Attaction of foreign inflows in East Asia
RUSSIAN STATE PEDAGOGICAL UNIVERSITY
BY HERZEN
Economic faculty
Department of applied economy
Course work on theme:
ATTACTION OF FOREIGN INFLOWS IN EAST
ASIA
Student of the third course
_________________
Superviser of studies,
Candidate of economic science,
Senior lecturer
Linkov Alexei Yakovlevich
St. Petersburg
2000 y.
Plan
1.
Integration,
globalization and economic openness- basical principles in attraction of
capital inflows
2.
Macroeconomic
considerations
3.
Private
investment:
a)
Commercial banks
b)
Foreign direct
portfolio investment
4.
Problems of
official investment and managing foreign assets liabilities
5.
Positive benefits
from capital inflows
International economic organizations
(IEOs), such as the World Bank, the World Trade Organization (WTO), and the
International Monetary Fund (IMF), have bun promoting economic openness and
integration, centered on free trade and capital flows. as not a complement but
a substitute for national development strategy.
Investment efforts in South
Korea and Taiwan were underwritten by active government strategy, including
subsidies, promotion, tax incentives, socialization of risk, and establishment
of public enterprises. Singapore’s economic growth was also predicated on a
high investment strategy implemented by the government, even though Singapore
relied relatively more on foreign investors than the other East Asian countries
did.
Regionalism is likely to
remain an important factor in global economic relations in the foreseeable
future, as countries continue to strive for greater access to foreign markets
and for solutions to economic problems and disputes that in many cases might be
resolved only through regional cooperation.
Managing large and perhaps
variable capital inflows- or, more aptly, managing the economy in such a manner
as to effectively and productively absorb these flows- is a major challenge for
East Asian countries. Each country has embarked in its own financial markets,
following initiatives in trade liberalization. Until recently, the bulk of
capital inflows in East Asia has been FDI and project- related lending, both
official and private. At the relativly lower levels of a decade ago, these
flows could be readily accomodated. The overall impact of foreign investment on
growth and exports has been very positive. As the capital flows have increased,
they have created macroeconomic pressures on exchange rates, domestic
absorption, investment policies, and the capacities of domestic capital
markets. The more recent expansion of portfolio investment implies much more
integration into global capital markets and a corresponding increase in
exposure to international market discipline- refferred to by some as market-
conditionality- that will circumscribe policy options and limit the range of
possible deviation from global norms on a number of variables.
The increased complexity of
these poses serious policy challenges to authorities, whose primary objective
is to promote real sector growth in economies in which the industrial and
financial sectors are still rapidly evolving.
Achieving sustainable,
rapid growth with open capital accounts and active capital markets my will be
more difficult than was true with the more closed financial structures that
used to be the norm in East Asia. Indeed, concern about losing control of
domestic policy contributed to some governments reluctance to liberalize their
financial sector and capital accounts in the past, and contributes to their
willingness to stop the process if they see it getting out of hand. However,
capital controls are becoming more porous, the pressures to liberalize
stronger, and the benefits from more open financial sectors more compelling
Government preferences and market forces are liberalization. East Asian
countries can continue their rapid growth only if they achieve the efficiency
gains that result from further liberalization. Furthermore, less distorted
markets provide fewer opportunities, for sent-seeking behavior and resource
misallocation caused by price and other market distortions.
As capital, domestic and
foreign, to seek the highest rate of return in only market. Investment levels
in countries that offer strong growth potential can be augmented by flows of
foreign saving. At the same time, sophisticated investors have expanded
opportunities to seek short-term gain from exploiting market imperfections,
implicit guarantees, and price fluctuations.
These latter activities and
the extent to which they influence other portfolio investments are more
worrisome because of their volatility and their potential impact on long-term
policy. They may or may not be responding to fundamentals. Theoretically,
speculation and arbitrage are believed to contribute to efficient markets and
to impose few net costs overall. Market forces represented by these speculative
flows have generally, but not always, created pressures toward needed
corrections, either of fundamental policy unbalances or of unwarranted implicit
guarantees or distortions.
