Mr. Grenville focuses on international capital flows and crises
Talk by the Deputy Governor of the Reserve Bank of Australia, Mr. Stephen Grenville, to Credit
Suisse First Boston Australia Conference entitled, "The Global Financial System - The Risks of
Closure" in Sydney on 13/11/98 (excluding bibliography).
There are many things that went wrong for the countries caught up in the Asian crisis of 1997, but
out of the myriad causes, two clear central problems can be identified: the fatal combination of large
and volatile international capital flows, interacting with fragile domestic financial sectors. Today, I
want to focus on the first of these issues: international capital flows.
International flows are now centre-stage in the international economic policy debate. This is
certainly a higher profile than capital flows usually have. Traditionally, the focus has been on the
real sector counterparts of these: the savings/investment balance and the current account surpluses
and deficits. Both theory and practical policymaking often assume that these are the "movers" of the
action, with capital flows largely a passive, accommodating residual. But the Asian crisis suggests
that the action may, instead, be in the capital flows themselves. The capital flows were certainly
excessive in the sense that they were greater than could be absorbed (i.e. the capital flows were
substantially larger than the current account deficits; see graph). The capital inflows into Indonesia,
Malaysia, the Philippines and Thailand in the five years 1990-94 were twice as large as the current
account deficits (Calvo and Goldstein. 1996, p. 125). Capital inflows into Thailand in 1996, for
example, were equal to 13% of GDP. The "excess" flows went to increase the foreign exchange
reserves of the recipient country (in effect, being recycled back to the capital-exporting countries).
But in the process they made the normal cycle in the recipient country much worse: providing the
funding to make the expansion phase of the cycle go more strongly and last longer, driving up
domestic demand and asset prices. While there were both "push" and "pull" factors for the capital
flows, it is clear that the capital flows were not simply a passive accommodating force responding to
the fundamental economic factors occurring in the capital-importing countries.
Graph 1
Capital Inflows and Current Account Deficits
percentage of GDP
10
9
Chile,1978-81
8
Philippines,
7
1978-83
Malaysia,1980-86
6
Thailand,1978-84
Mexico,1989-94
Thailand,1988-94
Mexico,1979-81
5
Venezuela,
1992-93
4
Malaysia,1989-94
Philippines,1989-94
3
Indonesia Argentina, 1992-93
Venezuela,1975-80
Argentina,
2
Chile,1989-94
1979-82
Colombia
1
0
Brazil
-1
0 1 2 3 4 5 6 7 8 9 10 11 12 13
Private Capital Inflow
Source: World Bank 1997, p. 243
Table 1: Capital Flows to Emerging Markets
(Annual averages, US$ billion)
1977-82 1983-89 1990-94 1995 1996 1997
All emerging markets
Total net capital inflows 30.5 8.8 120.8 192.0 240.8 173.7
Net foreign direct investment 11.2 13.3 46.2 96.0 114.9 138.2
Net portfolio investment -10.5 6.5 61.1 23.5 49.7 42.9
Other* 29.8 -11.0 13.5 72.5 76.2 -7.3
By region
Asia 15.8 16.7 40.1 95.8 110.4 13.9
Western Hemisphere 26.3 -16.6 40.8 35.7 80.5 91.1
Other -11.6 8.7 39.9 60.5 50.0 68.8
* Includes bank lending.
1977-89 figures exclude economies in transition and some Middle Eastern emerging markets.
Source: IMF 1995, p. 33 IMF 1998, p. 13.
Two things stand out from this overall picture. First, the extraordinary increase in the flows starting
in 1990, with this increase being truly phenomenal in Asia. By the mid-1990s, developing countries
were taking 40% of global foreign direct investment (compared with 15% in 1990) and accounted
for 30% of global portfolio equity flows (compared with 2% at the start of the decade) (World Bank
1997, p. 9). The second aspect to observe is just how volatile the flows could be, even in these
multi-year averages.1 Following the Latin American debt crisis of 1982, inflows to that region
turned into outflows nearly as large, and these outflows were sustained until the end of the decade.
