Survey responses and an analysis of the situation of several emerging markets during the crisis suggest that a possible starting point for an analysis of the crisis is the recent episode of capital inflows to developing economies. In the early 1990s, a cyclical downturn in global interest rates coupled with the search by international investors for higher yields and diversification opportunities, among other factors, led to the start of the most recent episode of private capital flows to developing economies.

Global capital flows afforded developing countries the opportunity to smooth their consumption and investment patterns and also brought along with them the accompanying benefit of "knowledge spill-over" and improved resource allocation. However, these capital flows were not totally without cost as they also brought along with them significant risks. The World Bank, in a prescient policy research report, noted that after the Mexican crisis, international investors had become more discerning and stringent in exacting market discipline whenever confidence was lost. It also noted that without the necessary pre-conditions to ensure the sound deployment of private capital flows, the risks of large reversals could be devastating. The East Asian crisis appears to suggest that initial conditions not only matter but are crucial in ensuring that developing countries can successfully tap the benefits of private capital flows while shielding themselves from the accompanying risks.

It has been argued that capital flows can be related to economic vulnerability along the following lines. Specifically, according to this analysis wweak initial conditions-among them, poor governance, inadequate supervision and regulation-as well as inappropriate policy responses to initial surges in capital flows-for example, lax fiscal policies and non-sterilised inflows-can result in a credit boom in the recipient economy. Existing structural weaknesses (see next section) allow this credit boom to be sustained and can also lead to the mis-channelling of capital inflows towards non-tradable and speculative sectors such as the real-estate and equity markets.

On the macroeconomic front, it is argued that capital influx in a regime of relatively rigid exchange rates-regimes that tend to be favoured by many developing countries as a means of providing a nominal anchor for the domestic price level and/or maintaining a competitive export position-can cause, in the absence of sterilisation, monetary aggregates to increase. This can feed economic activity, inflationary expectations and real exchange rate appreciation. Moreover, excess liquidity may well be channelled into asset markets and, thus, fuel an asset price bubble.

This combination of a credit boom, mis-allocated funds, lax monetary policy and an asset price bubble, driven by a surge in capital inflow, can increase the local currency denominated wealth of the economy. However, the vulnerability of the macroeconomy to sudden reversals in capital flow also increases significantly. Hence, a "virtuous" cycle continues until some "trigger-event" occurs-some exogenous shock such as the baht devaluation-causes investors to reassess and readjust their portfolios across a number of markets, geographically and by asset. However, at this stage, the macroeconomy is in no shape to absorb the adverse shocks associated with this portfolio readjustment and a crisis ensues (see figure below).

Figure 9: Capital flows, lending booms, and potential vulnerability

The figures in table 3 lend support to the framework above. Recent episodes of private capital flows have indeed resulted in significant credit booms in recipient economies. In most of these cases, structural weaknesses and implicit public sector guarantees (see the next section for further elaboration) are thought to have allowed the easy credit to channel resources to non-tradable sectors.

What this seems to suggest is that the economies receiving capital inflows were, in essence, borrowing foreign exchange and investing them in projects with significant gestation periods which earned domestic currency because they were in non-tradable sectors. This would have given rise to significant currency and maturity mismatches which significantly increased the vulnerability of the recipient economies to adverse external shocks. In one jurisdiction over-investment occurred in sectors which, even though they were traded, were experiencing declining demand. Therefore, there was significant excess capacity in those sectors.

Table 3: Net private capital inflows to a selection of developing countries, 1990s (net long-term international private capital as a percentage of GDP)
Country	Inflow episode1	Cumulative inflows/GDP at end of episode	Maximum annual inflow	Average annual monetary growth (M2)2 3 years before inflow period	Average annual monetary growth (M2)2 5 years before inflow period	Average annual monetary growth (M2)2 during the inflow period
East Asia
Indonesia	1990-95	8.30	3.60	28.67	26.86	24.88
Malaysia	1989-95	45.80	23.20	7.16	19.20	17.54
South Korea	1991-95	9.30	3.50	19.50	7.05	18.76
Philippines	1989-95	23.10	7.90	13.23	12.35	22.74
Thailand	1988-95	51.50	12.30	14.60	14.63	19.35
Rest of Asia
India	1992-95	6.40	2.70	16.87	16.80	16.20
Pakistan	1992-95	13.00	4.90	12.63	12.40	19.65
Sri Lanka	1991-95	22.60	8.20	14.77	12.78	20.10
Eastern Europe
Hungary	1993-95	41.50	18.40	28.07	20.58	17.70
Poland	1992-95	22.30	12.00	241.47	164.40	41.68
Latin America
Argentina	1991-94	9.70	3.80	1263.67	817.22	64.30
Brazil	1992-95	9.40	4.80	1152.23	928.46	1419.90
Chile	1989-95	25.80	8.60	29.13	33.68	23.80
Colombia	1992-95	16.20	6.20	67.13	49.88	36.20
Mexico	1989-94	27.10	8.50	69.37	62.85	50.00
Morocco	1990-95	18.30	5.00	12.43	13.48	12.11
Peru	1990-95	30.40	10.80	635.73	423.54	815.28
Venezuela	1992-93	5.40	3.30	52.00	39.24	20.90
Source: World Bank data; IMF, World Economic Outlook database; IMF, International Financial Statistic data base 1 The period during which the country experienced a significant surge in net private capital inflows. 2 Datastream/ICV (EIU Forecast)