International Capital Flows in Calm and Turbulent Times: The Need for New International Architecture

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International Capital Flows in Calm and Turbulent Times analyzes the financial crises of the late 1990s and draws attention to the type of lenders and investors that triggered and deepened the crises. It concentrates on institutional investors and banks and provides detailed analysis of the countries most affected by the 1997-98 Asian financial crisis as well as the Czech Republic and Brazil. It also suggests necessary international financial reforms to make crises less likely.
The book is unique in its scrutiny of the type of lenders and investors that triggered and deepened the crises, focusing particularly on institutional investors and banks; allocation of their assets; the criteria used in this process; and the impact of the nature of the investor on the volatility of different types of capital flow. It addresses such questions as: What determines or triggers massive changes in perceptions and sentiment by different investors and leaders? To what extent does contagion spread not just among countries but between actors? What are the policy implications of this analysis? The book concludes by examining the asymmetries in the financial architecture discussions and implementation and by offering policy proposals.
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International Capital Flows in Calm and Turbulent Times: the Need for New International Architecture

By Jacques Cailloux

University of Michigan Press

Copyright © 2003 Jacques Cailloux
All right reserved.

ISBN: 0472113097

CHAPTER 1 - Global Capital Flows to East Asia: Surges and Reversals

Jacques Cailloux and Stephany Griffith-Jones

Recent major currency crises in developing countries (and particularly those in Mexico in 1994-95 and East Asia in 1997-98) had three main characteristics. First, they were very sudden and very large, as measured by the scale of the capital flow reversal, by the size of the devaluation, and by the initial cost in terms of decreases in output and increases in unemployment and poverty. Second, particularly in relation to financial variables--such as capital flows, levels of stock prices, and so on--but also on the whole with regard to output, these crises lasted for relatively short periods and were followed by surprisingly large recoveries of both capital flows and growth. A third feature was that the crises themselves, as well as their massive scale and the resulting contagion to other countries, were largely unexpected.1

A central feature of the recent currency crises is the sudden and major reversal of capital flows that these economies experience. Such reversals are either mainly in bank loans (East Asia) or in debt portfolio flows (Mexico, Brazil, Russia). Clearly, these reversals are the immediate cause of such crises. This chapter explores in detail the features of the capital surges that preceded these crises and of the massive reversals that accompanied the crises. We focus on four Asian countries hit by the East Asian crisis (Thailand, Malaysia, South Korea, and Indonesia), although we make some comparisons with Latin America.

Given the large scale and suddenness of reversals of capital flows from countries that were previously regarded as highly successful, we hypothesize that an important--though clearly not the only--cause of such reversals is imperfections in international capital markets.

These imperfections contribute to excess volatility and large reversals in capital flows. They have almost always featured in the financial panics of earlier times, but their impact has increased significantly due to a number of factors, including the speed with which markets can react in today's global economy with its highly sophisticated information technology (Griffith-Jones 1998). Paradoxically, this impact sometimes appears to be strongest in economies that either were or were perceived to be in the process of becoming highly successful. It should be recognized that even though the East Asian countries had very strong fundamentals, especially in the macroeconomic sphere, they also had a number of structural weaknesses, particularly in their financial sectors and their regulation. Furthermore, policy mistakes were made in the East Asian economies--including the establishment of the Bangkok International Banking Facility (BIBF) in Thailand and freeing offshore bank borrowing in South Korea in the very early stages of its financial liberalization--that artificially favored short-term flows and thus made these countries more vulnerable to large reversals of capital flows. Clearly, it was the interaction of structural and policy weaknesses in the countries with imperfections in international capital markets that caused the 1997-98 crises. Indeed, Demirguc-Kunt and Detragiache (1998), Edwards (2000), and others have argued that it is the interaction between liberalization and poor institutions, such as, for example, lack of proper bank regulation and supervision that contributes to crises. This seems to reinforce the message that full liberalization should be postponed until a proper infrastructure is in place domestically. Although we agree with these insights, the main concern of this book is with the role of international capital flows and their imperfections in contributing to crises. Capital and financial markets are special in that, although they generally function well, they are prone to important imperfections. Asymmetric information and adverse selection play an important role in explaining these imperfections, as financial markets are particularly information intensive. Furthermore, there are strong incentives for "herding" (i.e., an investor trying to mimic another investor's investment decision).2

It is evident that surges and crises in emerging markets have been more frequent than in the past. It can be hypothesized that technological and institutional developments--which may reflect secular trends--can explain the increase in the volatility of capital flows experienced during the 1990s. Clearly, the development of information technology has increased the speed with which capital can flow in and out of countries and more generally the speed and ease with which financial transactions can be made and reversed. Furthermore, it has been argued that the growing importance of institutional investors and increased international diversification of their assets, the risk and reward structures of delegated portfolio fund managers, and the resulting growing appetite for liquid, transferable securities that can be easily sold may further contribute to the volatility of capital flows to developing countries.

A second factor is the massive scale of institutional investors' assets, which surpass $40 trillion, (see, e.g., Griffith-Jones 1998 and World Bank, 1997). This contrasts with the relatively small size of many recipient markets. This asymmetry highlights the potential for volatility, as marginal portfolio adjustments by institutional investors can lead to massive changes in the volume of capital flows to individual countries.

