Economic Report President

CHAPTER 6Capital Flows in the Global EconomyINTERNATIONAL FINANCIAL DEVELOPMENTS last year posedserious challenges for the world economy. What began in the summerof 1997 as a regional currency crisis in developing Southeast Asiaerupted into a wider and deeper economic disturbance in 1998. By latesummer the turmoil had extended to many other financial marketsand to a number of economies around the globe. The outbreak of financialand economic turmoil in Russia in August immediately threatenedto spread the contagion to Latin America. Interest rates in these andother emerging market countries rose sharply, and large-scale capitalflight raised risk premiums on their sovereign bonds. Several countriesexperienced sharp depreciations of their currencies or strains on theirforeign exchange reserves. Prices of stocks, bonds, and other financialand real assets fell. Commodity prices continued to fall, engenderingtalk of global deflation. Ultimately the financial turbulence led to ageneral flight from risky assets even within the United States andWestern Europe. Japan’s hopes for recovery from a long-enduringslump were dashed.Prompt policy action and signs of a turnaround in Asia improved theoutlook later in 1998. Even so, by late 1998 a third of the world’seconomies were in recession or experiencing markedly slower growth.The International Monetary Fund (IMF) has estimated world economicgrowth at only 2.2 percent in 1998 and projected that it wouldremain at that level in 1999, in stark contrast to robust growth of 4.2percent in 1997. Those estimates indicate a deceleration of globalgrowth to levels not seen since the pronounced world slowdowns of1974-75, 1980-83, and 1990-91. The risk of such a global slowdownposes new challenges to economic policy.The widespread financial turmoil—perhaps the most severe experiencedby the world economy during the last 50 years—followed a periodof increasing global integration of goods and financial markets.World trade has increased dramatically as trade restrictions havesteadily fallen and many countries have made a historic commitmentto opening their economies to international trade. Restrictions oninternational capital transactions have also been eased, and the integrationof financial markets has led to an unprecedented volume ofcross-border capital flows.The recent turbulence should not cloud the benefits of this ongoingtrend toward globalization. The integration of markets has provided219