However, short-term traders
can exert a great deal of influence on specific markets as specific times, with
can work against government policy objectives. It is argued that short-term
traders would do this only if policies were wrongheaded, but in practice market
forces make no judgments as to the inherent value of a policy- only as to
whether a profit can be made from expected market movements. Market agents have
been known to err and overshoot (although policymakers probably anticipate or
perceive more errors than are likely to occur). Nevertheless, it is not
generally wise policy to try to resist market pressures on the theory that they
may be wrong. They are not often wrong, and resistance can be expensive, since
today private international markets can mobilize vastly larger sums than even
industrial country governments. When market forces do err or overshoot, they
correct themselves usually quickly enough to avoid much lasting harm. In fact,
quick policy reaction when the market is applying pressure in response to some
perceives profit opportunity often sends a signal that large gains are unlikely
and mitigates the flow, whereas digging in against market trends may set up an
easy win for speculators at the government’s expense. Moreover, where policy
failures contribute to market pressures, resistance to adjustment can be vary
expensive. The burden is on governments to manage their economies so that easy
arbitrage opportunities are not readily available and official policies or
actions do not give rise to implicit guarantees or other distortions that
markets can exploit to the detriment of public objectives. Consistent application
of sound policy and clear direction goes a ling way toward reducing the
likelihood of overreaction by markets. In addition, policymakers can blunt
short-term flows that pose dangers to the economy through a variety of
instruments that reduce speculative short-term gains.
Governments should
naturally exercise caution in opening financial markets to international flows.
Liberalization needs to be predicated on (a) developing an appropriate
regulatory framework and supervisory system, (b) ensuring that the resulting
incentives promote prudent behavior, and (c) adopting a macroeconomic policy
structure that is consistent with open financial flows. Policies need to
promote both domestic and international equilibrium, be flexible enough to
respond to disturbances from the capital markets, and include safety features
to activate in periods of crisis. Even with such precautions, the world is a
highly uncertain and unpredictable place. There can be no assurances against
unforeseen crises, even with the best of policies. This is part of the price of
open market economies. The point is not to stifle an the economy in order to
avoid crises but to ensure that the economy is sufficiently flexible and robust
to weather the crises and continue to develop and liberalize despite such
interruptions.
The basic the theoretical
framework for analyzing the impact of external capital flows derives from the
pioneering work done by Flemming (1962) and Mundell (1963) on open- economy
stabilization policies. Their relatively simple models have been revised as the
issues addressed have become more complex. Policy guidelines have become more
complicated and much more dependent on a host of other factors that affect
economic activity, including expectations, which can be hard to pin down. The
theory provides a useful backdrop and guide for appropriate policy responses,
but practical policymaking requires a thorough understanding of the
characteristics of the economy in question, the exact nature of the capital
flows, and the range of available policy options and tradeoffs. East Asian
policymakers have been adept at pursuing reform until difficulties arise, then
slowing or even backtracking a bit to reassess and make corrections before
moving ahead once more. This pragmatism has proved its worth, as these
countries have generally avoided major crises.
The basic theoretical
models were initially developed to study the relative effects of monetary and
fiscal policies in achieving domestic stabilization. Impacts on the external
equilibrium were viewed as results and perhaps as constrains. Critical to the
analysis if the exchange regime- fixed or floating- and the openness of the
capital account (or the degree of substitutability between domestic and
financial capital assets).
Under most conditions, the
models indicate, that given a fixed nominal exchange rate regime, fiscal policy
is relatively more powerful than monetary policy in affecting domestic output.
Expansionary fiscal policy increases demand for domestic goods but also tends
to raise interest rates as additional public borrowing is required. Higher
interest rates attract more foreign capital, increasing reserves. The increase
in domestic resources to that sector. The current account balance deteriorates,
partly absorbing the increased capital flows. Real currency appreciation occurs
as domestic prices rise, even though the nominal rate if fixed.
Conversely, monetary policy
has a greater effect on the external account. Raising domestic interest rates
attracts foreign capital and builds reserves, the amount depending on the
substitutability of foreign and domestic assets. Attempts to stimulate domestic
demand by lowering interest rates are diluted, as capital flows overseas to
seek higher rates there, reducing any effect on domestic demand. The more
substitutable foreign and domestic assets are, the less the interest rate
change required for a given effect. Increased substitutability of assets leads
to other problems, however. Where governments try to constrain domestic demand
by raising interest rates, capital flows in, to benefit the higher rates, and
counteracts the restraint. If sterilization is attempted- if, for example,
governments sell bonds (tending to further increase domestic interest rates) to
absorb the increase in the money supply associated with the influx overwhelm
the authorities’ ability to continue to issue bonds to purchase foreign
exchange. In such circumstance, it is hand to prevent a real currency
appreciation.
