CAUSES AND CONSEQUENCES OF MASSIVE CAPITAL FLOWS [613147]

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CAUSES AND CONSEQUENCES OF MASSIVE CAPITAL FLOWS
Coroiu Sorina Ioana
University of Oradea, Faculty of Economics
Sabău Popa Claudia Diana
University of Oradea, Faculty of Economics

At this stage of global economic crisis that traverse, it was observed that m assive capital flows
have major impacts on economies. Therfore, it is important to analyze the factors behind th e
attraction of these massive capital flows, and the main consequences that followed.

Keywords: Massive capital flows, crises, causes, consequences.

JELL Classification: F21,F34, E52, E58.

In the current economic crisis, massive capital flows' analysis is very important because some
authors in the literature, Reinhart and Reinhart (2008) – believe that there may be links between
capital inflows and sovereign debt crises, exchange rates, inflation and the banking system.
Between 1975-1982, there were concomitant capital inflows, followed by the debt crisis. C apital
inflows reappeared during 1990-1993, followed by an emerging markets debt restructuri ng.
Since 2002, many countries faced with capital inflows. End this cycle coincided with the
financial crisis started in the second part of the year 2007. Massive capital inflo ws recorded by
the current global crisis occurrence, were due to several factors, including : financial
globalization, the existence of an abundant liquidity in developed economies, economic
development perspective of that country, following the accession to an economic union.
Globalization phenomenon is one of the main reason that caused financial globalization and
capital movement. Falling communication costs, strong competition, and rising costs in d omestic
markets, led firms in industrial countries to produce abroad to increase t heir efficiency and
profits. This not only triggered FDI, but also changed its nature in comparison to t he 1970s and
early 1980s. In those years, FDI was mainly driven by resource extraction and import
substitution, whereas the progressive globalization of production has led to a high proporti on of
current FDI being characterized as efficiency-seeking investments.
The second development in the financial structure of industrial countries that incre ased capital
flows to emerging markets was the growing importance of institutional investor s. These investors
found themselves more willing and able to invest abroad because of higher long-t erm expected
rates of return in developing countries and to wider opportunities of risk diversification.
Until the first signs of the current crisis, there was abundant liquidity in developed economies.
The liquidity has to keep interest rates at low levels and volatility in financial markets lower.
However, economic growth in developed countries has slowed in recent year, inv estors in these
markets have seen lower profits, so they began to seek new opportunities for profits. Increasingly,
investors began to look favorably emerging economies and capital inflows continued. Re inhart
and Reinhart (2008) analyzed 181 countries, from 1980 to 2008, and noted that the maximum
duration of the cycle of capital inflows was 3 years for more than 50 countri es, for 4 years for
more than 30 countries and almost 5 years to 20 countries.
Capital inflows have occurred both in low-income countries and middle-income or large incom e
countries, members of the OECD. For example, capital inflows have been relatively high in the
U.S. in the period 2002-2007, the United Kingdom and France between 2005 and 2007, in Spain
between 2004 and 2007.
In Romania, these inflows were higher in the period 2004-2008. Romania was an attrac tive
location for foreign investors due to cheap labor, facilities given by authorit ies, and so on.

