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Managing Capital Flows:Managing Capital Flows:An Asian PerspectiveAn Asian Perspective

Masahiro KawaiDean and CEO

Asian Development Bank Institute

PECC-USAPC-SINCPEC Conference“Growing APEC Economies:

New Challenges and Approaches”

Singapore 29-30 June 2011

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Motivation Motivation

• Recently, some emerging economies, including those in Asia, have imposed capital controls to limit speculative capital inflows

• This suggests that managing capital inflows remains an important policy issue for many emerging economies that needs to be clearly understood and debated openly

• Policymakers of emerging economies need to develop a framework for managing capital flows that is consistent with macroeconomic and financial sector stability

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Outline of the PresentationOutline of the Presentation

1. Introduction

2. Capital Flows in Emerging Asia

3. Impact of Capital Flows on Emerging Asia

4. Policy Challenges and Implications

5. Conclusion

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1. Introduction1. Introduction

• Benefits of capital inflows

- Greater economic opportunities and cushion against shocks: to expand investment, smooth consumption, and diversify risks

• Risks of capital inflows

- Loss of macroeconomic stability

- Damage to financial system stability

- Risk of sudden capital flow reversals

Procyclicality of global capital flows to emerging and developing economies can aggravate these risks

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IntroductionIntroduction (cont’d)(cont’d)• Past experience

- 15% of the large capital inflow episodes over the last 20 years ended in a crisis

- Emerging Asia experienced proportionately more episodes of hard landings, with the example being the Asian financial crisis of 1997-98

• Objectives of emerging Asia’s authorities:

- Manage these risks well so that they can fully enjoy the benefits of capital inflows

- Achieve macroeconomic and financial stability

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2. Capital Flows in Emerging Asia2. Capital Flows in Emerging AsiaEmerging Asian economies have received net capital inflows,

which have been volatile over the last 20 yearsGross Total Inflows- Emerging AsiaGross Total Inflows- Emerging AsiaGross Total Inflows- Emerging AsiaGross Total Inflows- Emerging Asia(400,000)(200,000)0200,000400,000600,000800,0001,000,000 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009US$ million Direct Inflows Portfolio Inflows Other Inflows Total Inflows

Net Inflows- Emerging AsiaNet Inflows- Emerging AsiaNet Inflows- Emerging AsiaNet Inflows- Emerging Asia-200,000-150,000-100,000-50,000050,000100,000150,000200,000250,000 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009US$ million Direct Inflows Portfolio Inflows Other Inflows Total Flows

Gross Total Inflows- Emerging AsiaGross Total Inflows- Emerging AsiaGross Total Inflows- Emerging AsiaGross Total Inflows- Emerging Asia(15.00)(10.00)(5.00)0.005.0010.0015.00 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009Percent of GDP Direct Inflows Portfolio Inflows Other Inflows Total Flows

Net Inflows- Emerging AsiaNet Inflows- Emerging AsiaNet Inflows- Emerging AsiaNet Inflows- Emerging Asia(6.00)(4.00)(2.00)0.002.004.006.00 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009Percent of GDP Direct Inflows Portfolio InflowsOther Inflows Total Flows

Notes: Emerging Asia: China, Hong Kong, India, Indonesia, Korea, Malaysia, Philippines, Singapore, and Thailand

Source: CEIC accessed on 15 April 15 2011

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Foreign Exchange Reserves, Emerging Asia

Notes: Emerging Asia: Cambodia, China, Hong Kong, India, Indonesia, Korea, Lao PDR, Malaysia,

Myanmar, Philippines, Singapore, Taipei,China, Thailand, and Viet Nam

Source: World Bank databank accessed on 14 April 2011; CEIC accessed on 14 April 2011;

Bloomberg accessed on 15 April 2011

Billion US$Billion US$ Percent of GDPPercent of GDP

01,0002,0003,0004,0005,0006,0002000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

TAPPRCKORINDHKGASEAN 20304050

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 20107

3. Impact of Capital Flows on 3. Impact of Capital Flows on

Emerging AsiaEmerging Asia

Real Real EEffective ffective EExchange xchange RRateate

ASEAN 5 Non-ASEAN

Source: Bank for International Settlements (BIS) accessed on 14 April 2011 8

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Inflation Inflation RRatesatesGGenerally low in the last decade except enerally low in the last decade except inin 2008 2008