Just as the law begins with a presumption of innocence, economics begins with a presumption that
market outcomes will be beneficial: there is an a priori case that international capital flows are a
Good Thing. Financial flows supplement domestic saving, allowing more investment to be done in
those countries where returns are highest; they buffer the variations over time between exports and
imports; foreign direct investment brings the advantages of technological transfer; there are gains
for savers from diversification; and, to complete the case for free capital flows, we should record the
argument that even speculative capital flows can serve a beneficial purpose.
Perhaps the classic model for the beneficial operation of capital flows is illustrated by Singapore in
the 1970s and 1980s. The flows were very large, amounting on average to around 10% of GDP and
in some years 15%. They were used to substantially increase the rate of investment (i.e. not for
consumption), and there was a substantial technological transfer that went with the foreign direct
investment which dominated the flows. Following the "stages of development" academic literature,
we can see these flows being used to partially fund the catch-up as Singapore moved towards the
technological frontier and its living standards rose to equal those of the industrialised Western
countries. This sustained increase in living standards is confirmation that the combination of
application of capital and education produced very large and sustainable increases in production per
head.2 In a mutually reinforcing process, the profit opportunities fostered the development of the
institutional channels which, at the same time, facilitated the capital flows.3
This experience might give us some clues to analysing why these flows occurred more generally,
why there was a huge increase in the 1990s, and the role capital flows played in the subsequent
Asian crisis. There are two broad groupings of factors involved:
the presence of abnormal profit opportunities as these countries moved towards the
•
technological frontier;
• an institutional structure which facilitates the flows of capital.
Profit differentials
The countries of Asia, with their high rates of growth, provided high profit levels and many
opportunities for profitable investment. Expected returns on equity in emerging markets were
consistently higher than those in mature markets, and their volatility was slightly below that of the
mature markets, indicating high risk-adjusted returns (IMF 1998, p. 32). Equity and stock prices
were also performing strongly (IMF 1998, p. 38).
Growth and foreign investment certainly went hand in hand, although it might be noted that there
was a stronger relationship in the 1980s than during the 1990s.4 Of course, on top of these potential
returns, there was also a question of exchange rate expectations, and we will return to this issue
when we look at reasons for the volatility of flows. For the moment, it is enough to record that there
were ex post large excess returns on investment in the emerging Asian markets, taken as a whole.
While it might seem, at first sight, that the main action in terms of profit differentials would come
from the great opportunities available in the capital-receiving countries, it seems that quite a bit of
the action - at least in the variability of the flows - came from changes in interest rates and
exchange rates in the capital-supplying countries: "push" factors rather than "pull" factors. A
powerful force encouraging greater flows was the lower interest rates in most developed countries in
the early 1990s (US interest rates fell by 200 basis points between 1991 and 1993). The low rates
made some investors search out higher returns overseas, and in seeking higher returns, they were
ready to accept greater risks. Such was this new attitude that spreads on Brady bonds were bid down
sharply in the early 1990s.
2
This is not to take sides in the Krugman debate on Singapore productivity: whether this came from more
capital or total factor productivity, the result - in terms of higher living standards - is not in dispute.
3
Foreign direct investment has been the key form of capital inflow for Singapore in its rapid development from
the 1970s onwards. Foreign direct investment accounted for around 50% of net capital inflows in the 1970s
and were the bulk of capital inflows in the 1980s, largely in manufacturing, trade and financial and business
services. Direct investment flows surged from 1987 onwards, spurred by Japanese and European investment,
particularly in financial and business services and, to a much lesser extent, in electronics manufacturing,
reflecting the changes in Singapore's industrial structure and comparative advantage. Foreign direct
investment as a proportion of investment accelerated during the late 1980s. (This was also the period of the
great surge in Singapore's share accumulation index, which captures capital and income gains from shares.)
Excluding cyclical effects, the incremental capital/output ratio for Singapore steadily fell from the 1970s to
the 1990s - which suggests that the marginal efficiency of capital was still rising and investment opportunities
were there to be exploited. Moreover, real interest rates were relatively high in this period. During the 1990s,
however, real interest rates have come down, and, in recent years at least, Singapore's incremental
capital/output ratio seems to have started to rise. At the same time, portfolio flows also rose substantially, in
both an absolute and relative sense.
