6 ideas
Shifting external borrowing from foreign-currency to local-currency debt sold to foreign investors did not remove external fragility; it moved the currency risk onto foreign lenders, who respond by exiting quickly when the exchange rate starts to fall. The capital losses they fear from depreciation make their holdings highly pro-cyclical, so local-currency liabilities held by non-residents can trigger sudden stops much like foreign-currency debt.
External vulnerability should be judged by gross external liabilities and who holds them, not by net positions or current-account balances. A country with a current-account surplus and large reserves can still face a crisis when non-residents sell domestic assets and residents move their own wealth abroad at the same moment, because gross outflows can far exceed any net figure.
Capital inflows to developing countries are driven mainly by conditions in advanced economies, above all interest rates, quantitative easing and global risk appetite, rather than by the recipients' own fundamentals. Monetary policy decisions in the US and other reserve-currency issuers therefore set the timing of surges and reversals, and deeper integration exposes domestic markets more fully to these external shocks.
Once capital accounts are liberalized, domestic residents gain the ability to move savings abroad, and their outflows become a major source of pressure during stress. Reserves built to cover foreign-held liabilities can therefore prove insufficient, because in a crisis the claims on reserves come from domestic wealth holders as well as foreign creditors.
After 1997, public external debt fell in many developing countries while non-financial corporations borrowed heavily abroad in foreign currency, often through offshore affiliates and bond markets. Governments may not track this debt well and cannot restructure it directly, yet when defaults spread it tends to end up as a public burden through bailouts and bank exposures.
Holding large foreign-exchange reserves protects against capital-flow reversals, but the protection is costly because reserves bought with borrowed capital earn less than the liabilities cost. A cheaper and more reliable defense is to manage the capital account directly with countercyclical controls on inflows and, if needed, outflows, together with macroprudential limits on currency and maturity mismatches, because the international system offers no adequate lender of last resort or orderly debt workout mechanism.