The Role of Short-Term Capital Flows to Emerging Markets

Financial Crisis and Management of Short-Term Capital Flows

By

Dwitya Estu Nurpramana

1 November 2007

Dwitya Estu Nurpramana

 The Role of Short-Term Capital Flows to Emerging Markets
Financial Crisis and Management of Short-Term Capital Flows

Introduction
In the last two decade of twentieth centuries, there are three major financial crises that
had great impact to emerging market economies in international scale. The first and
second crises attacked Latin America region while another crisis struck Asian region.
The first crisis which is known as debt crisis started in Mexico in 1982 when the
Mexican government announced that it could not perform its regularly scheduled
payment to international creditors (Edwards 1998). The second crisis attacked Mexico,
Argentina, Brazil, Peru, and Venezuela in 1994. The third is in 1997 which is Asian
crisis begun from Thailand and then pushed about one-third of countries in the world
into crisis during 1998 (Kim and Haque 2002).

Those three crises motivate many researchers to study the factors that cause financial
crisis and solution in order to avoid the similar event in the future. One of the studies
was done by Mishkin (1996). Mishkin said that the crisis in Mexico was caused by
increasing loan losses that made banks balance sheet deteriorate, increasing interest
rate, stock market decline, and increased in uncertainty. Those initial conditions worsen
the adverse selection and moral hazard problems which finally devaluation of peso and
brought Mexico to crisis.

Another research was done by Krongkaew (1999) mentioned six factors that contributed
to Asia crisis. They are mismanagement in financial sector, large current account
deficit, inflexible of exchange rate, decreasing in export, lack of politicians economic
leadership, and high domestic interest rate and the uncontrolled of capital flows. Kim
(1998) has other arguments of the causes of crisis. He states that the causes of crisis
includes the failure of governments to keep the exchange rate at high level, banking
systems and lending decisions were directed by government, crony capitalism, lack of
transparency, inadequate regulation and supervision in financial sector, inflexibility of
labor market, mismatch between assets and liabilities duration, and the massive
overinvestment which was funded by excessive short term capital. Neely (1999) also

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 argued that the increasing of current account deficit, falling in international reserve,
highly leveraged corporations, fragile financial systems, and overvalue of real exchange
rate contributed to the crisis in Asia.

Moreno (1998) has another perspective. He said that most of financial institutions in
Asia had borrowed significant amount and had not hedged against the volatility of
exchange rate. This would make them vulnerable when the exchange rate changes
sharply, because the amount of money that they have to pay will be larger. The
overflow of international capital into Thailand is as the major sins of financial crisis
which then spread throughout the world (Leenabanchong 1998). Taya (1999) also said
that in Asia, lose of fiscal policy or excessive supply of credit were not the triggered of
Asian crisis, but excessive capital inflows and subsequent outflows.

Although there are many studies and researches have been done by many researchers to
answer the factors that cause financial crisis in emerging market economies, there are
still many factors that need to be explored deeply. One of factor that will be explored in
this paper related to the cause of financial crises is short-term capital flow. This factor is
important because short-term capital flows not only have benefits for recipients such as
supported finance economic development, but also bring countries to more vulnerable
position as result of capital flows reversal (Aybar and Milman 1999). The organization
of this paper is as follows; first section is overview of short-term capital flows to
emerging market economy. Second is factors that cause capital inflows. Third is how
short-term capital flows caused financial crises. Fourth is management of short-term
capital flows, and last section is summary.

Overview of short-term capital flows to emerging market economy

The fast integration of capital markets during 1980s and 1990s was the incredible mark
of the economy in international scale. Significant capital mobility, even though is not a
new feature, according to International Monetary Fund (IMF) that in the 1990s capital
mobility to the emerging markets economy on large scale is not seen since the gold
standard era (IMF 1997).

