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Comparison of Capital Flows in Asia

Paper Type: Free Essay Subject: Economics
Wordcount: 3581 words Published: 18th Jan 2018

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1.1 Background of the Study

Capital controls were widely used to prevent the free flow of funds between countries until the late 1970s. A cautious relaxation of such controls during the 1980s proved consistent with greater economic integration among advanced countries and strengthened the case for capital market opening more generally. By the early 1990s, capital controls appeared to be finished as a serious policy tool for relatively open economies. The conventional view about international financial integration is that it should enable capital to flow from high income countries, with relatively high capital labor ratios, to low income countries with lower capital labor ratios. If investment in poor countries is constrained by the low level of domestic saving, access to foreign capital should boost their growth and it would also allow residents of richer countries to get higher returns on their savings invested abroad. Openness to capital flows can expose a country’s financial sector to competition, spur improvements in domestic corporate governance as foreign investors demand the same standards locally that they are used to at home, and impose discipline on macroeconomic policies and the government more generally. So, even if foreign capital is not needed for financing, financial openness, to both inflows and outflows, may create ‘collateral benefits’ such as domestic financial sector development which could enhance growth in total factor productivity[1]. Capital account liberalization in financially repressed economies often leads to a period of rapid capital inflows followed by financial crises with international financial integration and policy agenda for further liberalization of capital inflows. Concern has also been expressed as to whether the costs of increased vulnerability to financial fragility might not outweigh the gains from financial integration. But most of the countries continue to progress in dismantling capital controls to integrate their financial markets with the rest of the world.

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1.2 Justification and Relevance of the Study

Economic growth is thought to be a function of investment and other factors. The conventional belief is that foreign capital inflows bring new investible funds and foreign exchange with which the recipient country can achieve higher rates of investment and therefore growth. The role of foreign capital in economic growth is an issue that has provoked continuous debate. Foreign capital augments the total resource availability in a country, but its impact on investment and economic growth is controversial. If judiciously used, it could have favorable effects on economic growth through higher investment and other positive effects. But it is also possible that foreign capital investment might not yield any net benefit to the host country. Economic liberalization and globalization have resulted in rapid mobility of resources between nations as to reap the comparative advantage of the respective country. The 1990s saw a number of capital account crises in emerging market economies. The crises, which were precipitated by a sudden reversal of capital inflows, occurred against the background of financial market deregulation, capital account liberalization, and financial sector opening. Deregulation and liberalization have undoubtedly brought about benefits in the form of greater financial resource mobilization for domestic investment and economic growth. At the same time, this has created new sources of vulnerabilities in the balance sheets of commercial banks, corporations, and the public sector. For Countries that are still in the process of opening the capital account, how best and how fast to proceed remains an unresolved issue. There is no presumption that the resource requirements of implementing a quick transition are either smaller or larger than those of managing a long transition process or administering capital controls. Developing effective regulatory framework takes time, but a lengthy process may create wrong incentives and distortions. A big-bang approach may be appropriate if a prolonged transition is likely to create resistance from vested interests or if different elements of the existing system are so dependent upon each other that a piecemeal reform is not possible without creating significant distortions.

International capital movements can support long-term growth but are not without short-term risks. The long term benefits arise from an efficient allocation of saving and investment between surplus and deficit countries. However, large capital inflows may challenge the absorptive capacity of host countries in the short run by making them vulnerable to external shocks, heightening the risks of economic overheating and abrupt reversals in capital inflows, and facilitating the emergence of credit and asset price boom-and-bust cycles. The inflows expanded the available resources for funding productive investments and privatization, and for raising export capacity and helped finance current account deficits. They contributed to the development of domestic financial markets and the efficiency of banking systems. Foreign participation in domestic government securities markets contributed to liquidity of secondary markets and greater sophistication of financial services such as in Hungary and Poland. FDI helps in transferring the managerial and technological skills, and strengthen domestic institutions. For the European Union accession countries, capital inflows are a mutually reinforcing factor in the process of integration into the European Union[2]. The long term capital flows, particularly of direct investment have been an important factor in the capital account surplus, and the trend of higher long term inflows has intended to be sustained. A major reason for this has been the success of adjustment programes adopted in Indonesia, Malaysia and Thailand in the mid 1980, after a period of instability. In these three countries, an overvalued currency was depreciated, large fiscal deficits pattern was repeated in the Philippines in the early 1990s. In all four countries, macroeconomic stabilization was accompanied by policies to open the economy to foreign trade and reform the financial sector[3].

