Capital Flows in Asia Takatoshi Ito

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Capital Flows in AsiaTakatoshi Ito

• Present by
• Piyanart Silapachote
• Kim Young Hee
• 1 October 2001

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Importance of capital inflows for Asian countries

• Finance current account deficit
• allowed Asian countries to have current
  account deficit without running down their
  foreign reserves
• Help drive stock market bubbles and real estate
  booms

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Reasons for sharp rise in capital flows to Asia
1990 1996

• Declining trend of the interest rates in
  advanced countries caused investors to search for
  high yield in Asia
• Asian countries liberalized the restrictions on
  inward investment

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Net Private Capital Flows to Asia 1990-1997 by
categories Billions
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FDI flows to selected Asian countries millions
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Source countries of FDI to Asia in 1995
millions
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Reasons for FDI from Japan

• optimistic expectations
• yen appreciation
• low interest rate in Japan

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Effects of Yen appreciation

• Asian goods became more price competitive against
  Japanese goods
• Japanese manufacturing companies shifted their
  production to Asia
• There was a study confirming that FDI came with
  technological spillovers

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Growth rate of the Asian Economy

• Is a function of
• level of foreign direct investment ?
• change in the yen/dollar exchange rate
• (a measure of yen appreciation)
• Japans growth rate
  ?
• the US growth rate
  ?

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Another study confirmed that Yen appreciation
led to more capital flows in form of Japanese
direct investment FDI f Yen/,
average growth rate flow from Japan to Asia
-          Negative coefficient of the
(YEN/)implies that FDI from Japan to Asian
economies tends to increase as the Yen
appreciates -          Positive Coefficient of
the growth rate implies that an increase in
growth rates of Asian economies tends to increase
FDI from Japan to Asian countries.
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• appreciation of Yen
• led to more capital flows in form of
  Japanese direct investment (long-term
  investment)
• low interest rate in both Japan and other
  industrial countries
• led to more portfolios flow to Asian countries
• (short-term investment)

These are the factors supporting the period
called The East Asian Miracle
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2 Scenarios of Capital inflows

• Virtuous Cycles
• large capital inflows
• (Yen Appreciation and the low interest rate
  invited more inflows)
• increased investment
• higher economic growth
• attracted more inflows
• higher economic growth

• Vicious Cycles
• virtuous cycle was interrupted in 96-97 (Exports
  declined sharply due to Yen Depreciation )
• Asian competitiveness and
• economic growth rate declined
• Pessimistic expectation was made and
  Speculative attack occurred
• Thai currency was destabilized
• Capital outflows
• Lower investment and economic Growth
• More capital outflows

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• The conclusion that we can draw from these 2
  Scenarios is impossible trinity
• free capital mobility
• fixed exchange rate
• independent monetary policy

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Bank Lending

• One kind of short-term capital inflows
• 2 evidences in Asia
• Japanese and European Banks were the largest
  sources of bank lending
• Asian countries rely on bank lending for their
  economic developments

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• Bank lending is a good indicator in predicting
  Asian currency crisis
• the case of Thailand
• total bank liabilities is the highest
• Starting point of the crisis

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Thailand

• Deficits 8 of GDP(In 1996)
• Export growth rate Plummeted 20 per annum to
  virtually zero
• A decline in economic growth rate 9 to 7
• The dollar appreciation (yen depreciation)is bad
  for the Asian exports and growth

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• Thailand experienced a bubble economy from 1993
  to 1995
• The economy was overheated and stock prices
  soared in 1993 as capital flows increased. (
  especially in the form of portfolio flows)
• After the asset bubble burst, banks in Thailand
  had non-performing loans problems

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• Finance companies borrowed from domestic and
  foreign banks to finance their property loans.
• The weakness in financial system, along with
  large current account deficits ? invited attacks
  on the baht
• Some investors sold the baht in the spot market,
  and other in the futures(or swap) market.

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• The central bank intervened to defend the dollar
  peg regime, which was in place since 1984.
• The net result for the central bank position was
  to lose the foreign reserves in forward position.
• In Thai case, off-balance was not disclosed to
  the market and finally brought down the fixed
  exchange rate peg.

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• The Bank of Thailand was carrying large forward
  positions, and commercial banks had large
  short-term liabilities which may not be rolled
  over in the following months.
• Two kinds of the problems an IMF program for
  Thailand.
• 1) The amount of a support package would have
  to become large, and the limit in stand-by loans
  may not be enough
• 2) It was not clear what kind of
  conditionality should be placed.

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• Thailand experienced one of the problems what was
  the fragile financial system, in particular, huge
  non-performing loans problems.
• The loss of foreign reserves was a major concern
  in Thailand.
• The termination of foreign bank lending was also
  a cause and effect of depreciation.
• Capital flows out of Thailand were accute, and
  they took place mostly in terms of bank lending
  withdrawal.

