Capital Flows to Developing Economies: Implications for Saving and Investment

Barry P. Bosworth and
Barry P. Bosworth Nonresident Senior Fellow - Economic Studies

Susan M. Collins
headshot of Susan Collins
Susan M. Collins President - Federal Reserve Bank of Boston, Former Nonresident Senior Fellow - Economic Studies

March 1, 1999

The currency crises that broke out in East Asia in mid-1997 have been followed by a year of tumult in international financial markets. These crises have seriously impacted the emerging market economies, forcing many to raise domestic interest rates so as to stem an outflow of financial capital and prevent further exchange rate collapse. Interest rate increases have, in turn, depressed domestic economic activity. Not surprisingly, this severe financial instability has intensified ongoing discussions about the benefits and risks to developing economies from allowing capital to flow freely across national borders.

For many developing countries, the ability to draw upon an international pool of financial capital offers large potential benefits. Economic output in these countries is held down by low levels of capital per worker. Foreign resource inflows — current account deficits — can be used to augment their private saving and reach higher rates of capital accumulation and growth. Access to international capital markets provides the means to finance those resource flows. It is also argued that some types of foreign capital inflows, principally foreign direct investment, facilitate the transfer of managerial and technological knowhow. Portfolio investment and foreign bank lending are seen as adding to the depth and breadth of domestic financial markets. Some proponents have gone on to argue that, by increasing the rewards for good policies and the penalties for bad policies, the free flow of capital across national borders has the salutary effect of promoting more disciplined macroeconomic policies and reducing the frequency of policy errors. By the mid-1990s, support for open financial markets had grown to the extent that some officials suggested amending the IMF charter to place capital account convertibility on the same level of desirability as a convertible current account. Some analysts reason that the obvious benefits of open trade in goods and services creates a presumption of positive net benefits for open crossborder trade in all financial instruments.