Benefits of Capital Flows: New Role for Public Institutions.

After a worldwide removal of regulatory constraints, market forces have assumed a dominant role in the international financial system. The role of the public sector has been sharply curtailed, rendering it ineffectual in its efforts to handle essential functions: liquidity management and imposition of countercyclical policies to offset the boom/bust of business cycles. To remedy this problem, it will be necessary to rebuild the powers of the public sector to promote stability and growth in the global economy.

Cross-border securities transactions in the recurrent boom/bust cycles have plagued emerging markets in the 1990s. The establishment of a public international investment fund promoting steady, sustainable growth in developing countries while providing a basic, guaranteed return to investors, should be considered by policymakers.

Growth in cross-border securities investments mushroomed in the 1980s as portfolio investment became increasingly attractive and lending by international banks declined. By the end of the decade, these trends strengthened, as many countries removed capital controls and privatized state enterprises. Securities markets expanded dramatically in the developing world, Eastern Europe, and the former Soviet Union. With growth in the volume and mobility of capital flows, global integration accelerated.

Major shifts in saving and investment patterns in the large industrialized countries also contributed to the rise in foreign portfolio investment during the 1980s and 1990s. Increasingly, individuals have shifted savings from banks to pooled funds (e.g., private pensions, life insurance, and mutual funds) that invest in securities. Between 1978 and 1998, the share of total U.S. financial sector assets held by institutional investors rose from 32% to 54% while the share held by depository institutions fell from 57% to 27%.

U.S. and U.K. insurance companies and pension funds initiated the first wave of portfolio investment in emerging markets in Asia in the late 1980s. Interest soon shifted to Latin America--notably to Mexico, Brazil, and Argentina--as the repatriation of flight capital deepened those markets and as privatizations expanded the stock and diversity of new securities issues. Investments in emerging markets as a portion of industrialized countries' securities investment flows rose from 0.5% in 1987 to 16% in 1993. Foreign portfolio investment ($325 billion) replaced bank lending ($76 billion) as the dominant source of private capital flows to developing countries in the period 1990-1994.

In the early 1990s, the switch from bank lending to portfolio investment drove up securities prices. Foreign capital surged into certain developing countries, rising rapidly as a share of GDP. For example, from 1990 to 1993, capital flows into Mexico totaled $91 billion--20% of all net inflows to developing counties. Two-thirds of Mexico's net inflow was portfolio investment. Most of it was invested in the Mexican stock market, which rose 436% during this period.

In early 1994, the rate of foreign portfolio investment abated as the recession in industrialized countries eased, demand for credit rose, and the U.S. Federal Reserve Board hiked interest rates, thereby narrowing the spreads between U.S. and emerging market debt issues. Prices of Mexican stocks fell, eroding their value as collateral for bank loans and forcing liquidations. As that source of financing for its current-account deficit dried up, Mexico issued dollar-indexed, short-term debt. But political shocks and dwindling dollar reserves had unnerved investors. Their pullout in anticipation of a forced devaluation made the December 1994 decision to devalue the peso unavoidable.

After the Mexican peso crisis, discussion focused on how developing countries should handle capital inflows. According to the International Monetary Fund, heavy inflows into most emerging market countries caused exchange rate appreciation that eroded the competitiveness of export sectors, drove up asset prices, and increased the vulnerability of their financial systems.

In 1995, the Bank for International Settlements reported widespread agreement that controls on short-term transactions should not be liberalized until the soundness of a country's financial system was assured. However, this view conflicted with U.S. policies favoring the elimination of controls on international capital flows. The U.S. Treasury Department did not, therefore, use its influence to promote guidelines for or restraints on speculative transactions. Despite the heavy economic and social costs of volatile investment flows, the U.S. stepped up pressure for full capital account liberalization, both before and after the Asian crisis began to unfold in 1997. The Treasury Department ignored the call for reforms that could have averted the contagion brought on by unregulated financial flows to emerging markets.

Key Points

* Foreign portfolio investment replaced bank loans as the primary channel for international capital flows in the 1990s.

* Privatization programs and the removal of capital controls facilitated the rise of foreign portfolio investment in emerging markets.

* Rising securities prices allowed foreign capital to be absorbed more rapidly and in larger amounts than in the past, intensifying boom/bust cycles in developing countries.