When foreign capital surges into countries, there are two possible means of adjustment: financial adjustment through increases in resident capital outflows or reserves accumulation, or real adjustment through a larger current account deficit. Historically, surges in capital inflows to emerging market economies tended to lead to domestic booms and current account deficits and, when the flows reversed, as they almost inevitably did, painful adjustments and sometimes financial crisis. The global financial crisis, however, marked a change from the past. While some countries experienced the classical boom-and-bust cycle in response to volatile international capital flows, many did not. Rather, as international capital flows dried up, domestic residents stepped in to replace them by drawing down their own foreign assets. This pattern of buffering foreign capital flows with offsetting resident flows was a key contributor to these economies being more resilient to fluctuations in foreign capital inflows. This chapter examines the underlying explanations for this behavior and assesses whether it is possible for policymakers to encourage such behavior in countries where it may not currently occur.
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