Capital Inflows and Policy Responses in the AsEAN Region

This paper reviews the experience of four ASEAN countries in dealing with an unprecedently strong influx of foreign capital in the late 1980s and early 1990s. While there was some increase in inflation associated with the inflows, it was relatively minor, and real exchange rates did not appreciate. Countries responded in the first instance by using open market operations for sterilized intervention. Subsequently, the fiscal stance was tightened. There was reluctance to allow nominal currency appreciation and, with one exception, controls on capital inflows were avoided.


This paper reviews the experience of four ASEAN countries in dealing with an unprecedently strong influx of foreign capital in the late 1980s and early 1990s. While there was some increase in inflation associated with the inflows, it was relatively minor, and real exchange rates did not appreciate. Countries responded in the first instance by using open market operations for sterilized intervention. Subsequently, the fiscal stance was tightened. There was reluctance to allow nominal currency appreciation and, with one exception, controls on capital inflows were avoided.

I. Background

Since the late 1980s, Indonesia, Malaysia, the Philippines, and Thailand, all rapidly growing ASEAN economies, have experienced a marked increase in net capital inflows.2 These inflows reflected a number of factors, both domestic and external. Among the domestic factors were renewed confidence in macroeconomic management in the wake of successful stabilization programs, which led both to a return of domestic capital and to increased investments by nonresidents; and productivity gains arising from structural reform. External factors included appreciation of the yen, which induced Japanese industries to relocate to lower-cost centers; the decline in interest rates in the U.S. and other industrial countries, which increased interest rate differentials in favor of developing countries; and portfolio shifts by institutional investors toward the so-called “emerging markets.”3

In the ASEAN region, higher capital inflows were contemporaneous with high rates of domestic saving, investment, and economic growth and, to this extent, they could be absorbed with relatively little disruption to macroeconomic stability. However, higher inflows of the magnitude registered in the peak inflow years could not help but generate some demand pressures, which were manifested in a combination of higher inflation and increased imports of consumer, as well as capital, goods.

The reasons for higher capital flows, not only to the ASEAN economies but also to a number of other countries, particularly those in Latin America, have been examined in a number of studies conducted over the past two to three years. There in addition have been some attempts to analyze and evaluate countries’ policy responses. The most detailed work on the latter has been done on a single-country basis or across regions and for economies in quite different circumstances.4 No study has yet attempted to compare in detail the experiences of a more homogeneous group of countries in a single region.

The present paper has two principal aims. It will first, for the four ASEAN capital importers, analyze the composition of capital flows and describe their macroeconomic impact. It will then proceed to describe briefly the countries’ policy responses under four major rubrics (monetary, fiscal, exchange rate, and direct policies in respect of capital flows), pointing to commonalities and differences in the policies adopted.

II. Capital Inflows and Their Impact

As Chart 1 indicates, the present period of heavy net capital inflow into the ASEAN countries began in 1988 with Thailand, followed by Malaysia in 1989. Although as a percentage of GDP Thailand’s capital account surplus peaked in 1990-91, strong inflows continue to date. Net inflows into Malaysia increased very sharply until early 1994, when they reversed themselves as a consequence of measures undertaken to discourage short-term capital inflow. Indonesia experienced a period of relatively strong net capital inflow over 1990-92. Over 1993-94, Indonesia’s capital account surplus declined, but not to the levels of the mid-1980s; as in Malaysia, partial data suggest that net capital inflow may have risen in 1995. Finally, in the Philippines, the last of the countries to stabilize its economy, the capital account, previously negative, turned positive in 1989, and there is evidence of a slow but steady increase in net inflows since that date. If net workers’ remittances--a highly volatile part of the current account which are sensitive to swings in confidence--are treated as short-term capital inflows, the increase in net inflows since 1992 appears considerably more pronounced.5


SELECTED ASEAN COUNTRIES Sources of Capital Flows, 1985-94

(In percent of GDP)

Sources: National authorities.1/ Including errors and omissions.2/ Including portfolio investment.3/ Including workers’ remittances.

