Abstract
Since the 1980s, emerging countries have been urged to welcome foreign capital inflows. The result has often been a pattern of surges where excessive inflows were followed by damaging “sudden stops” and reversals. This was dramatically evident in the Asian financial crisis of 1997–1998. Since that crisis, the emerging countries of East Asia have typically run current account surpluses and have accumulated substantial foreign exchange reserves. This has kept them largely protected from the impact of volatile capital flows, but this strategy is neither sustainable nor optimal.
What is needed is a strategy that makes use of the potential benefits of capital “flowing downhill” (that would require these countries to run current account deficits) while at the same time protecting them from both the excessive inflows and the reversals. This strategy needs to take account not only of the fickle nature of the capital flows, but the structurally-higher profitability which is characteristic of emerging countries, which motivates the excessive inflows. This strategy would require more active management of both exchange rates and capital flows than has been the accepted “best practice”, this requires a substantial shift in the current policy mindset. The International Monetary Fund has shifted some distance on this issue, but has further to go.
This is a preview of subscription content, log in via an institution to check access.
Access this chapter
Tax calculation will be finalised at checkout
Purchases are for personal use only
Notes
- 1.
That said, it is noted that even in this period there were voices disagreeing with these efforts (for example, Bhagwati 1998).
- 2.
Hong Kong, China and Singapore now have foreign reserves as large as their GDP, and the People’s Republic of China, Malaysia, and Thailand have reserves equal to around half of their GDP. At these levels the problem is not so much a technical inability to sterilize, but the quasi-fiscal costs of doing so and the huge risks that central banks face in their foreign exchange exposure. Even a modest appreciation, recorded using internationally accepted accounting methods, would wipe out central bank capital and put them deeply into negative equity, subject to the sort of public criticism that weakens central bank independence (Filardo and Grenville 2011).
In any case this strategy provides very little positive benefit for the recipient economies. There is no real-resource transfer. Official reserves are just acting as a liquidity buffer ready to fund the outflow when foreigners (who have benefitted from the higher domestic returns) decide to get out.
- 3.
A large amount of literature (IMF 2005; Kawai and Takagi 2010), explored the ineffectiveness of such attempts particularly drawing on the experience of Latin America, with the Chilean encaje being the prime example. Attempts to answer the question of effectiveness through econometrics were limited by the endogenous policy response: controls were put on when the capital inflow was strongest and taken off when flows weakened.
More recently in East Asia, there were some attempts to use controls (for example, Thailand in December 2006) and some macroprudential measures in Indonesia and the Republic of Korea but most economies accepted the prevailing view that such controls had limited effectiveness.
- 4.
But also the OECD pressure on the Republic of Korea leading up to its membership in 1996.
- 5.
Just to complicate the story, however, some inflows have closely related outflows (for example, with derivatives and forward cover, and when the economy is acting as a financial intermediary for another economy as in Hong Kong, China for the People’s Republic of China).
- 6.
Becker and Noone (2008) note the predominance of the two-way flows and also draw the conclusion that the usual volatility relativities (with foreign direct investment (FDI) the most stable and bank flows the most volatile) do not hold for mature country flows.
- 7.
The importance of the Wicksellian interest differentials is best seen in the growing importance of the “carry-trade” flows. These are often seen in terms of a narrow definition of the carry trade—those flows directly involving two legs (borrowing and lending) in order to exploit the interest differential. But it is more useful to think of these flows that are responding to the higher-interest leg of the interest differential, which would include flows from fund-management portfolios (that is, which don’t have the borrowing leg) and those flows that are derivative-based, characteristically not including a “borrow” leg. With this broader notion in mind, it is not possible to establish the volume of these interest-driven flows.
- 8.
It is worth noting that the lowest equity returns are typically from those economies whose convergence is largely complete: Hong Kong, China and Singapore.
- 9.
The starting point is chosen to be the longest period post Asian crisis for equities, and for the longest period of data availability for bonds. Moving the starting point into the early 2000s for equities alters the detail, but not the message. Based in 2001, for example, the United States (US) shows a return on $100 invested in equities of just under $30, while Indonesia shows an increase of $1,000 and India $500. Ideally an accumulation index would be used for this comparison but dividend payments are not very different between these countries and the US.