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 The form of capital flows consist of wide variety range of financial transaction such as
lending between governments, Foreign Direct Investment (FDI), lending by commercial
bank, portfolio investment such as stocks and bonds, short-term debts (either in local or
foreign currency) which are issued and sold by private or public to overseas.
Furthermore, the capital flows to emerging countries were not only from official sector,
but also from private sector. As indicated in Table 1 (in Appendix), during 1990 and
1996, the proportion of private capital flows in aggregate net flows increased from 44.1
per cent to 85.7 per cent. Aligned with the study of IMF (1997) that the cumulative
amount of net capital flows from private sector to the emerging countries were about
$1,320 billion from 1973 to 1997.

Short-term capital flows as part of modern capital flows also increased significantly.
This phenomenon had been studied by Montiel and Reinhart (1999). They stated that in
Asian countries short-term capital flows in the period of 1990 to 1996 was recorded
about 39 per cent of total capital inflows, while for Latin America countries the amount
was around 32 per cent. The increasing of short-term capital flows is identified with the
large volatility of capital flows. Montiel and Reinhart also mentioned that the volatility
of short-term capital flows is more volatile than any types of capital flows in Asia and
Latin America between 1990 and 1996.

The foreign debt in Latin America increased until 1994 and after that slowed down
because affected by crisis (Figure 1). Short-term debts stopped to grow and stable at the
1994s level. However, short-term debts rose continuously at faster rate in Asia. In case
of short-term foreign debts to commercial bank both region were quietly different. The
short-term debts to commercial bank increased dramatically in 1990s in Asia, but in
Latin America their role is smaller.

In term of the composition of debt as shown in Table 2, both of regions were also
strictly different. The short-term debts to total debts ratio in Asia at the beginning of
1997 is higher than any region. Moreover, the share of short-term debts that owed to
commercial bank in Asia was also higher than any region, and twice than Latin America
(29 per cent compared to 15 per cent). Due to capital inflow in emerging countries

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 between 1990 and 1996 relative to GDP in Table 3, total capital inflows relative to GDP
for Asian region were larger than Latin America. The proportion of short-term capital
flows also bigger in Asia compared to Latin America. Those remarks also consider that
the other type of capital inflows particularly portfolio investment which is separated
from the short-term capital flows also has high volatility in nature. The role of portfolio
was greater than other regions.

Factors that Cause Capital Inflows

Viewing the facts that the direction and scale of capital inflows to emerging countries
from industrial countries rely on the comparative attractiveness between emerging
market and industrial market, it may be useful that the cause of capital inflows to
emerging market economies in 1990s classified into internal and external factors
(Dooley et. al. 1996). The internal factors or usually known as pull factors are
liberalization of financial market, increasing capital mobility, creditworthiness
improvement related to debt restructuring in emerging countries, and increasing of
productivity gains which came from structural reforms and better macroeconomic
management. Study by World Bank (WB) in 1996 also stated that countries which have
strongest fundamentals should receive large capital inflows. WB also noted that FDI as
the main component of the capital inflows is not sensitive to the change of world
interest rate, while the other components which are usually in short-term form are more
responsive due to the global interest rate. Therefore, the short term capital continued to
increase as the increasing of world interest rate in 1992-1993 (Lopez-Mejia, 1999).

Another factor which is external factor as factors that pushed capital flows to emerging
countries, especially in the case that caused of short-term capital flows since portfolio
flows and lending by commercial banks also have significant proportion and represent
the short term of capital flows (see Table 1). Study by Calvo et. al. (1996) suggested
that capital flows to the emerging countries is driven the cyclical condition in developed
countries. The declining of interest rate in developed countries in the early 1990s
pushed investors to pull out their fund in developed countries and put it in developing
countries because the higher returns in rather than in developed countries and reducing
of default risk. Furthermore, the fast growing of institution that have purpose for risk

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 diversification in world financial market also has contribution to the flows of capital to
developing countries such as country in Asia and Latin America (Calvo et. al. 1995).

How short-term capital flows cause financial crises

The integration of developing countries to international capital market has many effects.
As stated by Aybar and Milman (1999) that capital inflows can be used for investment
and encouraged economic growth, which subsequently increase welfare and standard of
living in the country. On the other hand, capital inflow also carry problem to the
emerging countries economy. It put on emerging countries more vulnerable as the
result of the reversal of capital flows. This vulnerability is showed up by Latin America
crises and Asian crisis.

