Regional and Global Capital Flows: Macroeconomic Causes and Consequences [NOOK Book]


The volume of capital flows between industrial and developing countries has grown dramatically in the past decade and has become a major issue in a world that is increasingly "globalized." Here Takatoshi Ito and Anne O. Krueger, two leading experts on this topic, have assembled a group of scholars who address different types of capital flows—bank lending, bonds, direct foreign investment—and the implications they hold for economic performance. With its particular focus on the Asian financial crises, this work ...
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Regional and Global Capital Flows: Macroeconomic Causes and Consequences

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The volume of capital flows between industrial and developing countries has grown dramatically in the past decade and has become a major issue in a world that is increasingly "globalized." Here Takatoshi Ito and Anne O. Krueger, two leading experts on this topic, have assembled a group of scholars who address different types of capital flows—bank lending, bonds, direct foreign investment—and the implications they hold for economic performance. With its particular focus on the Asian financial crises, this work presents a new model for policy makers everywhere in thinking about the role of private capital flows.
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Product Details

  • ISBN-13: 9780226387017
  • Publisher: University of Chicago Press
  • Publication date: 2/15/2009
  • Series: NBER-East Asia Seminar on Economics
  • Sold by: Barnes & Noble
  • Format: eBook
  • Pages: 392
  • File size: 9 MB

Meet the Author

Takatoshi Ito is a professor in the Institute of Economic Research at Hitotsubashi University, Tokyo, and a research associate of the National Bureau of Economic Research.

Anne O. Krueger is the Herald L. and Caroline L. Ritch Professor of Economics, a senior fellow of the Hoover Institution, the director of the Center for Research in Economic Development and Policy Reform at Stanford University, and a research associate of the National Bureau of Economic Research.
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Regional and Global Capital Flows: Macroeconomic Causes and Consequences

By Anne O. Krueger

University of Chicago Press

Copyright © 2001 Anne O. Krueger
All right reserved.

ISBN: 0226386767

1 Fundamental Determinants of the Asian Crisis

The Role of Financial Fragility and External Imbalances

Giancarlo Corsetti, Paolo Pesenti, and Nouriel Roubini

1.1 Introduction

Episodes of speculative attacks on currencies in the 1990s (such as the 1992-93 crisis in the European Monetary System, the 1994 Mexican peso collapse, and especially the Asian turmoil of 1997-98) have generated a considerable--and finely balanced--debate on whether currency and financial instability should be attributed to arbitrary shifts in market expectations and confidence, rather than to weaknesses in the state of economic fundamentals. Yet, advocates of both the "fundamentalist" and the "nonfundamentalist" views agree in principle that a deteriorating macroeconomic outlook increases the degree to which an economy is vulnerable to a crisis.

The problematic economic and financial conditions in Southeast Asia in the years preceding the crisis have been documented in a number of recent studies (including our own contribution in Corsetti, Pesenti, and Roubini 1999c). A widespread view holds that, regardless of whether the plunges in asset prices after the eruption of the crisis were driven byself-fulfilling expectations and panic, weak economic fundamentals were a crucial element in the genesis of the crisis and in its spread across countries. In support of this thesis, in this paper wepresent some preliminary formal evidence on the links between indicators of currency instability in 1997 and a number of indicators of real and financial fragility at the onset of the crisis. The proposed tests do not aim at discriminating among alternative explanations--rather, the goal here is to provide a set of baseline results to complement and integrate previous analyses pointing to the fragile state of the Southeast Asian economies before the eruption of the crisis.

One of the interesting pieces of evidence that corroborates a fundamental interpretation of the crisis is that well-performing Asian countries were spared its most pervasive consequences. Taiwan, Singapore, and Hong Kong were, relatively speaking, less affected by the regional turmoil. The Hong Kong currency parity was maintained despite strong speculative attacks. Taiwan and Singapore decided to let their currency float rather than lose reserves by attempting to stabilize the exchange rate; however, the depreciation rates of their currencies were modest, and, most importantly, these countries did not experience drastic reversals in market sentiment, financial panic, and large-scale debt crises.