But inflation But inflation has been risinghas been rising in recent monthsin recent monthsInflation Rates: Non-ASEANInflation Rates: Non-ASEANInflation Rates: Non-ASEANInflation Rates: Non-ASEAN

-10%-5%0%5%10%15%20%Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11

PRC Hong Kong, China IndiaKorea, Rep. Taipei,ChinaSource: CEIC accessed on 11 April 2011

Inflation Rates: ASEANInflation Rates: ASEANInflation Rates: ASEANInflation Rates: ASEAN

-10%0%10%20%30%40%50%Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11

Cambodia Indonesia Lao MalaysiaPhilippines Singapore Thailand Viet Nam9

Source: CEIC accessed on 14 April 2011

Stock Price Indexes, 2000Stock Price Indexes, 2000--2011 (Jan. 2000 = 100)2011 (Jan. 2000 = 100)

Asset Asset PPricesricesRRose markedly during large capital inflow episodes ose markedly during large capital inflow episodes

and dropped sharply during capital flow reversal episodesand dropped sharply during capital flow reversal episodes

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Property Price IndexProperty Price IndexSelected Asian Economies, March 2002Selected Asian Economies, March 2002--March 2011March 2011

(March 2002=100)(March 2002=100)

Notes: (1) INO- Residential Property PR, New Medium-Sized Houses (Big cities), PER DW,NSA

(2) MAL- Residential Property PR., All dwellings, PER SQ. M., Q-ALL Y-ALL NSA

(3) THA- Residential Property PR., All detached Houses (GR Bangkok), PER SQ.M,NSA

(4) HKG- Residential Property PR.,All dwellings, PER SQUARE M., M-ALL NSA

(5) KOR- Residential Property Prices, All dwellings, M-ALL NSA

Source: Bank for International Settlements (BIS) accessed on 14 April 2011

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Bond Bond YYieldsieldsGGenerally declined from 2000, but rose at the height of enerally declined from 2000, but rose at the height of

liquidity crunch, and liquidity crunch, and havehave generally generally been been stable thereafterstable thereafter

with the exception of Indiawith the exception of India Bond Yield, Emerging AsiaBond Yield, Emerging AsiaBond Yield, Emerging AsiaBond Yield, Emerging Asia02468101214

1618

Jan-00 Apr-00 Jul-00 Oct-00 Jan-01 Apr-01 Jul-01 Oct-01 Jan-02 Apr-02 Jul-02 Oct-02 Jan-03 Apr-03 Jul-03 Oct-03 Jan-04 Apr-04 Jul-04 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11Percent

India Korea, Rep. Malaysia PhilippinesSingapore Taipei,China Thailand PRC

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Challenges of capital inflows:• The past surges in capital inflows, followed by capital

flow reversals, still fresh in emerging Asia’s mind

• Most recently, foreign capital has started to return to

emerging Asia

- External conditions (record low interest rates in advanced economies)

- Internal conditions (rapid recovery and monetary policy tightening in emerging Asia)

• Massive capital inflows could continue, posing serious

policy challenges to emerging Asia for macroeconomic

& financial system stability

4. Policy Challenges and 4. Policy Challenges and ImplicationsImplications

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Advanced economy view on policy Advanced economy view on policy responses to large capital inflows responses to large capital inflows

• “Best” policy mix: Fully flexible exchange rate, capital account openness (no capital control), and low-inflationary monetary policy

• This is appropriate for advanced economieswith deep, liquid and broad financial markets

• Problems for emerging economies

- Lack of depth of foreign exchange markets, risk

tolerance, and industrial diversification for wide

exchange rate swings

- Shallow financial markets and systems, not resilient

enough to large inflows and outflows of capital 14

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Emerging economies’ realistic Emerging economies’ realistic policy responses to inflow surgespolicy responses to inflow surges• Structural measures

- Develop and deepen financial markets- Liberalize imports and capital outflows

• Macroeconomic measures- Sterilize FX market intervention- Ease monetary policy- Tighten fiscal policy- Allow exchange rate appreciation

• Macroprudential measures- Tighten macroprudential supervision and regulation over domestic markets- Control short-term capital inflows

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Pros & cons of currency appreciationPros & cons of currency appreciation

• If capital inflows are permanent and driven by fundamentals, the best response should include exchange rate appreciation

• Currency appreciation has the benefit of:- discouraging speculative capital inflows

- allowing the central bank to pursue independent monetary policy to contain inflation, asset price increases and financial vulnerabilities

• But, the loss of international price competitiveness is a major concern, when only one country allows currency appreciation