- 10.
The exchange rate is of course an important element in flow decisions. The role of the exchange rate has changed somewhat since the Asian crisis. Before 1997, cross-border decisions were predicated on stability vis-à-vis the US dollar. Foreigners seeking higher returns and domestic borrowers seeking cheaper funds came to rely on a stable exchange rate. When in 1997 this assumption proved unfounded, transactions were dramatically reversed. Since the crisis, exchange rates have been more flexible (albeit managed), which was supposed to make the flows less volatile. But Uncovered Interest Parity does not hold: in fact the underlying trend in the emerging countries is towards appreciation (another reflection of the higher Wicksellian interest rates and the Balassa-Samuelson effect). Thus foreign investors (and domestic firms borrowing overseas) could generally anticipate not just higher interest rates, but as well an exchange rate appreciation over the medium term (McCauley 2010). Countries with larger nominal interest differentials (because of higher inflation) might be expected to have smaller appreciations. Thus investors in Indonesia received most of the Wicksellian dividend in the form of higher interest rates and less in the form of appreciation.
- 11.
This is often seen in terms of the removal of capital flow restrictions (and there is a large amount of literature attempting to measure this), but this is only a part of the story. Indonesia, for example, had removed capital flow restrictions in the 1970s, but the inflows were still restricted by other factors until the 1990s.
- 12.
Some of these FDI inflows may, in fact, represent domestic capital “round-tripping” to gain benefits accorded to FDI.
- 13.
The Republic of Korea and Taipei,China are also included in this group.
- 14.
IMF (2011d) has analyzed gross flows to emerging economies in terms of surges (short periods where the inflow is large and large compared with trend), episodes (prolonged surges), and waves (where there is correlated movements across countries. The waves might be associated with changes in the foreign (investing) country. The IMF identifies these surges as 1995Q4–1998Q2, 2006Q4–2008Q2, and the ongoing wave which began in the third quarter (Q3) of 2009. The episodes do not coincide closely in their starting point (suggesting country-specific “pull” factors) although there is also evidence of correlated inflows (Richards 2005) but often end in coincidence (suggesting common foreign explanation such as global risk aversion). Frankel (2011) also sees the profile of flows in terms of cycles, not structurally excessive flows.
- 15.
Carry-traders usually have to mark-to-market and are often leveraged, subject to margin calls. They cannot afford to go on holding the investment, waiting for the exchange rate to revert.
- 16.
See, for example, IMF (2011c) box on the Republic of Korea. On Indonesia, see Hendrasah (2010) and Goeltom (2008). McCauley (2010) notes that 2008 was different from 1997, as liquidity was sucked out of emerging markets by problems in developed countries. For analysis of the role of the foreign flows and the foreign currency flows in Thailand and Indonesia during the Asian crisis, and the potential for such flows to become significantly disruptive again, see Borio et al. (2011). For discussion of the two-way links between capital flows and exchange rates, see Chai-Anant and Ho (2008). On Thailand’s experience, see Sangsubhan (2010), Thaicharoen and Ananchotikul (2008), and Bank of Thailand (2011).
- 17.
The Republic of Korea’s experience can be closely associated with the role of foreign banks in funding their balance sheets from foreign borrowing (in turn associated with the provision of forward export cover) (Ahn 2008; Cho 2009). There are also important lessons in the apparent limitations in the ability of intervention to stem the exchange rate fall (and, in contrast, the effectiveness of foreign central bank swaps in the case of the Republic of Korea).
- 18.
- 19.
With the exception of India and Viet Nam.
- 20.
Recall the 2008 Republic of Korea’s experience, when branches of foreign banks suddenly reversed their earlier capital inflows.
- 21.
Japan, with its high ratio of government debt to GDP, is seen as stable because most of this is held domestically.
- 22.
There are, however, cases where the opportunity of foreign diversification is clearly in the interests of the capital-receiving emerging economy. It has been a long-standing part of Singapore’s investment strategy to encourage both inflows of FDI and outflows of investment capital, to diversify what would otherwise be a narrow range of assets, excessively correlated with the performance of the domestic economy. It is worth noting that this diversification is initiated and managed by the recipient country.
