Managing Capital Flows in East Asia

The World Bank

The following selection is taken from Managing Capital Flows in East Asia, published by the World Bank.

Capital Flows to Developing Countries: An Overview
Evolution of Capital Flows to Developing Countries
The Impact of Capital Flows on East Asian Economies

Capital Flows to Developing Countries: An Overview

The developing countries of East Asia have grown rapidly during the past quarter century.1 This growth has been led by rapid export expansion and supported by substantial capital inflows. Initially, most inflows were in the form of official lending, followed by commercial bank lending with government guarantees, but more recently the composition has shifted toward a wider variety of private sources, often without government guarantees. Private-to-private flows now constitute most external capital flows-the bulk in the form of foreign direct investment (FDI), which also provides transfer of technology and management skills, enhanced access to external markets, and improved competitiveness and efficiency. The most remarkable growth in the past few years, however, has been in foreign portfolio investment (FPI) flows. Flows of FPI also contribute to the development of domestic capital markets, but, as recent events show, they can be more volatile than FDI.

External savings have been a welcome addition to East Asia's already high domestic saving, augmenting investment and helping to spur growth. However, in addition to the substantial benefits they can bring, large capital inflows confront recipient countries with new risks and challenges that require careful management to ensure that those benefits are realized. At the macro level, large external flows can affect an economy's competitiveness, saving, and investment performance, expose it to external shocks, and ultimately reduce its degree of policy independence from the rest of the world. At the micro level, sustained capital inflows can have profound effects on the policies of the financial, industrial, and other sectors, on the shape and regulation of domestic capital markets, and even on the extent and form of government activity in the economy. Furthermore, since not all external capital flows have the same characteristics, different types of capital flows will have different effects and require specific policy responses if the recipient country is to take best advantage of them. This book looks in greater detail at the relation between the macro- and the microeconomic impacts of external capital flows and the range of policy responses available for best managing these flows.

This chapter reviews the evolution of capital flows to developing countries in general and summarizes the findings of the rest of the report. Chapter 2 looks at the composition and volume of capital flows into East Asia in detail and examines their characteristics and sustainability. Recent experiences with capital flows in several East Asian countries are presented in chapter 3. Chapter 4 discusses macroeconomic and microeconomic issues that determine the scope for policy response in countries receiving capital inflows. Chapter 5 examines concerns about the overall environment within which capital circulates-the regulatory structure and the institutional infrastructure. The final chapter pulls the various threads of analysis together into a strategic framework, most of whose elements are individually known to policymakers directly involved in capital markets, and sets forth the challenges and the policy options for managing capital flows.

Evolution of Capital Flows to Developing Countries

The current surge of capital into East Asia represents a new phase in the evolution of capital flows to developing countries. It is the result of the liberalization of capital markets in both source and recipient countries and is characterized by the increasing variety and complexity of financial instruments. Since World War II the dominant trend has been toward an increasing internationalization of economic activity-beginning with international support for rebuilding war-torn Europe and Asia, expanding through successive rounds of trade liberalization in the General Agreement on Tariffs and Trade (GATT), and continuing through a more general removal of constraints on capital flows (This is not an entirely new phenomenon; see box 1.1.)

In its early stages, the move toward internationalization was part of an effort by the United States and its allies among industrial countries to immunize developing countries against the threat of communism. International economic activity has since blossomed and has developed its own dynamic and momentum, outgrowing the need for official nurture. Indeed, the end of the Cold War and the demise of the economic and ideological threat of communism have given further impetus to international transactions. Some nominally communist countries are now major participants in expanding international markets, and those in East Asia may soon become leaders.

Substantial official capital flows and trade reforms leading to growing intraregional and international trade were the initial pillars of global economic expansion following World War II. Increased flows of goods and vastly improved communications led to an expansion of multinational enterprise and sustained trade liberalization. Internationalization of capital flows followed-first to finance the growth of trade and support the migration of production to low-cost areas, and currently as part of portfolio management in a truly international capital market. As developing countries become more integrated into international flows of goods, they are being pulled into the international capital markets. East Asia is at the forefront on both counts.

