I Introduction

Carmen Reinhart, and Mohsin Khan
Published Date:
October 1995
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The developing economies of the Asia-Pacific Economic Cooperation Council (APEC) have been the recipients of a considerable volume of capital inflows in the 1990s.1 For example, in 1993 capital inflows to the APEC countries accounted for about 85 percent of the capital that went to developing economies. In some cases, such as Malaysia and Thailand, the inflows have on occasion amounted to as much as 15 percent of GDP. Not surprisingly, there has emerged among policy circles in these countries a considerable interest in understanding the causes, patterns, and nature of these international capital flows, as well as the effect that this surge would have on economic activity, relative prices, the banking system, and the stock market.

The issue of whether the inflows were primarily driven by sound domestic policies and market-oriented reforms—the “pull” factors—or declining international interest rates and poor returns in stock markets in industrial countries—the “push” factors—became a focal point of the policy discussions. If external conditions played a key role in inducing the inflows, it has been argued, then there is cause for greater caution, as a change in the international environment could prompt a reversal of the flows. On the other hand, if these inflows were responding primarily to conditions in the recipient countries, there is less reason to be concerned about swift reversals. Policies would thus need to be set according to which factors appeared dominant.

These sizable inflows were also having important macroeconomic effects; they were helping finance higher investment and growth, but there was also a tendency for the nominal and real exchange rate to appreciate and the current account to worsen. Given the increased integration of capital markets, it is not surprising to find that for many developing APEC economies monetary control became more difficult, particularly as the inflows persisted and an increasing share of inflows came in the form of short-term capital. Concerns also emerged that the banking system was not always adequately intermediating the inflows and that the stock market may have become more volatile as the role of foreign investors increased. Hence, formulating an appropriate policy response to these developments has naturally been an important issue during the early 1990s for the countries concerned and for the international community at large. The three papers that make up this Occasional Paper each examine different aspects of these issues.

Section II, “Portfolio Capital Flows to the Developing Country Members of APEC,” focuses on the pattern of capital flows to the APEC developing countries in recent years, analyzing the trends and describing the composition of the flows. The emphasis is on portfolio flows, which account for an increasingly important share of capital movements to these countries. Indeed, international issuance of bonds and equities by emerging market economies, most of which are APEC countries, reached unprecedented proportions in 1991–93. Hence, Section II examines the characteristics of international transactions in bonds and equities. With regard to the sources of the inflows, it provides a brief analysis of the investor base as well as presenting some indications of the destination of these capital flows at both the macroeconomic and microeconomic level.

The possible causes and macroeconomic effects of the surge in inflows are examined in Section III, “Macroeconomic Management in APEC Economies: The Response to Capital Inflows.” This section reviews the recent debate as to whether the inflows are primarily driven by sound domestic policies and an attractive investment climate or by external factors, such as interest rate developments in the United States. The issue remains particularly timely, given the increase in interest rates in the United States in 1994 and the current expectation that further increases are likely to follow. Section III analyzes the impact of the inflows on international reserves, the current account, the real exchange rate, and investment and growth. Where relevant, the experience of the APEC countries is compared to other developing countries that have also experienced a surge in capital inflows. The section concludes with a discussion of the relative merits of a variety of monetary, exchange rate, fiscal, and structural policies, such as capital account liberalization, that have often been implemented in these countries in response to the surge in inflows.

Section IV, “Effect of Capital Rows on the Domestic Financial Sectors in APEC Developing Countries,” analyzes the effect that sizable and often volatile capital inflows have on the domestic financial sectors in APEC developing countries. On the banking side, the emphasis is on assessing the ability of the banking systems in the recipient countries to intermediate the inflows adequately by satisfactorily assessing, pricing, and managing risk. Since sterilized intervention has been the policy most often implemented in the capital-importing countries, the section describes the various forms this policy has taken and analyzes how sterilized intervention affects the banking system and the financial sector at large. The adequacy of the regulatory and supervisory framework is examined in light of its intended role in containing systemic risk, particularly in the event of a reversal in capital flows. Furthermore, since much of the inflows have been funneled through the stock market, often leading to booms in these emerging markets, this section also investigates whether the surge in inflows has increased the volatility of stock prices in the emerging markets in the APEC region. The issues of whether the increased international capital flows have given rise to increased pricing inefficiencies and/or have led to increased “spillover” effects from the equity markets in industrial countries are also addressed.


The developing economies of APEC include the following: Brunei, China, Hong Kong, Indonesia, Korea, Malaysia, Mexico, Papua New Guinea, the Philippines, Singapore, Taiwan Province of China, and Thailand. The APEC industrial countries include Australia, Canada, Japan, New Zealand, and the United States. Chile became a member in 1994.

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