- 23.
The issue of discipline may also be relevant at the micro level. When there is a direct relationship between borrower and lender, the foreign lender may provide effective and appropriate discipline on the domestic borrower (just as a domestic direct lender would). But much of foreign inflow occurs in an indirect way (with the foreigner holding a market instrument such as a bond) without direct connection between foreign lender and domestic borrower.
- 24.
Does this ability to get foreign funding easily inhibit the growth in the domestic financial market? It is often argued that this is the reason for the thin corporate bond market in Australia, and may explain the small size of the Indonesian financial sector. This view can be seen in the argument that the PRC is not yet able to provide the full range of intermediation, so sends its surplus funds to be invested in safe US assets (foreign exchange reserves), with the US sending part of this back in the form of risk-capital investments into the PRC.
- 25.
OECD (2011: p. 300) shows that emerging economies that have experienced large capital inflows are more likely to experience a banking crisis.
- 26.
“…international financial integration is fundamentally beneficial to emerging market countries, since it eases financing constraints for productive investment projects, fosters the diversification of investment risk, promotes inter-temporal trade, and contributes to the development of financial markets. Inflow surges, however, require an appropriate policy response because they can lead to economic overheating, excessive appreciation, or pressures in particular sectors of the economy (such as sectoral credit booms and asset price bubbles)” (Ostry et al. 2011: p. 7).
- 27.
“…before imposing capital controls, countries need first to exhaust their macroeconomic-cum-exchange-rate policy options. The macro policy response needs to have primacy both because of its importance in helping to abate the inflow surge, and because it ensures that countries act in a multilaterally-consistent manner and do not impose controls merely to avoid necessary external and macro-policy adjustment” (Ostry et al. 2011).
- 28.
The IMF is still confused in making the distinction between sterilized and unsterilized intervention. In practice intervention is always sterilized.
- 29.
The standard textbook IS/LM diagram, showing the relationship between the savings/investment balance and monetary liquidity, is misleading here. It implies that the tighter fiscal policy will reduce interest rates and thus discourage capital inflow. However modern monetary policy sets interest rates directly (for many, the Taylor Rule replaces the LM). Thus there is no reason to expect tighter fiscal policy to affect interest rates and hence discourage inflows.
- 30.
- 31.
Of course this is only one element of the response: bringing about the real transfer of resources and steering them into productive investment may be the hard part. A well-developed domestic bond market might help to provide the funding for expanded infrastructure investment, but such expansion requires progress on the physical expenditure, governance and utility pricing issues as well.
- 32.
While the methodology for estimating FEERs is still very approximate, the concept is now well-developed, with alternative methodologies set out in IMF (2006) Methodology for CGER Exchange Rate Assessments providing the detail. Filardo et al. (2011) have a detailed appendix table setting out the various approaches to FEER calculation taken in different countries.
- 33.
This policy approach can be distinguished from the Guidotti approach (endorsed by Greenspan 1999). In the Guidotti approach, foreign exchange reserves are big enough to cope with an outflow equal to debt falling due over the next year. In effect the reserves act as a liquidity pool that allows carry-trade investors to get out of the currency when they want to (McCauley 2010). The quasi-fiscal cost of reserve holding is a cost to the domestic economy, while the benefit of the interest differential goes to the foreign investor. In the alternative strategy suggested here, the foreign investors can reverse their transaction, but only at a lower exchange rate, which shifts much of the carry-trade benefit back to the receiving country in the form of profit on exchange-rate intervention.
- 34.
There are at least two reasons why this may not be the case at present. As a legacy of the times when emerging economies had trouble funding their current account deficits, foreign capital was often encouraged through preferential tax treatment: lower tax rates or even tax exemptions. For example, in 2005 Thailand rescinded its withholding tax on foreign flows to encourage inflows (and restored it in 2010 when the inflows were putting excessive upward pressure on the exchange rate). Secondly, double tax agreements routinely shift the benefit of tax receipts to the investor country, leaving the investor untaxed in the recipient country. If tax is paid in the investor’s country of residence, there may be no resource misdistribution. But it is clear that many investors use tax havens that probably avoid tax altogether (IMF 2011b).
