Capital Flows in Central and Eastern Europe: Evidence and Policy Options
Capital Flows in Central and Eastern Europe: Evidence
and Policy Options by Guillermo Calvo, Ratna Sahay, and Carlos Végh
In contrast with the previous decade, capital has flowed in abundance
from industrial to developing countries in the early 1990s, most prominently
in Latin America and Asia, and with a lag in Central and Eastern Europe.
This paper examines emerging trends in capital flows in selected countries
in Central and Eastern Europe and analyzes policy options for these
The paper documents the pattern and composition of capital flows in the
region during 1987-93 and finds that, in many ways, 1992-93 was a common
turning point. In a remarkable turnaround, the capital account of the
region improved by about $20 billion in 1992-93, mostly reflecting a
reversal in external borrowing. The capital inflows have increasingly been
used to finance widening current account deficits. These large current
account deficits mainly mirror increases in consumption (predominantly
private consumption) rather than investment. Another common phenomenon has
been the appreciation of the real exchange rate during the capital inflows
It is argued that the rise in consumption and the real exchange rate
appreciation may not necessarily be a cause for concern on several grounds.
The higher consumption may reflect a move toward an equilibrium level from
artificially depressed levels rather than a temporary binge in consumption.
The real exchange rate appreciation may be a temporary phenomenon,
reflecting the relative inelasticity of the supply of nontraded goods, as
consumption and direct foreign investment rise. However, the real exchange
rate appreciation may have a permanent component if the productivity of
labor is rising as a result of qualitative changes in capital stock.
To the extent that capital inflows are financing temporary rises in
consumption and causing real wages to overshoot, the inflows may need to be
discouraged. In laying out the options facing policymakers, the paper
points to the inherent problems of pursuing second-best policies like
imposing capital controls, levying taxes, and raising interest rates on
government debt to attract capital away from the private sector. The
advantages and disadvantages of sterilized versus nonsterilized intervention
are also examined.