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Another factor behind the increase in capital inflows in a given country was t hat country's
economic development perspective, the accession to an economic union: the European Union,
NAFTA. The premise was that an economic union membership has more security, limit ed
exchange rate fluctuations, reduce capital costs by reducing risk spreads, stock prices are
maintained at satisfactory levels.
The World Bank (1997) noticed that Capital Flows suggesting Several trends have been driven
by more than external factors. Fundamentals Affect the Long-term rates of return to investors.
Fundamentals countries with the strongest (high investment-to-GDP ratio, low inflation, real
exchange rates and low variability) have received the largest flows as percentag e of GDP.
Whereas countries with very poor fundamentals have attracted private flows. FDI is one of the
largest component of private flows, but, although sensitive to macroeconomic fundamentals, it is
note explained by global interest rates. Portfolio flows is more sensitive to i nterest rates. Still,
they have shown year upward trend since 1992-93 despite the increase in global inter est rates.
Nevertheless, the role of foreign factors cannot be ignored.
A breakdown of sources of capital inflows in the countries of Central and Eastern Europe (CEE)
is provided by Lane and Milesi-Ferretti (Isarescu, 2009). In total foreign di rect investment in
Central and Eastern Europe, the euro zone countries had a share of 73% -95%. In 2004, in most
CEE countries, over 50% of total portfolio investment in the stock market came from the euro
area, which was the main source for foreign assets of the banking systems of C EE and long-term
investments that create debt.
In general, relatively high capital markets became relatively small and shallow. The discrepancy
between financial depth and volume of emerging economies in capital inflows l ed to appreciation
of currencies. To prevent the excessive appreciation of currencies, the reserves have
strengthened. This was more intense in countries that export energy resources. Also, to prevent
massive capital inflows, the authorities raised the reserve requirement, impositi on of taxes on
financial transactions and other administrative restrictions. However, positive devel opments have
dimmed prices real need for structural adjustment, which were postponed. This was prob ably the
most important implication for these economies since the long term, structural adjustment delay
adversely affects external competitiveness.
All episodes of inflows or sudden stop of capital have common characteristics, ev en though they
showed different features depending on the country or time period analyzed. These characteristics
refer to the dynamic indicators such as GDP, real exchange rate, inflation and cur rent account,
both before and after an episode of capital inflows. Using the results presente d in literature –
Reinhart and Reinhart (2008), Isarescu (2009), one can identify certain patterns of dynamic
indicators mentioned, 4 years before concluding episode of capital inflows and 4 years aft er this
time.
The graph in Figure 1 presents the evolution of current account deficit before and after the
episode of large capital inputs (denoted by zero on the horizontal axis). Note that during the
episode of capital inflows, it has been a deterioration in current account adj ustment, beginning to
previous levels. V-shape of the current account evolution is sharper for small and medium-
income countries.

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Fig. 1. The evolution of current account deficit (% in GDP)

0 = Moment of massive capital flows (MCF)

Source: Isarescu, 2009

Generally, there is a directly proportional relationship between inflows and GD P. During the
period of capital inflows, GDP recorded a relatively high growth, and decreas es sharply in
concluding episode, then again there is a noticeable trend. In other words, after completion of
large capital inflows, GDP has a V-shaped trajectory (Fig. 2).

Fig.2. The evolution of GDP (%)

Source: Isarescu, 2009

It has been difficult to identify a trend of inflation, because the data present ed in literature are
varied, because monetary policy plays an important role. Isarescu (2009) believes that the end of
the cycle of capital inflows followed by a short-term inflationary spurt, mainly due to exchange
rate channel. In subsequent years, however, inflation is at levels more or less sim ilar to those
before the end of episode than capital inputs.

No. of years
before MCF No. of years
after MCF
No. of years
before MCF No. of years
after MCF

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Fig. 3. Inflation rate evolution (%)

Source: Isarescu, 2009

Figure 4 presents the evolution of the exchange rate. If capital inflows last f ew years, real
appreciation of each year tends to be significant, so the cumulative assessment is also significant,
leading to downward slope of this graph. Literature shows that in most cases, r eal depreciation
occurs through nominal depreciation of the currency. In the graphic we see that real depreciation
is driven by falling prices only after the first year of the end episode.

Fig. 4. Exchange rate evolution (%)

Source: Isarescu, 2009

We have seen that massive capital flows have significant consequences, theref ore, the control of
the volume is necessary. The biggest challenge after the financial crisis, is to di rect capital flows
and avoid recurrence of imbalances, that have accelerated the decline in savings.

No. of years
before MCF No. of years
after MCF
No. of years
before MCF No. of years
after MCF
appreciation
depreciation

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References:
[1] Isarescu Mugur – National Bank of Romania Working Paper “Finantarea dezechilibrului
extern si ajustarea macroeconomica in conditiile crizei financiare. Cazul Ro maniei.”, 2009;
[2] Morris Goldstein, The World Bank – “Coping with Too Much of a Good Thing. Policy
Responses for Large Capital Inflows in Developing Countries.” Policy Research Work ing Paper
no. 1507, 1995;
[3] Reinhart, M. Carmen, and Reinhart, R. Vincent – “Capital Flow Bonanzas: An Encompassing
View of the Past and Present” , NBER Working Paper, No. 14321, September 2008;
[4] International Monetary Found Working Paper, prepared by Alejandro Lopez-Mejial,
authorized for distribution by Enzo Croce – “Lar ge Capital Flows: A Survey of the Causes,
Consequences, and Policy Responses” , 1999;
[5] The World Bank – “Private Capital Flows to Developing Countries: the Road to Financial
Integration,” Oxford University Press, 1997.