Conclusion

In summary, Singapore's experience with capital flows after the crisis appears to have been somewhat benign. Clearly, it is the overall package of policies—including strong economic fundamentals and a robust financial system, prudent policy management on both the fiscal and monetary side, and credible exchange rate policy aligned with underlying fundamentals—that serves to increase Singapore's resilience towards disruptive swings in capital flows. In addition, the government also relies on direct credit controls when appropriate, such as in curbing surging residential property prices due to availability of easy credit. In view of the destabilizing effects of sudden shifts in capital flows, particular emphasis has been placed on having the latitude to react promptly and on a sufficiently large scale to economic and financial developments.

Pronounced shifts in capital flows, regardless of whether they are triggered by misguided policies or contagion, are often associated with the loss of foreign investor confidence in the prospects for the domestic economy. Ocampo (2003) found that the variations in capital flows can be attributed primarily to shifts in risk evaluation. We have highlighted the need for disciplined macroeconomic and financial policies as well as the crucial role of strong mature institutions, strong human resource capacity, and strong governance in order to bolster the confidence of investors and other market participants. In this regard, it is important for the regional economies to continue the process of building a sound and efficient domestic financial system, and installing an effective system of prudential supervision.

Domestic financial development is often achieved through prudent external financial liberalization, which tends to catalyze both financial deepening and broadening. Chow and Kris (2007) pointed out that the extent of domestic financial development and the scope of capital account liberalization need to be managed holistically, as interactions between them present both opportunities for growth as well as potential risks.¹³ On the one hand, sufficiently developed domestic financial sectors are necessary to absorb and allocate capital inflows to their most efficient uses. On the other, domestic financial markets cannot fully realize their potential without exposure to international capital markets. For instance, partial international liberalization exerts pressure to overcome entrenched interest and policy inertia to reforms that are necessary to establish core institutional infrastructure. Further, the opening of the domestic sector to foreign financial institutions often leads to capacity building and increases the pressure to strengthen supervisory and regulatory frameworks.

Smooth responses to fluctuating capital flows not only require accelerated institutional reforms in individual countries but also an upgraded regional financial infrastructure. Although it is the domestic authorities and institutions that are ultimately responsibility for a country's financial development and stability, regional cooperation of policy measures can play a supportive role during the liberalization process. For instance, regional financial cooperation efforts such as the Chiang Mai Initiative, regional reserve pooling initiatives, and regional financial surveillance help to build the resilience of the region to financial shocks. Given that some countries in Asia are too small to have liquid domestic capital markets, the region could also proactively integrate the financial markets in order to benefit from economies of scale and liquidity agglomeration effects.

Is it possible for a country whose financial system is not yet well-developed to reap the potential advantages of capital movements without the costs of crises? Closing the capital account, at one extreme, would mean foregoing the potential benefits that capital mobility could bring. At the other extreme, complete capital account convertibility inevitably results in instability. A way forward is for such a country to strike a middle ground, by imposing selective restrictions to alter the composition capital inflows. The capital controls (provided they can be effectively enforced), should be targeted at curbing excessive inflows of short term loans that are prone to reversal. However, this may deter some investors from investing all in the country, resulting in a reduction in the other more beneficial forms of capital inflows. As pointed out by Williamson (2005), this calls for a judicious balance between the volume and stability of capital flows.

Appendix. Singapore Balance of Payments (in S$ millions) [ PDF 69.1KB | 3 pages ]

Download this Discussion Paper [ PDF 212.8KB| 31 pages ].

Comment(s)

There are [0] comment(s) for this entry. Post a comment.