II. The Evolving Nature of Capital Flows in Emerging Asia

International Monetary Fund. Asia and Pacific Dept
Published Date:
April 2007
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Gross cross-border capital flows in emerging Asia12 have grown significantly over the past decade, rising from about US$270 billion to US$830 billion.13 Such flows—into and out of Asia as well as within the region—bring many benefits and help facilitate economic growth and development. They reflect greater real and financial integration in the region, as well as the strengthening and development of financial institutions and markets. At the same time, sudden shifts in flows have, in the past, caused economic problems in many parts of Asia and in other emerging markets. These include macroeconomic imbalances such as the rapid appreciation of the real exchange rate; unproductive or imprudent investment, including in some cases asset price bubbles; destabilizing effects from sudden stops or outflows in capital; and risks associated with high levels of leverage. Recently, policymakers and economists in the region have expressed concerns that strong capital inflows might be leading to some of these problems, especially with regard to the rapid appreciation of exchange rates.

This chapter presents preliminary work analyzing capital flows in the region, highlighting changes over the past couple of years in the nature of these flows, and pointing out policy dilemmas and new risks. It explores the following issues: (i) the evolving nature of capital flows in emerging Asia; (ii) the possible macroeconomic risks associated with such flows; and (iii) policy challenges. Future work is needed to confirm some of the observed trends as well as to better understand factors behind these changes.

The chapter’s main findings are that:

  • Net capital inflows to emerging Asia remain close to their long-run average (in terms of GDP), while gross capital inflows and outflows are close to or at historical highs. Capital outflows from emerging Asian economies, particularly portfolio and other investments, have grown significantly from about US$80 billion to over US$380 billion over the past decade. This phenomenon very likely reflects reforms undertaken in the region to strengthen, develop, and liberalize financial systems. Consistent with greater financial integration, we observe that portfolio and other financial flows (both inflows and outflows) have also grown rapidly in recent years.

  • For the region as a whole, net capital inflows have not been the major source of foreign exchange inflows or a significant factor leading to macroeconomic imbalances. Robust current account surpluses continue to be the major factor supporting exchange rates. Moreover, inflation and credit growth remain well under control in most emerging Asian economies. Asset prices have shown sharper increases in some countries, but in general do not appear obviously out of line with economic fundamentals. Housing prices have generally increased but in many cases this reflects a catch-up after extended periods of decline or can be explained by rising incomes and financial sector development (see Chapter III). Equity valuations are beginning to look high, but the link between recent increases and inflows is not clear except for a few countries. Still there are exceptions: for example, inflation is higher in India and Vietnam, and equity markets in these countries have also experienced rapid runups supported by strong foreign investment.

  • The volatilities of gross capital flows have increased. The increase in volatilities for gross capital flows can be explained by their growing size and the increasing proportion of portfolio and other investments in overall capital flows. We also find some evidence of short-term surges in capital inflows. On the other hand, we find that the volatility of net capital inflows generally decreased after the mid-1990s, irrespective of the observed volatility increases in gross flows, indicating that outflows and inflows are now better synchronized, although the reason for this is not clear.

Box 2.1.Measuring Capital Flows

Data used in this analysis were constructed from the IMF’s International Financial Statistics (IFS) and supplemented with data from the CEIC Asia database, national authorities, and IMF staff estimates. We follow BPM5 in dividing capital flows into direct investment, portfolio investment, financial derivative transactions, and other investments. As many countries do not report detailed data on financial derivative transactions or nonfinancial capital account transactions, we include those that are available in other investments. Gross capital inflows in this paper are defined as nonresident investment (direct, portfolio, and other investment) into the domestic economy. Similarly, gross capital outflows are defined as resident investment abroad. Note that gross inflows (or outflows) as defined here are not fully gross and may be negative, reflecting nonresident accumulation of domestic assets or reduction in domestic liabilities (increase in residents’ foreign assets or decline in foreign liabilities). Unfortunately, the underlying data, i.e., true “gross” flows are not usually available. Net capital inflows correspond to the IFS’s Financial Account plus Capital Account, and are the sum of gross capital inflows and outflows.

In-depth analysis of capital flows is made more challenging owing to shortcomings in data on international capital flows and positions. These include:

  • Differences in the methodology used to compile data. Not all countries are, for instance, using BPM5 and this complicates cross-country comparisons.

  • Long lags in data compilation, or irregular reporting. For instance, in some countries, only semiannual balance of payments data are available. These may also only be available after a long lag, complicating analysis of very short-term or recent developments with capital flows.

  • Incomplete coverage. The lack of detailed information on the components of capital flows is a major drawback. This is compounded by greater use of more sophisticated financial instruments that may not be covered by existing reporting requirements.

In this environment, the challenge for policymakers is to implement and maintain policies that assist their economies to maximize the benefits and minimize the risks associated with larger and potentially more volatile cross-border capital flows. These challenges fall broadly into two categories.

  • First, while emerging Asian economies do not generally appear to be facing macroeconomic imbalances resulting from large net capital inflows, large gross inflows could complicate macroeconomic management in the short-term. Small open economies are likely to face difficult policy choices in dealing with such surges.

  • Second, increasingly large gross inflows and outflows highlight the importance of policies that strengthen risk management and increase the economies’ resilience to shifts in such flows (i.e., volatility). In many emerging Asian economies, reforms are in train and include efforts to promote better risk management in financial institutions, improve transparency and data, facilitate productive use of inflows, and reduce risks associated with high leverage.

How Has The Nature of Capital Flows Changed?

We find that gross capital flows—both inflows and outflows—are close to or at historical highs; outward investment from emerging Asia has increased dramatically, so net inflows are off their recent highs and close to historical levels; and financial flows have recently grown rapidly, but these are often poorly identified. There are country-specific variations to these broad patterns.

Asia Remains an Important Destination of Capital

Net private capital inflows to emerging market economies are estimated to have amounted to around US$250 billion in 2006, surpassing levels in the mid-1990s. Emerging Asia is no longer the largest recipient, receiving roughly 25 percent of these flows, down from 50 percent in the mid-1990s. More than half of recent flows went to the transition economies of eastern and central Europe, while flows to Latin America remained weak.

