MACROSCAN. Decoding capital flows to Asia

The global economic integration of the Asian region has been marked for some time now, but the significance of financial integration and of capital flows became evident only from the 1990s. The boom of capital inflows into some Asian economies in the 1990s came to a rather abrupt halt with the Asian financial crisis that drastically curtailed non-FDI flows especially to the crisis-hit countries of Thailand, Malaysia, South Korea, Indonesia and the Philippines.

But global investor perceptions altered by the early 2000s, and over the last decade the region has once again become a significant recipient of net capital inflows.

Chart 1 shows net capital inflows into major Asian economies (those included here are China, Hong Kong SAR, India, Indonesia, Malaysia, Philippines, Singapore, South Korea and Thailand) based on the IMF balance of payments database.

Throughout the period since 2005, and even during the years of the Global Financial Crisis and its aftermath, net capital inflows into these countries stayed positive.

However, this was dominantly because of FDI, as portfolio inflows were far more volatile and negative for particular years, notably 2006 and 2013, when the “taper tantrum” occurred.

This would appear to confirm the perception that FDI flows tend to be more stable and long-term in orientation than portfolio flows.

However, given the rather loose definition of FDI (including any purchases of more than 10 per cent of a firm’s equity) and the growing significance of private equity investment that is also designed for relatively quick turnaround, this may not be as true in the contemporary global economy as it was in the past.

What Chart 1 does not indicate is the relative significance of different Asian economies in this total, but that matters, essentially because so many of these capital flows have been destined for China and the indeed the pattern of capital movement across the region in general was largely driven by China.

Chart 2 shows the same data for this set of countries excluding China, and clearly the trend is very different.

Once China is excluded, we find that net capital inflows into these countries were more often than not negative over this period, incidentally despite very large gross inflows for certain countries in particular years.

Indeed, it was only in the four-year period immediately after the GFC that net capital flows to these Asian countries taken together were positive. While net FDI inflows were generally positive, they were also quite small, and indeed declined to near zero in 2014. Meanwhile net portfolio flows have been extremely volatile, but turned negative since 2012. Estimates suggest that the net outflow of portfolio capital from these countries would have been even larger in 2015.

Another peculiar feature of the patterns of capital flows, which has been evident for all emerging market economies but was especially evident in Asia, was the accumulation of foreign exchange reserves.

These were not only the result of current account surpluses — indeed in most cases they reflected either a combination of current and capital account surpluses or reserve build-up based in borrowed finance which involved significant interest rate losses for the concerned country.

This was yet another unfortunate by-product of the integration into global capital markets: the need to provide self-insurance against future crises by holding large amounts of foreign exchange reserves, which accentuated the attempt to manage exchange rates (so as to maintain external competitiveness) in the face of capital inflows.

What this indicates is that despite growing integration into global capital markets and the associated fragilities, most of the important economies of the Asian region did not really benefit from significant and stable inflows of foreign capital even in the most recent period.

Rather, other than for China, such flows have been highly volatile and generally in the net they have been relatively small, not constituting significant additions to domestic savings rates. However, they have been associated with other more problematic features of growth in these economies in the decade leading up to 2014, most notably the dramatic accretion of internal and external debt and the emergence of asset bubbles that have distorted domestic relative prices.

Chart 3 indicates the playing out of this dilemma in the Indian case.

The Indian economy has not yet gone through the extreme form of the classic boom-bust cycle driven by external capital flows, but it has experienced slightly milder versions of it. For example, during the “taper tantrum” of 2013 there was a dramatic outflow of funds from India in the middle of the year that caused a sharp depreciation of the rupee, even though the net inflows of both FDI and portfolio capital for the calendar year turned out eventually to be positive.

But in any case, such capital as came in even during the boom years was largely “saved” up as accumulation of reserves, rather than being directed towards more productive investment within the economy.

Only in the two years 2011 and 2012 were reserves drawn down, and that too occurred in a period when net capital inflows were also tapering off.

With the slight revival of net portfolio inflows in 2014, reserve accumulation also picked up — so the country saved more external foreign currency and essentially held it in very low paying assets abroad like US treasury Bills, even as domestic investment has stagnated.

So, even without going through a financial crisis, the Indian economy illustrates the wasteful and unproductive nature of too close an engagement with global capital markets.