In 2003, about two-thirds of all private capital flows to emerging markets went to Asia—about $100 billion in net terms. China attracted the bulk of flows to the region, mostly in the form of foreign direct investment (FDI). India was another major recipient, though in its case portfolio investment flows predominated. Indonesia, Korea, Malaysia, and Thailand also experienced a sharp increase in portfolio investment.
Why is Asia so attractive? Improving macroeconomic fundamentals in much of the region created a powerful magnet for foreign savings. Expectations of currency appreciation were another important pull factor, especially in China and India. Furthermore, low interest rates in the major industrial countries, easing geopolitical tensions, and a gradual strengthening of the global recovery spurred a quest for higher returns among investors, who ventured into riskier assets in emerging markets. The exceptions were Indonesia and the Philippines, where somewhat weaker macroeconomic conditions and heightened uncertainties muted private capital inflows.
Déjà vu all over again?
Yet some observers took the seemingly good news with a grain of salt, highlighting similarities between the recent capital inflow episode and the run-up to the Asian crisis, and voicing concerns that regional vulnerabilities might re-emerge. Why such nervousness? The underlying concern is that while capital inflows can benefit recipient economies by supplementing domestic savings, they can also lead to a real exchange rate appreciation, weakened external positions, and—ultimately—a capital flow reversal and an exchange rate crisis.
A closer inspection of the earlier capital inflow episode, however, puts these concerns in perspective.
In the early 1990s, private capital flows to all emerging markets expanded rapidly following the resolution of the international debt crisis. As in the recent episode, Asia was a major beneficiary of the pickup in capital flows, attracting some 40 percent of the $1 trillion global surge through 1996. Capital inflows were driven by low interest rates in advanced economies, relatively fixed exchange rates in the host countries, and structural changes in international financial markets—notably, liberalization of capital account transactions as well as financial innovations that underpinned greater capital mobility. The inflows eventually proved destabilizing, primarily because they exacerbated balance sheet weaknesses in the corporate and financial sectors through mismatches in the currency and maturity structure of debt. They also fueled inflationary pressures that had been gathering strength on the heels of a prolonged expansion.
Faced with a surge of capital inflows, policymakers have a variety of tools at their disposal, notably countercyclical macroeconomic measures (such as nominal exchange rate appreciation and fiscal tightening), administrative steps limiting capital inflows and/or encouraging outflows, and ad hoc prudential policies. Although most Asian countries adopted these measures to some degree, they were not adequate to deal with the tensions between internal and external balance that surging inflows had brought about by the mid-1990s. When capital flows reversed sharply in 1997 (in a rush-for-the-door as Thailand’s banking crisis ballooned into a regionwide collapse of confidence), the consequences were devastating for the regional economy.
A tale of two capital inflow episodes
At first glance, the recent surge of capital flows shares similarities with the run-up to the Asian crisis. In both cases, the inflows were very large, found their roots in similar global conditions, and elicited broadly similar policy responses. On closer examination, however, there are significant differences.
First, most economies in the region (with the possible exception of China) were not on the verge of overheating when capital inflows revived, as was the case in the mid-1990s. Economic growth in the region, while healthy, has been primarily export-led, and domestic demand pressures have been moderate. Also, local asset price bubbles (in equity or housing markets) have generally been absent.
One-sided intervention has produced a dramatic increase in the official reserves of Asian emerging economies.
Second, the scale of capital inflows this time around has been significantly smaller in relation to GDP. On average, capital inflows represented about 4 percent of GDP in 2003, whereas in 1996, the share was nearer to 10 percent (see top chart). The composition was also more favorable, with a lot less shortterm external borrowing and significantly more FDI and portfolio equity investment in 2003.
Finally, resilience to a reversal in capital flows has been strengthened. External vulnerability (as measured by external debt-to-GDP ratios and reserve cover in terms of short-term liabilities) is now much lower throughout the region. Current accounts are in surplus in most countries, implying that despite the sizable inflows, the region is still a net capital exporter. And exchange rate systems in the majority of emerging Asia’s economies are—de jure and de facto—some-what more flexible, thus providing a natural buffer for adjusting to any external pressures that might emerge. With regard to domestic vulnerabilities arising from high leverage ratios in the corporate sector and weak balance sheets in banks, most economies in emerging Asia are also in much stronger positions than before.