Figure 2.1.Net Private Capital Flows into Emerging Market and Developing Countries

(In billions of U.S. dollars)

Source: IMF, WEO database.

1 Including NIEs.

Gross Inflows Are Close to Historic Highs

Capital inflows to emerging Asia have exceeded slightly the highs reached during the mid-1990s. These flows are estimated to have been close to 8 percent of GDP in 2006 (US$455 billion). Omitting flows to Singapore and Hong Kong SAR, which are financial centers, gross inflows remain close to the highs of the mid-1990s, at 5–6 percent of GDP.14

Figure 2.2.Emerging Asia: Gross Capital Inflows

(In percent of GDP)
(In percent of GDP)
(In percent of GDP)
(In percent of GDP)

Sources: CEIC Data Company, Ltd.; IMF, International Financial Statistics; WEO database; and staff estimates.

1/ Excludes Hong Kong SAR until 1997.

As in the past, foreign direct investment (FDI) constitutes a major component—around 40 percent—of capital inflows. These inflows have grown steadily as a percentage of GDP in recent years, and are now greater than 3 percent of GDP (or above 2 percent of GDP excluding Singapore and Hong Kong SAR), and are approaching the levels seen in the last years of the 1990s. Portfolio inflows have also registered some growth: excluding Singapore and Hong Kong SAR, portfolio inflows have averaged between 1 and 2 percent of GDP over the last four years, a higher level than the previous peaks achieved in the mid-1990s. while equity inflows continue to be strong, investments into debt securities underpin the more recent increase.

The most dramatic movements, however, have been in “other investments,” a residual category accounting for capital flows not identified as FDI or as portfolio flows. This is the most volatile category of capital flows, as evinced by the large negative inflows from the late 1990s to the early years of the new millennium, followed by the recent upward surge. Since 2003, other investments have been positive and increasing, and are now at or above the historical highs of the previous decade. Some of these increases can be explained by bank-related inflows which retrenched in the mid-1990s. These flows have grown again, particularly to the newly industrialized economies (NIEs), China, and India.

Figure 2.3.International Banks' Claims on and Liabilities to Asia

(In billions of U.S. dollars)
(In billions of U.S. dollars)

Sources: Bank for International Settlements, Locational and Consolidated Banking Statistics.

Figure 2.4.Geographic Breakdown of Capital Inflows 2005-2006

Sources: CEIC Data Company, Ltd.; IMF, International Financial Statistics; WEO database; and staff estimates.

The increases in this category are also driven by nonbank flows, which may include complex financial transactions, that are harder to classify and whose motivation is not easily apparent (Box 2.2).

Box 2.2.Banking and Derivatives Flows: Hedging, Carry Trades, and Other Investments

To a considerable degree, banking and derivatives flows into Asian economies in 2006 represented responses to cross-border interest rate differentials or to anticipated currency appreciation. In contrast with 2005, when much of the increase in capital inflows to Asia arose from portfolio equity inflows, in 2006 the major areas of growth were portfolio bond, and banking and derivatives flows. Banking and derivatives flows into Korea and India, in particular, rose sharply from 2005 to 2006. The conjunction of positive interest rate differentials and expected exchange rate appreciation tended to support both carry trades into some Asian currencies (see Box 1.4) and hedging flows aimed at securing future expected export receipts against further domestic currency appreciation.1 This box provides a selective survey of recent developments, emphasizing financial linkages not covered elsewhere in this REO.

Emerging Asia1: Breakdown of Recent Capital Flows
Total Inflows220272303
Direct Investments85116120
Portfolio Investments739290
of which Equity527660
of which Debt211530
Other Investments626492
of which Banks291648
of which Others334844
Total Outflows64177190
Direct Investments223140
Portfolio Investments2678168
of which Equity202754
of which Debt550113
Other Investments21668-18
Sources: CEIC Data Company Ltd.; IMF, International Financial Statistics; WEO database; and staff estimates.

Hedging-related Flows

In Korea, demand for hedging future export receipts was an important factor driving capital inflows in 2006. Gross inflows under the “other” category rose from less than $10 billion in 2005 to about $50 billion in 2006, providing substantial support for the balance of payments, and underlying reserve accumulation of $22 billion for the year.2 This occurred even as nonresidents took advantage of strong domestic interest in equities to take profits and exit the market. These inflows appear to have been motivated to some extent by the experience of recent appreciation of the domestic currency. In this case, large exporters (notably, shipbuilders) expecting a flow of dollar receipts in coming years, but concerned that the dollar might continue to weaken against the domestic currency, sold dollars forward to domestic banks. To balance out their currency exposure,3 those banks in turn established short dollar positions visà-vis foreign banks, creating a capital inflow by borrowing dollars from the foreign banks. In addition, a proportion of “other” inflows (about $5–7 billion according to some market sources) represented short yen positions undertaken by Korean residents in response to the low yen interest rate. Some of these positions were in the form of yendenominated mortgages or loans to small businesses. A similar dynamic appears to have taken place in Thailand, although the magnitudes involved were not as great as those in Korea. There, an increase in “other” investment inflows to Thai corporations—from a negative amount in 2005 to $2.4 billion in inflows in 2006—pointed to some hedging by domestic exporters against the possibility of continued baht appreciation.

Korea: Capital Inflows by Type of Investments

(In billions of U.S. dollars)

Sources: CEIC Data Company, Ltd.; IMF, International Financial Statistics; WEO database; and staff estimates.

Alternative Channels for Investment

In India, “other” investment inflows spiked upward as investors sought alternative access channels to the nation’s equity and fixed income markets. “Other” inflows rose from a then-record $9 billion in 2005 to about $24 billion in 2006, as part of an overall wave of capital inflows that saw reserves increase by $40 billion even in the face of a current account deficit of about $13 billion. Abetted by continuing strong retail interest in India-focused mutual funds, inflows to the Indian equity market were about $8 billion in 2006, down from about $11 billion in 2005 in part to a spell of global market turbulence in May/June that struck Indian markets with some force. However, both equity and FDI inflows taken together account for no more than half of the capital account surplus. Although Indian capital controls generally prohibit the direct participation of investors other than registered foreign institutional investors (FIIs) in domestic markets, market participants indicate that offshore investors who lack direct access to the Indian market have been able to get exposure to the market by engaging in offshore transactions with counterparties who do have access. Accordingly, some investments in offshore structured products linked to Indian domestic markets have likely appeared in the balance of payments as “other” inflows, with offshore entities purchasing domestic-market-linked derivatives from registered FIIs.

