The latest paper from two of the best researchers on currency crises provides food for thought on the value of large capital inflows, http://www.nber.org/papers/w14321, "Capital Flow Bonanza: An Encompassing View of the Pat and Present". Large capital inflows actually lead to the greater economic stress once the flows decline.
There has been a strain of research in international finance that the vulnerability to sudden stops or changes in economic conditions will create longer-term havoc with an economy. An number of economies that have had currency crisis have faced sudden stops or changes in capital account conditions from an economic shock or contagion across economies. Much of this research has looked at what could be the policy response to global shocks and what conditions are necessary to reduce sudden stop shocks.
Generally, it has been been concluded that having flexible exchange rates will reduce the impact of any shocks. It is also necessary to have excess international reserves to protect against these sudden shocks. The degree of capital market openness has shown to have a mixed response as a contributor to shocks with some researchers finding that openness enhances the impact of any sudden shocks while others find that it is not important.
Reinhart and Reinhart find that economies that have been the beneficiaries of large capital inflows will suffer greatly once the flows are reversed. While this may not be surprising, it is a sobering tale. If you get used to obtaining global credit and it is turned off, there will be large consequences from the adjustment of lower credit availability.
This provides food for thought for all of the economies that have developed large capital account deficits or those who are planning to leverage up on foreign credit to stimulate an economy. Once the flows diminish other credit alternatives must be found and the result will not be pretty.
There has been a strain of research in international finance that the vulnerability to sudden stops or changes in economic conditions will create longer-term havoc with an economy. An number of economies that have had currency crisis have faced sudden stops or changes in capital account conditions from an economic shock or contagion across economies. Much of this research has looked at what could be the policy response to global shocks and what conditions are necessary to reduce sudden stop shocks.
Generally, it has been been concluded that having flexible exchange rates will reduce the impact of any shocks. It is also necessary to have excess international reserves to protect against these sudden shocks. The degree of capital market openness has shown to have a mixed response as a contributor to shocks with some researchers finding that openness enhances the impact of any sudden shocks while others find that it is not important.
Reinhart and Reinhart find that economies that have been the beneficiaries of large capital inflows will suffer greatly once the flows are reversed. While this may not be surprising, it is a sobering tale. If you get used to obtaining global credit and it is turned off, there will be large consequences from the adjustment of lower credit availability.
This provides food for thought for all of the economies that have developed large capital account deficits or those who are planning to leverage up on foreign credit to stimulate an economy. Once the flows diminish other credit alternatives must be found and the result will not be pretty.
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