APEC in the 21st Century

7. International Financial Flows and Regional Financial Safeguards in East Asia

188 Ramkishen S. Rajan 7 International Financial Flows and Regional Financial Safeguards in East Asia Ramkishen S. Rajan Introduction There exists a rich literature detailing the various channels through which a devaluation might be contractionary (see Bird and Rajan 2001a and Rajan and Shen 2002 and references cited within).1 An important channel that was not paid sufficient attention to in this literature is the so-called “balance-sheet effect” due to sizeable unhedged exposures to short-term foreign currency denominated debt (Aghion et al. 2000; and Krugman 1999a, 1999b).2 The rise in corporate bankruptcies due to an escalation in domestic currency liabilities inevitably lead to large-scale domestic “credit rationing”, as decapitalized banks, burdened by large nonperforming loans (NPLs), curtail their lending.3 In a recent review of the International Monetary Fund’s (IMF) response to the East Asian crisis, Fund economists acknowledged the importance of this balance-sheet channel: 07 Ramkishen 188-211 11/3/04, 10:35 AM 188 International Financial Flows and Regional Financial Safeguards 189 It was … not foreseen at the outset that these economies would adjust in a dysfunctional way of reduced external financing — largely through a collapse of private domestic demand rather than a boom in exports. This adjustment reflected in large part the harsh balance-sheet effects of the currency depreciations that occurred, given the unhedged foreign currency exposures of banks and corporations (Boorman et al. 2000, p. 6). Thus, while real exchange rate depreciation may boost the exportables sector (“competitiveness channel”), it could simultaneously contract domestic demand by lowering the net value of leveraged, bank constrained firms (“balance sheet channel”). The resultant impact of a real devaluation on aggregate demand therefore depends on the relative magnitudes of the two effects. Krugman (1999b) has noted that the procompetitive effects of a devaluation might dominate for “small” variations in the exchange rate, resulting in a devaluation being expansionary; the balance sheets effects may dominate for “large” devaluations, resulting in an income contraction. The conundrum is that even a small devaluation in developing countries may act as a trigger leading to sharp capital outflows and outright economic collapse after the initial devaluation. As Calvo (1996) has noted: if there is a “bad” equilibrium lurking in the background, a devaluation — especially, an unscheduled devaluation — could coordinate expectations and help push the economy to the “bad” equilibrium (p. 219). In other words, if devaluation damages confidence it can result in additional capital outflows. This in turn can cause a further decline in the currency’s value that is anticipated, leading to a vicious spiral of crisis-induced devaluation, illiquidity and insolvency of financial institutions and corporates, and an outright economic collapse eventually. Dornbusch (2001) refers to this as a “new-style” crisis. As he states: A new-style crisis involves doubt about credit worthiness of the balance sheet of a significant part of the economy — private or public — and the exchange rate … when there is a question about one, the implied capital flight makes it immediately a question about both … the central part of the new-style crisis is the focus on balance sheets and capital flight … Because new-style crises involve the national balance sheet they involve a far more dramatic impact on economic activity than mere current account disturbances … (p. 2). Models emphasizing the importance of post-devaluation capital reversals can be differentiated according to the type of capital flows that 07 Ramkishen 188-211 11/3/04, 10:35 AM 189 190 Ramkishen S. Rajan they focus on, viz. bank flows versus portfolio flows (Figure 1). These new-style crisis models provide the analytical basis for a detailed examination of the capital account transactions of the five crisis-hit East Asian economies (henceforth referred to as the Asia-5 economies). The remainder of the chapter is organized as follows. The next section provides an overview of trends and patterns in international capital flows to the Asia-5 economies and the larger East Asian region during the bust period and eventual recovery period that followed (1997 to 2000). Section 3 discusses the rationale for, and progress towards, the recent regional initiatives to buttress the international liquidity positions of participating East Asian member countries via a network of swap FIGURE 1 Source: Author Fundamentals based Crisis Induced Devaluation Self-fulfilling based Contractionary Current Account Capital Account Flow Stock (balance sheet effects) Liquidity based Solvency based Expansionary 07 Ramkishen 188-211 11/3...