A pattern has often been repeated in the modern era of global finance. Global investors turn with interest toward the latest "foreign" market. Capital flows in volume into the "hot" financial market. The exchange rate tends to appreciate, asset prices to rally, and local commodity prices to boom. These favourable asset price movements improve national fiscal indicators and encourage domestic credit expansion. These, in turn, exacerbate structural weaknesses in the domestic banking sector even as those local institutions are courted by global financial institutions seeking entry into a hot market.
But tides also go out when the fancy of global investors shift and the "new paradigm" looks shop worn. Flows reverse or suddenly stop à la Calvo and asset prices give back their gains, often forcing a painful adjustment on the economy.
In a recent paper, we examined the macroeconomic adjustments surrounding episodes of sizable capital inflows in a large set of countries. Identifying these "capital flow bonanzas" turns out to be a useful organising device for understanding the swings in investor interest in foreign markets as reflected in asset price booms and crashes and for predicting sovereign defaults and other crises.
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