Although disaggregated data on the capital account are quite deficient in all these countries, it is clear that long-term flows, particularly of direct investment, have been an important factor in the capital account surplus, and that the trend of higher long-term inflows has tended to be sustained. A major reason for this has been the success of adjustment programs adopted in Indonesia, Malaysia, and Thailand in the mid-1980s, after a period of instability. In the three countries, an overvalued currency was depreciated, large fiscal deficits were overcome, and the overall rate of credit expansion was brought down appreciably. This pattern was repeated in the Philippines in the early 1990s. In all four countries, macroeconomic stabilization was accompanied by policies to open the economy to foreign trade and reform the financial sector. The groundwork thus was laid for improved competitiveness and a tangible rise in investor confidence.

This period of stabilization and structural reform in the ASEAN region coincided with the appreciation of the Japanese yen in the wake of the 1985 Plaza Accord. The resulting rise in their production costs vis-à-vis those of the United States led Japanese manufacturers to begin shifting their operations westward to Southeast Asia, where the improved policy environment created fertile soil for the growth of export-oriented industries. This trend was bolstered by currency appreciation in Korea and Taiwan Province of China, which made these economies relatively less attractive for new manufacturing investment.

These developments are reflected in the steadily rising level of direct investment throughout the ASEAN region. (It is masked in the case of Thailand where, as a consequence of the establishment of an offshore banking center in 1994, an important part of direct investment flows now is channeled through the domestic banking system and, consequently, is registered as short term.) Given the continued high marginal productivity of capital in the ASEAN economies, it is fair to expect that, as long as sound macroeconomic policies continue to be pursued, substantial net direct and portfolio investment will continue for some time.

The story with respect to net short-term inflows other than portfolio investment is less clear. Leaving aside Thailand, where classification problems distort the picture, it can be seen that short-term flows experience a not unexpected recovery in the case of the Philippines, the most recent of the countries to stabilize. (If the inflow of worker remittances is added to the capital account, net capital inflow to the Philippines reaches very large proportions beginning in 1993.) In Indonesia and Malaysia, short-term capital flows have been much more volatile. In Indonesia, short-term capital flows, which had been positive during 1990-92, turned negative in 1993-94, in response to a more expansionary monetary policy stance, which brought about a marked decline in domestic interest rates. In Malaysia, massive short-term inflows brought on by a tight monetary policy led to overheating during 1991-93 and ultimately threatened to result in a loss of monetary control. In 1994, the authorities relaxed the monetary policy stance and, at the same time, adopted a number of direct restrictions on short-term inflows, which are described in a following section. The easing in policy and control measures brought about a reversal of short-term flows, allowing most of the latter to be lifted before the end of 1994. In Indonesia, short-term capital flows, which had been positive during 1990-92, turned negative in 1993-94, in response to a more expansionary monetary stance, which brought about a marked decline in domestic interest rates. Notwith-standing these trends, the portfolio component of short-term capital remained positive and in some cases rising in all four countries.

In three of the four countries--Indonesia, Malaysia, and Thailand--the years of peak capital inflow were accompanied by very rapid economic growth. In Thailand, real GDP growth was in double digits in the years 1988-90 and averaged over 8 percent per annum in the succeeding years; in Indonesia and Malaysia it averaged over 9 percent during 1989-96, declining only marginally thereafter.6 In the Philippines, peak GDP growth rates were registered in 1988-89, considerably before the inflow period, which began only in 1993. Real growth in the Philippines, which had been very disappointing in the decade of the 1990s, began to recover in 1994, as a product of progress in stabilization.