There are two main views that explain how the short-term capital flows cause financial
crises in Latin America and Asia (Neely 1999). The main views are fundamentalist view
which concentrates on how policies in the borrowing countries and practices that
brought to the crisis, while another view is panic view which focus on the role that was
played by lenders related to the crisis in the emerging countries.

The fundamentalist argued that the root of crisis and its spread is the flawed of financial
system. The starting point of financial crisis was actually indicated several years before
currency pressure when most Asian and Latin America countries which were smacked
by crisis were under fixed exchange regime and fixed their currencies against the dollar.
In Asian crisis case this regime worked well up to 1995 because it encourages low
inflation, maintains currency stability, and increased export. After that, the dollar
appreciated continuously and significantly against Asian currencies. This appreciation
brought Asian countries loss their competitiveness in the world export market and lead
to huge current account deficits (Corsetti et. al. 1998). Therefore, the appreciation of US
dollar in 1995 to 1997 has a contribution to the 1997 crisis in Asia. This condition is
also similar to the 1980s crisis in Latin America when the US dollar appreciated
significantly which made central bank in Mexico increased the interest rate and then end
up with the debt crisis (IMF 1998).

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 Corsetti et. al. (1998) also mentioned that maturity mismatch and currency mismatch
which is the used of short-term debts to finance long term investments or fixed assets
and the un-hedged of external or foreign debt made banks and financial institution in
weak position when the international investors confidence is shocked. Those two types
of mismatch is also believed as an effect of moral hazard problems in Asian region
since most financial institutions and companies that operated is under guarantee of
government implicitly or explicitly.

The proportion of short-term capital inflows to total capital inflows which was consisted
of the short-term portfolio investment such as short-term debt and security investment
(bonds and stocks) greater than the long-term direct investment or FDI (in Table 1).
Karminsky and Reinhart (1997) said that most of those liquid capital inflows were
directed to long-term and risky assets such as properties and real estates. Regularly,
those similar assets were used as investment and collateral, bringing the value of
existing collateral increase, and then stimulated banks or financial institutions to give
more lending and the increasing of asset prices. Risk that had to be considered also
increase when the local banks started to borrow funds from abroad as response of the
low of interest rate in abroad and under fixed exchange rate regime. Then, those local
banks converted the funds to local currency and lent that fund to domestic customers in
local currency, setting aside the risk of exchange rate. Those practices by local banks
also stated by Burnside et. al. (1998) that the poor quality of bank assets was famous
months before the devaluation as starting point of the crisis.

The fundamentalist view also identify that there were bubbles that exploded the shocks.
At the end of 1996, the asset price decreased which brought the increasing of non-
performing loan (NPL) and falling of the collateral value. Subsequently, domestic
lending declined and price of assets fell more. Capital began to flow out from the
region, which made monetary authorities increased interest rate to secure their currency
pegs. On the other hand, the increasing of interest rate caused the cost of funds to bank
increased and made more difficult for borrowers to payback their debts. The monetary
authority soon ran out their hard currencies, which as reason of monetary authorities to
lose their pegs and brought the local currencies depreciated against dollar. As the most

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 foreign loans that were borrowed by local banks were not hedged, they could not
service their loans because of currency depreciation which also led to the widespread
bankruptcies and slowed of economic growth (Moreno 1998).

The combination of dollar appreciation which caused the loss of competitiveness in

world export market and moral hazard in foreign lending can explain the severity of
crisis in Asia. The crisis then worsens when the local investors started to convert their
own currencies to dollar and the foreign investors refuse to renew their lending. Both
domestic and foreign investors which already spooked by crisis lost more their
confidence to countries in Asian region and dumped more currencies and stock, causing
them to the low level.

The panic view argues that the crisis was caused by a swift change of expectations as a
trigger of the huge capital outflow. There are three factors that support the argument of
panic view. First, there were no signs or alerts such as increasing of interest rate or
lowering of region debts rating by rating agencies. Second, before the crisis,
international banks gave large loan to local banks and private firms which have not
guarantee or insurance from their government. This fact disagrees with the moral hazard
idea, because the investors already knew when they made bad deal. It is inline with the
situation when the international investors panic and withdrew their money from all
investment whether it was bad or good. Third, during crisis the affected countries
experienced pervasive credit crunches. For example, feasible local exporters with
confirmed sales could not get credit because irrational behavior of some lenders (Neely
1999).

