Surviving the Great Capital Flood

Despite recent financial market turbulence, the underlying dynamic of the world economy remains essentially unchanged. The big issue is not how to deal with a downturn, but rather how to sustain today’s global boom and the capital flows that go with it. With the world expected to continue growing rapidly, there are excellent investment opportunities that will be funded only if capital continues to move into countries that can use it productively.

The good news is that some countries have large savings that they want to invest in other countries, and are not put off by short-run market gyrations. In fact, our projections show that gross (or total) capital inflows to emerging markets will increase from US$400-500 billion just before the Asian crisis of 1997 to US$800-900 billion both in 2007 and 2008. These inflows are expected to top US$1 trillion in the not-so-distant future.

With 20-20 hindsight, it is clear that in 1997-98, weak bank regulation and corporate governance aggravated the depth of the economic contraction that followed the “sudden stop” of capital flows. But what exactly does this imply for how middle- and low-income countries today should set their capital-account policies amid the current flood?

Should a country with weaknesses in its financial system simply avoid letting capital in? While this has become more difficult, countries can still choose – at least to some degree – how open they are to capital inflows.