As a consequence of the foreign capital surge experienced by a number of developing countries, since the early 1990s international economists and policy makers have been debating about whether foreign capital flows should be the object of specific policy. The debate crystallized around two opposite stances. On the one hand, there were those who claimed that capital flows were largely exogenous to the recipient countries and, in addition, very destabilizing. The implication of this view was that the economic authorities should design and implement policies to dampen the impact of capital flows on domestic macroeconomic variables. The opposite position departed from the assumption that capital flows largely respond to domestic variables, be they long-term i.e., those affecting the country’s risk premium, or related to short-term demand management. In either case, there is no need to worry explicitly about capital flows. Policy makers concentrate exclusively on improving domestic policies. An early, and influential, analysis of the capital surge to developing countries ascribes it mostly to the effect of falling international interest rates[4]. There were other factors as well, most of them exogenous to emerging economies. In particular, the recession in developed countries reduced rates of return on capital and made investors look for higher returns elsewhere. Likewise, since the Asian financial crisis, foreign capital has retreated from most emerging economies, regardless of the quality of domestic policies. In some cases, the sudden stop[5] has been particularly traumatic e.g., in case of Argentina and Chile. In Argentina, the sudden stop in capital flows created the fiscal and financial problems. In Chile, it has had less disastrous, although still quite unfavorable, effects. But in all cases, the reversal of the 1990s inflows has been dramatic, and it has been accompanied by a sharp deterioration in growth performance. Building upon Ricardo, the welfare gains from the international partition of labor are widely acknowledged. The economic policy implication has been to remove exchange rate volatility to foster trade and growth. The impact of exchange rate volatility on trade among two or a group of countries has both a micro and macroeconomic dimension. From a microeconomic perspective exchange rate volatility, for instance measured as day to day or week to week exchange rate fluctuations is associated with higher transactions costs because uncertainty is high and hedging foreign exchange risk is costly. Indirectly, fixed exchange rates enhance international price transparency as consumers can compare prices in different countries more easily. If exchange rate volatility is eliminated, international arbitrage enhances efficiency, productivity and welfare. These microeconomic benefits of exchange rate stabilization have been a detrimental motivation of the European monetary integration process. Low transaction costs play an important role for international and intra-regional trade and capital flows.

1.3 Research Questions

We have discussed above about the need of international financial integration, liberalization of capital accounts and potential benefits of capital flows. Many countries in the world opened their capital account to reap the benefits of international capital flows for their economic development and growth. A number of studies have been done so far for the study of capital flows on different issues. Some studies are related with benefits and liberalization of capital account which are: does capital account liberalization lead to growth? by Quinn and Toyoda in 2008; why capital account convertibility in India is premature? by Williamson; financial liberalization and the new dynamics of growth in India by Chandrasekhar in 2008; analysis of the capital account in India’s balance of payments by Ranjan et al in 2004; capital account liberalization and economic performance: survey and synthesis by Edison et al. Some are about the capital flows and economic growth such as; FDI and economic growth relationship: an empirical study on Malaysia by Mun in 2008; and what makes international capital flows promote economic growth? an international cross-country analysis by Shen et al, in 2010. While others focused on the impact of capital flows on different macroeconomic variable which are; capital flows and their macroeconomic effects in India by Kohli in 2001; differential macroeconomic effects of portfolio and foreign direct investment by Gunther et al in 1996; effects upon monetary conditions, saving and the domestic financial sector by Henry and Tesar in 1999 and many others. An empirical study of the impact of capital inflows upon output growth has been done by Gruben and McLeod in 1996.

The studies mentioned above give an idea about the capital flows and their relation with many economic indicators. These topics of capital flows give us keen interest to explore more and study extensively what could be the possible relation and effects with other variables. Capital inflow to Asian countries brought substantial benefit to them. These flows permitted higher levels of investment, facilitated the transfer of technology, enhanced management skills, and enlarged market access. The Asian countries adopted their policies to translate capital flows into capital formation and related imports, and thereby mitigated pressures on exchange rates. By successfully managing foreign capital flows, the East Asian countries could achieve high growth rates. Moreover, capital inflows which were a blessing to the East Asian economies in their development process, created problems in the nineties due to mismanagement. Countries with sound macroeconomic policies and well functioning institutions are in the best position to reap the benefits of capital flows and minimize the risks. Some countries are gaining from the capital inflows while some others are having negative impact of this on their economies. India and China are the two emerging economic giants of the developing world. Both the economies have immense natural resources, skilled and unskilled, cheap but quality labor force, huge domestic market and above all the relatively stable political environment. Both the economies hence have vast potential to attract Foreign Direct Investment (FDI) to serve the local market and to become a more important part of the global integration. After China’s entry into World Trade Organization (WTO) China has emerged into the most attractive FDI destination in the developing world. India’s FDI is far below than that of China. Hence, to know more about capital flows in China and India, we have selected these countries for the study of their capital flows and management. Apart from China we have selected Malaysia for the study. Foreign direct investment has been an important source of economic growth for Malaysia, bringing in capital investment, technology and management knowledge needed for economic growth. The most important benefit for a developing country like Malaysia is that FDI could create more employment. In addition, technology transfer is another benefit for the host countries. These three Asian counties attracted capital flows to reap the benefits of financial integration. Capital flows affect a wide range of economic variables such as; exchange rates, interest rates, foreign exchange reserves, domestic monetary condition and the financial system. The developments, which have been done in many Asian countries, have stimulated a keen interest to understand what have been the nature, trend, pattern and economic effects of capital inflows as well as the appropriate policy responses comparatively in the selected Asian Countries.

