Research Paper 37, March 2011

Capital Flows to Developing Countries in a Historical Perspective: Will the Current Boom End With a Bust?.

The paper argues that the policy of quantitative easing and close-to-zero interest rates in advanced economies, notably the US, are generating a surge in speculative capital flows to developing countries in search for yield and creating bubbles in foreign exchange, asset, credit and commodity markets.

This latest generalized surge constitutes the fourth post-war boom in capital flows to developing countries. All previous ones ended with busts, causing serious damages to recipient countries.  The conditions driving the current boom in capital flows and commodity prices are not sustainable and they are likely to be followed by a sharp downturn.  Various scenarios that can bring them to an abrupt end are discussed.

Examining the policy responses and financial and macroeconomic developments in major emerging economies, the paper concludes that deficit commodity-rich economies that have been enjoying the dual benefits of global liquidity expansion – that is, the boom in capital flows and commodity markets – are most vulnerable to a possible reversal, and urges them to manage capital flows more effectively.

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