On the other words, the trigger of crisis was not the declining of asset prices, as the
argument of fundamentalist view, but the rapid pulled out of capital from regions by
international investors because their irrational behavior. Radelet and Sachs (1998) also
stated that some of condition in crisis which IMF imposed financial assistance also
added to the panic of international investors.

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 Another feature that worsens crisis is contagion or spillover effect. Wolf (1997) defined
that contagion or spillover as co-movements of market which can not be traced to
common co-movements of fundamentals. In all crises which struck Latin America and
Asia in last two decades of twentieth century, a crisis started in one country and then
spread quickly beyond the borders. In some cases, the crisis contaminated neighbors and
trade partners or countries which also have similar policies. As in the last crisis in 1997,
that changed of investors sentiment and rose of risk aversion contributed to the
contagion within and across the borders.

In brief, the short-term capital flows has main role to the financial crises in emerging
countries either by fundamentalist view or panic view. When there were increases of
uncertainty in regions economic condition which worsened the asymmetric information
problems made the foreign investors rapidly pull out their money. This practice to pull
out money from regions and the existence of contagion or spill-over effect brought
countries in emerging market experienced financial crises.

Management of Short-term Capital Flows

Because of the financial crises that struck Asia and Latin America each government
should implement policies to manage capital inflows or outflows in order to avoid crisis
in the future. There are two methods that can be used by government to manage capital
flows which are indirect method and direct method.

The indirect method comprises with the policy to response capital flows by influence
the effect of capital flows to macroeconomy such as intervention in foreign exchange
rate. Hence, the last target can be achieved, which is to affect the volume or
composition of capital flows. One policy which is as the main form of indirect method
is sterilized intervention (Lee 1997). This intervention is influence the foreign exchange
market which the purpose to prevent nominal exchange rate appreciation because of
excessive capital inflows by open market operations. However, when the monetary
authorities implement open market operation usually exhaust domestic reserves to offset
the effect on the money supply. In spite of as the most policy that always use by most
governments in the world, the sterilized intervention has been proved least efficient.

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 One of empirical evidence related to the sterilized intervention is in Malaysia in 1993
when the government implemented policy; it caused interest rate increased dramatically
which made lots of foreign resident attracted to put their money in short-term deposit
(Montiel and Reinhart 1999). Another study by Reinhart and Reinhart (1998) also stated
that the sterilization intervention only had short-run effect in the emerging countries
which implemented this policy. Instead of to control the capital flows, this form of
policy looks to be a counter-productive method of intervention in discouraging volatility
of capital flows.

The direct method as response to capital flows tries to control either outflows or
inflows. This form of policy has proven to be more efficient compare with the
sterilization intervention method. Some studies also suggested that direct method policy
not only promote increasing of FDI, but also reducing portfolio and short-term flows
(Montiel and Reinhart 1999). However, it must be considered that direct control to
either outflows or inflows have different impact.

Controlling capital outflows as part of direct method can be implemented in two

approaches. First, governments can liberalize capital outflows as technique to encourage
capital to move away from domestic asset to foreign asset, so it can decrease net capital
inflows. This approach is based on two assumptions. First, the announcement to
liberalize capital outflows will has negative effect to capital inflows. Second, the
domestic investors to be assumed will increase their purchasing of foreign assets after
liberalization of capital outflows. However, this approach will be least effective when
influence capital outflow if the domestic interest rate high (may be caused by
sterilization). For example, the liberalization of capital outflows in Chile at the
beginning of 1990s, which more encourage capital inflows (Reinhart and Reinhart
1998).