Even though inflation showed a tendency to rise when capital inflows were at their highest, in the period covered by this paper (1988-94) it reached 6 percent only briefly in Thailand and remained below 5 percent in Malaysia (Chart 2). In these two countries, exchange rate policies tending to keep currency values close to the U.S. dollar (Thailand) or allowing for some limited appreciation vis-à-vis the dollar (Malaysia) deflected demand pressures onto the external sector. In contrast, in Indonesia and the Philippines, the exchange rate was depreciated frequently against the U.S. dollar. This policy protected the current account of the balance of payments (Chart 3), but accommodated higher inflation--especially in the Philippines, where monetary and fiscal policies were looser.



Source: IMF, International Financial Statistics.

SELECTED ASEAN COUNTRIES Main Balance of Payments Components, 1985-94

(In percent of GDP)

Sources: National authorities.1/ Includes workers’ remittances.2/ Excludes workers’ remittances.

In contrast to what occurred in a number of Latin American countries experiencing sizable capital inflows during this period, none of the four ASEAN capital importers experienced significant real exchange rate appreciation during the period of peak capital inflow. In the cases of Malaysia and Thailand, this reflected the authorities’ ability to keep inflation relatively in check. Indonesia’s exchange rate rule (entailing depreciation of between 4 percent and 5 percent per year vis-à-vis the U.S. dollar) allowed for a small cumulative real effective depreciation, while only in the case of the Philippines was some real effective appreciation registered during 1993-94--a not inappropriate development, as flight capital returned in the wake of the stabilization process. A major reason why sizable net capital inflows did not lead to significant real appreciation in the ASEAN countries, whereas they did in Latin America, is that during the inflow period, Latin American countries were using currency appreciation actively in an effort to bring down double-digit inflation rates. This imperative did not exist in the ASEAN countries, all of which were experiencing much lower inflation when capital inflows rose.7

III Monetary Policy Responses

Their concern with maintenance of low inflation led ASEAN authorities to respond swiftly and strongly to the increase in capital inflows. Since it could not be immediately determined whether this increase was of a temporary or a longer-term nature, sterilized intervention, intended to minimize their impact on the monetary aggregates, was the first course of action.

Indonesia, Malaysia, and Thailand all relied heavily on some form of money market intervention from the inception of heavy inflows--roughly in 1990 in all three cases--to minimize the monetary impact of their central banks’ purchases of foreign exchange. Indonesia operated principally with sales of Bank Indonesia bills, and Malaysia with sales of both treasury and central bank bills, and intervention in the interbank market. Thailand made an initial issue of Bank of Thailand bonds and, from late 1990, shifted to repurchase operations of government paper. In all three countries, open market operations were complemented by other actions intended to bring about monetary tightening, including cuts in central bank credit and rediscounts, increases in the rediscount rate, increases in reserve requirements (Indonesia and Malaysia), and forced sales of central bank instruments to the state enterprise sector (Indonesia). Malaysia and Thailand extended reserve requirements to nonresident deposits and certain other capital inflows (see below). Thailand relied increasingly on an indicative credit plan governing the credit expansion by banks, supplemented by moral suasion.8

Concern about the prudential risks associated with heavy capital inflows intermediated through their financial systems lent new urgency to countries’ ongoing efforts to strengthen supervision of banks and other financial institutions. During this period, all three countries implemented the capital adequacy standards of the Bank for International Settlements (BIS) and tightened rules on foreign exchange exposure, as did the Philippines. These actions--taken for prudential purposes--had the additional effect of somewhat attenuating banks’ ability to expand credit with the proceeds of foreign capital inflows.9

Although not a recipient of major capital inflows during the very early 1990s, the Philippines was moving to lower the rate of credit expansion strongly in the context of its adjustment program. The principal instrument chosen was the net sale of treasury bills. The Philippines also raised reserve requirements and the rediscount rate and took measures to strengthen prudential supervision (including adoption of the BIS standards).

Much has been written about the openness of capital accounts in the ASEAN region and consequent limitations of a contractionary monetary policy, but all evidence suggests that in the short run at least these sterilization efforts met with success in the four countries. As Chart 4 indicates, base or reserve money growth was reduced very sharply during the period of monetary tightening and, more important still, the decline in high-powered money brought with it a fall in both the rate of broad money growth and in bank credit expansion to the private sector.


