Sustainability of private capital flows to developing countries : is ageneralized reversal likely?

Developing countries that undertake adequate domestic reform should continue to expect capital inflows, despite recent events in Mexico and the U.S. Federal Reserve Board's raising of interest rates during 1994.Since 1989, private capital flows to a select group of developing countries have increased sharply, but developments in 1994 have caused concern about the sustainability of those flows. Several highly indebted developing countries that are implementing reform are concerned that a generalized reversal similar to episodes of capital flight in the early 1980s --- might disrupt their economies and threaten economic reform.Because the surge in private capital flows coincided with a period of low international interest rates and intensive policy reform in developing countries, debate has been active about whether the surge is driven mainly by domestic (pull) or external (push) factors. Under the pull hypothesis, successful domestic policies are the key to ensuring sustainable capital inflows; under the push hypothesis, an increase in international interest rates would cause a reversal of those flows (back to the industrial world).Using a partial adjustment model in which both domestic and external variables are defined, Hernandez and Rudolph explain why private capital flows to some developing countries but not to others (using panel data for 1986- 93 for 22 countries).They argue that a generalized reversal is unlikely in countries that maintain a fundamentally sound macroeconomic environment. In fact, their empirical results show that domestic factors such as domestic savings and investment ratios significantly affected the recent surge in capital inflows.Further, they suggest that countries that have not received significant foreign capital --- including countries in Sub Saharan Africa --- could begin to if they implemented structural reforms that allow them to export, save, and invest at higher rates. Reducing their foreign debt (which might call for a continuation of recent debt reduction operations) could also help attract foreign private investors.This paper --- a product of the International Finance Division, International Economics Department --- is part of a larger effort in the department to analyze policy implications of private capital flows to developing countries. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Rose Vo, room N3046, telephone 2024731047, fax 2025223277, Internet address hvo1@worldbank. org. (35 pages)The full report is available on the World Bank FTP server