4
See, for example, BIS (June) 1998, p. 36.
As the decade progressed, an important source of capital flow was Japan. Not only was it
intrinsically a large saver, but the drawn-out recession meant that interest rates were extremely low
(reaching half a percentage point) during most of the 1990s. Much of this capital flow went initially
to the United States, but with the size of the US current account deficit set by the
savings/investment balance, these extra inflows were recycled and, in effect, funded the outflows to
emerging countries. The interest differential between the major industrial countries and the
emerging countries was greatest for Japan - hence the rise of the "yen-carry" trade - borrowing at
low interest rates in yen, and onlending at high returns in other currencies, particularly in Asia.
When local currency borrowing rates were around 20% (which was the case, for example, in
Indonesia), yen-based interest rates seemed extraordinarily attractive.5
There was another important structural change in Japan which began in the late 1980s but
accelerated in the first half of the 1990s. With the very rapid and sustained appreciation of the yen,
Japanese manufacturers recognised that they needed to transfer a large proportion of Japan's
manufacturing production (particularly at the low end of the technology spectrum) to the lower
labour cost countries of Asia. This was a fundamental factor in driving the increase in foreign direct
investment to the region.6
Was "push" or "pull" more important? In a structural sense, the high-profit "pull" of the
capitalreceiving countries was clearly fundamental. But short-term variation (surges and reversals) was
often triggered by events in world markets. A number of researchers have found a close relationship
between interest rate movements in the capital-exporting countries and capital flows.7 The rise in
US interest rates in early 1994 was an important trigger in the Mexican problems, and the
strengthening of the yen in May/June 1997 was a factor in calling into question the continuing
profitability of the "yen carry".
Institutional structure
We noted earlier that profit opportunities in the emerging countries were probably greater in the
1980s than in the 1990s, yet the surge of capital did not come until 1990. This would suggest that,
while relative profit prospects were important, other factors were also involved. In this section, we
explore the importance of the institutional channels of transmission - did the institutions exist to
facilitate, in a fairly frictionless way, flows which were attracted by the high profit opportunities?
This is, of course, a chicken-and-egg issue: as the capital flowed, it encouraged the further
development of financial infrastructure. In the ten years between 1985 and 1994, for example, the
combined market capitalisation of the eighteen major developing countries in the IFC Emerging
Markets Index increased by a factor of thirteen. This process was spurred by greater knowledge
5
In thirteen of the twenty quarters to mid 1997, the "yen-carry" trade for yen/baht was profitable (i.e. exchange
rate changes did not outweigh the interest differential), and for the equivalent yen/US dollar transaction, it
proved profitable in eighteen of the twenty quarters (IMF 1998, p. 44).
6
Foreign direct investment from Japan tripled in the decade to 1997, rising from US$ 22.3 billion in 1986 to
US$ 66.2 billion in 1997. While the United States and Europe remain important destinations for Japan's
foreign direct investment, the Asian share noted the largest rise, increasing from around 10% of the total in
1986 to 25% in 1997. The rise is most spectacular in foreign direct investment into China, with its share
jumping from 1 to almost 9% over this period. Indonesia was another important beneficiary. These flows
were very important to the countries concerned; Japanese total foreign direct investment to Korea, Malaysia,
the Philippines, Singapore and Thailand accounted for around 46% of total net foreign direct investment to
these countries between 1990 and 1995.
7
See World Bank 1997, pp. 81-83.
about these countries. One measure of this was the increase in formal credit ratings given by major
agencies: eleven countries had ratings in 1989; by 1997 this had risen to over fifty.8
Part of the increase in the 1990s reflects the conclusion of the Latin American debt crisis of the
1980s, marked by the issue of Brady bonds in 1989. With these, previous debt was settled in a way
that could give new investors confidence that their debts would be honoured. Not only did the Brady
bonds settle the longstanding debt problems from the 1982 crisis, but they also signalled that the
authorities in the capital-exporting countries (particularly the United States) might help to sort out
problems when they arrived. This would have given institutional investors some comfort.
