Capital flows in East Asia since the crisis
Speech by Andrew Crockett, General Manager of the BIS, on the occasion of the meeting of deputies of the ASEAN Plus Three in Beijing, 11 October 2002.
In the aftermath of the crisis that hit East Asia five years ago, capital flows between the region and the rest of the world have exhibited two new features:
First, East Asia has become a very large net capital exporter. This has good and bad aspects. The external demand that has generated an export surplus has undoubtedly facilitated the region's recovery from the crisis. And countries with current account deficits, particularly the United States, have benefited from capital inflows to finance their deficits. Nonetheless, it is hard to believe that East Asia should be an exporter of savings in the longer-term, or that the US deficit is indefinitely sustainable.
The second new feature is that the region is exporting "safe" capital while importing "risky" capital. This international exchange of risk is restoring and strengthening national and corporate balance sheets in Asia and is thereby rendering the region's economies more resilient. Still, this pattern has drawn the criticism that it has impeded the development of East Asia's own bond markets.
I shall argue in these remarks that domestic financial reforms would help address some of the less satisfactory features of the current pattern of capital flows. They would enable the region to complement the strategy of export-led growth, which has served it well in the past, but which may not in itself be sufficient to produce stable and sustainable expansion in the future.
To begin, however, it is useful to review the factors lying behind the present pattern of capital flows.
In retrospect, the East Asian crisis can be seen as an abrupt reversal in the willingness of the rest of the world to finance the flow of deficits of the countries concerned. Before the crisis, in 1995-1996, ASEAN countries and Korea ran a collective current account deficit of $33 billion. In 1998-99, the current account swung to a surplus of $87 billion. While the surplus narrowed somewhat in 2000-2001, it remained at $57 billion. Taking the surpluses of East Asian economies as a group, the region is running a current account surplus of over $200 billion this year.
From a regional perspective, the export-led growth that improved the current account surplus provided a welcome economic stimulus, offsetting to varying extents the negative demand effects of financial and corporate restructuring.
The net outflow of capital from East Asia that is the counterpart of the current account surplus, went to finance deficits in the rest of the world. The main user of this capital is the United States. Of course, the United States was already running a substantial current account deficit before the crisis, at a time when the ASEAN countries and Korea were themselves running an aggregate deficit. Between 1995-96 and 1998-99, however, the US current account deficit widened by $165 billion, more than absorbing the $120 billion increase in the ASEAN and Korean net exports.
This widening of the current account deficit in the late 1990s was not on balance an unwelcome development for the United States. It coincided with rapid growth in US domestic demand that began to threaten price stability by late 1996. In the late 1990s, the Federal Reserve was tending to tighten monetary policy, albeit with interruptions during the Asian and LTCM crises. During this period, increased net imports from East Asia helped limit the degree of monetary tightening required.
Today, the US economy finds itself in a quite different position. Although the recession of 2001 was neither long nor deep, questions remain about the sustainability of household demand and the prospects for a recovery of business fixed investment. Inflation has receded as an issue. Perhaps of lesser significance, but not to be entirely overlooked, is the sheer size of the US current account deficit. This has now reached some 5% of GDP, almost 10% of the rest of the world's gross savings. The US net international investment position has risen to about a quarter of GDP and produces a drain on US income of 2% of GDP.
In these circumstances, it would not be prudent for policy-makers in East Asia to assume that the current account developments that were welcomed in the cyclical circumstances of the late 1990s can continue forever.
Movements in gross capital flows
Underlying these net capital flows has lain an international exchange of risk through substantial two-way gross flows. In particular, East Asia has been importing risk capital while exporting safe capital. Foreign direct investment has been the largest and most consistent of the inflows of risk capital. In addition, portfolio equity has on balance flowed into the region since the crisis, although flows have fluctuated with equity market performance in the major international centres. The medium-term trend seems to be upwards, however. Most Southeast Asian equity markets were neglected by international investors until about a year ago, but since then Indonesia, Malaysia, the Philippines and Thailand have all enjoyed somewhat greater attention.
Other forms of risk capital have also flowed into East Asia since the crisis. Private equity firms have bought into banks and acquired portfolios of bad loans. East Asian banks have sold subordinated debt to investors in New York. Bonds, both sovereign and corporate, and of subinvestment as well as investment grade, have been marketed in international markets.