Second approach in controlling capital outflow is imposing restrictions. Krugman

(1998) stated that his approach may need time for reformation to strengthen financial
system, or otherwise it would be ruled out if speculative attacks exist. The restrictions

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 may come from the voluntary actions of creditors or by control over capital outflow
in general, either directly through capital controls like in Malaysia or indirectly by dual-
exchange system as recommended by Krugman. Conversely, this approach often failed
to reach the purpose. It did not stimulate domestic restructuring, despite the fact that it
lead to a worsening in financial crisis such as Latin Americas debt crisis in 1980s
(Edwards 1999). Lastly, those controls would be interpreted by investors as a lack of
confidence in domestic economy, which can worsen the problem of capital flows.

Another method of direct control policy is controlling capital inflows. This form of
method is more reliable in affecting capital flows than controlling capital outflows.
Controlling capital inflows generally can be taken in one of two forms. First is
quantitative restriction which control capital inflows and outflows. It shifts from the
short-term to the longer maturities, rather than control the volume of capital flows such
as in Malaysia in 1994 (Montiel and Reinhart 1999). Second, tax based restriction
which is to control capital inflows that can make transfer more costly. For example, the
monetary authority in Chile imposed 20 per cent reserve requirement to firms which
borrowed directly in foreign currency from overseas lenders. This reserve must be
deposited in central bank in one year period as form to penalize investments which were
less than one year. In 1992 the reserve requirement was increased to 30 per cent based
on the reason that higher rate of reserve requirement would be more effective to
discourage capital inflows. Rodrik and Velasco (1999) also supported that this policy
had an effect to create a disincentive for short-term capital inflows as shown in Figure 2.

Even though the controlling of capital flows in Malaysia and Chile noticeably success,
there are still many criticism to this policy, especially related with effectiveness and
costs. This policy criticized less effective because in todays advanced financial
markets, capital flows can be re-routed through other channels such as use financial
derivative or over or under invoicing in imports and exports, since tax is exempted from
trade credits.

Costly is another criticisms for direct control of capital flows because it can slow down
countrys growth. However, there is evidence that direct controls to capital flows

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 without deterring growth such as in Malaysia (Rodrik and Velasco 1999). In line with
that Edwards (1999) also stated that restrictions on capital inflows raised cost of capital,
particularly for small medium size enterprises which have cost of financing is higher
than large companies.

The most important thing that must be noticed related to the efficiency of capital
controls is the length of implementation. Many countries which applied this policy
implemented longer than necessary, based on reason that the surge of capital flows may
occur if capital controls were removed. This is also stated by Reinhart and Smith (2000)
that it will create offset situation to the benefits of controls. It also should be noted that
when authorities implement direct control policies, they have to face many form of
participants in financial market.

Summary
Financial crises which struck emerging countries in Asia and Latin America region in
last two decade of twentieth century were affected by many factors. One of those factors
is short-term capital flows. International capital flows grew explosively especially for
short-term investment to the emerging countries at that time. Capital flows not only
have benefits for recipients such as supported finance economic development, but also
bring countries to more vulnerable position as result of capital flows reversal.

The surge of capital flows to emerging countries was affected by some factors such as
pull factors and push factors. Push factors are liberalization of financial market,
increasing capital mobility, creditworthiness improvement, and increasing of
productivity. Pull factors are cyclical condition in developed countries and fast growing
of institution that have purpose for risk diversification in world financial market.

The short-term capital flows has main role to the financial crises in emerging countries.
When there were increases of uncertainty in regions economic condition which
worsened the asymmetric information problems made the foreign investors rapidly pull
out their money. This practice to pull out money from regions and the existence of

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 contagion or spill-over effect brought countries in emerging market experienced
financial crises.

In order to avoid crisis in the future because of short-term capital flows volatility,
policies to manage capital flows are needed. The management of capital flows can be
done by indirectly or directly. Indirectly policies response capital flows by influence the
effect of capital flows to macroeconomic condition such as intervention in foreign
exchange rate. On the other hand, directly policies comprise of the authority
intervention to either capital outflows or capital inflows.

