Discuss the implications short-term capital flows into emerging countries have on the financial stability and the economic development of those countries.

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Discuss the implications short-term capital flows into emerging countries have on the financial stability and the economic development of those countries.

The impact and desirability of international capital flows on emerging markets’ financial and economic development is a subject of extensive debate. The macroeconomic policies and the globalization of financial markets in developing countries have changed the dynamics of these flows. Prior to the 1990s, portfolio capital flows went relatively unnoticed because most foreign capital inflow to emerging markets took the form of direct investment. (Campion M K, 2001) However, with higher levels of portfolio capital mobility, the recipient countries’ economies were affected. The overall impact of this new situation for recipient economies is however, rather ambiguous. On the one hand, capital flows provide countries with financial resources that help them bridge the gaps between domestic saving and investment, and between foreign exchange available and foreign exchange required; and they may also lead to more disciplined and coherent economic policies. On the other hand, the high volatility of short-term capital flows implies complications for macroeconomic management and permits greater vulnerability to changes in international investors’ perception of country incentives and risks. Almost all of the countries affected by financial turmoil in the last few years had one thing in common – large ratios of short-term capital inflows, whether public or private. In each case, large short-term liabilities combined with relatively scarce internationally liquid assets resulted in extreme vulnerability to a confidence crisis and a reversal of capital flows. (Rodrik D & Velasco A, 1999)

This essay attempts to evaluate the impact of short-term capital flows into emerging markets, for which, it will highlight the concerned areas of financial market behavior. Some advantages and drawbacks of such capital inflows will also be discussed with reference to empirical evidence. Moreover, it will endeavor to determine whether unregulated capital flows are a feasible option for the stability and development of emerging economies. If not, an attempt will be made to come to a pertinent solution to this problem. However, before exploring the aforementioned aspects, it is necessary that the key terms of the essay is dealt with, namely “emerging markets” and “capital flows.”

Broadly defined, an emerging market is a country making an effort to change and improve its economy with the goal of raising its performance to that of the world's more advanced nations. The 1980s and 1990s have witnessed the rapid rise in the significance of financial markets in most of the so-called newly industrialized countries. Stimulated by the rapid rates of economic growths in countries of South East Asia and Latin America, international investors favor emerging-market stocks and bonds because of the potential for high return in a relatively short period of time.  However there is a great deal of risk involved in these investments because emerging markets are by definition in a state of transition and subject to unexpected political and economic disorders. The values of their stocks, bonds, and currency can change radically and without notice. (Pilbeam K, 1998)

At an early stage of development, domestic savings of these countries were often not sufficient to finance the investment needed to achieve capital accumulation and faster economic growth. Machinery and technology which contributes to productivity growth needed to be imported from abroad. The rise of private capital flows has however changed the conventional notion of foreign finance filling a given resource gap. A large part of these recent inflows has been motivated by the genuine, professed, or the probable relative macroeconomic conditions of countries, namely, differences in interest rates and expectations pertaining to future inflation and movements of exchange rates across different countries. Such flows are thus not specifically in response to the developing countries' needs (South Centre, 1999). Before discerning the development impact of foreign private flows, it is necessary to consider the different components of such flows.

These can be commonly classified as foreign direct investment (FDI), long term bank lending, short-term bank lending, and portfolio investment, all of which have an impact on the recipient economies in different ways. This essay is concerned with short-term capital flows, and will thus deal with the latter two, which are related to critical financial instability and represent more difficulties for macroeconomic management. (Rodriguez Y, 2000)

While the 1980’s had commercial bank loans constituting the majority of the capital flows, the 1990’s witnessed the rise in portfolio investments to both industrialized and developing nations. Griffith-Jones (1998) cited three main reasons for this transition. Firstly, financial deregulation and the rapid reduction of cross-border capital control. Secondly, the rise of mutual and pension funds stimulated an important growth of the international investing community. Financial intermediation enabled ‘unskilled’ individual savings to be managed more ‘professionally.’ Thirdly, technological advances in communication systems allowed electronic transfers of capital to be realized immediately. As cited in Griffith-Jones 1998, global capital flows grew from $910 billion to $1,175 billion between 1987 and 1993; but the outstanding element was in the composition of these flows. Portfolio investments increased far more rapidly rising from $134 billion in 1987 to $672 in 1993, while developing countries’ share of these flows rose from 0.4% in 1987 to 12.5% in 1993.

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Portfolio inflows may help finance a current account deficit, but there is no guarantee that they will contribute to substantial capital accumulation. As mentioned earlier, the highly volatile nature of these short-term investments presents grave problems for maintaining economic stability in emergent economies, creating particular problems for the balance of payments and exchange rate stability. The volatility is largely rooted in the herd-like behavior of investors, and the "contagion effect", whereby what investors do in one market often affects what investors do in another. Illustrating this effect, World Bank (1997), pointed out that when the Mexican crisis erupted, investors were ...

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