• This suggests a need for coordination on exchange rates

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Effectiveness of capital inflow controlsEffectiveness of capital inflow controls

• The best market-based controls (temporary, selective, price-based controls a la Chilean unremunerated reserve requirements) are less distortionary and can lengthen the maturity of inflows without much impact on overall inflows

• Investor-based controls (e.g., China and India), rather than type-based controls, could be more effective in limiting the total volume of inflows as it is easier to monitor who is investing than how inflows are coming

• Authorities’ administrative capacity is essential

• Effectiveness of capital controls tends to weaken over time as agents in the markets find ways to circumvent them

• One country’s capital controls can potentially affect others’ capital inflows, suggesting a need for coordinated action

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Recent capital controls in emerging AsiaRecent capital controls in emerging Asia

China 2002: QFII introduced

2006: QDII limits introduced

2011: Limits on Hong Kong banks’ net open positions and ability to

access yuan through mainland foreign exchange market

India 2007: Capital controls introduced against “participatory notes”

Indonesia 2010: One-month holding period on SBIs (central bank notes)

2010: Sort-term external bank borrowing limited to 30% of capital

Korea 2010: Limits on FX derivative contracts on domestic banks (50% of

capital) and foreign banks (250%)

2010: Reimposing a withholding tax on foreign investors’ earnings

from government bonds

Taipei,China 2009: Prohibited use of time deposits by foreign funds

2010: One-week deadline for money to be invested or repatriated

Thailand 2006: Unremunerated reserve requirements (30%) on loans,

bonds, mutual funds, swaps and non-resident Baht accounts

2010: 15% withholding tax on capital gains and interest income on

foreign bonds

Notes: QFII = qualified foreign institutional investors; QDII = qualified domestic institutional investors

Source: Central bank reports and other reports

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New IMF Orthodoxy?• IMF now views capital controls, or so-called

“capital flow management measures” as part of the policy toolkit to manage capital inflows

• IMF recommends the use of macroeconomic policies and prudential policies as primary policy tools to respond to capital inflows

• IMF places capital controls at the bottom, that is, the use of capital controls must come after other tools have been adjusted in response to the inflow surge.

* Ostry, et.al., “Managing Capital Inflows: What Tools to Use?” IMF Staff Discussion Note, SDN/11/06 (April 2011)

But why should capital controls be a last resort policy measure? 19

Regional financial monitoring• A need to step up regional financial market monitoring• Creation of an Asian financial stability dialogue (AFSD) among

the region’s finance ministry officials, central bankers and financial regulators

Coordinated capital inflow controls• A country’s successful capital inflow controls could drive

foreign capital to countries without such controls

• To be effective, coordinated capital controls are desirable

Exchange rate policy coordination• Asian economies need to work together for collective currency

float vis-à-vis the USD while keeping relative currency stability within the region, so as to: (1) maintain national financial & macroeconomic stability,

(2) support intra-regional trade and investment

(3) minimize loss of national price competitiveness

• This requires greater exchange rate flexibility in China

Financial safety nets (CMIM and AMRO)

Scope for regional coordinationScope for regional coordination

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5. Conclusion 5. Conclusion

• Given the robust growth prospects in the region relative to the US and Europe, emerging Asia continues to attract capital inflows and, as a result, face significant challenges in macroeconomic management and financial sector reform

• Some of these economies exhibit signs of overheating, inflation and asset-price bubbles, and they need to consider its best response policy in the event of surges in capital inflows

• Advanced economy view would be to adopt a freely flexible exchange rates and an open capital account

• IMF policy responses include: macroeconomic policy (greater exchange rate flexibility, fiscal policy tightening) and prudential policy as primary tools

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5. Conclusion (cont’d) 5. Conclusion (cont’d) • A combination of policies is needed, including capital

inflow controls—as a macroprudential policy tool—to limit volatile capital inflows

• But it is often difficult to implement these policies at the national level alone because of regional interdependence

• Asia needs to strengthen regional financial and monetary cooperation:- Asian financial stability dialogue, CMIM/AMRO

- Coordinated capital inflow controls

- Exchange rate policy coordination for collective currency appreciation, to better achieve each country’s macroeconomic and financial sector stability while maintaining intraregional exchange rate stability

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Thank youFor more information:

Masahiro Kawai, Ph.D. Masahiro Kawai, Ph.D. Dean & CEO

Asian Development Bank Institutemkawai@adbi.org+81 3 3593 5527www.adbi.org

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