Understanding the determinants of capital inflows is essential to designing an effective policy framework to manage volatile capital flows and their disruptive potential.

The recent global financial crisis is a good illustration of the adverse effects of free financial flows and globalization. The wave of financial deregulation and globalization since the 1990s has transformed the nature of capital flows, which can be characterized by the dominance of private capital from a variety of sources.

Following a dip in late 2008 and early 2009, the strong rebound in capital inflows has been driven by foreign purchases of emerging Asia stocks and a rebound in foreign direct investment (FDI) flows

While capital inflows bring potentially substantial benefits to recipient economies, spurring investment and economic growth, 1 a surge in capital inflows can also bring significant risks and challenges to emerging market economies. 2 For example, capital flows, particularly driven by large short-term flows, have in the past disrupted the functioning of domestic monetary policy and created financial instability, with adverse consequences for growth.

The strong post-crisis economic recovery, together with the return of investors’ risk appetite for emerging market assets, led to a surge in capital flows to developing Asia in the latter half of 2009 and in 2010. Private capital flows to emerging Asia 3 were $447 billion in 2010 and are expected to be around $430 billion in 2011 (almost 40% of private capital flows to total emerging markets), according to the Institute of International Finance.

Following a dip in late 2008 and early 2009, the strong rebound in capital inflows has been driven by foreign purchases of emerging Asia stocks and a rebound in foreign direct investment (FDI) flows, particularly into the People’s Republic of China (PRC) and India. While the return of capital flows to developing Asia is welcome, today’s dramatic increase in capital inflows, driven particularly by short-term flows, may well presage tomorrow’s large outflows.

How to effectively manage capital flows has resurfaced as a major policy concern for many developing Asian economies. In this regard, understanding the forces that drive capital flows is essential for the effective management of such flows.

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