One reason often cited to explain the increase in capital flows in the 1990s was the reduction in
various forms of capital controls in the emerging countries. This must certainly have been a factor.9
But a number of these countries had an accommodating attitude to many forms of capital flows well
before the 1990s (Indonesia, for example, had essentially open capital markets since 1970).
While all of these factors played a part, the dominant new factor of the 1990s, not present in earlier
episodes, was the greatly increased importance of institutional funds managers.
Table 2: Assets of Institutional Investors
198 198 199 199 199 199 199 199
Total (US$ billion) 2,45 7,46 12,34 13,84 14,6 16,80 18,2 20,64
Total (per cent of GDP)
Canada 35.2 52.2 60.3 66.9 72.6 81.2 85.6 89.2
Germany 20.3 37.1 39.5 37.4 37.5 42.5 44.9 48.9
Japan 23.1 50.3 77.9 75.6 79.1 84.1 85.2 87.0
United Kingdom 64.1 118.3 117.5 129.7 143.3 175.2 156.1 176.0
United States 59.3 88.1 118.7 128.3 132.8 141.4 141.7 158.6
Source: IMF 1995, p. 166, IMF 1998, p. 184.
Figures from 1990 onwards include other forms of institutional saving outlined in IMF 1998 and include figures for
France and Italy.
See also BIS (June) 1998, p. 84.
With around US$ 1 to 2 trillion increase in the portfolios of the institutional investors each year
during the 1990s, there was clearly great potential to fund flows to emerging markets, when
attention turned to them. And turn to them it did. Not only were there big increases in these funds,
but during the 1990s they became more focused on the need for portfolio diversification and shifted
from having almost no exposure to emerging countries to having significant exposure (although still
substantially less than most rules of thumb for portfolio diversification would suggest10). At the
general level, we can see the increase in international integration from measures of cross-border
transactions in bonds and equities. For the United States, these were equal to less than 10% of GDP
in 1980, around 100% by 1989, and 200% by 1997.11 Another general measure: nonresident
holdings of US public debt were around 15% of total in the 1980s, but 40% by 1997.12
In addition to these institutional investors, banks have become more internationalised, readier to
lend to emerging countries. The high profile of the mutual funds (and, in particular, the hedge
funds) may distract attention from the central role of the banks. We will see, in a moment, that the
bank flows were not just large, but were very volatile.
Table 3: International Bank and Bond Finance for Five Asian Countries*
billion)
1990-9(US$ 1995 Q 1996 Q4 1997 Q 1998 Q
1996 Q 1997 Q
at annual rates at actual rates
Net interbank lending 14 43 11 -31 -31
Bank lending to nonbanks 2 15 11 -1 -4
Net bond issuance 3 17 32 1 -2
Total 19 75 54 -31 -37
* Indonesia, Korea, Malaysia, the Philippines and Thailand.
Source: BIS (August) 1998, BIS (June) 1998.
Variability
While the general case in favour of capital flows is a powerful one, the practical problem is their
variability: the surges and reversals. There has always been variation in capital flows, as relative
interest rates changed over the cycle, as profit opportunities opened up and were competed away,
and in response to general factors of confidence and exchange rate expectations. However, for the
most part, the variability is not enormous. Picking an example close to home, even when
international financial markets lost confidence in the Australian dollar in the mid 1980s (the
"Banana Republic" episode), the exchange rate reacted significantly, but capital continued to flow
to Australia - in fact, enough to fund a larger current account deficit as the crisis proceeded.
The recent experience in Asia has been very different, with strong surges and major reversals of the
flows.13
Worth noting is the difference of behaviour between banks and institutional investors, on the one
hand, and foreign direct investment, on the other. In this episode at least, foreign direct investment
has proven to be the most resilient inflow and bank inflows the most flighty (World Bank 1997,
p. 31). This accords with the presumption that direct investment is harder to reverse and is more
focused on the "fundamentals".