The nature and content of international capital flows have changed dramatically over the past two decades. As recently as the early 1970s, few countries, whether industrial or developing, were without substantial restrictions on capital movements. Most exchange rates were fixed and managed under the Bretton Woods system, and the bulk of external capital available to developing countries was from official sources, both bilateral and multilateral. Foreign direct investment in developing countries, other than for exploitation of natural resources, was low. Developing countries were asserting their national economic interests and encouraging domestic-often governmental-control of industry. Commercial bank lending and portfolio investment were nearly nonexistent.

Private capital flows to developing countries first surged in the mid-1970s in the form of commercial bank lending, following the initial round of oil price increases. Governments of developing countries were typically borrowers or guarantors (explicit or implicit) of these loans. They often used the capital inflows to fill budget and balance of payments gaps, either to support or (unfortunately) to postpone more fundamental adjustment. International banks had a great deal of liquidity to recycle, and Eurocredits emerged as what appeared to be a low-risk way to lend to developing countries (box 1.2). The countries themselves bore the interest and exchange risk, and sovereign risk was considered minimal at the time. Net flows to developing countries from commercial banks reached their peak by about 1980. Other sources of capital have become more important in recent years.

As the decade of the 1980s opened, too much lending by banks, heavy borrowing by many developing countries, and a severe tightening of monetary policy by most creditor countries caused a sharp reduction in these flows and much higher interest rates. A debt crisis in developing countries began in 1982, affecting mainly borrowers in Latin America, Africa, and Eastern Europe. East Asia (except for the Philippines) was spared the worst, although several countries wrestled with heavy debt burdens. Voluntary commercial bank lending to developing countries nearly ceased, and net flows on private lending turned negative in many countries because they were unable or unwilling to roll over their private debt.2 Official lending rose and partially offset the decline in private lending. Eventually, under the Brady plan, debt relief for some of the largest debtors received official support, but it was a wrenching period for both borrowers and private lenders.3 Toward the end of the 1980s there was widespread concern that all developing countries would face a long dry period before private capital flows returned. The scars remaining from the debt crisis, the expected high demand from investors in industrial countries, and the investment required for the reconstruction of Eastern Europe left many wondering whether enough capital would be available for developing countries.

As it turned out, the debt crisis was more an aberration in a longer-term trend toward increasing international capital flows than a watershed, and other demands turned out to be less than predicted. Aggregate flows to developing countries have recovered strongly since the end of the 1980s and have taken a much wider variety of forms. For example, the share of global FDI going to developing countries rose from 12 percent in 1990 to 38 percent in 1995 (World Bank 1996, p. 7). The reason is simple: the potential returns from investment are much higher in many developing countries than in industrial and transition countries.

The rapidity and magnitude of the resurgence of private flows in the 1990s surprised many observers. The growing internationalization of business and finance and the vast increase in the speed and volume of information flows have allowed much more rapid reassessment of and response to the real growth possibilities in many developing countries. And the spate of commercial lending in the 1970s, however misguided, made developing countries an object of continuing interest for international financiers. Investors in industrial countries are more willing and able to move funds internationally, and wealth holders in developing countries increasingly have international assets to place.4 Furthermore, the volume of international flows involving developing countries creates profitable opportunities for those promoting and handling the transactions. Private flows now greatly exceed public flows in aggregate and constitute about 80 percent of total net flows to developing countries. However, it should be noted that the surge in private flows is concentrated in only eighteen developing countries, which together received over 90 percent of all private flows during the period 1990-94 (World Bank 1996).5

Having borrowed cautiously in the 1970s, East Asian countries were better able to adjust and to ride out the oil shocks and debt crisis of the 1980s while maintaining high growth rates.6 East Asia's good policy record, dynamic growth, outstanding export performance, and continued reliance on the private sector created a high level of confidence among international investors. As a result, the region was not completely cut off from private lending despite general retrenchment. Furthermore, East Asia was able to attract substantial foreign direct investment during this period and to maintain high levels of investment and growth. Not surprisingly, East Asia has been the favorite region for private capital flows in the 1990s. Over one-third of expected growth in world income and trade between now and the end of the century is projected to come from the region, including its industrial countries (World Bank 1994a).