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• Indonesia
• Indonesia was thought to be doing well on the
  macroeconomics management.
• The exchange rate had flexibility, and
  intervention was restrained to conserve foreign
  reserves.
• The fundamentals were better than neighboring
  countires.

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• The evidences of asking IMF assistance
• 1. Need to build up foreign reserves
• 2. Inefficient big national projects and non-
• transparent Presidents family businesses
• IMF Program
• 1. Close down 16 banks with questionable
• assets
• 2. Not stop depreciation of the rupiah

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• A real currency crisis came after the IMF
  program was signed
• 1. A rumor of the President Suharto having
• poor health ? push down the rupiah
• (His cancellation of appearance in an
  international conference)
• 2. After a closed bank was replaced by a
• new bank run by the same person at the
• same site

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• The rupiahs movement was much more influenced by
  political news.
• In the process of rupiah depreciation, foreign
  investors role was not as heavy as capital
  flight.

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Korea

• Korea was initially thought to be remote from a
  crisis.
• The exchange controls were reasonably stringent,
  so that it would be difficult to speculate
  against the won.
• Foreign banks decided to withdraw funds, by not
  rolling over their lending
• Korean central bank lent foreign reserves to
  commercial banks

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• Korean central bank lent foreign reserves, as
  foreign-currency deposit, to commercial banks
• Commercial banks could not raise funds without
  paying prohibitively high risk premium( Korean
  premium)
• Decided to ask for an IMF assistance the end of
  Nov.1997

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• One of most critical elements in the Korean
  crisis How much would foreign banks roll over
  their lending to Korean bank?
• It was estimated that short-term liabilities
  would be close to 100 billion.
• Pressure on the won did not stop at IMF program
  of Dec. 4

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• Acuute problems in liquidity developed
  surrounding Korean banks.
• The short-term bank liability to foreign reserve
  ratio was highest in Korea

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Main reason for the capital inflow

• 1. Moral hazard
• - Implicit guarantee of deposits and financial
  institutions by emerging market invite too much
  capital flows
• - Investor investment are protected by the
  government guarantee.

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• - Borrower Tend to go for a high-risk,
  high-return project.
• - Explicit and implicit guarantees caused the
  moral hazard among investor and borrowers.

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• Solution of moral hazard
• - Borrower prudential regulation to avoid
  building the dangerous positions.
• - Lender burden sharing.
• - The involved parties to take losses from easy
  lending and borrowing.

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• 2. Bank run
• - Asian currency crises were caused by sudden
  shift in investors behavior
• - Those countries that relied on short-term
  capital inflows were caught in the liquidity
  crisis when investors refused to roll over
  lending.
• - In Thailand and Korea, domestic banks could
  not obtain enough dollars to repay short-term
  borrowings when roll-overs were refused.

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• - Banks were not insolvent, by any standard.
• ? liquidity problem, or problem of bank run.
• - Bank run investors behavior to withdrawal
  funds from the country may not have to be
  irrational.
• - The situation in Korea in Nov. and Dec 1997
  fits the bank run model best.

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• Solution To make IMF the international lender
  of last resort(lenders not to refuse roll over)
• Funding would have to be increased and
  conditionality would have to be relaxed.

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• 3. Herd Behavior
• - Developed in the finance literature
• - Investors behave in a herd
• (Profit maximizing)
• - The self-fulfilling prophecy works
• - This problem can be dealt with by capital
  controls, or a stand-still agreement imposed by
  IMF

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• 4. Irrational exuberance and a bubble
• - Excessive capital inflows can be characterized
  by irrational exuberance
• - Soon or later results in an eventual crash
• - Excessive capital inflows ? the stock prices
  and real estate prices increased ?high economy
  growth

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• 5. Early Warning Signal
• - An upturn in international interest rates
• - A mismatch between the governments banking
  systems short-term liabilities and its liquid
  assets
• - A large current account deficits
• - An overvalued exchange rate

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• - Weak banking system and large fiscal deficits
• - A boom in bank lending followed by a fall in
  asset prices.
• - High susceptibility to contagion due to
  similarities to a financial crisis elsewhere.
• Contagion effect A probability of a crisis
  increases if a neighboring country experiences a
  crisis.

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Conclusion

• - Each crisis has its own idiosyncratic factors
• - Thailand A classic attack on the reserve for
  a country with large current account deficits
• - Korea An international bank run
• - Indonesia Related with investigating
  political and social shocks
• - The differences reflect underlying bank and
  corporate liability structures

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• Common features of crisis
• 1. External shocks
• 2. The yen/dollar exchange rate movement
• 3. Weak banking system
• 4. Short-term borrowings
• 5. Suddenly changes investors mind about the
  prospects of other countries
•