Cross-border capital flows
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The past year has seen a moderate recovery in capital flows to the transition economies in tandem with the resurgence of the regional and global economies. However, capital flows have become clearly more differentiated since the crisis in Russia in 1998, both in terms of recipient countries and of types of flows. Between 1998 and 1999 capital flows into the region fell by roughly two-thirds. Nearly all of this was due to a decline in flows to Russia. Meanwhile, capital flows to the more advanced countries of the region remained relatively stable in 1999, and there are signs of an increase in 2000. In terms of types of capital flows, foreign direct investment (FDI) has been more robust and less affected by market volatility than other types, such as bonds, equity flows and syndicated lending.
International capital flows into the region are of fundamental importance to the economic transition, and can make a significant contribution to realising the region’s growth potential. Domestic financial systems are still unable to offer sufficient support to investors. In addition, savings are limited, especially during the recovery from the transition recession when the expectations of future earnings stimulate consumption. Capital flows have contributed significantly to lowering the costs of financing investment and have been a key source for the financing of rising investment demand, particularly in the advanced countries (see Chapter 3).
The potential productivity (and profitability) of new capital, moreover, is likely to be higher than in advanced industrialised economies. Plant and equipment in transition economies is significant by any standards but inefficiently employed and partly obsolete. This also applies to job skills. Restructuring investment, combined with improved management and advanced technology, offers opportunities for improving the productivity of existing resources at relatively low cost. The impact of capital inflows on the transition goes, therefore, far beyond the simple flow of capital.
In contrast to these benefits are the risks to the transition countries of exposure to a volatile international environment. As shown by the market turbulence in 1998, these risks are highest in countries that have integrated themselves into the international capital markets without establishing the foundations for macroeconomic and financial stability. This chapter investigates the conditions under which countries in the region have been exposed to such volatility.
While emphasising the importance of appropriate macroeconomic policies, the chapter argues that to limit the impact of volatile capital flows, it is necessary to access a wide range of international financing instruments. In countries such as Russia, Romania or Ukraine, reliance on just one or two types of flows, and the absence of significant FDI in particular, has contributed to economic volatility as a result of swings in net capital flows. Moreover, the chapter shows that progress in structural reforms in banking, corporate governance and the regulation of securities markets has had a positive impact on attracting a range of capital flows to the transition economies. Capital inflows and progress in the transition are therefore closely linked.
The chapter starts by providing an overview of trends in international capital flows, with a particular emphasis on developments over the past year (see Section 4.2). This is followed by a discussion of the various types of flows: FDI (Section 4.3), portfolio inflows and international security issues (Section 4.4), and international bank lending (Section 4.5). Each section highlights the reasons for particular trends and fluctuations in each type of flow. Section 4.6 discusses the characteristics of the countries that have been most successful– and least successful– in attracting private international capital. There is evidence that declines in capital flows can be minimised by attracting a range of different flows. This has been achieved in countries that have given adequate support to structural reforms.
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