The Surge in Capital Inflows to Developing Countries: An Analytical Overview Eduardo Fernandez-Arias and Peter J. Montiel After being excluded from world capital markets during the debt crisis, many devel- oping countries have experienced large capital inflows during the past five years. The challenges that these inflows pose for domestic policy in recipient countries have generated a substantial literature. This article presents an overview of that literature, describing the characteristics of the new inflows, analyzing the policy issues they raise, assessing their causes and likely sustainability, and evaluating po- tential policy responses. The desirable policy response is tied to characteristics of the flows themselves as well as to the characteristics of the recipient economy. Flows of foreign financial capital to developing countries have been episodic in the past two decades. The period 1973-81 witnessed massive capital flows to countries in many parts of the developing world, largely in the form of private syndicated bank loans directed to the public sector. Such lending effectively dried up for many (but not all) developing countries during the period of the debt crisis, 1982-89. But in recent years several developing countries around the world have again begun to receive substantial flows of foreign capital. These flows are notable because of their magnitude and because they represent a break from the period of the debt crisis for many of the recipient countries. Although reduced access to foreign savings was once perceived as a serious constraint to growth for many developing countries, the recent surge in capital inflows has not been taken as an unmitigated blessing. Indeed, the surge of in- flows has triggered a new literature investigating the appropriate policy response of the recipient countries. The urgency of this issue increased following the Mexican financial crisis at the end of 1994. This article assesses the state of this literature. It summarizes what is currently known about the new episode of capital inflows, focusing specifically on its causes and sustainability, and evalu- ates suggested policy responses on the part of the recipient countries. The article does not treat policy issues that may arise either in the creditor countries or for the international financial community in association with the new patterns of capital movements (for the latter, see Bacha 1993). Eduardo Fernindez-Arias is currently with the Office of the Chief Economist at the Inter-American Development Bank (on external service from the World Bank), and Peter J. Montiel is with the Department of Economics at Oberlin College. The authors would like to thank William Easterly, Leonardo Hernandez, Carmen Reinhart, and Luis Served for helpful comments on an earlier draft. © 1996 The International Bank for Reconstruction and Development / THE WORLD BANK SI