Few things motivate finance ministers in emerging markets more than becoming attractive to international capital markets. Attaining investment-grade rating, as Brazil did earlier this year, is often cause for national celebration. The expectation is that capital inflows will reduce domestic costs of borrowing, boost investment, and raise growth.
But what really happens when you are the beneficiary of a sudden increase in capital inflows? In a new paper, Carmen and Vincent Reinhart look at the experience of 181 countries from 1980 to 2007 and document some very interesting findings.
They find that capital inflow bonanzas have become more frequent as restrictions on international capital flows have been removed, that these episodes can last for quite some time (lulling policy makers into thinking that they are permanent), that they end with an abrupt reversal "more often than not," that they are are associated with greater incidence of banking, currency, and inflation crises (except for in the high income countries), and that economic growth tends to be higher in the run-up to a bonanza and then systematically lower. As the authors note, with significant understatement, "a bonanza is not to be confused with a blessing."
What lesson should domestic and international policy makers take from these facts? The standard response is that what is needed is more vigilance on the part of the authorities: do not pursue pro-cyclical fiscal policies, improve your banking supervision and prudential regulations, enhance your institutions all around. The paradoxical nature of these policy conclusions is that they turn capital inflows into an imperative for even deeper reform, instead of treating them as a reward for good behavior. It is a topsy-turvy world.