Proponents of capital account liberalization cite the growth-promoting attributes of capital flows as a key benefit of financial integration for developing countries. For many developing countries ability to draw upon an international pool of financial capital offers large potential benefits. Low levels of capital per worker in these countries is one of the major reasons for low levels of GDP in these countries.Net foreign resource inflows can augment private savings and help these countries reach higher rates of capital accumulation and growth. Access to international capital markets provides the means to finance those resource flows. Some types of foreign capital flows, like Foreign Direct Investment, may also facilitate the transfer of managerial and technological know-how. Portfolio investment and foreign bank lending add to the depth and breadth of domestic financial markets. In some cases the free flow of capital across borders promotes more disciplined macroeconomic policies on the part of the nations receiving these capital flows. On the other hand, opening domestic financial markets to international transactions creates added risks, as has been seen during the east-Asian crisis. Developing countries that experience large inflows of foreign capital, as many Southeast-Asian countries did prior to the crisis, make themselves vulnerable to sudden and destabilizing withdrawals.
Causes of the capital flows
The factors that led to such capital flows in the developing countries can be categorized into two: ones that are external to the countries receiving the flows and others that are internal to the economy. The various factors are:
1) There was a substantial decline in world interest rates. For example, short-term interest rates in the US declined steadily in early 1990’s. Lower interest rates in the developed nations attracted investors to the high investment yields and improving economies in Asia and Latin America. Also the investors viewed investments in these economies less risky than before. However with the tightening of monetary policy in the US and the resulting rise in interest rates made investment in Asia and Latin America less attractive. This triggered market corrections in several emerging stock markets as a large portion of investment in these countries was in form of portfolio equity which can be easily withdrawn.
2) The early 1990’s brought recessions to the United States, Japan, and many countries of Europe. This international swing in developing countries made profit opportunities in developing countries appear relatively more attractive. However, as the OECD economies move towards recovery in the mid-1990s, this factor became less important in generating capital flows to Latin America. The increased flow to developing countries thereafter was mainly because the relatively high returns on their emerging stock markets. This is one of the major reasons for increased capital flows to Brazil and India in the last few years.
3) There has been a trend towards international diversification of investments in major financial centres and towards growing integration of world capital markets. Increasing amounts of funds managed by institutional investors such as mutual...