In the other direction, East Asian capital has flowed largely into low-risk securities, interbank deposits and repayment of bank debts. Prominent among the securities acquired have been US Treasuries, US agency paper and European and Japanese sovereign debt. While the paydown of the region's corporate debts in dollars has retired risky obligations, the funds have flowed through the international interbank market as low risk funds. In summary, East Asia has been selling risky assets to the rest of the world while acquiring or funding safe assets.
Stepping back, these gross flows of capital have clearly strengthened financial structures in East Asia. That is, in attracting equity and subordinated debt flows, while paying back debts and accumulating liquid assets, East Asia has used global financial markets to deleverage and to improve liquidity. The cost of doing so is conceptually similar to an equity premium. Yields on liabilities have tended to exceed those on claims. For instance, subordinated debt sold by Korean banks has yielded three to four percentage points over safe yields.
Looked at from the perspective of the United States, its provision of risk capital to East Asia adds further to the gross flows that it has to attract to finance its current account deficit.
In financing risky East Asian assets with safer liabilities, the US economy serves as an international financial intermediary or bank. Over the long run, however, a bank cannot expand on the basis of a shrinking capital base: by analogy, one could argue that economies too are not wholly exempt from the market discipline codified in the Basel Accord. There is a latent, if admittedly only long-term, conflict between the deteriorating net international investment position of the United States and its role in international financial risk intermediation.
What has driven reserve growth?
East Asia's accumulation of official foreign exchange reserves has raised the region's share of global reserves to over 50%. This abundance of reserves no doubt made it easier for central banks in the region to agree to make some of their reserves available to each other under the Chiang Mai initiative.
Many observers see official reserve growth as strictly the result of current account surpluses. Some also consider the cost of reserves as being very high: namely the marginal productivity of capital less the international risk-free rate. In this interpretation, reserve growth is less than fully rational. Real resources are being absorbed, through the balance of payments, to acquire financial assets that yield less than alternative investments.
It is, however, worth noting that there is no one-to-one relationship between the growth of reserves and the size of current account surpluses in the region. In China, for example, while private capital outflows moderated the build-up of official reserves in 1998-2000, more recently reserve growth has far exceeded the current account surplus. Similarly in Korea, reserves grew almost twice as fast over the past 2½ years as its current account surpluses would have suggested.
Nor can it be readily assumed that less reserve accumulation would have been balanced by more domestic investment. Moreover, within limits, there have been non-pecuniary benefits from reserve holding, via the impact on a country's perceived international credit standing.
Looking ahead, it is not easy to predict reserve trends. Relatively low US dollar interest rates, especially if combined with the prospect of a weakening dollar, could encourage the private sector in East Asia to move out of dollars into home- currency assets. If the authorities were to resist the implications of this tendency for the exchange rate, the stage could be set for further substantial official dollar purchases.
Criticisms of the patterns of capital flows
Two criticisms have been levelled at the patterns of capital flows which I have just described.
- First, some observers have questioned, on welfare grounds, a flow of capital from East Asia to the United States. It means, after all, that funds are flowing from economies catching up in productivity and with relatively young populations to a mature economy, albeit one enjoying a recent acceleration of productivity growth. Also, there is a concern that the longer that the US deficits continue, the greater the eventual adjustment will have to be.
- Second, there is concern that the gross flows from Asia to major financial centres and back to East Asia represent a missed opportunity for greater financial intermediation within Asia. As a corollary, flows from East Asia are said to be helping simply to deepen the US bond market, rather than contributing to the development of East Asian bond markets.
There is some truth in both criticisms, but each can be overstated. With regard to the first point, the region's current account surplus should begin to narrow as investment picks up following the strengthening of corporate balance sheets. Some of the possible policy initiatives that I will come to in a moment could also raise investment relative to saving.
With regard to intermediation and the financial integration of East Asia, it has in fact proceeded further than is generally recognised. In the primary market for loans, it is already evident that East Asian banks have provided a 40-80% share of syndicated lending to East Asian borrowers. Even though foreign firms often act as lead underwriters in bonds issued by East Asian borrowers, it should be remembered that underwriting spreads represents only a very small fraction of total costs. Among the buyers of the bonds, East Asian accounts take almost half of the issues, and an even higher share of issues of the shorter maturities suitable for the portfolios of commercial and central banks. Subsequent trading in bonds issued by East Asian names almost surely moves more of the paper into East Asian portfolios. Direct investment by East Asian firms in other countries of the region, clearly set back by the crisis, is once again one of the fastest growing segment of foreign direct investment in the world.
