The imminent (or not) taper of purchases of securities by the Federal Reserve has resulted in a great deal of speculation about its effects on other countries. Among the more intriguing views that have been advanced is the claim that a withdrawal of foreign capital will lead to much-needed reform measures in emerging markets.  This is an interesting assertion, in part because it contradicts the meme that capital inflows act as a catalyst for “collateral benefits” that contribute to the establishment of better institutions. So, which is it—will a reversal of foreign money lead to an improvement in domestic governance or not?

The collateral benefits view was advanced after empirical analyses failed to find evidence that capital account liberalization contributed to economic growth. Then-IMF economists Ayhan Kose, Eswar Prasad, Kenneth Rogoff and Shang-Jin Wei (Prasad is now at Cornell, Rogoff at Harvard and Wei at Columbia) claimed that capital inflows promoted the development of the domestic financial sector, and contributed to institutional development, better governance and macroeconomic discipline. There was an intuitive appeal to this argument: shouldn’t foreign investors favor conditions that facilitate the development of local markets and institutions that lead to profits?

The problem is the (lack of) evidence for this linkage. Indeed, the wreckage of a decade of financial crises in Mexico, East Asia, Russia, Brazil, Turkey and Mexico suggested that foreign lenders had been blind to local conditions. Dani Rodrik and Arvind Subramanian, in their review of the arguments for financial globalization,  were unconvinced that collateral benefits could be found, and pointed to Turkey as a counter-example.

The second perspective builds off this contrasting view that capital inflows serve as a stopgap measure that allows recalcitrant governments to avoid implementing the reforms that domestic lenders demand. Easy money from aboard allows government officials to finance fiscal deficits that may include payments to supporters of the regime. Once the conditions that led to the inflows of foreign money disappear, the government is forced to deal with the domestic creditors.

Another version of this story sees capital inflows as contributing to bubbles in the country’s financial markets and institutions. A reversal of foreign money reveals the fragility of the domestic financial conditions and necessitates reforms. South Korea is sometimes cited as an example of a country that enacted economic and financial reform measures after its 1997-98 crisis that made the country better off.  Of course, a country pays a high price if a capital outflow occurs precipitously.

Recent concerns have centered on the “Fragile Five” of  Brazil, Indonesia, India, Turkey and South Africa. Their currencies depreciated when Federal Reserve Chair Ben Bernanke first raised the issue of cutting back on asset purchases last year. Increasing current account deficits in all but India have revealed a dependence on foreign capital. But it is India that most requires reform of the financial sector. Raghuram Rajan, governor of the country’s central bank, has sought to modernize the financial system, but faces political opposition and inertia. It would be unfortunate if he needed a crisis to get the attention of domestic politicians.