Introduction

Capital inflows provide emerging market economies with invaluable benefits in pursuing economic development and growth by enabling them to finance investment, smooth consumption, diversify risks, and expand economic opportunities. However, large capital inflows, if not managed properly, can expose capital-recipient countries to at least three types of risks (Kawai and Takagi, 2008). The first is macroeconomic risk. Capital inflows could accelerate the growth of domestic credit, create economic overheating including inflation, and cause the real exchange rate to appreciate, thus affecting macroeconomic performance in a way not consistent or compatible with domestic policy objectives such as sustainable economic growth with price stability. The second is risk of financial instability. Capital inflows could create maturity and currency mismatches in the balance sheets of private sector debtors (particularly banks and corporations), push up equity and other asset prices, and potentially reduce the quality of assets, thereby contributing to greater financial fragility. The third is risk of capital flow reversal. Capital inflows could stop suddenly or even reverse themselves within a short period, resulting in depleted reserves or sharp currency depreciation. About 15% of the large capital inflow episodes over the past 20 years ended in crisis, with emerging Asia experiencing proportionately more episodes of hard landings (Schadler, 2008). The most devastating of these episodes occurred in 1997–98. This stresses the point that emerging Asian economies need to manage these risks well so that they can enjoy the benefits of capital inflows.

The nine emerging Asian economies included in this study¹ have posted remarkable growth rates since 2000, with the People's Republic of China (PRC), Viet Nam, and India showing the fastest growth rates. The International Monetary Fund (2007a) identified India, Pakistan, Thailand, and Viet Nam as Asian countries that were experiencing capital inflow episodes in the late summer of 2007. In contrast to the years before the crisis, all economies in the region except Viet Nam and India have experienced current account surpluses. One unhealthy development is the dramatic fall in investment ratios of crisisaffected economies after the Asian financial crisis, and there is no clear sign yet that the ratios will return to their pre-crisis levels in some countries. In contrast, the investment ratios of the PRC, India, and Viet Nam have risen and exceeded those of the crisis-affected economies in recent years.

Despite sizeable current account surpluses, many emerging Asian economies have received significant private capital inflows.² This has led to the accumulation of massive foreign exchange reserves in these economies. It is to be noted that capital inflows have considerably slowed in the past few quarters due to the deepening of the United States (US) subprime loan crisis and the uncertainty it has brought to the global financial market. US financial institutions in particular have become cautious about extending loans and investment, domestically and internationally, in order to protect their balance sheets and capital bases. While realizing losses on their impaired assets, several major banks are trying to recapitalize through private sources. This is the factor behind the ongoing credit crunch in the US. However, once US financial stability is restored, financial institutions rebuild the capital base, and the credit crunch eases, capital inflows to Asia will likely resume and in a big way, posing serious policy challenges, including for macroeconomic management, exchange rate policy, and financial sector supervision. Emerging Asian economies must therefore be prepared to deal with another surge in capital inflows, even though the region as a whole is likely to maintain a surplus in its current account. Now is the time for emerging Asian economies to put in place measures to manage risks arising from such future surges.

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