Stop me if this sounds familiar: Global investors turn with interest toward some “foreign” market. Capital flows in volume into the “hot” financial market. The exchange rate tends to appreciate, asset prices rally, and local commodity prices boom. These favorable asset price movements improve national fiscal indicators, allowing authorities to slack off reform efforts, and encourage domestic credit expansion. This, in turn, exacerbates structural weaknesses in the domestic banking sector, even as global entities seeking entry into the now “exclusive” club court local institutions. But tides also go out when investor fancy shifts and the “new paradigm” looks shopworn. Flows reverse and asset prices give back their gains, often forcing a painful adjustment in the economy.
About ten years ago for a National Bureau of Economic Research (NBER) conference volume, Carmen Reinhart and I examined the macroeconomic adjustments surrounding episodes of sizable capital inflows in a large set of countries.1 Identifying these “capital flow bonanzas” turns out to be a useful organizing device for understanding the swings in investor interest in foreign markets as reflected in asset price booms and crashes as well as for predicting sovereign defaults and other crises. What follows updates that paper using the latest International Monetary Fund’s World Economic Outlook (April 2018) for 192 economies from 1980 to 2018. We define a capital flow bonanza as an episode when there are larger-than-normal net inflows (operationally identifying current account deficits relative to GDP bigger than the 80th percentile of the entire sample after weeding out some data problems and the few economies that always run surpluses). As can be seen in the share of countries experiencing a capital bonanza year by year plotted in the figure to the right, bonanzas are clustered in time even though they were defined using country-specific cutoffs.
1The working paper version is found here: http://www.nber.org/papers/w14321.pdf. The book is J. Frankel and C. Pissarides, editors, NBER International Seminar on Macroeconomics (University of Chicago Press, 2009), found here: http://papers.nber.org/books/fran08-1.