FPI in domestic markets is a different matter. The bulk of this inflow has been in equities, as investors have been seeking high yields, mostly through appreciation. These flows purchase existing portfolio assets and sometimes new issues. To the extent that the new issues fund new investment, the effects would be quite similar would be owned by the domestic issuer rather than the foreign investor. New issues may also be used to recapitalize existing operations. Here the effect would be through the banking system and the rest of the domestic financial market, where debt would be retired by the new equity-generated flows. Although this could ease pressure on the banking system, it would tend to lower interest rates and increase domestic liquidity. That, in turn, would increase aggregate demand and create more pressure on the exchange rate than if the funds had been invested in new equipment with a high import content.
The bulk of equity investment has been into existing stocks in East Asian markets, driving up the prices of equity. the cost of capital drops for those floating new issues, but there are for also strong wealth effects on existing asset holders- as their wealth increases, consumption is likely to go up as well. This will tend to raise domestic prices and appreciate the currency in real terms, Whether these foreign equity, investments increase physical investment depends on the behavior of the other asset holders- those who sold to foreign investors and those whose assets appreciated. If they invest in new projects, physical investment will also increase, otherwise, it will not. It is more likely that domestic savings will fall when there are large portfolio investment flows than when the flows take the form of FDI. In Latin America, which has experienced more portfolio inflows decline, rather than physical investment to increase. In the past East Asia has avoided this result, partly because its overall policy regime has favored investment, partly because of the greater degree of sterilization it has been able to achieve, and partly because the share of portfolio investment has been smaller. Portfolio flows are a very recent phenomenon, and it is still to soon to measure many of their effects in East Asia.
It is particularly worrisome when large private capital flows move into commercial real estate. Experience in many countries, both industrial and developing, indicates the ease with which speculative bubbles can develop in real estate during an investment boom. Asset inflation in this sector can generate very high rates of return- much higher than are available from investment in manufacturing- over a few years. But such rates are not sustainable. When the bottom falls out, as it inevitably does, there are frequently severe repercussions on the banking sector, since domestic banks are usually major financiers of the real estate, and governments often end up bailing out the financial sector. Indonesia faced this problem in 1993; Thailand saw carliev bouts of these bubbles; and they are not unknown in other countries, including the United States and Japan.
The sustainability of flows into stock markets is a complex matter. To the extent that the flows depend on continued high gains, mostly appreciation, one could wonder whether the high of return of 1992-93 will resume after the 1994 correction. Even in the best of circumstances, one would expect some flow reversals, in addition to normal volatility. Unfortunately, the best of circumstances rarely occurs, and the Mexican episode of December 1994 has precipitated outflows in many emerging markets as fund managers have bailed out everywhere. It is hard not to view this as herd behavior with a tinge of panic, but it caused a 3 percent devaluation in Thailand and more than doubled short-term interest rates there. Other East Asian markets have also suffered outflows as international investors have generally reduced their exposure in emerging markets. However, giver the long-term growth potential of the East Asian economies and the indications of a longer-term stock adjustment process, there is reason to except that such reactions will be temporary set backs in a persistent trend toward a lager share of sound emerging market stocks in global portfolios. The spectacular yields witnessed recently may not be sustainable, but the East Asian countries should offer high rates of return over the long term and should continue to attract investment.
A number of countries in East Asia and elsewhere have begun attracting foreign portfolio investors into their own fixed-income markets ,purchasing, instruments in local currency. In this case the foreign bondholder takes the exchange risk, for which he expects added compensation. It is encouraging that these economies are becoming attractive enough, and their exchange management is considered stable enough, to attract investment in local currency securities. For obvious reasons, interest tends to be in bank deposits, in shorter maturities, and in guaranteed instruments of government or their agencies.
To the extent that short-term capital flows exceed working balances, trade financing, or bridge activities to long-term investment, they are most likely the result of relatively high interest rates not offset by an expected devolution. For the most part, these flows are seeking high short-term rates of return and reflect cash management or speculative decisions rather than long-term investment decisions rather than long-term investment decisions. But like long-term flows, they tend to lower domestic interest rates and appreciate the exchange rate. They are likely to expand bank reserves and lead to more credit expansion, although on a potentially more volatile base. To the extend that a government is trying to restrain domestic demand with high interest rates, the inflow would undermine its policy. These flows may not directly influence long-term savings and investment, but they may do so.