- 35.
The aim here is to confine the tax to that part of flows which is responding most directly to the interest differential. Thus FDI would be excluded. For a related approach, see Korinek (2010). The differences between this sort of tax and an Unremunerated Reserve Requirement (URR) are subtle (IMF (2011c, Box p. 28), although the argument made here suggests that the tax should be applied to the entire foreign asset holding for the full period of the investment, rather than apply for a restricted period only. For a recent IMF assessment of the effectiveness of these controls, see Habermeier et al. (2011).
- 36.
This approach may not always fit with overall macro objectives. Countries like New Zealand have used the carry-trade-type flows to fund the persistent structural current account deficit.
- 37.
Even at the height of the global financial crisis, Australian banks (backed by the Australian government’s AAA rating) were still able to access funds in the New York money market. This difference between the high-gross-flow developed countries and the less deeply integrated emerging economies is analyzed in Becker and Noone (2008).
- 38.
It is possible to identify examples where this kind of stability may be beginning to occur. In Indonesia, for example, where foreigners own around 70 % of the equity capitalization, a fall in the exchange rate does not seem to trigger outflows (Bank Indonesia 2010).
- 39.
- 40.
An example would be the one-month holding period for Bank Indonesia Certificates (SBIs) in Indonesia as these are the favored investment instrument of carry-trade foreign investors.
- 41.
IMF (2011c), p. 36 provides assessments on Brazil, Thailand, Indonesia, and the Republic of Korea in the Appendix. Regressions aimed at identifying the effects of various controls are found in IMF (2011c). For a discussion of the rival merits of URRs and taxes, see Box in IMF (2011c) p. 28. Frankel’s (2011) views would find wide agreement: the controls should be on inflows rather than outflows: they should be modest price penalties rather than prohibitions; and they should steer the flows towards more stable categories. See also Magud et al. (2011).
- 42.
“All things considered, the stage seems set for the ongoing wave of inflows to be both large and persistent, bringing important investment and growth benefits to emerging markets” (IMF 2011c: p. 4).
- 43.
“Structural portfolio reallocation toward emerging market assets is also likely to support flows to Asia, as despite a threefold increase during 2004–2009, the weight of emerging Asia equities in the Morgan Stanley Capital International (MSCI) all country world index is still only half the share of emerging Asia in global production” IMF (2011d: p. 16). See also IMF (2007), Box 1.4.
- 44.
There is no strong cross-section evidence that capital flows promote growth (IMF 2011c), although many would accept that, properly handled, it does. Kose et al (2006) give a cautious endorsement that capital flows may help growth. See also Levine (2011) and the references cited therein and in Aizenman et al. (2011).
References
Ahn, B. C. (2008). Capital flows and effects on financial markets in Korea: Developments and policy responses (BIS Papers 44). Basel, Switzerland: Bank for International Settlements.
Aizenman, J., Jinjarak, Y., & Park, D. (2011). Capital flows and economic growth in the era of financial integration and crisis, 1990–2010. Vox–EU. http://www.voxeu.org/index.php?q=node/7172. Accessed 28 October 2011.
Bank Indonesia. (2010). Financial stability report. Jakarta: Bank Indonesia.
Bank of Thailand. (2011). Monetary policy in the post-crisis world: The perspective from Thailand (BIS Papers 57). Basel, Switzerland: Bank for International Settlements.
Becker, C., & Noone, C. (2008). Volatility and persistence of capital flows (BIS Papers 42). Basel, Switzerland: Bank for International Settlements.
Bhagwati, J. (1998). The capital myth: The difference between trade in widgets and dollars. Foreign Affairs, 77, 7–12.
Borio, C., & Disyatat, P. (2011). Global imbalances and the financial crisis: Link or no link? (BIS Working Papers 346). Basel, Switzerland: Bank for International Settlements. September 2011.
Borio, C., McCauley, R., & McGuire, P. (2011). Global credit and domestic credit booms. BIS Quarterly Review, 43–57. September 2011.