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 Reference
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 Appendix

Table 1 Total Net Capital Flows to Emerging Countries between 1990 and 1996
(In billion of US dollars)

1990 1991 1992 1993 1994 1995 1996

Total Net Capital Flows 100.6 122.5 146.0 212.0 207.0 237.3 284.6

Official Capital Flows 56.3 65.6 55.4 55.0 45.7 53.0 40.8
Proportion of Official Capital
Flows (%) 56.0 53.6 37.9 25.9 22.1 22.3 14.3

Private Capital Flows 44.4 56.9 90.6 157.0 161.3 184.3 243.8
a. Portfolio Flows 5.5 17.3 20.9 80.9 62.0 60.6 91.8
- Bonds 2.3 10.1 9.9 35.9 29.3 28.5 46.1
- Equity 3.2 7.2 11.0 45.0 32.7 32.1 45.7
b. FDI 24.5 33.5 43.6 67.2 83.7 95.5 109.5
c. Commercial Banks 3.0 2.8 12.5 -0.3 11.0 26.5 34.2
d. Others 11.3 3.3 13.5 9.2 4.6 1.7 8.3
Proportion of Private Capital
Flows (%) 44.1 46.4 62.1 74.1 77.9 77.7 85.7
Source: Montiel, P. and Reinhart, C., Do Capital Controls and Macroeconomic
Policies Influence the Volume and Composition of Capital Flows? Evidence
from the 1990s, 1999.

Table 2 Composition of Foreign Debt by Region (in per cent)

1988 1989 1990 1991 1992 1993 1994 1995 1996 1997
Asia/Pacific
ST (commercial
banks) 13.6 14.8 18.7 20.3 22 21.8 22.4 26 29.2 23.8
ST (other) 6.8 6.6 6 6 5.4 6.4 4.7 4.3 4.2 4
M and LT 79.6 78.6 75.2 73.7 72.5 71.8 72.9 69.8 66.6 72.2

Latin America
ST (commercial
banks) 9.3 8 8.9 8.5 10.3 11.1 12.4 13.9 15 15.2
ST (other) 3.1 9.6 9.4 12.5 12.7 14 12.4 8.3 6.9 4.9
M and LT 87.6 82.4 81.7 79 77 75 75.2 77.8 78.1 79.9

Europe
ST (commercial
banks) 9.7 10 9.4 9.9 9.5 10.3 6.4 7.9 10 11.9
ST (other) 5.3 4.6 7.4 7.9 7.8 7 5.6 6.6 8.7 11
M and LT 85.1 85.5 83.2 82.2 82.7 82.7 88 85.5 81.2 77.1

Africa/Middle East
ST (commercial
banks) 19 18.9 17.7 14.7 14.4 14 14.8 13.4 15.7 16.1
ST (other) 10.3 10.2 11.9 12.8 12.8 12 10.6 10.8 11.1 12.6
M and LT 70.7 70.9 70.4 72.5 72.5 73.6 74.6 75.9 73.2 71.4
Source: Rodrik and Velasco, Short-term Capital Flows, 1999

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 Table 3 Capital Flows as percentage of GDP

1990 1991 1992 1993 1994 1995 1996

Asia
Total 6.2 8.1 6.5 8.9 5.8 7.3 6.6
Portfolio 0.6 0.2 0.7 1.8 0.6 1.2 1.0
Short term 3.0 3.4 3.6 3.0 1.4 2.6 2.6
Latin
America
Total 3.1 2.1 4.6 5.4 4.2 3.5 4.5
Portfolio 0.2 0.8 1.5 3.5 2.1 -0.5 1.5
Short term 0.6 0.2 2.6 2.0 1.3 1.1 1.0
Other
Region
Total -0.4 -0.7 2.5 4.8 5.0 6.5 3.6
Portfolio 0.0 0.0 0.0 1.3 0.6 0.8 0.7
Short term 1.9 0.7 -1.8 -0.3 0.4 1.6 -0.7
Source: Montiel, P. and Reinhart, C., Do Capital Controls and Macroeconomic
Policies Influence the Volume and Composition of Capital Flows? Evidence
from the 1990s, 1999.

16
Dwitya Estu Nurpramana
 Figure 1

Source: Rodrik and Velasco, Short-term Capital Flows, 1999

17
Dwitya Estu Nurpramana
 Figure 2

Source: Rodrik and Velasco, Short-term Capital Flows, 1999

18
Dwitya Estu Nurpramana