A familiar trade-off
Despite these differences, however, the recent capital inflows episode presented policymakers with the same challenges that they faced during the previous episode. And policy responses were not unlike those in the runup to the Asian crisis. Burgeoning capital inflows exerted pressure on regional currencies to appreciate. And central banks, seeking to avoid a loss of competitiveness that could undermine economic performance, chose to intervene in foreign exchange markets by purchasing foreign currencies. This one-sided intervention has produced a dramatic increase in the official reserves of Asian emerging economies. Indeed, reserves rose (see bottom chart) by some $450 billion between the beginning of 2003 and mid-2004.
And intervention, in turn, created its own problems. To limit the inflationary impact of an expanding domestic money supply, monetary authorities have drained liquidity through the issuance of central bank paper or the sale of government securities. Allowing pressure for an eventual exchange rate appreciation to build, however, this policy may have validated investor perceptions of a one-way currency bet, further encouraging capital inflows. Administrative measures to facilitate outflows may similarly have added to the attractiveness of investing in the region. This vicious circle shows the difficulties involved in trying to use monetary policy to simultaneously address both domestic (inflation) and external (exchange rate) policy objectives.
Capital inflows in 2003 were smaller
Data: IMF and national authorities
As it happened, the recent capital inflow episode fizzled out before the tension between achieving domestic and external policy objectives became unsustainable. A reversal (and in some cases, a slowdown) in portfolio and other investment flows was sparked by several factors, including an upward adjustment in U.S. interest rate expectations and rising concerns about a “hard landing” in China.
However, as expectations of a rapid rise in U.S. interest rates have moderated, global investment funds are once again casting an eye on Asia’s emerging markets, and some countries are already experiencing a revival in capital inflows.
Intervention led to soaring reserves
1China, Hong Kong SAR, India, Indonesia, Korea, Malaysia, Philippines, Singapore, Taiwan Province of China, and Thailand.
2Excludes the effects of the end–2003 recapitalization of two large commercial banks in China with foreign reserves of the People’s Bank of China ($45 billion).
Data: IMF, CEIC, and national authorities
As expectations of a rapid rise in U.S. interest rates have moderated, global investment funds are once again casting an eye on Asia’s emerging markets.
Should capital inflows to emerging Asia pick up in earnest again, policymakers in the region are likely to face a greater challenge than before in meeting internal and external objectives simultaneously. Headline inflation has been rising across the region and is now averaging about 4 percent a year, some 2 percentage points higher than a year ago. Although supply-side shocks related to high oil and commodity prices mean that core inflation remains low in most countries, in some of them inflation expectations are ratcheting up, raising the fear of more entrenched cost pressures. Against this backdrop, any foreign exchange market intervention by the central bank would need to be heavily sterilized, lest the nascent price spiral gain momentum. The scope for further sterilized intervention may be reaching its limits, however, because of a shrinking availability of official securities or because of the prospect of rising domestic interest rates (where official securities are imperfect substitutes for the domestic assets that foreign investors want).
A move toward flexible exchange rate systems will be needed across the region to mitigate the inflationary impact of renewed capital inflows.
This suggests that a move toward more flexible exchange rate systems will be needed across the region to mitigate the inflationary impact of renewed capital inflows. More flexible exchange rate systems would be beneficial from both a domestic and a global perspective. It would allow monetary policy to be better geared toward domestic stabilization, reduce susceptibility to external shocks, and contribute to resolving the global current account imbalances that continue to threaten the world’s economic recovery.
This article is based on a paper prepared by Charles Adams, Andrea Richter Hume, Romuald Semblat, and Alessandro Zanello for a high-level seminar on capital flows co-sponsored by the Bank of Thailand and the IMF. Copies of the paper are available on request from the authors.