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CHAPTE R 1 Global Capital Flows to East Asia: Surges and Reversals Jacques Cailloux and Stephany Griffith-Jones Recent major currency crises in developing countries (and particularly those in Mexico in 1994-95 and East Asia in 1997-98) had three main characteristics. First, they were very sudden and very large, as measured by the scale of the capital flow reversal, by the size of the devaluation, and by the initial cost in terms ofdecreases in output and increases in unemployment and poverty. Second, particularly in relation to financial variables-such as capital flows, levels ofstock prices, and so on-but also on the whole with regard to output, these crises lasted for relatively short periods and were followed by surprisingly large recoveries of both capital flows and growth. A third feature was that the crises themselves, as well as their massive scale and the resulting contagion to other countries, were largely unexpected.1 A central feature of the recent currency crises is the sudden and major reversal of capital flows that these economies experience. Such reversals are either mainly in bank loans (East Asia) or in debt portfolio flows (Mexico, Brazil, Russia). Clearly, these reversals are the immediate cause of such crises. This chapter explores in detail the features of the capital surges that preceded these crises and of the massive reversals that accompanied the crises. We focus on four Asian countries hit by the East Asian crisis (Thailand, Malaysia, South Korea, and Indonesia), although we make some comparisons with Latin America. Given the large scale and suddenness of reversals of capital flows from countries that were previously regarded as highly successful, we hypothesize that an important-though clearly not the only-cause of such reversals is imperfections in international capital markets. These imperfections contribute to excess volatility and large reversals in capital flows. They have almost always featured in the financial panics ofearlier times, but their impact has increased significantly due to a number offactors , including the speed with which markets can react in today's global economy with its highly sophisticated information technology (Griffith-Jones 2 International Capital Flows in Calm and Turbulent Times 1998). Paradoxically, this impact sometimes appears to be strongest in economies that either were or were perceived to be in the process of becoming highly successful. It should be recognized that even though the East Asian countries had very strong fundamentals, especially in the macroeconomic sphere, they also had a number ofstructural weaknesses, particularly in their financial sectors and their regulation. Furthermore, policy mistakes were made in the East Asian economies-including the establishment of the Bangkok International Banking Facility (BIBF) in Thailand and freeing offshore bank borrowing in South Korea in the very early stages of its financial liberalization-that artificially favored short-term flows and thus made these countries more vulnerable to large reversals of capital flows. Clearly, it was the interaction ofstructural and policy weaknesses in the countries with imperfections in international capital markets that caused the 1997-98 crises. Indeed, Demirguc-Kunt and Detragiache (1998), Edwards (2000), and others have argued that it is the interaction between liberalization and poor institutions, such as, for example, lack of proper bank regulation and supervision that contributes to crises. This seems to reinforce the message that full liberalization should be postponed until a proper infrastructure is in place domestically. Although we agree with these insights, the main concern of this book is with the role of international capital flows and their imperfections in contributing to crises. Capital and financial markets are special in that, although they generally function well, they are prone to important imperfections. Asymmetric information and adverse selection play an important role in explaining these imperfections, as financial markets are particularly information intensive. Furthermore, there are strong incentives for "herding" (i.e., an investor trying to mimic another investor's investment decision).2 It is evident that surges and crises in emerging markets have been more frequent than in the past. It can be hypothesized that technological and institutional developments-which may reflect secular trends-can explain the increase in the volatility of capital flows experienced during the 1990s. Clearly, the development of information technology has increased the speed with which capital can flow in and out of countries and more generally the speed and ease with which financial transactions can be made and reversed. Furthermore , it has been argued that the growing importance of institutional investors and increased international diversification of their assets, the risk and reward structures of...

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