Hedging, Exports, and Capital Outflows

In some cases, hedging and export activities may result not in inflows but capital outflows under the “other” category. Most directly, when domestic firms realize a larger-than-expected flow of income from exports, they may “recycle” that income either by leaving it deposited abroad, or by making a dollar-denominated deposit in a domestic bank, prompting the bank to acquire overseas dollar deposits. A portion of the capital outflows from Thai banks in 2006 appears to reflect the latter phenomenon. Alternatively, in certain cases, domestic exporters or banks may decide to let a hedge expire rather than rolling it over, resulting in a recorded capital outflow. Finally, central bank swaps or forward transactions with local banks may also lead to outflows, as may have occurred in Thailand and the Philippines. In these cases, central bank purchases of dollars forward with commercial banks led the commercial banks to increase their foreign assets in order to limit their foreign currency exposure.

Other Investment Inflows, Net

(In millions of U.S. dollars)
Note: The main author of this box is Chris Walker.1 As used here, the term “carry trade” refers to an investment in which an investor borrows in a currency with a lower interest rate to invest in a currency with a higher interest rate, thereby collecting the interest rate differential but taking on exposure to exchange rate fluctuations.2 “Other” flows in the capital/financial account include banking and derivatives flows—these are often the main components of capital flows.3 In Korea and several other Asian countries, prudential regulations require banks to limit their net foreign currency exposure.

China remains an important destination for capital, especially FDI inflows, but other countries have grown in significance. Inflows to NIEs and ASEAN (in this chapter, this refers to Indonesia, Malaysia, the Philippines, and Thailand) economies account for most of the recent increase. The NIEs are the major destinations for portfolio and other inflows, which is not surprising given the roles of Hong Kong SAR and Singapore as financial centers.

The recent pickup in capital inflows to emerging Asia partly reflects improved fundamentals in much of the region. However, there are several broader factors that have supported the increase in capital inflows.

  • Supportive global financial conditions: Global financial conditions in recent years have been highly accommodative, with ample global liquidity and demand for higher yielding assets. For instance, the EMBIG spread index hit an all-time low of 168 basis points at end-December 2006 and has remained at around that level. The MSCI Emerging Market Index also reached a record high at the end of last year.

  • Growth in the investor base. An increasing number of institutional investors, including insurance companies, pension funds, and hedge funds are investing in emerging markets, as investors diversify and search for higher returns.15

  • Capital market development and increasing liberalization. Recent reforms have deepened domestic capital markets in Asia, introduced new types of financial instruments, and liberalized participation by nonresidents. Australia, Hong Kong SAR, New Zealand, and Singapore have the most open markets, with limited restrictions on cross-border investment. Meanwhile the broadening and deepening of markets in the ASEAN countries have encouraged inflows, particularly portfolio investments.

  • Attractive portfolio investment opportunities. Positive interest rate differentials on domestic holdings (especially against the yen) as well as expectations of currency appreciation in the region were another important factor driving capital inflows. In countries with higher interest rates, such as Australia and New Zealand and perhaps India and some ASEAN economies, this may contributed to the recent pick-up in capital inflows.

Gross Capital Outflows Are at Historic Highs

In tandem with inflows, capital outflows have increased rapidly in recent years and have reached unprecedented levels. Gross capital outflows reached nearly 7 percent of GDP for Asia (US$380 billion) in 2006, nearly doubling from levels a decade ago. Both Hong Kong SAR and Singapore are major sources of capital outflows but, even excluding them, capital outflows from emerging Asia have doubled to US$190 billion over the last 10 years.

Figure 2.5.Emerging Asia: Gross Capital Outflows

(In percent of GDP)
(In percent of GDP)
(In percent of GDP)
(In percent of GDP)

Sources: CEIC Data Company, Ltd.; IMF, International Financial Statistics; WEO database; and staff estimates.

1/ Excludes Hong Kong SAR until 1997.

Portfolio investments comprise the major component of outflows and have grown rapidly, especially over the last two years. Portfolio outflows are estimated to have reached nearly 4 percent of GDP for emerging Asia, or about US$215 billion. Other investment outflows are also high and volatile but, as with inflows, data shortcomings make it difficult to fully analyze the behavior of this component of capital outflows. Nevertheless, at least some of the more recent increase seems closely related to the recycling of current account surpluses through the banking system (e.g., Thailand and the Philippines). Finally, reflecting a more developed corporate sector and increasing economic integration, emerging Asia’s direct investment abroad has increased at a steady pace, reaching close to 2 percent of GDP, from about 1 percent a decade ago.

China and the NIEs, particularly Korea more recently, are the major sources of capital outflows, closely followed by the ASEAN economies. A large proportion of this reflects Chinese banks’ purchases of nonresident debt securities while the NIEs continue to be significant portfolio investors.

Figure 2.6.Geographic Breakdown of Capital Outflows 2005-2006

Sources: CEIC Data Company, Ltd.; and IMF, International Financial Statistics; WEO database; and staff estimates.

A confluence of factors has led to the upward trend in Asian capital outflows (Box 2.3).

Box 2.3.Emerging Asia’s Experiences in Liberalizing Outflows

Measures to promote capital outflows have constituted an important policy response by Asian authorities to an increasingly wealthy and sophisticated investor base as well as to pressures from growing official reserves. In some cases governments may be able to increase capital outflows directly, through official or quasi-official entities such as national pension funds. Many of these have, in fact, moved to increase the share of foreign assets in their portfolios. Within the private sector, regulatory reform has made it easier for institutional investors to acquire and hold foreign assets. Regulatory changes, along with market development, have also provided individual investors with better access to foreign assets. The measures have borne some fruit, yielding increases in bond outflows in 2005 and 2006. Equity outflows also increased in 2005, falling back only slightly in 2006.1

Emerging Asia: Composition of Capital Outflows

(In billions of U.S. dollars)

Sources: CEIC Data Company Ltd.; IMF, International Financial Statistics; and staff calculations.

