Capital flows & current account deficits in the 1990s: why did Latin America & East Asian countries respond differently?

The return of private capital to highly indebted less-developed countries (LDCs) in the late 1980s was accompanied by widening current account deficits in the recipient countries, which were primarily attributed to a consumption boom in Latin America and an investment surge in East Asia. Interpreting the return as an increase in the external debt ceiling, the maximum amount that can be borrowed, this paper analyzes and compares the different response of the two regions using the conceptual framework of a borrowing-constrained agent. According to it, an increase in the debt ceiling can reduce precautionary savings, and induce higher demand (and widening current account deficits) even when the borrowing constraint does not bind. Moreover, the increase in demand should be decreasing in the original ceiling. The results from a panel of fourteen Latin American and a panel of eight East Asian countries are consistent with the framework. They also indicate that the different response of the two regions can, to a large extent, be explained by Latin America's lower ceiling prior to the return. Further, the results identify several developments that have not received sufficient attention in the literature and, among other policy implications, suggest that controls on capital inflows may not be effective in preventing a current account deterioration.