SELECTED ASEAN COUNTRIES Monetary Indicators, 1985-94

(Moving average quarterly change)

Sources: IMF, International Financial Statistics; and national authorities.

A measure of this success is the interest rate differential, here defined as the spread between a key market-determined short-term interest rate and the rate on 90-day U.S. treasury bills, corrected for variations in the exchange rate vis-à-vis the dollar. The differential increased in all four countries and became particularly pronounced in the case of Indonesia, where the reduction in broad money growth and credit expansion to the private sector were the greatest (Chart 5).


SELECTED ASEAN COUNTRIES Interest Rate Differentials, 1985-94 1/

Sources: IMF, International Financial Statistics; and staff calculations.1/ In percentage points, measured as domestic rates adjusted for exchange rate changes minus the three-month U.S. Treasury bill rate.

By end-1992 or over 1993 (early 1994 in the case of Malaysia), signs that high interest rates increasingly were generating additional capital inflows, concerns about the fiscal or quasi-fiscal cost of money market interventions, political resistance to prolonged high rate levels and--in at least one case--a genuine cooling in economic activity caused the four central banks to modify the tight stance of policy. Operations in the money market became expansionary in all four countries and, over time, growth in the monetary aggregates responded accordingly. It is interesting to note, however, that, consistent with the shift toward reliance on open market operations to influence monetary conditions, central bank credit lines to banks--which had to be cut sharply in the period of tightening--generally were not increased during this period of relaxation, nor in the case of Malaysia--the only country to have increased reserve requirements on bank deposits--were these requirements lowered.10 Rather, where excess demand related to capital inflows was judged to remain a problem, the authorities turned to other policy areas for solutions.

IV. Fiscal Policy

It was logical that a tightening of monetary policies would be accompanied by a tightening of the other key element of demand management, fiscal policies. Even though discretionary fiscal actions normally need more time for their implementation than do monetary actions, some tightening should have come about in any event through the operation of the so-called “automatic stabilizers,” which cause tax collections to exceed cyclically neutral levels at times of strong economic activity (and certain social welfare payments, such as unemployment benefits, to fall short of them).

Chart 6 abstracts from the operation of the stabilizers by showing the fiscal stance--the overall government deficit corrected for cyclical effects. It further shows the fiscal impulse, which is the change in the fiscal stance from one period to the next.11


SELECTED ASEAN COUNTRIES Fiscal Indicators, 1985-94

(In percent of GDP)

Source: IMF, staff calculations.

Here we see that for most of the countries discretionary fiscal tightening “kicked in” about the same time that tight monetary policies were beginning to be relaxed. For example, Malaysia made a major fiscal effort in the late 1980s and early 1990s--an effort badly needed since sizable deficits had been run earlier in the 1980s. Revenue collections were raised in relation to GDP, notwithstanding rate cuts principally for the corporate income tax, through major improvements in tax administration. Strict control meanwhile was instituted over most expenditure categories. As a consequence of this, the Government’s fiscal position moved from a deficit of 3 percent in 1989 to a small surplus in 1993.

The Philippines also successfully improved fiscal performance in the context of its stabilization program, principally through strict expenditure control.

On the other hand, Thailand, which entered the late 1980s with a fiscal surplus, adopted an expansionary stance: tax collections fell in relation to GDP as a new value-added tax initially designed for implementation at a 10 percent revenue-neutral rate instead was implemented at a 7 percent rate. In addition, government salary scales were raised, and spending for transport infrastructure, especially road construction outside Bangkok, was appreciably increased. The raises in government pay scales were viewed as necessary to reduce the large gap between government and private sector salary levels, and increased investment in highways unquestionably was needed to relieve bottlenecks, but the injection of an expansionary impulse over a sustained period was hardly supportive of the effort to cool off the economy. In this respect, Thailand’s experience shows the political difficulties authorities encounter in tightening-or even maintaining--the fiscal stance when economic conditions are strong and the fiscal position is in surplus.12