Public Outflows

Governments seeking to redirect capital outflows from the accumulation of official reserves to other channels have, in some cases, the option of shifting reserves from the central bank or finance ministry to another agency.2 Singapore’s Government Investment Corporation (GIC), which manages a substantial portion of the nation’s official external assets, has served in some cases as a model for such agencies. China, the holder of more than $1 trillion in official reserves, recently announced that it may transfer up to $250 billion of those reserves into a State Foreign Exchange Investment Corporation (SFEIC). The announced purpose of the SFEIC will be to promote outward investment and increase returns on a relatively substantial proportion of the nation’s wealth. In a similar vein, Korea established the Korea Investment Corporation (KIC) in 2005, with the aim of having it manage up to $20 billion of the nation’s $239 billion (December 2006) in foreign reserves. In contrast with the arrangement in Singapore, however, the assets entrusted by the Bank of Korea to KIC (thus far only about $1 billion) will continue to be treated as official reserves.

Governments have also moved to encourage capital outflows through institutions under their control, notably national pension funds. The example of Japan’s Government Pension Investment Fund, although outside of emerging Asia, is instructive. The GPIF has increased the share of foreign stocks and bonds in its ¥70 trillion ($600 billion) portfolio to about 25 percent in 2005, from an initial level near zero in 2001. Korea’s Pension Fund Association raised its allocation to foreign assets to about 8 percent of its 156 trillion won ($170 billion) in 2005. More than nine-tenths of the allocation is in foreign fixed income, almost all of which is currency hedged. National pension funds elsewhere, including Thailand, have also raised targets for holdings of foreign assets.

Private Portfolio Flows

Investment vehicles now being made available to individual households could constitute an important channel for expansion of capital outflows. In April 2006, China announced a set of measures to give individual savers greater access to foreign assets. Among these, depositors in domestic banks were permitted to purchase foreign exchange and foreign-exchange-linked products with renminbi funds; previously depositors had been required to furnish foreign exchange in order to have access to such products. In addition, individual investors are now permitted to acquire up to $20,000 a year in foreign-asset-based mutual funds under the qualified domestic institutional investor program (QDII), although the availability of such funds is currently quite limited. Although the measures represent a potentially important alternative for Chinese domestic investors, early results from the program have been somewhat disappointing. A major difficulty with the channels made available so far is that they been restricted to fixed income, and retail investors have come to expect that any interest rate gains from higher yields outside of China will be absorbed by future renminbi appreciation. Accordingly, some recent statements from officials suggest that QDII may soon be expanded to accommodate equity outflows.

The Malaysian authorities increased the limit on holdings of foreign assets by some institutional investors and investment trusts from 10 to 30 percent in 2005, and raised the limit again to 50 percent in early 2007. Investors are reported to have responded to these measures as portfolio outflows have increased from $715 million in 2005 to $2.2 billion in 2006. (Other factors, including de-pegging of the currency may also have contributed to this increase.)

Likewise, measures taken to liberalize and encourage private sector outflows have been successful in Korea. These outflows have accelerated in the past two years, with equity outflows rising from less $4 billion a year in 2004 and 2005 to more than $15 billion, due in part to the successful marketing efforts of mutual funds investing in foreign equities, often in emerging markets. Bond outflows have also accelerated, but this has been primarily due to purchases by institutional investors including life insurers, since the spreads between domestic and foreign interest rates are not large. Thus far, such purchases of foreign fixed income instruments have generally been hedged, limiting exposure to currency fluctuations.

Foreign direct investment outflows have also increased, as public or large private firms in emerging economies have sought to benefit from access to overseas natural resources, labor, or distribution networks. Outward FDI from China has grown particularly rapidly, although even at more than $12 billion in 2006 it was only one-sixth the total of inward FDI in the same year. Recent streamlining of licensing requirements has apparently contributed to the rapid expansion of outward FDI. In Korea, FDI outflows have also increased, though not as steeply, as the country’s leading automobile and electronics manufacturers have expanded some production overseas. Some Indian firms in the information technology industry have pursued overseas expansion through FDI, raising direct investment outflows to $2.5 billion in 2006, over 25 times the annual average rate in the late 1990s.

Note: The main author of this box is Chris Walker.1 The apparent decline reflects a $19 billion reduction in equity outflows from Hong Kong SAR. A large proportion of those flows in 2005, however, likely remained in the region, as they were generated by the public offerings of mainland Chinese firms, particularly state-owned banks. Accordingly, equity portfolio outflows from the region taken as a whole may in fact have increased in 2006.2 There is, in general, no impact on domestic liquidity from such a transfer, which, from the central bank’s perspective, merely substitutes a domestic for a foreign asset on its balance sheet. However, if the agency proceeds to raise funds by issuing local currency bonds or raising deposits from the public and investing them overseas, the pressure on the monetary authority to sterilize inflows may diminish.
  • Increasing integration and market development. Better integration of markets and economies, especially within the region, an increasingly sophisticated and wealthier investor base, and financial market development, are likely to have supported this trend.

  • Recycling of current account surpluses. Presented with large and growing stocks of foreign reserves, some governments have moved to establish agencies to manage these reserves and attain higher rates of return. To an extent, the increase in gross outflows is also a consequence of rising inflows, with some outward portfolio flows (such as from financial centers) representing the onward distribution of investment flows into the region, and other outflows representing hedging associated with portfolio or FDI inflows.

  • Capital account liberalization. At the same time, restrictions on private sector outflows are being relaxed, reflecting both a desire to reduce the burden of sterilizing net inflows and a recognition of the value of portfolio diversification by the private sector. China and Korea have both liberalized restrictions on resident investments abroad, and have seen an increase in outward portfolio investments. Liberalization in some ASEAN economies has led to a pick-up in outward flows, such as equity portfolio investment in the case of Malaysia.

  • More global and developed corporate sectors. FDI outflows have increased as Asian firms have moved to establish global supply and sales networks.

Net Capital Inflows Are Lower

One major consequence of the growth in capital outflows from the region is that after reaching a peak in 2004, net inflows to the region have actually decreased over the last two years.

