The surge of private capital flows to developing countries
that occurred in the 1990s has been the most significant phenomenon of
the decade for these countries. By the middle of the decade many
developing countries in Asia and Latin America were awash with private
foreign capital. In contrast to earlier periods when the scarcity of
foreign capital dominated economic policy-making in these countries, the
issue now for governments was how to manage the largescale capital
inflows to generate higher rates ofinvestrnent and growth. While a
number of developing countries were able to benefit substantially from
the private foreign financing that globalisation made available to them,
it also became apparent that capital inflows were not a complete
blessing and could even turn out to be a curse. Indeed, in some
countries capital inflows led to rapid monetary expansion, inflationary
pressures, real exchange rate appreciation, fmancial sector
difficulties, widening current account deficits, and a rapid build-up of
foreign debt. In addition, as the experience of Mexico in 1994 and the
Asian crisis of 1997-98 demonstrated, financial integration and
globalisation can cut both ways. Private capital flows are volatile and
eventually there can be a large reversal of capital because of changes
in expected asset returns, investor herding behaviour, and contagion
effects. Such reversals can lead to recessions and serious problems for
financial systems. This paper examines the characteristics, causes and
consequences of capital flows to developing countries in the 1990s. It
also highlights the appropriate policy responses for governments facing
such inflows, specifically to prevent overheating of the economy, and to
limit the vulnerability to reversals of capital flows.
A Financial Accelerator through Coordination Failure