Therefore, here, we are interested to know what have been the surges of capital flows in Asian countries. What caused a need of financial sector reforms in India? How and why liberalization was done and what are the recent trends and composition of capital flows in India? What has been the pattern of capital flows in selected Asian countries? And, further what is the relation of capital flows with exchange rate in selected Asian countries? What could be the policies to manage the flow of capital? To get the answer of the questions mentioned above, some objectives have been set to study and discuss in an appropriate manner. The objectives of the present study have been given below.

1.4 Objectives

The broad objective of the present study is to analyze the capital flows comparatively in selected Asian countries. To fulfill the broad objective, there are some small objectives such as:

  1. To study the surges of capital flows in Asia;
  2. To study the financial sector restructuring, liberalization and capital flows in India;
  3. To analyze the trend and pattern of capital flows in India, China and Malaysia comparatively;
  4. To analyze the impact of net capital flows on real effective exchange rate and management of capital flows comparatively in selected countries; and
  5. To give policy implications.

1.5 Research Design and Methodology

The present study is designed to have eight chapters including Introduction and Conclusion. The first chapter is an introductory chapter where the background and justification of capital flows has been given. This chapter gives us a glimpse of the whole study design including the methodology. Liberalization led to greater capital mobility to all the Asian countries and so we are interested to explore more about capital flows. Some objectives are set based on the research questions. To fulfill the objectives, chapter outline has been made. In the second chapter, theoretical perspective of capital flows has been given on various issues related to capital flows. In this chapter a literature survey of existing studies on capital flows has been done and explored what has been the nature, causes and outcomes of capital flows and what kind of financial system and policies are the best suitable to reap the benefits of capital flows. Then, in the third chapter, analysis of surges of capital flows into Asia has been given. Causes of Asian crisis, consequences, restructuring and improvement of the financial system under various programemes has been given. Average annual growth rate of FDI flows in Asia had been calculated and analyzed to know the surges of capital flows in different regions of Asia. In the fourth chapter, financial sector restructuring in India under various schemes has been given. With the report of Narsimham Committee in 1991, various reforms have been done in money market and capital market. The details of these reforms, different policies improvement in financial sector and their impact on different market indicators has been discussed in this chapter. A discussion of liberalization of the market for international trade and capital mobility in India has been elaborated in the fifth chapter. In this chapter, the trend, pattern and composition of capital flows in India has been analyzed. Percentage of source-wise and industry-wise capital flows in India has also been calculated and analyzed in this chapter. In the sixth chapter, background of capital flows in India, China and Malaysia has been given. Origin and starting of capital mobilization and changing trend of different capital flows in these countries have been analyzed in this chapter. A comparative analysis of trend and pattern of capital flows in India, China and Malaysia has been done in this chapter. A comparative analysis of the relationship between exchange rate and capital flows in India China and Malaysia has been done in chapter 7. For the purpose of empirical analysis to see the impact of net capital flows on real effective exchange rate with some other explanatory variables, OLS method of multivariate linear regression model has been used. Unit root test to fulfill the stationary condition of time series has been done based on three methods; one is ADF test, second is Phillip-Perron test and third is KPSS. A comparative analysis of capital flows and the behavior of real effective exchange rate have been done and then the management of capital in these three countries has been discussed. Conclusion and Policy Implications is the eighth chapter which includes the crux of the present study followed by Bibliography and Appendix.

1.5.1 Countries for the Study

The countries for the study of capital flows are chosen from Asia. Selected countries are:

1. India

2. China

3. Malaysia

1.5.2 Data Sources

The data for the present study has been taken from various secondary sources. The data sources which have been used in the present study are given below:

1. World Development Indicators (The World Bank).

2. International Debt Statistics (The World Bank).

3. International Financial Statistics (IMF).

4. World Economic Outlook (IMF).

5. Publications of Reserve Bank of India like:

i. Report on Currency and Finance.

ii. Handbook of Statistics on Indian Economy.

6. UNCTAD database.


[1] Eswar S. Prasad and Raghuram G. Rajan, “A Pragmatic Approach to Capital Account Liberalization”, Journal of Economic Perspectives, Volume 22, Number 3, Summer, 2008, pp. 150-153.

[2] See Inci Otker Robe, Zbigniew Polanski, Bany Topf and David Vavra, “Coping with Capital Inflows: Experience of Selected European Countries”, IMF Working Paper, WP/07/190, 2007, pp. 7.

[3] Linda M Koenig, “Capital Inflows and Policy Responses in the Asian Region”, IMF Working Paper, WP/96/25, 1996, p. 6.

[4] Also see Calvo, Leiderman, and Reinhart, 1993.

[5] Calvo, Izquierdo, and Talvi, have felicitously labeled this term, 2002, pp. 3-4


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