In this episode of our series Rethinking Asia, we spoke with Brad Setser, a Senior Fellow for International Economics at the Council on Foreign Relations. Brad also served as the deputy assistant secretary for international economic analysis in the U.S. Treasury and was previously the director for international economics, serving jointly on the staff of the National Economic Council and the National Security Council.
Brad walked us through the evolution and recent trends in cross-border capital flows in Asia. In the wake of the Global Financial Crisis, capital flows were primarily driven by current account surplus countries in Asia, whose governments were investing money abroad to offset appreciatory pressures on their exchange rates. In recent years, however, divergent global interest rates, economic developments, and a search for yield have spawned a complex web of flows across the pacific. Key takeaways from the discussion with Brad include:
- Throughout the post-crisis period, Asia has been a net exporter of capital. The bulk of financial outflows arose through a buildup in foreign exchange reserves among Asia’s current account surplus economies, though movement out of Japan was also driven by private investors seeking higher yield in a zero-interest rate environment.
- Immediately after the crisis, China experienced significant capital inflows. This reflected China’s gradual liberalization of its financial account. Comparably higher interest rates in China led to a growing carry trade, but these inflows reversed sharply in 2015 as the economic outlook deteriorated. In recent years, however, flows have stabilized as China restricted outflows and entered a modest economic recovery.
- Capital inflows into emerging Asia have generally followed global investors’ interests in emerging market exposure more broadly. While bank flows were a major component of pre-crisis inflows to the region, regulations have changed to limit banks’ short-term and foreign currency exposure compared to the pre-crisis period (though China is a notable exception). Portfolio flows into the region have taken on a greater role post-crisis.
- Across Asia, financial institutions increased purchases of offshore assets in a search for yield as the Fed began rate normalization. The biggest shift in trend over the past five years has been the rise of private capital flows, assuming the dominant role of official flows immediately post-crisis.
- The ongoing trade dispute has had a relatively minimal impact on regional capital flows, particularly when compared to the tumultuous effect of China’s exchange rate adjustment in 2015. U.S. tariffs have put downward pressure on the yuan, which in turn put regional currencies under pressure. Rising production costs in China have raised the appeal of neighboring economies, and could lead to rising foreign direct investment in other Southeast Asian nations.
- Funding mismatches among the Asian financial institutions is a growing vulnerability. In particular, growing dollar balance sheets in Asia have become an important source of funding for the U.S. economy and recall the experience of European banks pre-crisis. This risk is mitigated somewhat by large reserves in surplus countries and international swap lines, but the systemic implications of the global network of funding demand greater attention.