A third factor is linked to the risk and reward structures of fund managers and in particular to the frequent (every three or even every one month) evaluation of fund managers' investment performances with reference to market benchmarks and peer performance. As a result, fund managers fear underperformance because it can imply loss of business and therefore lower fees. This discourages positions that differ from benchmarks or peer averages. There is evidence that these incentives contribute to herding and therefore to high volatility of capital flows.

A fourth, broader factor may be linked to the fact that capital market financing is more rapidly affected by changes in market sentiment, as securities investors have looser relationships with borrowers and are more easily influenced by daily price movements--as they mark to market their assets-- than commercial banks are (BIS 1999). This would help explain why fund managers seemed to withdraw earlier than commercial banks in East Asia (see chap. 2). However, the evidence on this point is not totally clear-cut, as various types of intermediaries--especially large ones--have adopted similar risk management systems. Indeed, the fact that different actors (e.g., banks, pension funds, and mutual funds) have increasingly highly correlated strategies may contribute to an aggravation of capital flow volatility and of the scale of asset price movements. This is an area in which further research is needed, which is at present beginning to be carried out. Combined with the asymmetries of scale--between total assets globally and the size of emerging market economies--this raises the possibility that in the future high capital flow volatility will remain or even increase, particularly if effective measures are not taken nationally and internationally to counteract it.

This chapter attempts to bring out the key features of private capital flows and their reversal, with special reference to the most affected economies in Asia, namely, Indonesia, Malaysia, South Korea, and Thailand (the Asian-4). Indeed, the project on which this book is based was initially about the East Asian crisis; this is why we focused this chapter on capital flows to and from the four East Asian countries hit by 1997-98 crises. In the middle of the project, a currency crisis hit Brazil. For the sake of completeness, we added a case study of Brazil (which incorporates detailed analysis of the flows); for an additional comparative perspective, we also added the Czech minicrisis. Section 1 reviews the inflow and outflow periods before and during the crisis, with special attention to the volume, maturity, and composition of flows. The key role of accumulated stocks or external liabilities is highlighted. Each of the four countries is studied, assessing similarities and differences. Section 2 contributes to the discussion of the so-called hierarchy of volatility by providing new measurements of the volatility of capital flows that are linked to the stock of foreign investment held by recipient countries. Section 3 studies the reversals experienced by crisis countries in an attempt to identify patterns across time and countries. Section 4 presents our conclusions and discusses policy implications. Finally, the appendix at the end of the chapter presents some graphic comparisons of foreign investments in Indonesia, Korea, and Thailand and in Argentina, Brazil, and Mexico.


In this section, we present key stylized facts concerning the inflow (1989-96) and outflow (1997-98) periods in East Asia,3 with some comparisons with Latin American countries. Our analysis is restricted in several respects by data availability, even though we made a great effort to compile all the existing data. For example, we would have liked to examine empirically the role of highly leveraged institutions (HLIs). Unfortunately, not enough systematic data are available on HLI positions to do a full empirical analysis. One of our conclusions is that significantly improved data on international capital markets are essential, not just for research but for policymakers as well.

Surges of capital flows to Asia and Latin America have been studied with respect to the first half of the 1990s, a period that has been described as "the return of private finance" to emerging markets.4 The picture that emerges from this literature is, first, that both Asia and Latin America experienced surges, though at different periods of time, and Asia received large capital flows earlier than Latin America did. Second, the composition of the flows between Asia and Latin America was quite different until the mid-1990s, though, as we shall see, the composition became more similar later.


Between 1989 and 1996, the Asian-4 received very high and sustained levels of private capital flows, amounting on average to 7.6 percent of gross domestic product (GDP) per year (see table 1.1). This compares to an average of 3.4 percent in the case of the three largest Latin American countries (the LA-3). The seven-year period of high inflows can be divided into two subperiods, 1989-94 and 1995-96, which correspond to the pre and post-Mexican crisis.

During the first period (1989-94), the Asian-4 were already experiencing very high levels of inflows as a proportion of GDP. Annual average inflows amounted to 7.1 percent of GDP compared to 3.3 percent in Latin America; the flows to East Asia were even higher (though only slightly so) than the 6.7 percent of GDP of capital inflows experienced by Mexico in its 1989-94 pre-crisis period. It is worth stressing that, although the East Asian region experienced very high levels of inflows during that period together with large current account deficits, it did not undergo any major financial crisis at that time. This can be explained partly by the very high levels of GDP and export growth (especially the latter) achieved. The structure of external financing did not explain the resilience of the Asian economies. Indeed, although the composition of flows to Asia seemed to be more stable than those to other regions because of the very large foreign direct investment (FDI) inflows (as was highlighted in the literature up to the mid-1990s), it was China and Singapore that attracted the bulk of these flows and not the Asian-4. Thus, the latter was already receiving in the 1989-94 period a very significant share of potentially reversible financial flows.

