The 1985-1994 Global Real Estate Cycle. Page 10 Simultaneously, the sharp 50% decline of equities through the year 1990 iimnediately affected the capital position of the banks. Under the Basle accord, banks are permitted to count 45 percent of the unrealized capital gains on securities (but not real estate) as Tier 2 capital. This declin in Tier 2 capital induces Japanese banks to restrain the growth of their assets, including the international markets. Other institutions such as pensions funds and insurance companies have also sharply curtailed their intemational portfolio investment. II At home, in 1993, the share of non-housing building in the Japanese GNP had fallen to 4.2 percent, its lowest level in 35 years.

# _2.6 Other Causes of Surges in Capital Inflows_

Clearly, Japan has been the dominant source of international capital during this first global cycle. Yet, to model national real estate cycles and determine key volatility factors it will be necessary to sort out the importance of external versus domestic causes of surges in capital inflows. Surges of capital inflows tend to produce a predictable pattern of macroeconomic effects: an acceleration in domestic demand and activity, a deterioration in the extemal current account, pressures on the price of real estate, on financial assets, and on the price of goods.. Schadler et al [1993] consider four basic categories of causes of inflows: external developments, policy changes affecting the real economy, credit policy changes, bandwagon effects. Among the six country cases they analyze, three are particularly illustrative of different causes of real estate booms: Thailand, Spain, and Mexico. These three cases illustrate well the magnitudes of the massive capital inflows that small and medium-size open economies can now face.

- _Thailand_ is a middle-income developing country which illustrates well the impact of the Plaza currency realigment on South East Asian economies. The first year of the surge was 1988, the amplitude of the flows was very large, reaching a level of USD 11.8 bn i.e. 12.6 percent of GNP in the fourth years.<sup>12</sup>

- e _Spain's_ surge of capital inflows started in 1987. The triggers were a series of concurrent financial liberalization, fiscal, and labor market reforms designed to harmonize domestic policies with those of the European Union. Owing to the larger size of the Spanish economy, the inflows were larger in absolute amount than in Thailand (USD 14.6 bn at the peak) but represented a smaller share of GNP (3.8 percent). Japanese investment did not appear to play a very significant role. The real estate boom in the major markets of Madrid and Barcelona followed the European pattern. However the volatility of the office price cycle was more severe in Madrid than in any of the other cities tracked by the JLW data. The JLW index for office capital values in Madrid (1980= 100) exploded from 150 in early 1985 to 927 by the end of 1990. Its fall was even more brutal as this index was already down to 316 by mid-1993.<sup>13</sup>

- _Mexico_ represents a different case again. Accelerated inflows started in 1989. They were affected by Japanese manufacturing investments but they were essentially motivated by the far reaching opening of the economy, trade liberalization, tax reforms, deregulation and privatization. These Mexican domestic structural reforms were leading up to the start of the NAFTA treaty negotiations of 1990. In

In 1987, Japanese financial institutions bought US S137 bn of long-term securities. During the first half of 1994, that figure is down to a net amount of S8 bn. _(Financial 7imes,_ 22-23 October 1994).

12 Data on real estate volatility in SeouL Korea and Taipei, Taiwan also show a relative peak in real estate prices in 1988. In these two cases, however, domestic policy factors should also be taken into account as they played a very significant role. See Renaud. [1993]), Chang et al. [1994].

- 13 See "The Non-Residential Real Estate Market" _Argentwma Real Estate,_ Issue 7, Oct.1994, 31-4.