Economic Report President

INTERNATIONAL CAPITAL FLOWS, THEIR CAUSES,AND THE RISK OF FINANCIAL CRISISTRENDS IN FINANCIAL INTEGRATIONThe phenomenal growth of international capital flows is one of themost important developments in the world economy since the breakdownof the Bretton Woods system of fixed exchange rates in the early1970s. Their growth can be traced to the oil shock of 1973-74, whichspurred financial intermediation on a global scale. Mounting surplusesin the oil-exporting countries could not be absorbed productivelywithin those economies, and at the same time the correspondingdeficits among oil importers had to be financed. The recycling of“petrodollars” from the surplus to the deficit countries, via the growingEuromarkets (offshore markets for deposits and loans denominated inkey currencies, particularly the dollar), produced the first post-BrettonWoods surge of international capital flows. As a result, many developingcountries gained access to international capital markets, wherethey were able to finance their growing external imbalances. Most ofthis intermediation occurred in the form of bank lending, as largebanks in the industrial countries built up large exposures to developingcountries’ debt.The buildup of these external liabilities eventually became excessiveand, together with loose monetary and fiscal policies in the borrowingcountries, sharp declines in their terms of trade, and high internationalinterest rates, triggered the debt crisis of the 1980s. Starting in Mexicoin 1982, that crisis rapidly engulfed a large number of developingcountries in Latin America and elsewhere. The rest of the 1980s saw aperiod of retrenchment, with a significant slowdown in capital flows toemerging markets (especially in Latin America) as burdensome foreigndebts were rescheduled, restructured, and finally reduced with theinception of the Brady Plan in 1989.The resolution of the 1980s debt crisis led to new large-scale privatecapital inflows to emerging markets in the 1990s. Several factorsencouraged this renewed surge of international financing. Many LatinAmerican countries were adopting policies emphasizing economic liberalization,privatization, market opening, and macroeconomic stability.Countries in Central and Eastern Europe had embarked on their historictransition toward market economies. And rapid growth in a groupof economies in East Asia had caught the attention of investors worldwide.Net long-term private flows to developing countries increasedfrom $42 billion in 1990 to $256 billion in 1997.The largest share of these flows took the form of foreign directinvestment—investment by multinational corporations in overseasoperations under their own control. These flows totaled $120 billion in1997 (Chart 6-1). However, bond and portfolio equity flows accounted221