Graph 2
Asian Private Capital Flows Prior to the Crisis
US $ Bil
73
%
63
6
53
43
4
Percent of
33
GDP (RHS)
23
US$ BILLIONS (LHS) 2
133
0
-7
-17
-2
-27
US $ Bil
US $ Bil
Other
45 45
35 35
25 25
Portfolio
15 15
FDI
5 5
-5 -5
-15 -15
1990 1991 1992 1993 1994 1995 1996 1997
Source: IMF 1998
Graph 3
Capital Flow Reversals
Mexico Affected Asian Countries *
US$
US$ US$ US$
Bil
FDI Bil
Bil Bil
25 25
40 40
Portfolio
Other (Bank lending)
20 20
30 30
15 15
20 20
10 10
10 10
5 5
0 0
0 0
-10 -10
-5 -5
-20 -20
-10 -10
-30 -30
-15 -15
-20 -20
-40 -40
1993 1994 1995
1996 1997
* Indonesia, Korea, Malaysia, Philippines, and Thailand
Source: IMF 1998
It was the banks which reversed their positions dramatically as the crisis broke: having averaged
US$ 16 billion annual inflow to the five troubled Asian countries, it rose to US$ 58 billion for most
of 1995 and 1996, fell to an annual rate of US$ 22 billion in the last quarter of 1996 and for most of
1997, but by the last quarter of 1997 and the first quarter of 1998 recorded an actual outflow of over
US$ 75 billion.14 This might give us the first clue as to reasons for the much sharper variation in
flows in the 1990s. Not only did these institutional developments mean that the volume of flows
increased, but, with the greatly increased importance of portfolio and banking flows, its nature (and
particularly its volatility) changed.
In this section, I will argue that the volatility of flows was a product of:
• the tiny size of financial markets in the emerging countries, relative to the capital-exporting
countries. Size - or relative size - does matter. Minor portfolio adjustments for fund managers
were large changes for the recipient countries;
• there was a lack of information and understanding about the emerging markets, which meant
that opinion was fickle and not well anchored by the fundamentals;
• risk premia do not seem to follow a monotonic process, increasing steadily as risk increases.
Rather, risk seems to be more like a binary ("on or off") process;
• finally, the emerging economies were in such a state of transition or flux that it is not sensible
to think of this as an equilibrium process, with profit expectations continuously equilibrated
across international markets. This disequilibrium manifests itself most clearly in the exchange
rate (what Obstfeld (1998, p. 6) calls "an open economy's most important price"). This central
linking price which is at the heart of cross-border profit calculations is uncertain and
unanchored - it could shift sharply, and there were no strong forces at work bringing it back
towards its starting point. As exchange rate expectations changed, capital flows responded
strongly.
(a) Relative size
These recipients of the capital inflows were small relative to the size of the flows. While net capital
inflows into the United States were over US$ 180 billion,15 this figure was only a little over twice
the size of the flows going into Indonesia, Korea, Malaysia, the Philippines and Thailand. Compare
this to the size of these economies, credit systems and share markets, where the United States
dwarfs these countries by a ratio of around ten to one.
The problem has been described by the BIS this way: "This asymmetry, coupled with the ebbs and
flows that have historically characterised portfolio investment in emerging countries, highlights the
potential for instability as a marginal portfolio adjustment by the investor can easily amount to a
first-order event for the recipient" (BIS (June) 1998, p. 90). "The sums involved were relatively
small from the perspective of individual investors, even if of dangerous size from the perspective of
the recipients" (BIS (June) 1998, p. 169).
Graph 4
Output, Credit and Equity Capitalisation, 1996
US$ Bil
US$ Bil
USA
Asian affected 5
175 7000
150 6000
125 5000
100 4000
75 3000
50 2000
25 1000
0 0
Net Private
GDP Credit Stock Market
Capital Inflow
15
Measured as the sum of foreign direct investment, portfolio flows and other.
Some of the explanation for the reversals can be found in the paucity of information, among
investors, about the emerging markets. For the most part, their knowledge was so superficial that it
could be (and was) overwhelmed by the arrival of relatively small amounts of new information.
More importantly, investors without their own knowledge base simply followed the herd. In such a
world, it is rational for any individual player to shift with the herd when new perceptions arrive.