The three countries that were only mildly affected by the turmoil shared anumber of characteristics: First, their trade and current account balances were in surplus in the 1990s and their respective foreign debts were low (Taiwan was a net foreign creditor toward Bank for International Settlements [BIS] banks); second, they had a relatively large stock of foreign exchange reserves compared to the crisis countries; third, their financial and banking systems did not suffer from the same structural weaknesses and fragility observed in the crisis countries; and finally, they were perhaps less exposed to forms of so-called "crony capitalism"--that is, from the system of intermingled interests among financial institutions, political leaders, and the corporate elite characteristic of Korea, Indonesia, Malaysia, and Thailand. China also falls in the category of countries that were not subject to disruptive speculative pressure--the Chinese currency did not depreciate in 1997; however, the presence of constraints on capital mobility makes it difficult to compare the performance of this country with the others.

Conversely, as a group, the countries that came under attack in 1997 had the largest current account deficits throughout the 1990s. While the degree of real appreciation over the 1990s differed widely across Asian countries, with the important exception of Korea all the currencies that crashed in 1997 had experienced a real appreciation.

The literature has pointed out several factors that contributed to the deterioration of fundamentals in East Asia. The region experienced significant negative terms of trade shocks in 1996, with the fall in price of semiconductors and other goods. For most countries hit by the crisis, the long stagnation of the Japanese economy had led to a significant slowdown of export growth. Close to the onset of the crisis, the abortive Japanese recovery of 1996 was overshadowed by a decline in activity in 1997. Last butnot least, the increasing weight of China in total exports from the region enhanced competitive pressures over the period.

On the financial side, a large body of evidence shows that the corporate, banking, and financial systems of the crisis countries were very fragile: poorly supervised, poorly regulated, and already in shaky conditions before the onset of the crisis (see, e.g., International Monetary Fund [IMF] 1998; Ito 1998; Organization for Economic Cooperation and Development [OECD] 1998; Pomerleano 1998). The evidence suggests a sustained lending boom in the Philippines, Thailand, and Malaysia--strikingly, these were also the first countries to be hit by currency speculation in 1997. It also suggests a severe mismatch between foreign liabilities and foreign assets of Asian banks and nonbank firms. Domestic banks borrowed heavily from foreign banks but lent mostly to domestic investors.

By the end of 1996, a share of short-term foreign liabilities above 50 percent was the norm in the region. At the same time, the ratio between M2 and foreign reserves in most Asian countries was dangerously high: In the event of a liquidity crisis--with BIS banks no longer willing to roll over short-term loans--foreign reserves in Korea, Indonesia, and Thailand were insufficient to cover short-term liabilities, let alone to service interest payments and to repay the principal on long-term debt coming to maturity in the period. One could certainly hold the view that the creditors' panic in Korea and Indonesia resulted purely from a standard "collective action" problem faced by a large number of creditors in their decisions whether to roll over existing credits or call in their loans (see, e.g., Chang and Velasco 1998, 2000). It should also be recognized that market reactions took place under conditions of extreme political uncertainty, low credibility of the existing governments, and skepticism about the direction of (and the commitment to) structural reforms.

Although Asian countries were characterized by very high savings rates throughout the 1990s, the deficiencies of their financial sectors placed a severe burden on the fiscal balances of the affected countries. Such costs represented an implicit fiscal liability not reflected bydataon public deficits until the eruption of the crisis, but large enough to affect the sustainability of the precrisis current account imbalances. The size of this liability contributed to expectations of drastic, but uncertain, policy changes (a fiscal reform required to finance the costs of financial bailouts) and currency devaluations (as a result of higher recourse to seigniorage revenues) (see, e.g., Corsetti, Pesenti, and Roubini 1999b and Burnside,Eichenbaum, and Rebelo 1998).

This paper reports and discusses a number of tests of the empirical relevance of the set of macroeconomic factors recalled above. In our tests we compare the performance of all the Asian countries subject to pressures in 1997 with the performance of other emerging economies, for a total sample of twenty-four countries whoseselection has been determined by data availability.

The paper is organized as follows. In section 1.2, we present a summary of the analytical model that is the basis of the empirical tests in the paper. In section 1.3, we present the results of our empirical analysis. Next, in section 1.4, we elaborate on the role played by the banking-sector weaknesses and the financial distress of over-leveraged firms in explaining the financial crisis in Asia in the late 1990s. Section 1.5 concludes.

1.2 A Model of the Asian Crisis

After the outburst of the currency and financial crises in Southeast Asia in the summer of 1997, many observers noted that the traditional conceptual and interpretive schemes did not appear, prima facie, to fit the data well and fell short in a number of dimensions.