Figure 2.7.Net Capital Inflows

(In percent of GDP)

Consistent with the rapid increase of outward portfolio flows, a fall in net portfolio inflows is the main driver behind the fall in net capital inflows to the region.16 The fall in net portfolio flows is being driven, more recently, by large increases in emerging Asia’s outward investment in debt securities.

Figure 2.8.Emerging Asia:1 Net Portfolio Investments

(In percent of GDP)

Sources: CEIC Data Company, Ltd.; IMF, International Financial Statistics; WEO database; and staff estimates.

1 Excludes Hong Kong SAR and Singapore.

These broad features mask differences in the region. China is a large net capital importer, despite its large current account surplus, and more recently, an increase in gross capital outflows. India is also a large capital importer. Among the NIEs, Korea saw a large rebound in net inflows, especially in 2006, reflecting large increases in bank related flows. Hong Kong SAR and Singapore continued to experience net capital outflows. By contrast, net capital flows to the ASEAN countries are about zero.

What Risks and Challenges Do Recent Capital Flows Bring?

Net capital inflows are off their recent highs but gross flows have become more volatile.

Exchange Rates Have Appreciated Reflecting Strong Current Account Positions

Emerging Asian exchange rates have been under pressure to appreciate. Indeed, despite significant intervention, there has been a region-wide trend toward nominal appreciation for several years. Since end-2004, a simple average of exchange rate indices for emerging Asia indicates local currency appreciation of over 5 percent. Excluding Hong Kong SAR (currency board), and India and Vietnam (which are outliers whose currencies have depreciated slightly), the appreciation over the past two years has been closer to 7 percent. There has been considerable variation between countries, with some countries experiencing more rapid appreciation, notably the Philippines, Korea, and Thailand.

Figure 2.9.Emerging Asia: Exchange Market Pressure Index

Sources: IMF, International Financial Statistics; and staff calculations.

1 The index is the sum of the rate of appreciation of nominal exchange rate and the normalized rate of international reserve accumulation.

Net capital inflows are contributing to foreign exchange inflows but in contrast to 2004, strong current account surpluses are more significant. As a whole, emerging Asia continues to run significant current account surpluses, equivalent to about US$296 billion or about 80 percent of emerging Asia’s reserve accumulation of US$376 billion in 2006. Excluding China, Hong Kong SAR, and Singapore, which run large current account surpluses, lowers the ratio of the current account surplus to reserve accumulation to about 60 percent.17

Figure 2.10.Balance of Payments and Reserve Accumulation

(In percent of GDP)

Sources: CEIC Data Company, Ltd.; IMF, International Financial Statistics; WEO database; and staff estimates.

Even if net capital inflows are not the main contributor to foreign exchange inflows, capital flows may still bring macroeconomic challenges. For one, gross flows may sometimes be more relevant when examining the possible impact of capital flows since inflows and outflows affect different sectors (e.g., nonresident investment in domestic securities markets and resident investment in global financial markets). The impact of any flows on financial markets is likely to be greater in smaller and more undeveloped markets. Second, our analysis—which is based on available capital account data—may not pick up short-term surges in capital flows. These surges are discussed in the following section. What follows is a brief discussion of possible areas of concern. We conclude that, with some important exceptions, emerging Asia is not facing overheating economies or historically high housing prices resulting from capital inflows. The evidence for high equity prices is more mixed.

Across Emerging Asia, Inflation and Credit Growth Remain Moderate, While Asset Prices Are Rising to Varying Degrees

Most emerging Asian economies are not on the verge of overheating as they were in the mid-1990s. Economic growth and credit growth is more modest, and inflation remains low in much of the region, albeit somewhat less so in India and Vietnam. External vulnerabilities look much lower, as evidenced by the current account surplus throughout much of the region, lower external debt-to-GDP ratios, and high reserve levels.

Figure 2.11.Emerging Asia: Pre-Crisis Vs. Post-Crisis1

Real GDP Growth

(In percent)


(Year-on-year percent change)

Total Foreign Debt

(In percent of GDP)

Total Foreign Reserves2

(In billions of U.S. dollars)

Sources: The PRS Group Inc.; and staff calculations.

1 Simple averages of emerging Asia.

2 Sum of emerging Asia.

While housing prices have been rising more than inflation, most economies in Asia are not experiencing unusually rapid housing price hikes (see Chapter III). True, mortgage lending has grown faster than lending to other sectors. However, these increases can be explained in part by increased financial innovation and rising income, which have led to increased access to financial products and demand for housing. Gaps in data make it difficult to track (gross) foreign investment in this sector but the lack of generalized price pressures make it hard to point to inflows as creating major pressures on housing prices. Nevertheless, in New Zealand, and to a lesser extent Australia, net capital inflows in the context of current account deficits may be supporting demand for real estate by making financing easier.

The situation regarding equity prices is more mixed, with the very latest increases pushing up valuations. Up until 2006, the usual indicators of equity valuation did not appear to be inordinately high.18 In addition, both gross and net inflows into equity investments have been, in aggregate, modest compared to previous highs. However since late 2006, equity markets in the region have risen rapidly and valuations are now higher than recent averages and most other emerging markets. This holds true even after the correction in late February. The extent that capital inflows have supported the recent increase is hard to tell given data limitations, but concerns have been expressed in India and Vietnam19 over equity investments by nonresidents. The Thai equity market (among the lowest-valued in the region) has also been supported by strong foreign interest.

Table 2.1.Price- Earning Ratio1(Period Average)
2007 End-Feb20062001-06Pre-1997 high2
Hong Kong SAR19.
EM Latin America14.213.513.117.93
EM Europe & Middle East13.615.814.725.73
Sources: Datastream; and IMF staff calculations.

Figure 2.12.Equity Investment Inflows into Asia and Pacific Economies1

(In billions of U.S. dollars)

Sources: CEIC Data Company, Ltd.; IMF, International Financial Statistics; and staff estimates.