Whatever the fundamentals, when the herd is running, you run with it. In its usual understated way,
the BIS observed that: "highly correlated strategies across different players may have contributed to
an aggravation of asset price movements" (BIS (June) 1998, p. 95).
The informational problems were compounded by the biased and ill-founded nature of much of the
information and commentary. Looking back on it, it might seem surprising that there were not more
pundits, highlighting the excessive nature of the flows and the domestic policymaking deficiencies
of the recipient countries. But who would these pundits be? Among the policy officials in the
recipient countries, the flows (and the development of sophisticated financial sectors) were a sign of
progress and modernity: who would want to express doubts about that? In academic circles, the
dominant paradigm was "efficient markets" - who would be bold enough to question the outcome
of the market? Any unexplained differential was passed off as a "risk premium" - the academic
"fifth ace" that could square any circle and explain any regression result, no matter how different
from the "priors". In the financial markets themselves, who was going to bite the hand that fed
them?16 Some of the subsequent commentary suggests naivety on the part of the investors (they
"received repeated assurances that the financial sector was well supervised... and that there would
be no changes in exchange rate policy" (IMF 1998, p. 41)). In hindsight, the degree of ignorance is
so great as to border on the comic. Business Week (22 September 1998) reports a fund manager's
response to the Russians' halting of trade in their domestic debt market in this way: "Nobody in the
history of the world has ever done anything this foolish". Some sense of history!
was
At the same time, it should be noted that information that available was not used. The BIS
banking data provided a comprehensive view on what turned out to be the most volatile element of
the flows, but the existence of these data was either unknown or ignored.17 As far as the outcome is
concerned, however, unused information was as irrelevant as unavailable information.
(c) The behaviour of risk premia
The process of assessing and reassessing risk is captured, to some extent, in the pricing of emerging
market debt.
Graph 5
EMBI Spread to US Treasuries
Daily
Basis
Basis
Points
Points
1800 1800
1600 1600
1400 1400
1200 1200
1000 1000
800 800
600 600
400 400
200 200
l l l l l l l
0 0
1991 1992 1993 1994 1995 1996 1997 1998
Note: Covers Asian and Latin American securities, from JP Morgan
But this does not capture the full extent of the problem. As Sachs (1997) observed: "euphoria turned
to panic without missing a beat". One of the characteristics of capital flows in the crisis was their
reversal - it was not simply a matter of the capital-receiving countries being forced to pay
somewhat more for the capital, because of a changing perception of risk. New flows dried up and
existing capital fled, and could not be lured back at any price. Considerations of risk seem to be a
binary (on/off) process, rather than a monotonic function. In part, this was a rational response by
lenders. Even well-run enterprises had their profit (and repayment) prospects radically altered by the
new environment of high interest rates, massive falls in exchange rates and shattered growth
prospects. Once interest rates rose sharply, a different calculus became relevant - the credit risk
overwhelmed any risk-premium calculation. Credit lines were cut. This is in keeping with the
theoretical work of Stiglitz and Weiss (1981), who show that when interest rates go up sharply,
lenders recognise that the only borrowers who are willing to pay these high rates are those who do
not intend to pay back.
This process was not helped by the behaviour of credit rating agencies, who went along with the
general pre-crisis euphoria, and exacerbated the turnaround of opinion by substantial downgradings
after the crisis had occurred. As these downgrades shifted some financial instruments below
investment grade, institutions with portfolio constraints on asset quality were forced to sell - at any
price. The fact that many of these portfolios were judged month-by-month or even day-by-day led to
strong short-termism.
Graph 6
Asian Credit Ratings
Moody's Credit Rating Agency
Aaa Aaa
Singapore
Aa1 Aa1
Aa2 Aa2
Taiwan
Aa3 Aa3
A1 A1
South Korea Thailand
A2 A2
A3 A3
Hong Kong
Baa1 Baa1
Malaysia
Baa2 Baa2
Baa3
Baa3
Indonesia
Ba1 Ba1
Ba2 Ba2
Philippines
Ba3
Ba3
B1 B1
B2 B2
B3 B3
86 88 90 92 94 96 9886 88 90 92 94 96 98
It may be useful to recall, also, the old distinction between risk and uncertainty - it was the latter
(whose characteristic is unpredictability) rather than the former that was relevant, and perhaps we
should not be surprised that uncertainty premia can shift dramatically.
