mostly flows in the form of FDI.<sup>2</sup> " Three factors were important: implicit insurance provided to financial institutions; high domestic finding costs and market segmentation; and certain specific institutional changes in the 1 990s in some East Asian countries.

- **Implicit Insurance.** The (implicit or explicit) insurance on liabilities provided by the government to the financial system, as well as implicit guarantees provided to the corporate sector has been an important factor in motivating excessive risk-taking, including large foreign exchange risks (McKinnon and Pill, 1997, provide an analytical model). As some of the cost of a default of an individual borrower (or the negative impact of a general financial crisis on a borrower) were expected to be passed on to the rest of the domestic economy, risks were underpriced. This happened in case of Chile in the late 1 970s, in Mexico in the early 1 990s, and has been an important factor, especially in the case of Thailand and Korea.

- **High Domestic Funding Costs and Market Segmentation.** A decomposition of the nominal lending rate for non-prime borrowers for Thailand over the period 1991-1996 shows that domestic financial intermediation costs accounted for a significant part of the nominal Baht interest cost: almost 28% of the average nominal interest rate.<sup>22</sup> Individual bank data confirm that overall intermediation costs, as measured by net intermediation margins, were high in East Asia. As a result, domestic costs of funds were significantly higher offshore costs even after taking into account exchange rate risks, leading to (further) incentive to access foreign funds. Typically, however, this access was only available to the largest and best credit corporates and financial institutions, while smaller and less creditworthy firms were confined to the domestic market. This market segmentation, not uncommon in other countries, made it more difficult to limit offshore borrowings to prudent levels as it in effect created a strong constituency favoring a regime with implicit insurance and other distortions.

- **Specific Institutional Changes.** Specific institutional changes played a role in encouraging foreign inflows. Important among these was the creation of offshore financial markets where local financial institutions were to provide clients in nearby countries with financial services. Malaysia promoted, for example, Labuan as a financial center, and the Philippines developed an offshore Euro-peso market. These markets were often given regulatory and tax advantages over domestic markets. Because of the regulatory and tax advantages, much external financing was channeled through these centers.<sup>2 4</sup> They also put pressures to reform and deregulate local markets, as firms would otherwise switch to tlhe offshore market. The offshore markets created, however, adverse dynamics, mainly as they ended up servicing domestic firns ("out-in" transactions) rather than firms in nearby countries ("out-out" transactions). Put differently, the offshore centers became vehicles for funding doimestic firms, rather than vehicles

> **21** Kaminsky and Reinhart, 1997 confirm this finding for a wider set of countries.

> **22** Macro and currency risk factors constituted 16% of the total of the average nominal interest rate of 16% over this period, while the base US risk-free rate represented on average 28% of the nominal interest costs.

> **23** The net financing gain in unclear, however, as it depends on the degree of substitutability: if foreign or domestic investment simply moves from the domestic market to the offshore market, there will be no net financing gain and only a loss of tax and regulatory coverage.

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