1 Excludes Japan.

Gross Capital Flows Are More Volatile

Given higher gross flows, a natural concern is whether these flows are more volatile.20 The answer depends partly on how exactly volatility is measured. The measure that we hold most useful—in that it provides the best indicator of how vulnerabilities are affected—is the standard deviation of the change in capital inflow or outflow relative to GDP. By this indicator, volatilities of both gross inflows and outflows have increased in recent years,21 mainly because of increased flow volumes (relative to GDP) and because of a significant rise in the volatility of portfolio investments.

As might be expected, portfolio and other investments tend to exhibit greater volatility than FDI. The volatility of direct investment is both lower than that of other flows, and tends to change the least between the precrisis and postcrisis period. The significant exceptions to this rule are Australia and New Zealand, which saw large increases in FDI volatility during the postcrisis period. The volatility of portfolio investment inflows and outflows increased significantly after the crisis. Other investment flows do not show systematic increases in volatility, but tend to be the most volatile component of flows.

Table 2.2.Volatilities of Capital Flows in Asia-Pacific Countries1
InflowsOutflowsBalance (net inflows)
Emerging Asia (excluding Hong Kong SAR and Singapore)2
Total Capital Flows2.763.48*31.292.62**2.952.65
Direct Investment Flows0.551.03**0.280.47*0.680.82
Portfolio Investment Flows0.792.01**0.191.01**0.872.04**
Other Investment Flows2.451.881.082.26**2.522.15
Total Capital Flows3.314.54*1.172.79**3.203.35
Direct Investment Flows0.781.53**0.120.68**0.781.24*
Portfolio Investment Flows1.122.23**0.230.66*1.232.30**
Other Investment Flows2.912.331.112.64**2.772.10
Korea and Taiwan Province of China
Total Capital Flows3.163.702.363.234.062.46
Direct Investment Flows0.160.71**0.750.340.700.53
Portfolio Investment Flows0.483.11**0.272.10**0.592.59**
Other Investment Flows3.141.871.741.973.672.67
Total Capital Flows10.8014.5712.1415.745.954.08
Direct Investment Flows4.295.742.0612.10**4.199.94*
Portfolio Investment Flows2.264.155.524.095.435.49
Other Investment Flows12.1410.8411.2713.995.466.21
Total Capital Flows1.291.240.492.53**1.511.87
Direct Investment Flows0.840.460.260.300.840.37
Portfolio Investment Flows0.260.330.041.29**0.241.30**
Other Investment Flows0.810.900.252.85**0.982.29*
Australia and New Zealand
Total Capital Flows3.185.292.526.34**2.921.84
Direct Investment Flows1.095.33**1.783.17*2.222.86
Portfolio Investment Flows1.883.93**0.611.59**1.734.34**
Other Investment Flows2.542.980.993.73**2.362.80
Sources: CEIC Data Company, Ltd.; IMF, International Financial Statistics; WEO database; and staff estimates.

Some Evidence for Surges

One manifestation of the increase in volatility of gross inflows is that “surges”—sharp increases or decreases in capital inflows—have become more frequent recently. This is true especially for the ASEAN countries, even when compared to Hong Kong SAR and Singapore, which are financial centers and experience large variations in capital flows. We measure the “surge” by looking at one-quarter changes in capital inflows.22 These surges may explain why policymakers have expressed concern about the macroeconomic consequences of capital inflows in seeming contradiction to this chapter’s general finding that net inflows are a less important factor compared to the recent past.

Indeed, there is evidence that exchange rate pressures coincided with these surges. Certainly, other factors are likely to influence exchange rates (e.g., the current account, market expectations, global financial conditions, etc.) and the macroeconomic consequences of surges go beyond exchange rate pressures. But this simple exercise illustrates, albeit in a crude manner, the impact of volatility on a few emerging Asian economies.

Figure 2.13.Selected Asia: Standard Deviation of Quarterly Changes in Portfolio and Other Investment Inflows

Sources: CEIC Data Company, Ltd.; IMF, International Financial Statistics; WEO database; and staff estimates.

Figure 2.14.“Surges” and Exchange Market Pressure Index (EMPI)

Sources: CEIC Data Company, Ltd.; IMF, International Financial Statistics; WEO database; and staff estimates.

1 Net inflows refer to portfolio and other investment.

Volatility of Net Inflows Has Not Changed

Consistent with the September 2006 edition of the Regional Economic Outlook, we find that the volatility of net capital flows generally decreased after the mid-1990s, irrespective of the observed volatility increases in both gross inflows and outflows, indicating that inflows and outflows are better synchronized in the postcrisis period. For financial centers, the strong correlation can be explained by their role as intermediaries. But for other cases such close synchronization seems counterintuitive if, for example, interest rate differentials were to be a major driving force behind capital flows. Hedging by nonresident investors might account for the close correlation. Similarly, some resident investors might acquire foreign assets if they perceive the currency to be over-appreciated. Nevertheless, the reason for the recent close correlation is not clear and should be explored further. While closer correlation between outflows and inflows reduced concerns associated with volatile flows, there is no reason to believe that the strong correlation would continue during periods of stress or structural changes.

Figure 2.15.Emerging Asia: Capital Flows Volatilities1

(In percent of GDP)

Sources: CEIC Data Company, Ltd.; IMF, International Financial Statistics; WEO database; and staff estimates.

1 Excludes Hong Kong SAR and Singapore.

Policy Challenges

Large capital inflows—whether temporary or more permanent, or in response to real or financial incentives—have posed difficult choices for policy-makers. These include:

  • Trade-offs between domestic and external objectives. In some countries, strong capital inflows do complicate macroeconomic management. A few countries are experiencing capital inflows in the context of higher inflation and current account deficits where tighter monetary policy could encourage stronger inflows. Exchange rate flexibility, in the context of strong financial institutions, has helped the adjustment process, as for example in New Zealand. At the same time, monetary policy has been complicated by the impact of monetary tightening on capital inflows: increases in short-term rates have not necessarily led to increases in long-term rates as capital inflows depress longer-term yields.