(d) A disequilibrium process
These capital-receiving emerging countries were being transformed at such a pace that it is not
sensible or realistic to see the process in terms of the usual textbook notions of returns equilibrated
at the margin and smooth allocation of resources, particularly capital. Systems were in flux, and
production functions were changing continuously. This general notion manifested itself in various
ways, but three examples will illustrate the issue.
The first example of apparent disequilibrium in capital flows was identified nearly two decades
ago - the Feldstein/Horioka paradox (1980) - there seemed to be too much correlation between
domestic saving and investment rates in individual countries, with the implication that capital flows
between countries were smaller than would occur in a well integrated world. So here, perhaps, is
another clue to the puzzle. It is not so much that capital flows rose suddenly to achieve abnormally
high levels, but that they were - for some reason - less than optimal earlier, and so the big increase
was a move towards a more normal or equilibrium situation.18 These are asset or stock equilibria.
When these ill-defined and easily changeable temporary equilibria are displaced by a shift of
confidence, the flow requirements to shift from the old to the new stock equilibrium may be very
large (and very disruptive).
Second, profits (or even expected profits) were not equilibrated across countries. For a sustained
period (through the 1980s), excess profits had been earned, illustrated by equity returns and high
domestic real interest rates in Indonesia, Korea and Thailand.
Graph 7
Asian Share Markets
December 1987 = 100
Index
Index
800 800
Indonesia
700 700
600 600
500 500
400 400
Thailand
300 300
200 200
Malaysia
South
100 100
Korea
Philippines
0 0
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998
Source: Datastream.
Table 4: Average Real Interest Rates*
1980-89 1990-98
South Korea 4.6 7.7
Thailand 6.1 5.0
Indonesia# 5.3 6.6
Malaysia 2.7 3.0
Philippines -6.2 2.4
* Average of end-month short-term real interest rates.
# Note: 1980-89 average for Indonesia starts from 1983 and has 13 monthly observations missing over the period.
Source: IFS.
The high interest rates were imposed by the authorities to rein in very dynamic economies, where
many investors wanted to borrow to exploit the profit opportunities.19 The capital flows which
occurred were not sufficient (or could not be absorbed sufficiently quickly) to exploit all the
opportunities. There was a widespread belief (based on actual experience, pre-crisis) that whatever
factory or office building was constructed would prove profitable, because of the tremendous
growth of these economies. No matter how much capital flowed, the marginal investor did not feel
that his actions had used up the last abnormal profit opportunity, and that a "normal profit"
equilibrium had been reached. Investors could not tell if what they were seeing were temporary
abnormal profits (in which they should try to get themselves a share of the action), or high return
because of high risk. Too many assumed it was the former. To the extent that markets acted to
equilibrate returns, they did so by bidding up asset prices (thus reducing the profit return of the
investor who paid the higher price). But this was a knife-edge equilibration: as asset prices rose,
investors extrapolated the rise, so that even if the profit flow on the asset was normal, investors
expected to benefit from continuing asset price increases. So investment continued until obvious
excess capacity emerged, and the bubble burst.
The third manifestation of disequilibrium was in the exchange rate. What is the "right" exchange
rate for a country receiving large capital inflows and likely to go on receiving them for a protracted
period - perhaps a decade or more - before investment returns are reduced to "normal"? This relates
to the old issue of the "transfer problem" - how to bring about the current account deficit that is the
real resources counterpart of the financial capital inflow. For this, the exchange rate probably has to
appreciate from its underlying value. But how far? Portfolio equilibrium would suggest that the
appreciation must be enough to create the expectation of a subsequent depreciation, at a rate to
balance the higher expected returns on domestic, compared with foreign, assets, i.e. to balance the
differential between the domestic interest rate and the foreign rate. If this view-of