One reason is the role of fiscal imbalances. At the core of "first generation" (or "exogenous-policy") models of speculative attacks (a´ la Krugman 1979 and Flood and Garber 1984), the key factor explaining the loss of reserves that led to a crisis is the acceleration in domestic credit expansion related to the monetization of fiscal deficits. In the case of Southeast Asia, the precrisis budget balances of the countries suffering from speculative attacks were either in surplus or limited deficit.

In "second generation" (or "endogenous-policy") models of currency crisis, governments rationally choose--on the basis of their assessment of costs and benefits in terms of social welfare--whether to maintain a fixed rate regime. A crisis can be driven by a worsening of domestic economic fundamentals, or can be the result of self-validating shifts in expectations in the presence of multiple equilibria, provided that the fundamentals are weak enough to push the economy in the region of parameters where self-validating shifts in market expectations can occur as rational events. The indicators of weak macroeconomic performance typically considered in the literature focus on output growth, employment, and inflation. In the Asian economies prior to the 1997 crisis, however, GDP growth rates were very high and unemployment and inflation rates quite low.

In Corsetti, Pesenti, and Roubini (1999b) we have suggested a formal interpretive scheme that, while revisiting the classical models, brings forward new elements of particular relevance for the analysis of the 1997-98 events. Specifically, we have analyzed financial and currency crises as interrelated phenomena, focusing on moral hazard as the common factor underlying the twin crises.

At the core of our model is the consideration that, counting on future bailout interventions, weakly regulated private institutions have a strong incentive to engage in excessively risky investment. A bailout intervention can take different forms, but ultimately has a fiscal nature and directly affects the distribution of income and wealth between financial intermediaries and taxpayers: An implicit system of financial insurance is equivalent to astock of contingent public liabilities that are not reflected by debt and deficit figures until the crisis occurs.

These liabilities may be manageable in the presence of firm-specific or even mild sector-specific shocks. They becomea concern in the presence of cumulative sizable macroeconomic shocks, which fully reveal the financial fragility associated with excessive investment and risktaking. While fiscal deficits before a crisis are low, the bailouts represent a serious burden on the future fiscal balances. The currency side of a financial crisis can therefore be understood as a consequence of the anticipated fiscal costs of financial restructuring that generate expectations of a partial monetization of future fiscal deficits.

It is important to stress that the financial side of the crisis likely results in a severe fall in economic activity induced by the required structural adjustment. This is because implicit guarantees on investment projects lead the private sector to undertake projects that are not profitable. In the tradables sector, the scale and type of technology adopted are not optimal. In the nontraded sector, the profitability of investment suffers from changes in the real exchange rate accompanying the devaluation--changes that do not necessarily depend on the presence of nominal rigidities. Even in the absence of a self-fulfilling panic at the root of the crisis, the adjustment to the existing fundamental imbalance may take more than a correction in the level of the real exchange rate. The economy must pay the cumulative bill from distorted investment decisions in the past.

In addition, political uncertainty about the distribution of the costs from the crisis, and about their effecton the political stability of the leadership, may dramatically increase the risk premium charged by international and domestic investors--Indonesia being a striking example. A deterioration of the financial conditions may therefore deepen and prolong the recession accompanying the crisis. These considerations are important in assessing the relative merits of fundamentalist and nonfundamentalists views of the Southeast Asian events. The first view is not necessarily associated with a quickrecovery after a devaluation, since the correction of fundamental imbalances due to moral hazard takes more than a relative price change.

In assessing the role of moral hazard in a financial crisis we should note that investment-distorting expectations of a future bailout need not be based on an explicit promise or policy by the government. Bailouts can be rationally anticipated by both domestic and foreign agents even when no public insurance scheme is in place and the government explicitly disavows future interventions and guarantees in favor of the corporate and banking sectors. In his celebrated analysis of currency and financial crises of the early 1980s, Carlos Diaz-Alejandro (1985) stresses the time-consistency problem inherent in moral hazard:

Whether or not deposits are explicitly insured, the public expects governments to intervene to save most depositors from losses when financial intermediaries run into trouble. Warnings that intervention will not be forthcoming appear to be simply not believable. (374)
This is because no ex ante announcement by policy makers can convince the public that, ex post (that is, in the midst of a generalized financial turmoil), the government will cross its arms and let the financial system proceed toward itsdebacle. Agents will therefore expect a bailout regardless of "laissez-faire commitments"--in the words of Diaz-Alejandro--"which a misguided minister of finance or central bank president may occasionally utter in a moment of dogmatic exaltation" (379).