  • Dealing with sudden surges in capital inflows. Such surges may complicate exchange rate management and monetary policy, as policymakers have an imperfect set of instruments with which to facilitate markets-led adjustments or limit the impact of such temporary surges. These instruments have traditionally included allowing greater exchange rate flexibility, engaging in foreign exchange market intervention, cutting interest rates, or putting in administrative controls.23 Yet all these measures have advantages and costs: abrupt movements in the exchange rate can affect competitiveness or financial stability, and interventions may be costly, monetary policy may be oriented toward domestic objectives, while administrative controls can have adverse effects on investor confidence and market development.

  • Living with larger flows and dealing with volatility. Given that the key finding of this chapter is that gross capital flows are increasing—especially financial flows and outflows from emerging Asia—a key challenge will be to put in place policies that will help countries maximize benefits while minimizing risks such as those associated with sudden stops or increased volatility. For example, insofar as some recent flows might be associated with “carry trades,” they might unwind quickly and be disruptive, despite largely smooth recent corrections. There is no “silver bullet” that will reduce risks and maximize benefits from cross-border capital flows. Instead, a set of mutually reinforcing and consistent policies is needed. Obviously, the nature of the policies and priorities needed will depend on each economy’s circumstances and the structure of its financial system. The overall objective of such policies should be to promote investor confidence and sound risk management; provide high quality, timely, and relevant information; facilitate productive use of inflows; and reduce risks associated with high levels of leverage or mismatches.

Table 2.3.Balance of Payments and Reserve Accumulation in Emerging Asia(In billions of U.S. dollars)
19992000200120022003200420052006 Est.
Emerging Asia 1
Current account balance1037884117159173248296
Capital account balance3-81021451295376
Direct investment, net64595150665810293
Direct investment outflows-40-81-48-34-21-76-63-92
Direct investment inflows1041391008487134165184
Portfolio investment, net3414-60-71-81-26-96
Portfolio investment outflows-52-58-89-86-89-77-132-215
Portfolio investment inflows867329158178107119
Other investment, net-95-821942-1470-2379
Other investment outflows9-4310073-38-55-94-73
Other investment inflows-103-39-81-312312071151
Reserve asset accumulation876286150227336285376
Emerging Asia (excl. Hong Kong SAR and Singapore)
Current account balance78616393120135199242
Capital account balance17-530538415795114
Direct investment, net5046435351638680
Direct investment outflows-12-15-17-14-13-22-31-40
Direct investment inflows636160676385116120
Portfolio investment, net105-12-19364714-77
Portfolio investment outflows-15-23-38-35-39-26-78-168
Portfolio investment inflows2528261675739290
Other investment, net-44-56-219-246-5111
Other investment outflows-35-542515-19-16-6818
Other investment inflows-9-1-26517626492
Reserve asset accumulation734582151219320272351
Emerging Asia (excl. Hong Kong SAR, Singapore, and China)
Current account balance5740455875673959
Capital account balance12-7-52132463236
Direct investment, net138663101818
Direct investment outflows-11-14-10-11-13-20-19-27
Direct investment inflows2423161816303746
Portfolio investment, net2298-9252819-19
Portfolio investment outflows-4-12-17-23-42-32-52-78
Portfolio investment inflows2620251466607159
Other investment, net-23-24-192348-537
Other investment outflows-10-10418-1-18-24-26
Other investment inflows-13-14-2265261962
Reserve asset accumulation6435357610311464104
Current account balance2824181927211441
Capital account balance-19-21-15-6-8851
Direct investment, net7326571613
Direct investment outflows-2-2-1-2-2-6-7-11
Direct investment inflows95388132324
Portfolio investment, net1-6-1-14161014
Portfolio investment outflows-1-10-2-20-3-7
Portfolio investment inflows1-4-116151321
Other investment, net-27-18-15-11-17-15-21-27
Other investment outflows-10-5-2-3-4-14-19-23
Other investment inflows-17-13-13-8-140-2-5
Reserve asset accumulation16211214251037
NIEs 3
Current account balance5739485580848085
Capital account balance81-18-17-18-14-35-43
Direct investment, net17168-710-6149
Direct investment outflows-36-77-39-27-18-66-43-66
Direct investment inflows5393472128605775
Portfolio investment, net4222-42-60-31-43-43-60
Portfolio investment outflows-41-46-68-72-90-84-103-119
Portfolio investment inflows8368261159416059
Other investment, net-52-371650336-68
Other investment outflows4418273-19-43-30-95
Other investment inflows-96-38-65-24207324102
Reserve asset accumulation5643294471815453
Current account balance212117354669161183
Capital account balance523532531116378
Direct investment, net3737374747536862
Direct investment outflows-2-1-7-30-2-11-13
Direct investment inflows3938444947557975
Portfolio investment, net-11-4-19-101120-5-58
Portfolio investment outflows-11-11-21-1236-26-90
Portfolio investment inflows-17128132131
Other investment, net-21-3217-4-638074
Other investment outflows-24-4421-3-182-4544
Other investment inflows412-4-112364530
Reserve asset accumulation9114775117206207247
Sources: CEIC Data Company, Ltd.; IMF, International Financial Statistics; WEO database; and staff estimates.
Table 2.4.Balance of Payments and Reserve Accumulation in Emerging Asia(In percent of GDP)
19992000200120022003200420052006 Est.
Emerging Asia 1
Current account balance3.
Capital account balance0.1-
Direct investment, net2.
Direct investment outflows-1.3-2.5-1.5-0.9-0.5-1.7-1.2-1.6
Direct investment inflows3.
Portfolio investment, net1.10.5-1.8-2.0-0.20.0-0.5-1.6
Portfolio investment outflows-1.8-1.8-2.7-2.4-2.3-1.7-2.6-3.7
Portfolio investment inflows2.
Other investment, net-3.2-
Other investment outflows0.3-
Other investment inflows-3.5-1.2-2.5-
Reserve asset accumulation3.
Emerging Asia (excl. Hong Kong SAR and Singapore)
Current account balance2.
Capital account balance0.6-
Direct investment, net1.
Direct investment outflows-0.5-0.5-0.6-0.4-0.3-0.5-0.6-0.7
Direct investment inflows2.
Portfolio investment, net0.40.2-0.4-
Portfolio investment outflows-0.5-0.8-1.3-1.1-1.0-0.6-1.6-3.0
Portfolio investment inflows0.
Other investment, net-1.6-1.9-0.10.6-0.11.1-0.12.0
Other investment outflows-1.3-
Other investment inflows-0.30.0-
Reserve asset accumulation2.
Emerging Asia (excl. Hong Kong SAR, Singapore, and China)
Current account balance3.
Capital account balance0.7-0.4-
Direct investment, net0.
Direct investment outflows-0.7-0.8-0.6-0.6-0.6-0.9-0.7-0.9
Direct investment inflows1.
Portfolio investment, net1.30.50.5-
Portfolio investment outflows-0.2-0.7-1.0-1.2-2.0-1.4-2.0-2.7
Portfolio investment inflows1.
Other investment, net-1.4-1.4-
Other investment outflows-0.6-
Other investment inflows-0.8-0.8-
Reserve asset accumulation4.
Current account balance6.
Capital account balance-4.5-4.7-3.3-1.1-
Direct investment, net1.
Direct investment outflows-0.4-0.5-0.1-0.4-0.4-1.0-1.0-1.3
Direct investment inflows2.
Portfolio investment, net0.2-1.3-0.3-
Portfolio investment outflows-0.2-0.30.0-0.4-0.30.1-0.5-0.8
Portfolio investment inflows0.3-1.0-
Other investment, net-6.4-4.0-3.5-2.2-3.1-2.4-3.1-3.2
Other investment outflows-2.4-1.1-0.4-0.5-0.7-2.3-2.8-2.7
Other investment inflows-4.0-2.9-3.1-1.6-2.4-0.1-0.3-0.6
Reserve asset accumulation3.
NIEs 3
Current account balance5.
Capital account balance0.80.0-1.7-1.6-1.6-1.1-2.4-2.8
Direct investment, net1.81.40.7-0.60.9-
Direct investment outflows-3.6-7.0-3.8-2.5-1.5-5.2-3.0-4.3
Direct investment inflows5.
Portfolio investment, net4.22.0-4.1-5.5-2.7-3.4-3.0-3.9
Portfolio investment outflows-4.2-4.2-6.6-6.5-7.8-6.6-7.2-7.7
Portfolio investment inflows8.
Other investment, net-5.2-
Other investment outflows4.
Other investment inflows-9.7-3.5-6.4-
Reserve asset accumulation5.
Current account balance1.
Capital account balance0.
Direct investment, net3.
Direct investment outflows-0.2-0.1-0.5-0.20.0-0.1-0.5-0.5
Direct investment inflows3.
Portfolio investment, net-1.0-0.3-1.5-
Portfolio investment outflows-1.0-0.9-1.6-
Portfolio investment inflows-
Other investment, net-1.9-2.61.3-0.3-
Other investment outflows-2.3-3.71.6-0.2-1.10.1-2.01.7
Other investment inflows0.41.0-0.3-
Reserve asset accumulation0.
Sources: CEIC Data Company, Ltd.; IMF, International Financial Statistics; WEO database; and staff estimates.
Table 2.5.Balance of Payments and Reserve Accumulation in Emerging Asia1(In percent of GDP)
199519961997199819992000200120022003200420052006 Est.
Emerging Asia
Current account balance-0.9-
Capital inflows, net3.53.70.0-2.20.1-
Direct investment, net1.
Portfolio investment, net0.
Other investment, net1.11.3-2.0-4.4-3.2-
Reserve accumulation1.
Emerging Asia (excl. Hong Kong SAR and Singapore)
Current account balance-1.6-
Capital inflows, net3.94.30.3-1.20.6-
Direct investment, net1.
Portfolio investment, net1.01.20.7-
Other investment, net1.21.3-2.3-3.0-1.6-1.9-0.10.6-0.11.1-0.12.0
Reserve accumulation1.
Sources: CEIC Data Company, Ltd.; IMF, International Financial Statistics; WEO database; and staff estimates.