For an economy dependent on
export growth, as most East Asian countries are, the dangers of expansionary
fiscal policy, combined with monetary constraint to keep inflation under
control, are evident. East Asian countries generally adopt more conservative
fiscal stances than Latin American countries.
Under a floating-rate
regime, the additional exchange rate flexibility dampens some of these effects,
but at the cost of loss of control over the nominal exchange rate. Fiscal
policy becomes relatively lass effective in influencing domestic output. The
increase in demand from expansion leads to an appreciation of the nominal (and,
consequently, the real) exchange rate, increased imports and lower exports, and
less demanded for money and bonds.
Interest rates rise, but
less than in the fixed-rate case, and the floating rate keeps the external
accounts in balance. The increase in capital inflows offsets the higher current
account deficit. Under most reasonable assumptions, output rises, but less than
under a fixed exchange rate for a given increase in expenditures. By contrast,
monetary policy can have a more compelling effect. An expansionary action, such
as open market purchase of domestic bonds, increases output through the effects
of money supply on demand. It also leads to a depreciation, which shifts
resources to the tradable sector and decreases the current account deficit,
offsetting the outflow of capital brought about by the more perfect
substitutability of assets, although the interest rate change will be smaller.
These models can also be
used in reverse to examine the effects of a change in external variables on the
domestic economy. What are the implications when we look at the effect on
domestic policy of increases in foreign capital inflows? For a regime with a
fixed nominal exchange rate, an increase in foreign inflows tends to reduce the
domestic interest rate and increase domestic demand. This, in turn, leads to an
increase in domestic prices that will bring about a real appreciation through
higher domestic inflation. Reserves tend to accumulate, although by less than
the capital inflows, as the current account also deteriorates.
Monetary policy action to absorb the capital inflows through, for example,
open-market sales of bonds (sterilized intervention) could offset the impact on
demand. But such an action would tend to increase interest rates, which could
well attract more capital inflow. It is not likely to be effective in the long
term if there are practical limits on how many bonds can be issued, and it
could be costly (because of negative carry on the reserves accumulated). The
more substitutability there is between domestic and foreign assets, the less
variance is possible between domestic and foreign interest rates before
increase in the domestic interest rate become self-defeating. Fiscal contraction
would offset the increase in demand and perhaps allow a reduction in interest
rates, which would diminish the attraction of domestic assets to foreign
investors. A fiscal response would take longer to orchestrate than a monetary
response, however, become public budgets are hard to cut in the short run.
Under a floating-rate
regime, a foreign capital inflow leads directly to an appreciation of the
nominal and real exchange rates. The impact on output depends on the relative
strengths of the increase in demand resulting from the capital inflow and the
reduction in demand for domestic output because of the appreciation, but an
increase in output is likely. If the exchange rate is allowed to adjust, the
real appreciation attributable to the capital inflow has less effect on the
domestic economy. Prices may rise, and interest rates may fall. However, for
export-oriented economies a sustained appreciation may pose serious long-term
problems for the export sector. Many fear that appreciation would cause significant
loss of exports and eventually overall growth, as markets are lost to
lower-cost competitors. Depending on the relative strengths of different
effects, the expansion of domestic demand could be counteracted by either
tighter fiscal policy or monetary contraction, offsetting some of the
appreciation. The former still raises the same questions about the speed of
response; the latter may raise interest rates enough to attract more foreign
inflows, exacerbating the initial problem. Furthermore, exchange rate
appreciation induced by capital inflows will increase the yield to foreign
investors as measured in their own currencies, which may extend the capital
inflows, particularly short-term, yield-sensitive flows. The ability of
floating exchange rates to insulate an economy from external influences depends
on the authorities’ willingness to accept exchange rate movements determined,
in part, by foreign investment demand. A floating-rate regime also depends on
the flexibility of domestic prices and wages and on adequate factor mobility to
be effective. The prevailing fixed or managed exchange rate regimes in East
Asia and most other countries indicate a marked reluctance to accept the
implications of fully floating exchange rates.
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