Finally, Indonesia in this period experienced considerable variation in its overall fiscal position, largely for the worse, because of the decline in government oil and gas revenues. But if only non-oil and gas revenues are considered, the fiscal stance is seen to have deteriorated over FY 1991/92 and FY 1992/93, and then to have improved over FY 1993/94 and FY 1994/95. This was mainly the consequence of improved expenditure control.13

V. Exchange Rate Policies

To the extent that a higher level of net capital inflow reflected an improvement in competitive position arising from structural reforms and the restoration of sound macroeconomic policies, it would entail some appreciation in the real equilibrium exchange rate. In countries with flexible exchange rates, real appreciation would occur naturally through upward movement of the nominal exchange rate; in those where exchange rates were fixed or only partially floating, and where the limitations of sterilization had been reached, real appreciation could be expected to result in any case from higher domestic inflation, which would erode the initial competitive advantage. From a policy standpoint, real appreciation brought about in this second manner normally would be less desirable than real appreciation through nominal exchange rate change, as it would result in price distortions and possibly initiate an inflationary process.

Of the four Southeast Asian capital importers, three--Indonesia, Malaysia, and the Philippines--declare themselves to have an exchange rate system based on a managed float, while one, Thailand, pegs the baht to an undisclosed basket of currencies (and also allows it to move “in response to other considerations”). In none of them is the exchange rate determined through the unfettered play of market forces.

Indonesia pursues a policy targeting depreciation of its currency, the rupiah, against the U.S. dollar in small steps on an almost daily basis, with the cumulative annual depreciation vis-à-vis the dollar having tended to range between 3 percent and 5 percent since this policy was introduced in 1986; in other words, there has been little adjustment in exchange rate policy to compensate for changes in the dollar’s strength.

While it is technically based on an undisclosed basket of currencies, the Thai baht has in fact been kept very close to the rate of B 25 per U.S. dollar. Malaysia and the Philippines have allowed their currencies to fluctuate somewhat more, but still have shown reluctance to allow nominal effective appreciation beyond a certain point, and in fact have managed their floats in such a way that their currencies depreciated somewhat in nominal effective terms when the U.S. dollar was particularly weak. This policy could be justified in the case of the Philippines, which remained prone to short-term capital outflow in the 1990s, but less so in that of Malaysia.

As a consequence of these exchange rate policies, the currencies of all four countries depreciated in nominal effective terms over the period 1986-94. The hesitancy to allow appreciation, even vis-à-vis the U.S. dollar, at a time of rising capital inflows, seems to have reflected deep-rooted concern about export competitiveness and, of equal importance, a conviction that it would be a mistake to “tinker” with exchange rate rules--substantial stability vis-à-vis the U.S. dollar in Malaysia, the Philippines, and Thailand, and a crawl of 3 percent to 5 percent in Indonesia--which were viewed as having been fundamental in achieving the restoration of investor confidence and locking in of low inflationary expectations during the early 1980s.14

Contrary to expectations, the nominal effective exchange rate depreciation registered in the four countries did not produce a measurable sustained increase in inflation in those countries and real exchange rates were stable or even slightly depreciating over the period. A number of reasons can be adduced for this, including the openness of the economies concerned and the structural reforms undertaken, which worked to lower production costs in the short run.

VI. Trade and Payments Policies

In the 1980s, in the context of the move to freer markets and export-led development, trade and payments restrictions were lifted and/or relaxed throughout the ASEAN region. Actions taken included the elimination of nontariff barriers; reductions in import duty levels (which, in some cases, had been increased during the 1970s); and actions to liberalize profit remittances and outward capital movements. These steps were intended both to increase efficiency and to attract foreign investment. This opening of the economy had the additional effect of defusing inflationary pressures which might arise from large capital inflows.

