Financial Times, TUESDAY MARCH 3 1998

Martin Wolf: Flows and blows

Can one still justify freedom of capital flows? How, in particular, can one persuade leaders of emerging economies that the "reward" for liberalising capital will not be as ghastly as, say, Indonesia's? These questions must be addressed while memories of east Asia's crisis are fresh.

The International Monetary Fund and the US Treasury have thrown themselves into the breach opened up by the markets' loss of confidence in Asia with vigour and, it appears, success. They have also put forward a view of the crisis that justifies the continued push for liberalisation of the capital account.

I admire their energy and wish with all my heart to agree with their recommendations. A world in which people are able to put their money wherever they wish has great attractions.

It also has big dangers. The nature of those dangers emerges from the table, which comes from the Washington-based Institute for International Finance.* The five countries that have been most damaged by the crisis - Indonesia, Malaysia, South Korea, Thailand and the Philippines - had net private inflows of $41bn (£24.5bn) in 1994. By 1996, this had jumped to $93bn. Over these years the inflows substantially exceeded the total current account deficit, allowing governments to accumulate $37bn in additional reserves.

Then, in 1997, came the panic: the net inflow turned into an estimated outflow of $12bn. The swing in the net supply of private capital was $105bn in just one year, a staggering 10 per cent of the combined pre-crisis gross domestic product of the five economies.

It is the same story on the current account. Notwithstanding net official flows of $27bn in 1997 and $25bn forecast for 1998, total current accounts are expected to shift from a deficit of $55bn in 1996 to a surplus of $18bn in 1998. This swing is about 7 per cent of the combined GDP. If a comparably large shift were forced on the US, its current account deficit of $148bn in 1996 would become a surplus of more than $400bn this year. Imagine the howls of pain this would cause.

Let us look a little more closely at the flows. Direct equity investment has been chugging along in a pleasingly stable manner. Flows from non-bank private creditors are quite stable too, with a net inflow of $18bn in 1996 and $14bn in 1997. Portfolio equity is more fickle, shifting from a net inflow of $12bn in 1996 to a similar outflow in 1997. Yet the real villains are our old friends, the commercial banks, whose net lending jumped from $24bn in 1994 to $56bn in 1996, before turning into net repayment of $21bn last year.

So what crimes did these countries commit deserving of so savage a punishment? In a speech delivered at the end of January, Stanley Fischer, deputy managing director of the IMF, described the problems as "mostly homegrown", listing, in particular, the following:

• Failure to dampen overheating, manifested in large external deficits and asset price bubbles.
  
• Maintenance of pegged exchange rates for too long, which stimulated excessive external borrowing.
  
• Lax financial regulation, which allowed a sharp deterioration in the quality of banks' loan portfolios.
  
• Doubt about the authorities' commitment to the needed adjustment when the crisis was under way.
  

Such faults hardly justify the enormity of the punishment. After all, against the dollar the Thai baht and the Korean won have lost close to half their value since last July. The Indonesian rupiah has fallen by three-quarters.

Dwell, for a moment, on Indonesia: its current account deficit was less than 4 per cent of GDP throughout the 1990s; its budget was in balance; inflation was below 10 per cent; at the end of 1996 the real exchange rate (as estimated by J.P. Morgan) was just 4 per cent higher than at the end of 1994; and the ratio to GDP of domestic bank credit to the private sector had risen merely from 50 per cent in 1990 to 55 per cent in 1996. True, the banking system had mountains of bad debt, but foreign lending to Indonesian companies had largely bypassed it.

Is anyone prepared to assert that this is a country whose exchange rate one might expect to depreciate by about 75 per cent? Some exchange-rate adjustment was certainly necessary; what happened beggars belief.

A defender of the role of international capital flows could concede that the punishment has far exceeded the policy "crime". He could also point, as does Mr Fischer, to how the external environment of the mid-1990s fuelled the capital inflow and consequent instability: poor investment opportunities in Japan and continental Europe; low interest rates in the industrial countries; and volatility of the yen/dollar exchange rate. Nevertheless, the capital flows could be viewed more as messengers than as bearers of disease.

Alas, it is not that simple. Remember that the mistake is alleged to have been toleration of "excessive" current-account deficits, accompanied by over-valuation of the real exchange rate, over-lending by unsound banks and over-investment in property. This certainly is the story of Thailand, whose crisis marked the start of the saga. Thailand had current account deficits of some 8 per cent of GDP, which financed investment at more than 40 per cent of GDP.

Yet remember that the greatest benefit of large-scale international lending should be the opportunity to invest more than a country can itself save; that this can only happen if there is a current account deficit; that a real appreciation is how such a current account deficit is produced; that the appreciation works by reducing the relative incentive to invest in production of exports and import substitutes; and that, under a fixed exchange rate, a rise in the domestic price of non-tradeables, including property, is how this change in incentives takes place.

So the capital inflows were carriers of the new Asian flu. To appreciate this, contrast those countries that have emerged unscathed. They did so simply by inoculating themselves. China, Singapore and Taiwan ran current account surpluses in the 1990s, thereby re-exporting the net inflows as reserves: last October mainland China's reserves were $141bn, Taiwan's $83bn, Hong Kong's $79bn and Singapore's $74bn. The UK's, by comparison, were $38bn.

The view of capital flows taken by these successful governments was just like President Bill Clinton's of marijuana: it's fine to smoke, so long as one does not inhale.

This seems crazy. Capital flows offer two big potential benefits to rapidly developing economies: transfer of technology and the chance to raise investment. Foreign direct investment is the chief vehicle for transfer of technology. The strongest case for the other flows, particularly borrowing, is provision of additional investible resources. But they have, once again, proved too unstable for that.

It is still possible to argue that the afflicted economies will end up healthier, eventually. But it impossible to pretend that the traditional case for capital market liberalisation remains unscathed. Either far greater stability than at present is injected into the international monetary system as a whole or the unavoidably fragile emerging countries must protect themselves from the virus of short-term lending, particularly by - and to - banks. After the crisis, the question can no longer be whether these flows should be regulated in some way. It can only be how.

*Capital Flows to Emerging Market Economies - Washington D.C: Institute for International Finance

Contact Martin Wolf: martin.wolf@ft.com
 

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