Coping with Accelerated Capital Flows from the Globalization of Financial Markets

Abstract

The usual response to the tremendous increase in international capital flows to the emerging markets in the last two' decades is an optimistic one because this development allows the poorer economies to accelerate their development by borrowing more from abroad. As long as the investment yields a return rate that is higher than the loan rate, the borrower is better off. The fact that private capital has come to account for an increasing share of capital flows increases the probability that the preceding condition holds. However, the Asian financial crisis, that started with the devaluation of the Thai baht on 2 July 1997, has caused a reconsideration of the optimistic view about the globalization of financial markets. It is possible that the widespread acceleration of capital account liberalization in the last decade has introduced a very high degree of volatility into international capital movements. The greatly increased volatility may have rendered capital flows to be an important new negative shock to the world economy, especially to the developing economies because of their shallow financial markets. Some observers have hence argued for a halt in financial market integration. However, many other observers have interpreted the recent sharp reversal of capital flows in Asia to be the result and not the cause of the economic collapse in these countries. Economic fundamentals, it is argued, had deteriorated significantly under the crony capitalism practised in these countries, and the large capital outflows were the sensible economic response to this development. The correct response to the Asian financial crisis should therefore be focussed on the reform of the domestic economy, and to continue to keep the capital account open. Obviously, what should be done to avoid future financial crises depends on the diagnosis of the present Asian financial crisis. To anticipate our analysis, we conclude that the process of international integration of financial markets should be continued even though capital account shocks were the most important cause of the Asian financial crisis. We can reduce the cost of external financial shocks by reforming international institutions and coordinating international actions on several financial practices to reduce the occurrence of financial crises, and by restructuring the domestic economy to strengthen it against financial crises. I. Opposite Movements in Asian Default Premia In retrospect, only the collapse of the Thai baht could be argued to have been anticipated by the international financial markets. The basis of the preceding statement lies in that the interest rate linkage between the interest rate in country X on loans denominated in X's currency ([r.sub.x]) and the interest rate on U.S. Treasury bonds ([r.sub.us]) can be decomposed as follows: [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] where [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] = interest rate on US$ loans borrowed by X's enterprises in the Eurocurrency market (Euromarket, for short). The two right hand side terms can be interpreted as follows: * ([MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]) is the currency premium which is a function of, one, the penalty paid by X's enterprises that have no access to Euromarket loans; and, two, the premium charged to cover the devaluation risk of X's currency. * ([MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]) is the default premium, commonly called the Eurobond spread, paid on Euromarket loans by X's enterprises. So, the movements in the Eurobond spread of a particular country indicate changes in the expectations of the international financial markets about the probability of default by enterprises in that country. The record indicates that, generally, there was growing optimism about the future of the emerging market economies up to the eve of the Asian financial crisis. …