It is very interesting to note that in the aftermath of the peso crisis (1995-96) the Asian-4 received even larger inflows than in the 1989-94 period, with an average of 9.2 percent of GDP. This very high level of inflows was two and a half times higher than inflows to Argentina, Brazil, and Mexico at the time. The Asian-4 thus experienced a second surge just before the crisis.

Over that period, GDP growth was still very high, but current account deficits grew substantially, increasing the external vulnerability of the region. Furthermore, the rapidly growing stock of external liabilities, with a high proportion of them easily reversible, made these economies increasingly vulnerable to changes in investors' and lenders' perceptions.

The very steep increase of private flows in 1989-94 can be explained by means of two main driving forces. The first is the deepening of the liberalization process of capital accounts in Asia, with Korea being the most notable example (see chap. 10). The second driving force can be found in the increased share of international investments and loans allocated to emerging markets by institutional investors and banks as well as a broader trend toward the globalization of finance. As for the 1995-96 period, it is likely that as a response to the Mexican peso crisis international investors reallocated a higher share of their emerging market portfolios to Asia.

Compared to that of Latin America, the Asian surge lasted longer (seven years versus four or five in Latin America) and amounted to significantly larger annual amounts as a proportion of GDP. This contributed to much higher accumulated stocks of external liabilities in Asia, which may have contributed to the greater severity of the Asian crisis than that of Mexico.

As far as the composition of capital flows is concerned, and as can be seen in tables 1.2 and 1.3, between 1989 and 1996 the Asian-4 received, on average, 66 percent of flows in the form of foreign portfolio investments (FPI) and other investments (OI) (representing mainly credits). They respectively accounted for 15 and 51 percent of total inflows. Thus, credits were by far the main source of external financing. It is important to stress that as early as 1992, as shown in figure 1.1, most bank loans already had a maturity date of less than one year. This high ratio of short-term to total borrowing was consistently higher than in Latin America throughout the 1990s.

The FDI share was relatively small (34 percent) compared to the emerging market average of 50 percent and declined, for the Asian-4, from 37 percent in the period 1989-94 to 25 percent in 1995-96. This decline was mainly compensated for by an increase in the share of FPI, which rose from 12 to 22 percent, though credits also rose a bit (see table 1.3). As a consequence, the share of flows that were more easily reversible increased in the 1995-96 period.

When looking at individual countries, there are differences in terms of levels, particularly in the composition of flows.

Between 1989 and 1996, Thailand, the largest recipient of net private flows among the Asian-4, had an annual average inflow of 12.2 percent of GDP, while Malaysia, Korea, and Indonesia received 9.3, 4.7, and 4.2 percent, respectively (see table 1.1).

During the first period (1989-94), while Korea and Indonesia did not receive very large amounts of inflows, Thailand and Malaysia experienced surges, with levels significantly higher than those witnessed by Latin American countries, with, on average, 12.0 and 9.2 percent of GDP. During 1995 and 1996, further increases in total inflows brought the relative size of net private capital flows to new heights, with Thailand and Malaysia (in that order) again having the largest flows (see table 1.1). South Korea's net inflows almost tripled while Indonesia's inflows increased by far less. As a result, three out of the four East Asian countries experienced their largest yearly inflow in the 1995-96 period, with a peak in Thailand in 1995 of about 15 percent of GDP. Malaysia's inflows had peaked in the previous period, with an inflow as high as 20 percent of GDP in 1993 (see table 1.1).

As far as the composition of flows is concerned, and as can be seen in table 1.3, the bulk of private capital flows to South Korea took the form of loans; between 1989 and 1996, 52 percent of inflows were bank loans. Korea's inflows of FDI only accounted for 7 percent of its overall external private financing. This was mainly due to the deliberate policy of restricting FDI to avoid other countries' firms controlling South Korea's assets. Similarly, the Thai economy was mainly financed with bank loans. The two countries also shared a similar structure of maturity of their external debt, with more than 65 percent being short term.

On the other hand, Malaysia's inflows were more than 60 percent via FDI, a ratio far higher than the average for emerging markets. The remaining source of international finance was bank loans. Portfolio flows were negative during most of the period covered.


Excerpted from International Capital Flows in Calm and Turbulent Times: the Need for New International Architecture by Jacques Cailloux Copyright © 2003 by Jacques Cailloux. Excerpted by permission.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

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Table of Contents

List of Figures
List of Tables
1 Global Capital Flows to East Asia: Surges and Reversals 1
2 The Role of Mutual Funds and Other International Investors in Currency Crises 29
3 International Bank Lending and the East Asian Crisis 49
4 Foreign Capital Flows to Thailand: Determinants and Impact 75
5 Capital Flows into and from Malaysia 107
6 The Recent Economic Crisis in Indonesia: Causes, Impacts, and Responses 162
7 Who Destabilized the Korean Stock Market? 195
8 The Currency Shake-up in 1997: A Case Study of the Czech Economy 231
9 The Swings in Capital Flows and the Brazilian Crisis 267
10 The Financial Crises of the Late 1990s: Summary and Policy Lessons 291
11 Key Elements for a New International Financial Architecture 310
Contributors 337
Index 339
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