To summarize, in our model, private agents act under the presumption that there exist public guarantees on corporate and financial investment, so that the return on domestic assets is perceived as implicitly insured against adverse circumstances. To the extent that foreign creditors are willing to lend against future bailout revenue, unprofitable projects and cash shortfalls are refinanced through external borrowing. Such a process translates into an unsustainable path of current account deficits.

While public deficits need not be high before a crisis, the eventual refusal of foreign creditors to refinance the country's cumulative losses forces the government to step in and guarantee the outstanding stock of external liabilities. To satisfy solvency, the government must then undertake appropriate domestic fiscal reforms, possibly involving recourse to seigniorage revenues through money creation. Speculation in the foreign exchange market, driven by expectations of inflationary financing, causes a collapse of the currency and brings the event of a financial crisis forward in time.

Financial and currency crises thus become indissolubly interwoven in an emerging economy characterized by weak cyclical performances, low foreign exchange reserves, and financial deficiencies, eventually resulting in high shares of nonperforming loans. Our empirical exercise below is cast within this conceptual framework. Adopting the methodology suggested in previous studies (e.g., Eichengreen, Rose, and Wyplosz 1996; Sachs, Tornell, and Velasco 1996; Kaminsky, Lizondo, and Reinhart 1998), in the next sections we first construct a crisis index as a measure of speculative pressure on a country's currency. Then, we compute a set of indexes of financial fragility, external imbalances, official reserves adequacy, and fundamental performance. Finally, we report the results of the regressions of the crisis index on the above indexes.

1.3 A Preliminary Empirical Assessment

1.3.1 The Crisis Index

Our crisis index (IND) is a weighted average of the percentage rate of exchange rate depreciation relative to the U.S. dollar--if such depreciation canbedeemed as abnormal, as explained below--and the percentage rate of change in foreign reserves between the end of December 1996 and the end of December 1997. The logic underlying the index IND is quite simple. A speculative attack against a currency is signaled either by a sharp depreciation of the exchange rate or by a contraction in foreign reserves which prevents a devaluation. We present the values for IND in table 1.1: A large negative value for IND corresponds to a high devaluation rate and/or a large fall in foreign reserves, i.e. a more severe currency crisis.


Excerpted from Regional and Global Capital Flows: Macroeconomic Causes and Consequences by Anne O. Krueger Copyright © 2001 by Anne O. Krueger. 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

1. Fundamental Determinants of the Asian Crisis: The Role of Financial Fragility and External Imbalances
Giancarlo Corsetti, Paolo Pesenti, and Nouriel Roubini
Comment: Carmen M. Reinhart
Comment: Aaron Tornell
2. Lending Booms and Currency Crises: Empirical Link
Aaron Tornell
Comment: Shinji Takagi
Comment: Chi-Wa Yuen
3. Bank Lending and Contagion: Evidence from the Asian Crisis
Graciela L. Kaminsky and Carmen M. Reinhart
Comment: Eiji Ogawa
Comment: Mahani Zainal-Abidin
4. The Impacts of Bank Loans on Economic Development: An Implication for East Asia from an Equilibrium Contract Theory
Shin-Ichi Fukuda
Comment: Takatoshi Ito
Comment: Yukiko Fukagawa
5. How Were Capital Inflows Stimulated under the Dollar Peg System?
Eiji Ogawa and Lijian Sun
Comment: Francis T. Lui
Comment: Pranee Tinakorn
6. Sterilization and the Capital Inflow Problem in East Asia, 1987-97
Shinji Takagi and Taro Esaka
Comment: Leonard K. Cheng
Comment: Mahani Zainal-Abidin
7. Credibility of Hong Kong’s Currency Board: The Role of Institutional Arrangements
Yum K. Kwan, Francis T. Lui, and Leonard K. Cheng
Comment: Shin-Ichi Fukuda
Comment: Takatoshi Ito
8. How Japanese Subsidiaries in Asia Responded to the Regional Crisis: An Empirical Analysis Based on the MITI Survey
Kyoji Fukao
Comment: Mario B. Lamberte
Comment: Assaf Razin
9. Social Benefits and Losses from FDI: Two Non-Traditional Views
Assaf Razin, Efraim Sadka, and Chi-Wa Yuen
Comment: Anne O. Krueger
Comment: Mario B. Lamberte
10. Currency Crisis of Korea: Internal Weakness or External Interdependence?
Dongchul Cho and Kiseok Hong
Comment: Nouriel Roubini
Comment: Ponciano S. Intal, Jr.
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