Caballero, R. J., Cowan, K., & Kearns, J. (2004). Fear of sudden stops: Lessons from Australia and Chile (Reserve Bank of Australia Research Discussion Paper 2004–03). Sydney, Australia: Reserve Bank of Australia.
Chai-Anant, C., & Ho, C. (2008). Understanding Asian equity flows, market returns and exchange rates (BIS Working Papers No 245). Basel, Switzerland: Bank for International Settlements.
Cho, D. C. (2009). The Republic of Korea's economy in the swirl of global crisis (ADBI Working Paper 147). Tokyo: Asian Development Bank Institute.
Filardo, A., & Grenville, S. (2011). Central bank balance sheets and foreign exchange rate regimes: Understanding the nexus in Asia (Bank for International Settlements Working Paper). Unpublished.
Filardo, A., Ma, G., & Mihaljek, D. (2011). Exchange rates and monetary policy frameworks in EMEs (BIS Working Papers 57). Basel, Switzerland: Bank for International Settlements.
Fischer, S. (2001). Exchange rate regimes: Is the bipolar view correct? Delivered at the meetings of the American Economic Association, New Orleans. January 6, 2001.
Frankel, J. (2011). Coping with Asia's large capital inflows in a multi-speed global economy. In: IMF–Bank Indonesia Joint Conference, Bali, Indonesia. March 11, 2011.
Goeltom, M. S. (2008). Capital flows in Indonesia: Challenges and policy responses (BIS Papers 44). Basel, Switzerland: Bank for International Settlements.
Greenspan, A. (1999). Currency reserves and debt. In: Remarks at the World Bank Conference on Recent Trends in Reserves Management, Washington, DC. April 29, 1999.
Habermeier, K., Kokenyne, A., & Baba, C. (2011). The effectiveness of capital controls and prudential policies in managing large inflows (IMF Staff Discussion Note 11/14). Washington, DC: International Monetary Fund.
Hendrasah, N. (2010). Challenges and policy options in managing portfolio flows: Bank Indonesia's recent experiences. Jakarta: Bank Indonesia.
Institute of International Finance (IIF). (2011). Capital flows to emerging countries (IIF Research Note). Washington, DC: Institute of International Finance.
International Monetary Fund (IMF). (2006). Methodology for CGER exchange rate assessments. Washington, DC: International Monetary Fund.
International Monetary Fund (IMF). (2007). Regional economic outlook Asia. Washington, DC: International Monetary Fund.
International Monetary Fund (IMF). (2010a). The Fund's role regarding cross-border capital flows. Washington, DC: International Monetary Fund.
International Monetary Fund (IMF). (2010b). Regional economic outlook Asia. Washington, DC: International Monetary Fund.
International Monetary Fund (IMF). (2010c). Regional economic outlook. Washington, DC: International Monetary Fund.
International Monetary Fund (IMF). (2011a). Balance of payment statistics. CD-ROM. Washington, DC: International Monetary Fund. http://elibrary-data.imf.org/.
International Monetary Fund (IMF). (2011b). Global financial stability report. Washington, DC: International Monetary Fund.
International Monetary Fund (IMF). (2011c). Recent experiences in managing capital inflows—Cross-cutting themes and possible policy framework. Washington, DC: International Monetary Fund.
International Monetary Fund (IMF). (2011d). Regional economic outlook Asia and Pacific. Washington, DC: International Monetary Fund.
International Monetary Fund (IMF). (2011e). World economic outlook. Washington, DC: International Monetary Fund. http://www.imf.org/external/pubs/ft/weo/2011/02/weodata/index.aspx.
International Monetary Fund (IMF). Independent Evaluation Office. (2005). Report on the evaluation of the IMF's approach to capital account liberalization. Washington, DC: International Monetary Fund.
Kawai, M., & Lamberte, M. B. (2010). Managing capital flows: Emerging Asia's experiences, policy issues, and challenges. In M. Kawai & M. B. Lamberte (Eds.), Managing capital flows: The search for a framework (pp. 9–45). Cheltenham, UK: ADBI and Edward Elgar.
