In some East Asian countries (Indonesia, Korea, and Thailand) domestic banks have been major issuers of bonds into external markets. Since 1990, 40 percent of placements have been by financial institutions, with banks accounting for 27 percent. Large banks obviously have better credit rating than many of their clients and are thus able to raise funds less expensively. This is a legitimate intermediation function and has opened financing opportunities to many domestic firms that would otherwise have had less access to funds. For the ultimate borrower, lower interest rates, not foreign exchange rates, are typically the critical factor. For the intermediating banks, the spreads and volumes are attractive, and the operations help establish the banks international presence. These actions, however, pose two risks. First, there may be a relative decrease in the effectiveness of monetary police, since in the effectiveness of monetary policy, since the financial system can miligate or offset government attempts to expand or contract credit by modulating its foreign borrowing for domestic clients. When foreign interest rates are lower than domestic rates, borrowers will be tempted to seek more funds abroad, which may undermine domestic policies of monetary restraint. Second, banks (especially public or quasi-public banks) may be borrowing abroad with the implicit or explicit expectation of a government quartette. They may not take full account of the exchange risk and may face interest risks as well, since they are intermediating across currencies and between short-term liabilities and long-term assets. These risks are likely to be passed on to the government, should they adversely affect the banks. The recently reported instance of BAPINDO, a troubled Indonesian bank that borrowed internatinally, seems to have involved an implicit guarantee, as that bank would not have been able to borrow on its own account. More generally, central banks may be forces to intervene to protect the banking sector with official reserves if there are major disruptions of commercial banks capacity to refinance abroad. For some large borrowers, domestic markets may not yet be deep enough to absorb the size and other requirements of their financing needs, so that these enterprises must turn to international markets.
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 Asias problems “Reducing expectations of bailouts, ” declared the IMF, must be step number one in restructuring Asias 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 bail