The new wave of private capital inflows : push or pull?

Widespread private capital inflows to middle-income countries have surged over the past three years. At the same time, Brady-type debt reduction operations and domestic policy reform took place, indicators of country creditworthiness improved dramatically, and international interest rates plummeted. Which factors most fully explain the wave of capital inflows? How sustainable is it? Some see this new wave of voluntary capital inflows as being mostly"pulled"by attractive domestic conditions, which open new and profitable investment opportunities in the domestic economy and improve country creditworthiness. Under this interpretation, if successful domestic policies are maintained, capital inflows will be sustained. Others see these inflows as being mostly"pushed"by conditions (especially low interest rates) in industrial countries. Under this interpretation, capital inflows would diminish and possibly turn to outflows if international real interest rates returned to the higher levels of the 1980s. The author presents an analytical model of international portfolio investment in developing countries based on non-arbitrage conditions between external returns and domestic returns adjusted by country risk. The author uses the model to explain why the new wave of private capital inflows is mostly a middle-income country phenomenon. To analyze the issue of private capital inflows, he applies the model of data for a representative panel of middle-income countries. The main empirical result is that (except in Argentina, the Republic of Korea, and notably, Mexico), the surge of capital inflows appears to be driven more by low returns in industrial countries than by domestic factors. So recent levels of capital inflows would be unsustainable if global interest rates returned soon to higher levels and cautious policies should be followed. Two other important conclusions are obtained. First, depressed returns in industrial countries caused the improved creditworthiness in indebted countries through their effects on discount rates. Country creditworthiness was an important transmission mechanism for external shocks and is the key to reconciling the push and pull interpretations of market data. Second, a soft landing appears feasible. Stock adjustment does not appear to be a significant component of the adjustment mechanism manifested in the surge of capital inflows. In other words, the evidence so far suggests that gradual increase in international interest rates would result in less capital inflow, or moderate capital outflows in some countries, rather than massive capital outflows that quickly bring down the stock of foreign liabilities. By and large, if there are capital outflows, they are unlikely to match past inflows unless the reversal in external conditions coincides with a worsening of domestic conditions.