Kawai, M., & Takagi, S. (2010). A survey of the literature on managing capital inflows. In M. Kawai & M. B. Lamberte (Eds.), Managing capital flows: The search for a framework (pp. 46–72). Cheltenham, UK: ADBI and Edward Elgar.
Korinek, A. (2010). Regulating capital flows to emerging markets: Design and implementation issues. Vox–EU. http://www.voxeu.org/index.php?q=node/5953. Accessed 22 December 2010.
Kose, M. A., Prasad, E. S., Rogoff, K., & Wei, S-J. (2006). Financial globalization: A reappraisal (IMF Working Papers 06/189). Washington, DC: International Monetary Fund.
Kose, M. A., Prasad, E. S., & Terrones, M. E. (2007). How does financial globalization affect risk sharing? Patterns and channels (IMF Working Paper WP/07/238). Washington, DC: International Monetary Fund.
Levine, R. (2011). Finance, long-run growth, and economic opportunity. Vox–EU. http://www.voxeu.org/index.php?q=node/7123. Accessed 25 October 2011.
Magud, N. E., Reinhart, C. M., & Rogoff, K. S. (2011). Capital controls: Myth and reality—A portfolio balance approach (Peterson Institute for International Economics Working Paper 11-7). Washington, DC: PIIE.
McCauley, R. N. (2010). Managing recent hot money inflows in Asia. In M. Kawai & M. Lamberte (Eds.), Managing capital flows: The search for a framework (pp. 129–159). Cheltenham, UK: ADBI and Edward Elgar Publishing.
Mihaljek, D., & Subelyte, A. (2011). Alternative central bank policy instruments (BIS Papers 57). Basel, Switzerland: Bank for International Settlements.
Organisation for Economic Co-operation and Development (OECD). (2011). Getting the most out of capital flows. In OECD economic outlook issue 1 (pp. 287–308). Paris: OECD.
Ostry, J. D., Ghosh, A. R., Habermeier, K., Chamon, M., Qureshi, M. S., & Reinhardt, D. B. S. (2010). Capital inflows: The role of controls (IMF Staff Position Note SPN/10/04). Washington, DC: International Monetary Fund.
Ostry, J. D., Ghosh, A. R., Habermeier, K., Laeven, L., Chamon, M., Qureshi, M. S., et al. (2011). Managing capital inflows: What tools to use? (IMF Staff Discussion Paper SDN/11/06). Washington, DC: International Monetary Fund.
Richards, T. (2005). Big fish in small ponds: The trading behavior and price impact of foreign investors in Asian emerging equity markets. Journal of Financial and Quantitative Analysis, 40, 1–27.
Sangsubhan, K. (2010). Managing capital flows: The case of Thailand. In M. Kawai & M. Lamberte (Eds.), Managing capital flows: The search for a framework (pp. 386–410). Cheltenham, UK: ADBI and Edward Elgar Publishing.
Thaicharoen, Y., & Ananchotikul, N. (2008). Thailand’s experiences with rising capital flows: Recent challenges and policy responses (BIS Papers 44). Basel, Switzerland: BIS.
Williamson, J. (2005). Curbing the boom-bust cycle: Stabilizing capital flows to emerging markets. Washington, DC: Peterson Institute for International Economics.
Williamson, J. (2008). Exchange rate economics (Peterson Institute for International Economics Working Paper 08/03). Washington, DC: Peterson Institute for International Economics.
Author information
Authors and Affiliations
Corresponding author
Editor information
Editors and Affiliations
Rights and permissions
Copyright information
© 2014 Asian Development Bank Institute
About this chapter
Cite this chapter
Grenville, S. (2014). Rethinking Capital Flows for Emerging East Asia. In: Kawai, M., Lamberte, M., Morgan, P. (eds) Reform of the International Monetary System. Springer, Tokyo. https://doi.org/10.1007/978-4-431-55034-1_3
Download citation
DOI: https://doi.org/10.1007/978-4-431-55034-1_3
Published:
Publisher Name: Springer, Tokyo
Print ISBN: 978-4-431-55033-4
Online ISBN: 978-4-431-55034-1
eBook Packages: Business and EconomicsEconomics and Finance (R0)