FRBSF Economic Letter
98-22; July 17, 1998
Capital Flows and Exchange Rates
in the Pacific Basin
The greater integration of emerging market countries with international
capital markets has brought problems as well as benefits for recipients.
On the one hand, access to foreign funds has helped finance economic development.
On the other hand, greater integration has rendered developing countries
more vulnerable to the effects of capital flow reversals, whether due
to bad policies or bad luck. This vulnerability is highlighted by the
Mexican peso crisis of 1994-95 and the recent Asian financial crisis.
This Economic Letter briefly reviews 14 papers that provide
a comprehensive analysis of the theoretical and policy issues associated
with international capital flows, as well as the responses of policymakers
in Asia and Latin America. These papers were prepared for a conference
on "Managing Capital Flows and Exchange Rates: Perspectives from the Pacific
Basin," sponsored by the Federal Reserve Bank's Center
for Pacific Basin Monetary and Economic Studies in 1996, and they
have recently been published in a conference volume (Glick 1998).
Determinants of capital flows and exchange
rates
Determining the relative roles of domestic and external factors in driving
capital flows is critical to determining the appropriate response of policymakers.
To the extent that domestic factors, such as favorable economic reforms
and investment returns, "pulled" capital into developing countries, a
reversal of flows can be avoided by maintaining sound domestic economic
policies. In contrast, if capital is "pushed" by external conditions,
such as low interest rates or adverse business conditions in industrial
countries, domestic policymakers must be prepared for the possibility
that capital flows may reverse when foreign economic conditions change.
Henning Bohn and Linda Tesar analyze whether U.S. portfolio equity investments
in Asia responded to the "pull" of higher expected returns in Asian markets
or the "push" of lower U.S. interest rates. They conclude from the significant
differences in the timing of investment across individual countries and
from time series estimation of a portfolio model over the period 1986-95
that domestic "pull" factors in Asia rather than "push" factors in the
U.S. were more important in explaining U.S. investment in foreign equity
markets.
Another factor affecting international investment flows, particularly
direct investment, has been currency realignment. The yen appreciation
of over 50% against the U.S. dollar in the late 1980s boosted the international
competitiveness of the Newly Industrialized Economies, including Korea,
Taiwan, and Singapore, and led Japanese investment to shift towards lower-cost
production locations in Southeast Asia, such as Malaysia and Thailand.
Linda Goldberg and Michael Klein analyze the role of exchange rate changes
for the pattern of direct investment flows and trade among Japan, the
U.S., East Asia, and Latin America over the period 1978-93. They find
that the appreciation of the yen increased direct investment from Japan
to Asia and to some extent "crowded out" direct investment from the U.S.
to Asia. They also find Japanese direct investment tended to stimulate
East Asian imports from Japan, while U.S. direct investment substituted
for U.S. imports from Asian countries.
A more complete analysis of capital flows and exchange rates necessarily
requires recognizing their simultaneous determination. With a small open
economy model, Pierre-Richard Agenor and Alexander Hoffmaister analyze
theoretically the responses of capital flows and the exchange rate to
underlying shocks, such as a world interest rate decrease or a domestic
fiscal stimulus. Using vector autoregressive empirical techniques, they
find that world interest rate declines explain much of the pattern of
capital inflows and real exchange rate appreciation observed in Asian
countries.
Risk also plays an important role in international capital movements.
Theo Eicher and Stephen Turnovsky formulate a stochastic growth model
to assess the effects of changes in risk associated with various external
and domestic shocks on key macroeconomic variables. They use the model
to explain cross-country and cross-time differences in the economic performances
of Mexico and Indonesia during the period 1973-95. Their model explains
the behavior of interest rates and exchange rates reasonably well, but
does less well in explaining other variables, such as capital flows and
output growth rates.
Exchange rate crises and contagion
Exchange rate crises are characterized by sudden, large outflows of capital
that trigger devaluations, often spreading contagiously across countries.
What explains such events?
Economic theory suggests that a pegged exchange rate regime can become
unviable when cross-border capital flows are freely mobile and market
participants suspect that the government will not or cannot maintain the
peg. For example, excessive monetary expansion to monetize fiscal deficits
or bail out an insolvent domestic banking system can deplete the central
bank's foreign exchange reserves and weaken its ability to defend a peg.
Or conditions such as high unemployment or a weak banking system may compromise
the central bank's willingness to defend a currency peg by raising interest
rates.
Richard Meese and Andrew Rose study how well various macroeconomic indicators
predict currency crises in developing countries. They find that high foreign
interest rates, a high external debt burden, loose monetary policy, and
domestic recessions all are associated with currency crises. However,
they do not find evidence that low levels of foreign currency reserves,
the degree of overvaluation relative to purchasing power parity, or current
account deficits are consistently associated with currency crashes.
Peter Garber and Subir Lall study how offshore financial derivatives
markets contributed to Mexico's 1994 exchange rate crisis by allowing
domestic Mexican banks to circumvent prudential and anti-speculative regulations
and build up undetected off-balance-sheet dollar liabilities through their
New York financial subsidiaries. When the peso depreciated and Mexican
banks found it more expensive to pay off these positions, a crisis in
the Mexican banking system evolved. The authors argue that policymakers
should not respond by banning derivative usage, since doing so just drives
it more offshore; rather, they should create a regulatory environment
that brings the markets on-shore and improve banking supervision.
In the wake of the Mexican crisis of December 1994, Argentina and Brazil
came under the most severe pressure. Several countries in Asia also came
under attack in early 1995, though to a lesser extent than in Latin America.
Following the devaluation of the Thai baht in July 1997, contagion effects
were experienced primarily in Asia. What explains why some emerging markets
experienced more of a "tequila hangover" or "bahtulism" effect than others?
