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Volatility and Contagion

Commercial capital flows generally tend to be variable and unpredictable, depending heavily on market conditions. Equity investment, in particular, is subject to strong herd instincts on the part of investors, which makes it potentially a very volatile source of capital. This greatly increases the risks of financial crises and makes it much more difficult to plan economic policy effectively.

When a country’s economic fundamentals are seen to be good and investment opportunities attract foreign equity investors, this can draw in still more investment. The effect of large scale investment inflows is to push up the values of shares and scarce assets such as real estate. If investors (domestic as well as foreign) expect this process to start, or to continue happening, they will deliberately invest in these assets, so as to profit from the capital gains they anticipate; and their investments, by increasing demand, will help to push prices up still further. This process can become self-perpetuating, so that a “speculative bubble” of unsustainable asset prices is created.
Ultimately, the realisation will set in (possibly because of adverse political or economic developments or just as a result of a change in market sentiment) that the prices of the assets have become unsustainable. At this point, investors will try to sell the assets, so as to avoid incurring losses as the prices fall; and the market will become flooded so that prices collapse. The whole process is largely self-fulfilling: prices go up mainly because investors expect them to, then they collapse because investors change their minds. See Figure ?.
Such speculative investments are almost entirely unproductive13, and bring few if any benefits beyond the private gain to the investor. In fact, the overall economic effects can be seriously negative, as domestic resources are diverted away from productive uses by the much higher rates of return available from speculation. As the East Asian financial crisis has amply demonstrated, the effects of the ultimate collapse of the market can be profoundly negative, in both economic and development terms14.
FDI is generally seen as much less volatile than equity investment, because, by its nature, it implies a longer-term relationship between the investor and the host country. Moreover, its proponents argue that profits will be lower when the economy is weak, reducing profit remittances.

Nonetheless, FDI may seriously compound the impact of shocks arising from the external economic environment or adverse domestic developments. This is because FDI flows are strongly procyclical in nature - that is, they are greatest when the economy is performing well, but may fall dramatically when it encounters problems15. While they are generally limited in scale, net outflows of FDI can occur and may persist for some time (Woodward, 1996a, p44 and footnote 18).
Moreover, recorded profits by no means always change in the opposite direction to investment flows, and may actually compound the problem. In South Africa, for example, profits on inward FDI ranged between $500 and $800m per year in 1984-8, rising dramatically to $2.3-2.8bn per year in the politically uncertain period of 1989-93, before returning to their earlier level in 1994-516. Coupled with some disinvestment, this gave rise to a cumulative outward net transfer of some $14bn (more than 10% of annual GNP) over a 5-year period.
The East Asian crisis of 1997-8 and the Mexican crisis of 1994-5 have also demonstrated strong contagion effects between developing country equity markets. The Mexican crisis occurred for entirely predictable and country-specific reasons; but it led to a general loss of confidence in Latin American markets and "emerging markets" more generally, not for any rational reason, but largely because they were seen by creditors as a single category of markets. The same applied to a lesser extent in East Asia. Contagion creates an additional source of volatility: not only may a country be directly hit by adverse developments domestically or in international markets; it may also face a major reduction in capital flows due to problems in another country, merely because investors associate the two markets.
To give themselves some protection against the risks of a capital outflow, countries which receive substantial amounts of equity investment need to keep a high level of foreign exchange reserves, so that they can be sure of meeting the potential costs of capital repatriation, and to counter any speculative attack on the currency. This means that the foreign exchange cannot be used for other purposes, such as purchasing imports, which further reduces the potential benefits of the capital inflows arising from equity investment. For example, for each $100m that comes into the country, perhaps $50m might need to be kept in the reserves; and, while the return on the equity investment might be 25-30% PA, the return on reserves is likely to be in the order of 5% PA. Effectively, the country as a whole is borrowing money at a cost of 25-30% per year to invest it at 5% PA.

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