Capital Flows in Emerging Asia

Patterns of Capital Inflows

Capital inflows into emerging economies have been facilitated by liberalization of the capital account. Although most emerging Asian economies have maintained various types of controls on cross-border capital flows as reported in the International Monetary Fund's Annual Report on Exchange Arrangements and Exchange Restrictions, 2007, their capital accounts are much more open than they appear to be, as suggested by the high and generally rising ratios of total stocks of foreign assets and liabilities to gross domestic product (GDP). Capital inflows have also been facilitated by “push” and “pull” factors. The push factors have included low interest rates globally, slow growth and the lack of investment opportunities, and deregulation that has allowed greater global risk diversification in industrial countries. The pull factors have included the robust economic performance and the improved investment climate in emerging Asian economies, which are the results of a series of trade, financial-sector, and legal reforms and other economic liberalization measures.

Turning to the composition of capital inflows, foreign direct investment (FDI) began to take the dominant role in total capital flows in the middle of the 1990s. By the late 1990s, FDI accounted for more than half of all private capital flows to emerging Asian economies as portfolio investment shrank. The total FDI inflows in emerging Asian economies amounted to US$147 billion in 2006, of which more than half went to the PRC. FDI is expected to remain an important source of capital inflows in the region.

Portfolio equity inflows have increased in the region since the Asian financial crisis. Most Asian economies have reduced barriers to investment on equity markets to recapitalize ailing banks and non-financial corporations. As a result, equity financing rapidly increased in 1999, but its momentum was reversed in 2000 due to the bursting of the IT bubble and the subsequent recession in the US. Portfolio equity inflows resurged in recent years in the region from US$4.8 billion in 2002 to US$60 billion in 2006. The recent increases in equity inflows were dominated by the PRC (US$43 billion) and India (US$10 billion). Moreover, equity inflows have shown volatile movements in the last several quarters as the US subprime loan crisis deepened.

Unlike equity, portfolio debt financing is a relatively small component of capital inflows in emerging Asia. Underdevelopment of the local currency bond market was pointed out as one of the main reasons behind the Asian crisis. Several policy initiatives have been undertaken to promote local-currency denominated bond markets, and the size of regional bond markets has been expanding. In recent years, debt-financing inflows are increasing, especially in the Republic of Korea (hereafter Korea).

Bank financing in Asia has shown the most volatile pattern, plummeting first in the early 1990s and again in the middle of the Asian financial crisis in 1997–98. Since then, bank lending has accounted for a negligible proportion of capital inflows in Asia. However, bank loans are picking up in recent years for the PRC, Korea, Singapore, and, to a lesser extent, India.

Total capital outflows from emerging Asia have also increased, reaching US$328 billion in 2006. Capital flows in the region have therefore become increasingly two-way in recent years. The PRC had the largest amount of capital outflows in 2006; its US$160 billion accounted for more than half of the total outflows in these economies that year, followed by Singapore and Korea. Countries with large capital outflows appear to be seeking risk diversification in their wealth holding.

As the amount of total capital outflows has increased since the Asian financial crisis, the composition of capital outflows has also changed. Portfolio equity outflows increased dramatically in 2006. Singapore had been a dominant equity investor abroad, but that year Korea surpassed Singapore's equity investment abroad. Portfolio debt outflows also increased in 2006. The PRC's debt outflows reached US$110 billion in 2006, which was 80 percent of emerging Asian economies' total portfolio debt outflows for the year.

Even though more than half of net capital inflows to the world's emerging market economies went to transition economies of eastern and central Europe, emerging Asia's share has increased recently while flows to Latin America have remained weak. It is noteworthy that although the volatility of net flows varies greatly across countries in the region, it is generally high (Burton, 2008).

Impact of Capital Flows

The combination of persistent current account surpluses, rising capital inflows, and accumulation of foreign exchange reserves in Asia with persistent US deficits has exerted upward pressure on the exchange rates in emerging Asian economies. More specifically, the real effective exchange rates in the nine emerging Asian economies have tended to appreciate since the early 2000s regardless of their exchange rate regimes.

Accumulation of massive foreign exchange reserves is one of the most significant changes in the region's landscape since the Asian financial crisis. The reserve accumulation has been the result of intervention in the currency market to stabilize exchange rates vis-à-vis the US dollar with varying degrees. Much of this has been sterilized. Sterilized interventions adopted by emerging Asian economies include the sale of government securities and/or central bank debt instruments to absorb liquidity. In Korea and India, the national governments issued securities and deposited the proceeds with their central banks to mop up excess liquidity brought about by the central banks' currency market interventions. This has made the operation of sterilization in these countries more transparent to the general public with appropriate checks and balances between the ministries of finance and the central banks.

Equity prices in most Asian economies have increased markedly since late 2003. Indonesia's equity market started to boom in 2003. The PRC and India had shown strong price hikes in equity markets for three years until recently. However, there have been significant reversals in stock price booms over the past quarters following the US and global credit market turmoil. A future surge in capital inflows to emerging Asia could once again lead to stock price booms and even create another bubbly sentiment in the market.

In contrast to equity prices, until recently goods and services price inflation had stayed at lower levels, albeit inflation rates in Indonesia, Philippines, and Viet Nam were generally higher than those of other countries. However, the risks of higher inflation have increased over the last several quarters as a result not only of the monetary impact of rising foreign exchange reserves, but more importantly of increases in the prices of oil, food, and other commodities in the global markets.

Challenges

The deepening of the subprime crisis has reduced the volume of capital inflows, particularly the volatile portfolio capital, into emerging Asia in recent months. In August and November 2007 alone, foreign investors liquidated over US$12 billion in six Asian markets (McCauley, 2008).³ Partly as a consequence of this, equity prices in the region have dropped significantly. Nonetheless, many of these economies indicate signs of robust economic growth, with economic overheating still a concern in some of them—including the PRC. The Korean won and Indonesian rupiah have started to depreciate, while other Asian currencies remain strong against the US dollar. At the same time, inflationary pressure from rising oil and food prices has continued to build up. These have added to the challenges in managing capital flows.

Following the restoration of US financial stability and the easing of the ongoing credit crunch, capital inflows to emerging Asia will likely resume in a big way given the robustness of the region's economy relative to the US economy. This will pose serious policy challenges for macroeconomic management, exchange rate policy, and financial sector supervision. Allowing one's currency to appreciate in response to significant capital inflows is desirable for better macroeconomic and financialsector outcomes—from the perspective of containing domestic inflationary pressure and incipient asset price bubbles and reducing financial sector vulnerability—as it can prevent the accumulation of foreign exchange reserves, ensure more prudent monetary policymaking, and set the ground for facilitating possible external adjustment. However, it could damage international price competitiveness of the concerned country.

Comment(s)

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