All that said, however, East Asia would no doubt benefit from more financial integration and in particular still more development of its domestic bond markets. Thus, the region has a vital interest in short-circuiting some of the gross flows of capital which I have just described. Moreover, the finances of the region would be significantly improved if local borrowers could issue local currency rather than dollar or euro bonds either to secure longer duration liabilities or to tap the risk appetite of potential buyers. Equally, institutional investors with long-duration liabilities would benefit from being able to buy longer duration bonds in their home currencies. Given these demand and supply side conditions, and given Asia's broadly favourable history of price stability, the potential for bond market development is, in my view, strong. In the case of China, this potential could be realised in parallel with capital account liberalisation.
Central banks are interested in broader, deeper and more liquid bond markets for operational as well as other reasons. Increasingly there is a recognition of the opportunity afforded by prudent but strategic management of foreign exchange reserves to further the goals of developing regional bond markets. Reserve managers in the region see potential in investing in the securities of East Asian borrowers, especially in view of the momentum toward rating upgrades in the region. This would presumably start with issues denominated in major currencies, but in the longer-term, investment vehicles in local currency cannot be excluded. The BIS is ready to play its part in this process.
Conclusion: The policy challenges
Strong financial systems support balanced growth. In the absence of a healthy banking system, the production and marketing of exports must be financed by internal funds or by borrowing in the international securities markets and from international banks. Smaller firms have limited access to such credit. An unhealthy financial system holds back private domestic demand. Small and medium-sized firms typically depend on bank finance, and larger domestic firms can invest more steadily if they can finance themselves by issuing bonds in domestic currency. And households with access to mortgage and personal credit can ride out declines in income with lesser retrenchment in spending.
Thus three policy objectives should be understood as complementing each other to bring better balance to both capital flows and economic structures in East Asia. They are:
- Strengthening of banking systems to help support domestic demand in the face of export weakness. Financial strengthening may need to be complemented with restructuring of over-indebted and loss-making firms.
- Developing long-term investing institutions and bond markets denominated in domestic currency. This would enhance the borrowing capacity of firms producing for the domestic market without introducing the financial fragility that comes with currency mismatches.
- Lessening reliance on exports as the leading sector in economic development, thus reducing exposure to export cycles. Along with healthier domestic balance sheets, this should attenuate the risks of exchange rate fluctuations.
Korea's recent experience gives some idea of the potential impact of this policy orientation. Measures to recapitalise its banks, to re-orient them to making profits and to improve their governance have been noteworthy. To be sure, with the government still a major shareholder of many banks, the process remains to be completed. For its part, the Korean bond market has, with interruptions, developed away from dependence on bank guarantees. These financial improvements, I submit, are intimately linked to two significant and related macroeconomic developments. First, in 2001, despite a sharp drop in exports, the strength of domestic demand enabled the Korean economy to grow at a rate well above that of other economies with similar exposure to the technology cycle. Second, since the crisis, Korea's household savings rate and the current account surplus have both been reduced substantially.
Significant developments elsewhere point to the same conclusions. How robust would domestic demand have been in China had not the Chinese banks promoted the rapid growth of mortgage and personal lending over the past several years? And how deep a recession would Malaysia have experienced had banks not competed vigourously to make home mortgage loans?
Now, I would be remiss if I did not also flag the risks of financial restructuring intended to increase access to credit. The Korean authorities are already deeply concerned about the rate of growth of household borrowing and the acceleration of asset prices. We have also had many historical examples, both in industrial countries and emerging markets, where a "stock adjustment" of household debt levels in response to deregulation has got significantly out of hand.
It is important, therefore, that policy-makers remain vigilant to the risk that financial restructuring leads to excesses of credit. However, the conclusion is already inescapable, that financial reform can serve the larger purpose of better balancing international capital flows and economic growth alike. With due awareness of the practical challenges, this is surely the path that the economies of this region should follow.