Note: The main authors of this chapter are Shekhar Aiyar, Masahiro Hori, and Leslie Teo.

In this chapter, emerging Asia includes China, Hong Kong SAR, India, Indonesia, Korea, Malaysia, the Philippines, Singapore, Taiwan Province of China, and Thailand. Other economies are included where relevant (Australia, New Zealand, and Vietnam).

Gross capital inflows are defined as nonresident investment (direct, portfolio, other) in the economy. Gross capital outflows correspond to resident investment abroad. Net capital inflows are defined as the sum of gross inflows and outflows. For details see Box 2.1.

This chapter’s findings hold true even if China were excluded. See Tables 2.3 and 2.4 for detailed data.

For instance, the number of hedge funds in Asia that are regionally focused has grown to about 800.

By construction, net capital inflows to the region exclude intraregional flows, despite the fact that our measures of gross inflows and gross outflows include intraregional flows.

See Table 2.5 for details.

The September 2006 Asia and Pacific Regional Outlook discusses this further.

Rather tellingly, data on valuations are difficult to obtain for the Vietnamese stock exchange, which has increased by over 100 percent in the past year.

Unteroberdoerster (2007) reports that growth performance appears to be negatively associated with capital flows volatility.

An appealing feature of the measure we use—the standard deviation of the change in capital inflow or outflow relative to GDP—is that it tends to increase with an increase in capital flows as a percentage of GDP. This is desirable because, for instance, the greater the level of these inflows, the more vulnerable a recipient of capital inflows is to sudden stops or reversals. A dimensionless measure of volatility, such as the coefficient of variation, shows the same broad pattern but is less useful precisely because it is insensitive to the level of capital flows. Finally, another popular measure of variability is the standard deviation of capital flows scaled not by GDP but by international reserves. While it is true that this measure captures even more precisely a country’s vulnerability to capital reversals, it conflates capital movements with the policy response to capital movements, which may well take the form of reserves accumulation. Other measures could be explored in future work.

A surge is defined as a one-quarter change in portfolio and other investments greater than two standard deviations with the standard deviations calculated over the historical period. This filter is designed to identify large and episodic changes in capital flows.

Other policies to deal with capital inflows include fiscal policy, steps to liberalize capital outflows; and structural reforms to strengthen the financial sector, deepen financial markets, and more generally improve the efficiency of the economy. These are not likely to be effective in dealing with short-term surges although they may affect expectations.

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