|
|
|
|
The OECD Observer
October/November 1998, No. 214
Liberalising Capital Flows: Lessons from Asia
By Pierre Poret
The Asian crisis has prompted calls from several quarters for tighter controls on foreign investment and capital flows in emerging markets. But such calls are misplaced. There are several compelling arguments in favour of freeing up capital flows in these markets, provided it is done in an orderly and properly structured way.
The Asian crisis has provided a reminder—and a particularly dramatic one—that countries which open themselves to capital inflows become more vulnerable to large capital outflows when investor sentiment turns downwards. This could result in sharp currency depreciation, financial instability and severe recession. Net private flows to Korea, Indonesia, Malaysia, the Philippines and Thailand, which increased rapidly in the 1990s to reach $97 billion in 1996, turned into a large net outflow of $12 billion in 1997. Output was expected to fall in these countries by nearly 6% in 1998 after 4.5% growth last year.
The financial turmoil in Asia has led to several calls for tighter controls on inflows of foreign investment, particularly short-term. Yet, there is plenty of evidence to show that as markets and institutions mature, the efficiency and regulatory gains arising from the liberalisation of capital movements outweigh the risks. None of the developed OECD countries maintain general capital controls, even on short-term capital, and there is no indication of a change in their position. And with reason, as estimates suggest that the annual gains arising from the mobility of international capital are on average of the order of at least 1 percentage point of GDP, possibly much higher. (‘Regulatory Reform in the Financial Services Industry’ (http://www.oecd.org/subject/regreform/finance.htm), OECD Report on Regulatory Reform, Vol. I: Sectoral Studies, OECD Publications, Paris, 1997.) As emerging market economies persevere in their efforts to close the gap with advanced OECD economies, further global integration in financial markets will become all the more necessary. In other words, the question for emerging market economies is not whether capital movements should be liberalised, but how to move towards this objective with a minimum of risk.
Several conditions are important to maximise the benefits of foreign investment and reduce the risks associated with capital liberalisation. They include prudent macro-economic policies and responsive exchange rate regimes. A robust domestic banking system and securities markets and good corporate governance are also key, as is the removal of distortions from government support and guarantees. Another requirement is to instil market discipline through transparency and disclosure, for example, by providing timely and reliable statistics to guide decision-making. The experience with the implementation of the OECD Code of Liberalisation of Capital Movements—one of the main substantive obligations of OECD membership—also points to complementary measures which, rather than focusing on restricting short-term investment, actually encourage longer-term foreign investment.
Promoting Foreign Equity Investment
In most OECD countries foreign investment in equity is considered extremely important to sustaining the liberalisation process. One reason is simply that foreign corporate investors are not usually willing to take long-term commitments unless they have an opportunity to exert influence on the enterprises they invest in. Equity investment provides a way of doing this. Foreign equity investment also has the potential to enhance local corporate governance practices and the investor can help develop the financial infrastructure and institutions needed to cope with free capital flows. Furthermore, equity investment, unlike debt-creating instruments, imposes no obligation on the debtor to make pre-established interest payments and to reimburse the principal at a set date. Equity investment is also generally denominated in the currency of the recipient country so that the exchange-rate risk is shared by the foreign investor.
The Asian emerging economies which were most affected by the recent crisis (Korea, Indonesia, Malaysia, Thailand) all maintained tight quantitative ceilings—never more than 49%—on non-resident purchases on the stock market, together with the possibility of general discretionary screening procedures for foreign equity investments. Even stricter limits on foreign ownership in protected sectors such as banking and finance were imposed in some of them.
The Disciplining Effect of International Exposure
Excessive reliance on short-term foreign funds intermediated by banks poorly equipped to perform market-based credit selection has been identified as one of the main causes for the recent crises in Asian emerging economies. Net interbank lending to Korea, Indonesia, Malaysia, the Philippines and Thailand rose from $14 billion per year in 1990-94 to $43 billion in 1995-96, two thirds of which had maturities with less than a year; these figures compare with net equity inflows of only $11 billion and $17 billion over the same periods. (1998 Annual Report of the Bank for International Settlements.)
Recourse to direct corporate finance from abroad, in particular through the issue and introduction of domestic securities on foreign run markets, contributes to alleviating the burden on domestic banks, thereby reducing their vulnerability to shocks. It also exposes domestic corporations to the disclosure requirements and other disciplines of international capital markets, and allows investors and fund managers to keep a closer watch on the investment behaviour and financial standing of the companies they hold interests in.
Again, in the same four economies most affected by the crisis (Korea, Indonesia, Malaysia, Thailand), prior approval and other restrictions governed the issue and introduction of domestic corporate securities on international markets. Moreover, accounting rules and corporate practices were not always well adapted to international standards and hampered admission to world securities markets.
Improving Credit-risk Management
Several critics watching the Asian crisis have advocated a tightening of regulations on the intermediation of banks in cross-border capital flows to help reduce reliance on short-term lending. Yet such limitations on banks’ external borrowing, which are permitted under the OECD Code through regulations on net foreign exchange exposure and net external positions, already existed in Asian emerging market economies before the crisis. True, there may have been room for more effective enforcement of existing regulations. But there were always limits to what the rules could achieve without interfering with the normal conduct of business, in particular trade finance. And in any case the Asian crisis had less to do with controlling cross-border flows to banks, than with a breakdown in internal credit management. No amount of regulation on capital flows could have prevented that.
Another option, therefore, is to regulate and supervise the local lending practices of domestic banks so as to ensure prudent and effective credit-risk management. Banks would then have less incentive to look to external funds to finance indiscriminate investment. Appropriate guidelines for credit selection, diversification rules for debtor exposure, adequate provisioning against default risks and effective enforcement mechanisms—the lack of which was very much at the root of the crisis in Asian emerging markets—would go a long way towards achieving this objective. Consistent with the practice in a number of OECD countries for years, requirements that certain credits extended by domestic banks to residents be settled in local currency might have been tightened in Asia’s emerging markets.
In the OECD Code, liberalisation means that residents and non-residents should be allowed to transact freely between each other—subject only to possible reporting and other simple formalities to ensure data collection and avoid illegal activities. In the case of the worst-hit Asian economies, the opening of their capital account was to a large extent primarily the result of discretionary authorisation granted to selected sectors. Apart from the favouritism and corruption that discretionary and ad hoc liberal policies almost inevitably give rise to, they also create the perception among foreign financiers and domestic debtors that the government is sharing the risk, a perception which may encourage excessive inflows of capital. At the same time, such practices cast doubt over the transparency of the rules and the strength of the authorities’ commitment to liberalisation. That, in turn, discourages long-term financial investment.
Policies to liberalise capital movements were not in themselves the cause of the recent Asian problem. The aim of continuing policies should therefore be to shift the structure of capital inflows in favour of high-quality foreign investment and gain the confidence of long-term investors. That means promoting foreign equity investment, allowing direct exposure of corporations to the disciplines of international securities markets and reducing the scope for opaque and patronising authorisation policies. And if prudent rules for credit-risk management are effectively implemented, excessive reliance on short-term external borrowing through fragile banking systems and misallocation of investment resources would be reduced. The outcome would be an orderly liberalisation process that works.
OECD Bibliography
Report on Regulatory Reform, 1997
(http://www.oecd.org/subject/regreform/)
OECD Observer No. 206—Regulatory Reform (June/July 1997)
(http://www.oecd.org/publications/observer/206/ob206e.html)
Pierre Poret is the Directorate for Financial, Fiscal and Enterprise Affairs.