As capital inflows grew in the late 1980s and 1990s, the various liberalization measures were accelerated. Remaining nontariff barriers were largely eliminated and tariffs were lowered further. In Thailand, for example, major tariff reductions on capital goods were implemented in 1990 and this was followed, in the succeeding years, by reductions on a very broad range of products including not only raw materials and intermediate goods, but also finished products. Malaysia’s tariffs were subject to wide ranging cuts in the early 1990s, as were those of Indonesia and the Philippines. Moreover, commitments had been made entailing further reductions well into the next century in the context of the ASEAN Common Effective Preferential Tariff (CEPT), APEC, and the Uruguay Round.

At the same time as trade restrictions were being relaxed, barriers to outward capital flows were, as mentioned earlier, also being lowered in those countries where they still existed.15 This process was stepped up markedly in the 1990s. The extent to which the relaxation of controls on capital outflows actually mitigated net inflows is, however, debatable, as the increase in gross outflows resulting from the liberalization is likely to have been at least offset by higher inflows arising from the increase in investor confidence.

In the context of surging inflows of short-term capital, in the early 1990s, direct controls on such inflows offered themselves as a complement to monetary, fiscal, and exchange rate policies. However, because of the strong tradition of an open capital account, the ASEAN countries generally eschewed the imposition of such controls, even when balance of payments statistics suggested that an important part of inflows was of a short-term nature. To the extent that actions to discourage inflows were taken, they more frequently had the character of measures of a prudential nature related to the banking system and/or actions to limit public sector foreign borrowing. For example, Bank Indonesia, after unwinding the so-called “swap premium,” which had provided an incentive for Indonesian banks to engage in foreign exchange swaps with the monetary authority, supplemented this in late 1991 by a reduction on banks’ net open foreign exchange positions. At the same time, Indonesia introduced the requirement of government approval of all foreign commercial borrowing by state-owned enterprises, and established annual ceilings for such borrowing. Similarly, in 1994, the Central Bank of the Philippines moved to discourage forward cover arrangements of domestic banks with their foreign correspondents.

Only in the case of Malaysia were major restrictions adopted on the inflow of foreign capital, this in the context of the authorities’ growing concern about possible loss of monetary control and their inability to appreciably reduce the level of inflows by other means.16 Measures adopted by Malaysia in January and February 1994 included the extension of bank reserve requirements to banks’ foreign liabilities, a ceiling on their net external liability position (excluding trade-related and direct investment inflows), a prohibition on the sale to nonresidents of monetary instruments of less than one year’s maturity, and the requirement that commercial banks transfer to the Central Bank the noninterest-bearing accounts of foreign banking institutions and the punitive extension to these accounts of the standard legal reserve requirement. Also introduced was a prohibition on banks’ forward transactions (on the bid side) and nontrade-related swaps with their foreign customers. These measures were viewed as being of a strictly temporary nature, and their possible costs--in terms of introducing uncertainty in the minds of investors and leading to higher effective interest rates-were seen as far outweighed by the benefits for macroeconomic stability.

The introduction of these direct controls coincided with an easing off in Bank Negara’s sterilization operations as a result of which interest rate differentials were lowered and even became negative. In response, short-term capital inflow fell off quickly and net outflow was registered at mid-year. By August 1994, Bank Negara had lifted most of the controls which had been introduced and, as of end-January 1995, only the reserve requirements on foreign liabilities remained in effect, as these were viewed as a leveling of the playing field rather than as controls. Since imposition of the controls on short-term inflows coincided with the period of monetary easing, it is difficult to quantify their effect. Undoubtedly, they were supportive of the change in policy stance. However, the easing in monetary policy stance itself may have contributed to continued strong demand pressures even as net short-term inflows were reversed.

VII. Conclusions

The foregoing account of the ASEAN experience with capital inflow in the late 1980s and early to mid-1990s suggests a number of conclusions.