The World Bank and investment bankers regularly provide advice to developing countries on asset and liability management. But that advice often is non optimal or simply wrong. Although many tactical tools for active risk management in developing countries have been developed in the past decade, a framework for developing a strategy that incorporates country-specific factors has lagged far behind.
For example, in case when the Federal Reserve Bank (the “Fed”) last September arranged a $3.6 billion bailout of Long Term Capital Management (LTCM)- a Connecticut- based hedge fund- critics of the US financial establishment cries foul. The bailout contrasted strikingly with IMF treatment of indebted firms in Asia. When indebted businesses in Asia were unable to replay foreign loads, US and IMF officials insisted that they be forced to close and their assets sold off to creditors. Bailing out ailing businesses with endless lines of bank credit was, US officials claimed, the essence of “crony capitalism” and the cause of all Asia’s problems “Reducing expectations of bailouts, ” declared the IMF, must be step number one in restructuring Asia’s financial markets.
To Japanese officials, the LTCM bailout was a clear case of the US “ignoring its own principles”. Representative Bruce Vento (Democrat, Minnesota), in a Congressional investigation of the LTCM bailout, said that “there seem to be two rules, a double standard.” But this view is incorrect. Where bailouts are concerned, there is only one standard. Whether in Korea, Thailand, Connecticut or Brazil, US- and IMF- organized bailouts conform, to the same quiding principle: whatever happens, whoever is at fault, the wealth of Western credits must be protected and enhanced.
Until 1997, Western creditors were bullish on Asia and “emerging markets” generally. They poured billions into stocks, banks and businesses in Thailand, Indonesia, Korea, expecting mega-returns and a piece of the action as the former “Third World” embraced freemarket capitalism. Beginning in 1997, though, Western investors began to worry that they might have over-lent. They pulled out of Thailand first, selling baht for dollars; as the baht’s value collapsed, worry turned to panic. Soon, international financial operators were selling won, ringgit, rupiah and rubles in an effort to cut potential losses and get their funds safety back to Europe and the US. In the ensuing capital flight, Asian stock prices plunged and the value of Asian currencies collapsed. Local businesses that had taken out dollar payments to Western creditors.
For a time, local governments tries to stave off default by lending their reserves of foreign currency to indebted firms. South Korea used up some $30 billion in this way. But this money soon ran out. Western banks refused to make new loans or roll over old debts. Asian businesses defaulted, cutting output and laying off workers. As the economies worsened, panic intensified. Asian currencies lost 35 to 85 per cent of their foreign- exchange value, driving up prices on imported goods and pushing down the standard of living. Businesses large and small were driven to bankruptcy by the sudden drying up of credit; within a year, millions of workers had lost jobs while prices of basic foodstuffs soared.
As the crisis unfolded, IMF officials flew to Asia to arrange a bailout, agreeing ultimately to loan $120 billion to Thailand, Indonesia and South Korea. When announcing these loans, the press used terms like “emergency assistance” and “international rescue package,” leading the casual reader to presume that the money will be spent on food for the hungry, or aid to the jobless. In float, the money is used to “help” countries pay bank their debts to international banks and brokerage houses. Which international banks and brokerage house? The same ones who made speculative loans in the first place, then panicked and brought about the collapse of the Asian economies. The IMF rescue packages are intended only to rescue the Western creditors.
The Western financial industry, moreover, has been lobbying heavily for even more secure protection from future losses. One plan, put forward last year by the US and US Treasuries, envisions a $90 billion fund of public money, supposedly to avert currency crises. The idea is that G7 governments will, henceforth, underwrite the finance industry’s speculative ventures into emerging, markets before, rather than after, they turn sour. In this way, when bankers and fund mangers grow bored with a particular market, withdraw their funds and send the currency into a tailspin, they can collect on their losses immediately, without the tedious and time- consuming delays generated by IMF negotiations.
