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CHAPTER 2 The Role of Mutual Funds and Other International Investors in Currency Crises Stephany Griffith-Jones As we have seen in chapter I, the key source of the reversals of capital flows that triggered the Asian crisis was bank loans. However, portfolio flows also played an important, if more secondary, role, representing 27 percent of the reversal of flows during the crisis, that is, between 1996 and 1998, according to International Monetary Fund (IMF) data (see table 1.2 in chap. 1). Furthermore, as we also saw in chapter I, as a proportion of the total stock of liabilities of different categories of flows, portfolio flows are far more reversible than loans. Finally, it should be stressed that in the Mexican peso crisis, (see, e.g., Griffith-Jones 1996), portfolio flows were the main source of the reversal. In this chapter, we wish to gather the empirical evidence available on the role that portfolio flows in general (sec. 1) and one major category of international institutional investors, mutual funds (sec. 2), have played, particularly in recent currency crises. Our review of the evidence will show that international mutual funds, in particular, did playa fairly important role in outflows from the four Asian countries most affected by the crisis; investments of mutual funds also were extremely volatile in Latin America during the Mexican, Asian, and Russian crises. In section 3, we review the evidence on the link between changes in investments by foreign institutional investors and market returns. Most of the existing literature has indeed focused on this aspect. However, even though this is an important channel for transmitting and magnifying crises (lower stock prices may affect the quality of banks' portfolios of loans and they may also indirectly encourage further capital outflows), it is clearly not the main channel, which is via the direct impact on capital flows. This will be discussed in sections 1 and 2. Whereas sections I, 2, and 3 provide the empirical basis for regulating inflows by institutional investors , section 4 briefly reviews the theoretical case. It also emphasizes the growing importance of mutual funds, particularly in the u.s. financial sector, 29 30 International Capital Flows in Calm and Turbulent Times which further strengthens the case for some source country regulations of that sector. Section 5 concludes with some regulatory proposals. 1. THE ROLE OF PORTFOLIO FLOWS IN THE ASIAN CRISIS As any serious analyst of capital flows knows only too well, data on these flows suffer from a number of problems. Furthermore, data from different sources show extremely large differences that are only partly explained by differences in methodology and coverage. This is particularly so for portfolio flows. We will nevertheless attempt to provide as precise an overview as possible. We will begin with what seems to be the most reliable source of data, the IMF.1 As can be seen in table 2.1, in the beginning ofthe 1990s portfolio flows to the Asian-4 were not very large, with the exception of South Korea, which received significant inflows as early as 1991, flows whose level grew very rapidly till 1996. Indonesia and Thailand became major recipients from 1993 onward. Malaysia experienced mainly outflows over the period. Interestingly, there is no evidence of an impact of the 1994 Mexican crisis on any of the four Asian countries. On the contrary, all four Asian economies experienced higher flows in 1995, suggesting that portfolio flows were somewhat diverted TABLE 2.1. Portfolio Flows to the Four Most Affected Asian Economies (billions of current U.S.$) 1990 1991 1992 1993 1994 1995 1996 1997 Indonesia portfolio investment -0.09 -0.01 -0.09 1.81 3.88 4.10 5.01 -2.63 Equity securities 1.81 1.90 1.49 1.82 -4.99 Debt securities -0.09 -0.01 -0.09 1.98 2.61 3.19 2.36 South Korea portfolio investment 0.22 2.34 4.95 10.55 8.15 13.87 21.18 12.29 Equity securities 0.38 0.20 2.48 6.62 3.61 4.22 5.95 2.53 Debt securities -0.16 2.14 2.47 3.94 4.53 9.66 15.23 9.76 Malaysia portfolio investment -0.25 0.17 -1.12 -0.71 -1.65 -0.44 -0.27 -0.25 Debt securities -0.25 0.17 -1.12 -0.71 -1.65 -0.44 -0.27 -0.25 Thailand portfolio investment -0.04 -0.08 0.92 5.46...

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