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Positive and negative figures of the market in May

Capital inflows in emerging markets

Capital inflows can overwhelm the domestic financial system, resulting in macroeconomic overheating as well as imprudent lending and borrowing activities at the microlevel. Studies of banking crises show that many have occurred after periods of high liquidity.

The financial systems in emerging economies also include institutions that are not as yet able to deal with major increases in capital inflows. As such, some of them make bad decisions, often with significantly negative results for them and for the system as a whole.

The unfortunate irony is that countries may end up actually worse off after a period of sudden large capital inflows. At first, this sounds counterintuitive. After all, these inflows are beneficial inflows. Surely, at worst, the countries will simply be no better off. How can they be worse off?
A recent IMF study has shown that the risks of developing countries’ winding up worse off after experiencing large sudden capital inflows are particularly elevated for countries that run large current account deficits. The reason is that the surge in capital inflows enables a set of activities that are inconsistent with the countries’ fundamentals. As such, the economies’ underlying vulnerabilities increase. These risks are especially acute for those countries with weak banking systems and inadequate supervision and regulation.


(From When markets collide)