986 created expectations of a major change in the potential for trade with Europe, and in Thailand, where the currency realignments for several large Asian economies in the mid-1980s turned Asian investors toward lower-cost investments in Southeast Asia. Mexico also benefited from the initiation of negotiations for the North American Free Trade Agreement (NAFTA) in 1990. Other external developments that appear to have affected capital, although probably less profoundly than those mentioned above, were regulatory changes in the United States in 1990 that resulted in a reduction in transaction costs and liquidity requirements for countries tapping the U.S. capital markets; regulatory changes that adversely affected the junk bond market in the United States; and the 1990 disruptions in the Middle East, which probably motivated a relocation of regional savings.

Policy Changes Affecting the Real Economy

Each of the countries under review achieved a sizable reduction relative to GDP in the deficits of the central government or of the overall public sector within the three years leading up to the surge in inflows or, for Egypt, in the first year of the inflow (Table 2). The strength and quality of these adjustments varied considerably. In most of the countries, changes in taxes, tax enforcement, public enterprise prices, and current expenditure policies contributed significantly to the reductions. Each of the countries also benefited, however, from cyclical factors or unsustainable changes, for example, in capital spending: these types of influences were relatively important in Colombia and Egypt. To the extent that the improvements in public sector positions were perceived as sustainable, they created expectations of lower inflation, stable or improving external competitiveness, and a stronger external position. This increased the attractiveness of domestic investments and raised the demand for domestic financial assets.

Table 2.Fiscal Policy Prior to Surge in Inflows1(In percent of GDP)
Years Before Inflow EpisodeFirst Year of

Inflow Episode
Chile (1990)
Nonfinancial public sector balance–
General government revenue222.221.521.118.3
General government current expenditure27.024.422.021.1
Operating surplus of nonfinancial public enterprises311.413.011.510.9
Capital expenditure6.
Colombia (1991)
Nonfinancial public sector balance–1.8–2.0–0.6–0.2
Current expenditure16.216.716.818.1
Capital expenditure7.
Egypt (1991/92, July–June)
Overall government balance–15.0–15.8–17.2–5.0
Current expenditure28.328.430.130.6
Capital expenditure12.512.016.09.2
Mexico (1989)
Operational balance4–1.82.0–4.5–1.7
Primary balance4,
Current expenditure520.121.320.618.0
Capital expenditure7.
Spain (1987)
General government balance–5.5–7.0–6.0–3.1
Current expenditure36.639.338.537.5
Capital expenditure3.
Thailand (1987/88, October–September)
Nonfinancial public sector balance–6.3–4.8–1.61.3
Central government balance–5.4–4.8–2.20.7
Current expenditure17.116.615.313.6
Capital expenditure4.
Source: IMF staff reports and estimates.

First year of episode noted in parentheses after country name.

Includes net capital revenue.

Before taxes and transfers.

Includes public enterprise earnings (primarily oil revenues).

Excluding interest.

Including grants from abroad.

Source: IMF staff reports and estimates.

First year of episode noted in parentheses after country name.

Includes net capital revenue.

Before taxes and transfers.

Includes public enterprise earnings (primarily oil revenues).

Excluding interest.

Including grants from abroad.

Three other components of the reorientation of domestic policies played key roles in attracting the inflows. For several countries, the fiscal adjustment, together with a nominal depreciation had significantly improved the domestic cost structure prior to the inflows (Chart 2). In Thailand, in part reflecting the currency realignments of several large Asian economies mentioned above, a large real depreciation during the three years prior to the surge in inflows was perceived as having changed its role in the structure of regional production. Chile and Colombia entered the inflow period with strong competitive positions: most of the shift had occurred with adjustments in fiscal and exchange rate policies in the mid-1980s. In Egypt, several nominal depreciations during the preceding years had been partially reflected in the real exchange rate. In these cases, a question arises of whether an overshooting of the exchange rate—in the sense that a preceding change had exceeded that consistent with other macroeconomic policy adjustments—contributed to the inflows.

Chart 2.Real Effective Exchange Rates1

(Indices, 1980 = 100)

Source: Information Notice System.

1 Period t is the first year of the surge in capital inflows, the timing of which is indicated in parentheses after country name.

Structural reforms to improve supply conditions and liberalize financial markets were implemented in each of the countries during the years immediately prior to the surge in inflows (Table A2). Reforms were far-reaching in Mexico, where they comprised privatization, trade liberalization, tax reform, and deregulation. Chile, which by the late 1980s was further along in the reform process, pushed ahead with reforms in most of these areas. Colombia initiated trade and financial sector reform, the latter contributing to an increase in interest rates and openness of financial markets. Reform in Spain was directed toward reducing wage rigidities and harmonizing with the EC regulations on capital transactions and taxes. Egypt, which was less advanced in structural reform than the other countries, took first steps in financial sector liberalization—removing controls on interest rates and market participation and unifying exchange rates. Thailand, which by the mid-1980s was perhaps the least plagued by structural rigidities, continued a process of gradual reform focused on improving financial supervision, prudential control, and conditions for direct foreign investment.

Debt restructuring or reduction, while not strictly matters of domestic policy, resulted from the adjustment efforts in Chile, Egypt, and Mexico. This helped remove perceptions of a debt overhang and paved the way for reentry to capital markets. In addition, restructuring arrangements de facto subordinated old claims and raised expected returns on activities financed by new inflows.

Credit Policy Change

Although there was substantial fiscal adjustment and structural reform in each of the countries under review, in most of the countries inflows were also attracted by a tightening of credit policies beyond that supported by fiscal adjustment. For the Latin American countries, the shift in credit policy was typically a followup to a sizable fiscal adjustment that had reduced inflation but not to targeted levels. In an effort to reach these targets, credit was tightened, with little or no further fiscal adjustment; an exchange rate crawl (in Mexico, a preannounced depreciation) was used to influence inflation expectations. Interest rates rose, because of tighter credit conditions, the easing of controls, or administered increases. When inflows were attracted by interest rate differentials in excess of the preannounced or expected depreciation, they tended toward relatively liquid assets and were responsive to any change in the credibility of the exchange rate rule. Developments in interest rates leading up to the inflow episode followed this pattern at least to some degree in most of the countries under review (Chart 3). Except in Thailand, real short-term interest rates rose (relative to recent levels) in the year prior to and coincident with the beginning of the surge in inflows.

Chart 3.Real Short-Term Interest Rates1

(In percent)

Source: International Monetary Fund, International Financial Statistics (IFS); and staff estimates.

1 Domestic interest rate adjusted for consumer price inflation. Domestic interest rates are rates on 90-day certificates of deposit (Colombia), 3-month deposit rate (Egypt), 3-month treasury securities, CETES (Mexico), average rate on interbank operations (Spain), I-month repurchase market rate (Thailand), and 3-month rates on treasury bills (United States). Period t is the first year of the surge in capital inflows, the timing of which is indicated in parentheses after country name.

2 SDR denotes special drawing right.

Bandwagon Effects

Bandwagon effects are notoriously difficult to identify, particularly because, to the extent that they exist, they probably augment inflows caused by the more substantive factors. Suffice it to say here that most governments believed, during at least some stage of the inflow episodes, that the volume of inflows surpassed what would have been expected from policy or external changes. Substantiating this hunch, however, is not possible.

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