Taking the experience of 181 countries since 1980, the authors reckon that middle- and low-income countries had a roughly 20% chance of suffering a banking crisis and a 30% chance of a currency crisis, external-debt default or inflation spike (to more than 20% a year) if they experienced what the authors call a “capital-flow bonanza” in the three years beforehand. (They define such a bonanza as an unusual shift of the current account into the red, using that as a proxy for capital inflows since the capital and current accounts mirror each other.) These seem unenviable odds.
The authors point out that countries might have suffered disasters anyway, without being showered with money. That turns out to be true-but their chances were quite a bit lower: between 14% and 24% for countries that did not attract so many dollars. In other words, a foreign inflow, as well as financing good things such as public infrastructure and corporate investment, is also associated with debt defaults, inflation and currency crises.
The authors focus on the level of capital flows, rather than their composition. Presumably, countries that attract more foreign direct investment suffer less than those that have a greater amount of footloose portfolio investment or short-term bank lending. But overall, most countries that suck in foreign money show the classic signs of an economic bubble. Using a subset of 66 countries for which there are more detailed figures, the authors show that share prices rose by more than 10% in real terms in the two years before what they call a bonanza, then fell relentlessly for four years, ending below where they started. House prices went up by more than that-15% in real terms over four years during a bonanza-before falling back.
So why would countries seek out foreign money at all, if its impact is so malign? The answer is that it is not so much the amount of investment that is the trouble; it is its volatility, and especially its tendency to dry up. That makes today’s climate worrying. Mansoor Dailami, the World Bank’s manager of international finance, says private inflows to emerging markets may fall from $1 trillion to only $800 billion-850 billion this year. That may be particularly troublesome because of another difference between this crisis and the Asian one: in 1997-98, more debt was sovereign. Now, much of it is corporate, taken out by Indian, Chinese and other emerging-market companies. That implies a global credit tightening could have as big an impact on emerging markets as slowing import demand in the rich world.