Jeffrey Frankel and Sergio Schmukler assess the contagion effects of
the Mexican financial crisis with return data on domestic stock indexes
and closed-end country equity funds for Asian and Latin American countries.
They find that the Mexican shock spilled over strongly to other countries
in Latin America, and to a lesser extent "passed through" Asian country
funds traded in New York to stock markets in Asia. The authors also assess
the extent to which these spillover effects can be attributed to economic
fundamentals, and conclude that countries with weaker external positions,
as measured by high debt-export and current account deficit-GNP ratios,
or low foreign reserve-GNP ratios, experienced more adverse spillover
effects.
Holger Wolf takes a longer-term view in assessing the linkages among
the equity markets of emerging countries, using data spanning the mid-1980s
to 1995. He finds evidence that cross-country similarities in economic
fundamentals, such as macroeconomic performance, market development stage,
risk exposure, and geographic location, explain much of the co-movement
in cross-country equity returns. After controlling for the effects of
fundamentals, he also finds evidence of contagion effects in the form
of residual co-movements in returns.
Effects of capital inflows
Some researchers have analyzed the extent to which capital inflows to
developing countries have adversely affected domestic economic performance
and/or worsened banking sector fragility.
Helmut Reisen formulates a measure of the long-run sustainability of
capital inflows for a number of developing countries. While in many cases
foreign borrowing increases have been associated with spending booms,
asset market bubbles, and banking crises, he suggests that these developments
are more attributable to domestic financial market distortions than to
capital flows per se. He also suggests that foreign direct investment
should be encouraged over other forms of capital inflows, since it is
less subject to reversals and is more likely to convey positive growth
externalities.
Ronald McKinnon and Huw Pill discuss how financial deregulation and implicit
or explicit government guarantees for banks can engender excessively risky
borrowing and a spending boom that culminates in crisis. In their view,
foreign capital flows compound this cycle. Examining data on the magnitude
and composition of credit expansion through 1995, they find symptoms of
overborrowing in Mexico and, to a lesser extent, in several East Asian
countries. They attribute the Asian financial crisis of 1997-98 to overinvestment
in poor quality projects rather than to overconsumption, as in the case
of Mexico. They conclude that maintaining the strength and efficiency
of financial institutions is crucial to avoiding overborrowing problems.
Steven Kamin and Paul Wood examine the impact of capital inflows on Mexico's
macroeconomic performance in the pre-crisis period when it experienced
rapid money growth, sharp interest rate declines, rapid bank lending growth,
and a consumption boom. While these developments are consistent with the
purported effects of capital inflows, they are also consistent with an
exogenous expansion in domestic monetary policy. Kamin and Wood find that
Mexican capital inflows measurably reduced interest rates and raised money
growth in the 1990s, but even without capital inflows, money would have
increased substantially. They find that capital inflows also stimulated
Mexican consumption positively. In other Latin American countries, as
well as East Asian countries, the authors find capital inflows had no
influence on money growth and interest rates, but had a greater impact
on investment than on consumption.
Policy responses to capital inflows
To the extent that capital inflows appreciate a currency's value, efforts
to maintain a peg imply that the central bank must intervene by absorbing
the foreign exchange brought in by the capital inflows. However, such
purchases increase the monetary base, generating inflationary pressure.
To the extent that capital inflows are intermediated through the domestic
banking system, they also may lead to the expansion of bank deposits and
loans. If bank supervision is not fully effective, the expansion of bank
balance sheets associated with capital inflows may worsen the fragility
of the banking system.
One way to limit the impact of capital inflows on monetary control and
the financial system without changing the exchange rate is to "sterilize"
the expansionary effects of foreign exchange intervention on the money
supply by simultaneously contracting domestic credit. Ken Kletzer and
Mark Spiegel evaluate the costs of sterilization arising from buying foreign
securities whose nominal yield is less than that paid on the domestic
bonds issued to absorb credit. They construct sterilization cost estimates
for several developing countries and find that these costs became large
during periods of inflow surges, and that sterilization was typically
only partially successful in maintaining domestic monetary and exchange
rate goals.
When capital inflows are persistent and sterilized intervention too costly,
a country may adopt measures to limit inflows through controls such as
ceilings on foreign borrowing by domestic residents or taxes on domestic
assets acquired by foreigners. Carmen Reinhart and R. Todd Smith examine
several countries that imposed controls on capital inflows and conclude
that, while these policies may have been effective in the short run in
reducing the volume of inflows or in lengthening their maturity composition,
they have had little discernible long-run effects on consumption, the
real exchange rate, or the current account.
Kevin Cowan and Jose De Gregorio examine Chile's experience in managing
capital flows when confronted by an inflow surge in the early 1990s. Chilean
policymakers reacted by treating the inflows as temporary, resisting a
nominal exchange rate appreciation, and mostly sterilizing the foreign
exchange intervention. As the inflows persisted, a combination of short-term
capital inflow restrictions and greater exchange rate flexibility was
implemented. The authors attribute Chile's success not to any single instrument,
but to its implementation of a comprehensive policy package.
The current Asian financial crisis will undoubtedly yield further lessons
for researchers and policymakers.
Reuven Glick
Vice President and Director
Center for Pacific Basin Monetary and Economic Studies
Reference
Glick, Reuven, ed. 1998. Managing Capital Flows and Exchange Rates:
Perspectives from the Pacific Basin. Cambridge University Press.
Inquiries about ordering the book should be directed to Cambridge
University Press, 40 West 20th Street, New York, N.Y. 10011-4211 or
its website http://www.cup.org.
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco,
or of the Board of Governors of the Federal Reserve System. Editorial
comments may be addressed to the editor or to the author. Mail comments
to:
Research Department
Federal Reserve Bank of San Francisco
P.O. Box 7702
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