First, while in certain countries inflow of short-term capital other than portfolio investment appears to be past its peak--in part, perhaps, because of lesser reliance on aggressive sterilization policies--it seems equally clear that longer term flows remain substantial and are likely to continue strong for a considerable period. This reflects the fact that, while some element of the inflows was linked to interest rate differentials with industrial countries, a major part was in response to improved competitive conditions in the ASEAN region. In view of these countries’ continued strong competitive position, sizable inflows of long-term loans and direct and portfolio investment should continue for some time, provided sound macroeconomic policies continue to be pursued.

The substantial positive interest rate differentials which led to heavy short-term inflows, especially in Malaysia and Thailand, probably were set off by the decline in U.S. and other industrial country interest rates but subsequently were sustained by massive use of sterilized intervention, which was effective in maintaining monetary control in the short run. Even after such intervention was abandoned, inflows continued strong in Malaysia as market participants bet on an appreciation of the ringgit; flows were reversed only when monetary policy was relaxed further and direct controls on short-term inflows were introduced for a transitory period.

In general, ASEAN governments were quite successful in preventing a major buildup of inflationary pressures during the peak inflow period. Growing labor productivity, stable exchange rates, and very open economies all played a role in this. There was a tendency for current account deficits to increase, especially in Malaysia and Thailand, but again the increase was attenuated by rising labor productivity, which was reflected in robust export growth. Also, an important part of the rise in current account deficits reflected imports of capital goods linked to increased investment, and to that extent would be less a source of concern than one mainly reflecting higher consumption.

Regarding policy responses, open market operations were the instrument of choice during the first one to two years of the inflow period. Initially, these were quite successful in controlling money supply growth and limiting demand pressures.

As monetary policy tightening began to lose its “bite” (and the fiscal costs of sterilization mounted), most governments moved to tighten the fiscal stance. Major improvements were made in expenditure control (Indonesia, Malaysia, and the Philippines) tax administration (Malaysia), and the control of public enterprise operations (Thailand and the Philippines). However, the case of Thailand illustrates the difficulty of tightening or even maintaining a tight fiscal stance when government finances already are in surplus and there is a perceived need for higher expenditure.

Out of concern for export competitiveness and fear of producing uncertainty, governments shied away from exchange rate flexibility (nominal appreciation) to support the anti-inflationary effort. However, such appreciation where it did occur was a useful adjunct to fiscal and monetary policies. Over the longer run, the introduction of a greater degree of exchange rate flexibility would be helpful in moderating the amplitude of swings in short-term capital flows and in supporting other policy instruments.

With the exception of Malaysia--the magnitude of whose inflows of short-term capital in relation to GDP exceeded the others--the ASEAN countries also avoided adopting direct controls on such inflows. The controls adopted by Malaysia, while broad-ranging, were targeted to short-term nonstock market inflows, and they were lifted after a brief period. To what extent these controls, rather than the simultaneous relaxation of monetary policy, caused short-term flows to reverse cannot readily be determined. Undoubtedly, they reinforced the actions taken in the monetary policy area, and only time will tell whether they entailed any costs in terms of an adverse impact on confidence, as some observers have suggested.

All in all, there exist a limited number of options as regards the policy areas available to deal with the macroeconomic problems caused by a sudden large increase (“surge”) in capital inflows. Unquestionably, the mix of policies chosen in a particular case will be influenced by the nature of the inflows, by the authorities’ judgment as to whether their increase is transitory or more enduring, and by other policy objectives. In general, it would seem desirable that no policy options be closed off ex ante.

Finally, even though in this writer’s judgment long-term capital inflows into the ASEAN region are likely to continue for the foreseeable future, assuming the countries’ pursuit of sound macroeconomic policies, openness to these inflows inevitably increases countries’ exposure to sudden shifts in market sentiment arising from exogenous developments (e.g., Mexico) or unforeseen domestic events. This increased vulnerability would appear to be an unavoidable consequence of integration into world capital markets. Countries’ best response is policy consistency, careful monitoring of developments, and timely policy action when conditions require.