The growth in private capital flows to East Asia is part of a global trend of increasing integration of capital markets. FDI grew from $1.3 billion (10 percent of net capital flows to East Asian countries) in 1980 to $43.0 billion, or 50 percent, in 1994 (World Bank 1996).7 FPI increased from nil to $18.1 billion, or 24 percent of capital flows, in the same period. East Asia is now the destination of over half of total direct and portfolio investment flows to all developing countries and is expected to remain the leading recipient region. In East Asian countries these flows now represent 3 percent of gross domestic product (GDP), or 10 percent of investment, on average. Foreign capital from all sources accounts for about 15 percent of investment. This surge in private capital flows since the late 1980s has been the result of both "pull" and "push" factors-the former consisting of rapid growth and high rates of return in recipient countries and the latter of declining rates of return, fewer restrictions on foreign investment, and large pools of investable funds in source countries. Recent regulatory changes in source countries have allowed the issuing of developing country securities in industrial country markets. Technological advances in communications and financial instruments make it much easier to undertake these transactions.

There are strong reasons for believing that the flows we are seeing will be sustained, although with variations from country to country. Favorable economic policies and liberalization of investment requirements will continue to attract FDI flows that are seeking lower-cost production for an expanding list of products. These flows contribute to high rates of growth that help generate the high yields attractive to portfolio investors in industrial countries, particularly the United States and the United Kingdom. Portfolio optimization models indicate that more international diversification would improve the risk-return profiles of investor portfolios in industrial countries. The current share of international and emerging market assets is well below that indicated by portfolio allocation models on the basis of the current and expected share of these assets in world market capitalization. Accordingly, one would expect to see a period of portfolio stock adjustment that would generate sustained demand for the more attractive assets of the better-performing developing countries, many of which are in East Asia. The GATT Uruguay Round agreement to reduce protection in consuming markets worldwide will make investment in efficient export producers more attractive, and this will also favor East Asia. Although higher interest rates in capital-exporting markets and turbulence in other developing areas (such as Mexico) will tend to reduce the attractiveness of emerging markets everywhere, these conjunctural factors are unlikely to impede the long-term growth of capital flows to successful developing countries, such as those in East Asia.

The Impact of Capital Flows on East Asian Economies

Freer capital flows improve the allocation of capital globally, allowing resources to move to areas with high rates of return. Furthermore, attempts to restrict capital flows lead to distortions that are generally costly to the economy imposing the controls. Where significant gains are to be made, capital controls can be evaded and usually are, although often at substantial cost to the parties and to the orderliness and integrity of the financial system of the country involved. However, large capital flows challenge some traditional policy approaches in East Asia and have led to periodic stresses in capital markets and financial sectors. Inevitably, countries will continue to open their capital accounts and capital markets to private international capital flows. As they do, they will experience some loss of policy independence and face more risks from external shocks.8 It is therefore important to ensure that increased capital flows, greater mobility of capital, and greater international portfolio diversification produce the expected benefits to compensate for the increased risks (box 1.3). Evidence suggests that the potential gains can far outweigh the risks but that success depends on appropriate domestic policy and its effective implementation. Prudent macroeconomic management is essential if capital inflows are to be effectively absorbed and efficiently allocated to complement domestic resources. As capital markets become more open, policy management becomes more complex. Because some forms of capital flows are highly mobile, there is now less scope for deviation from international levels of key variables. Greater weight needs to be put on achieving the right policy mix.

Country Experience

Large capital flows affect all levels of an economy. Greater capital flows into East Asian countries have brought substantial benefits: they have permitted higher levels of investment, facilitated the transfer of technology, enhanced management skills, and enlarged market access. The countries of East Asia have adapted their policies to increase investment and related imports and to mitigate pressures on exchange rates, and in so doing they have been able to sustain their high growth rates. At the same time, East Asian countries have also raised domestic saving, which has facilitated absorption of foreign capital and reduced the countries' vulnerability to variations in those flows. By contrast, for many Latin American recipients of large capital inflows, investment shares of GDP have not increased, and savings have fallen. East Asian countries, however, have discovered they are less able to intervene in their financial markets to promote industries and may have less scope for managing the exchange rate to promote exports than was the case when capital did not flow so easily.

East Asian countries have followed different paths in opening their external capital accounts and domestic markets to foreign participation. Indonesia has had an open account for over two decades, but only in the mid-1980s did it begin to expand the range of domestic assets foreigners could own, as part of a series of reforms to move the economy away from heavy dependence on oil exports. Chronically high interest rates led to short-term capital inflows as authorities liberalized the financial sector. These inflows resulted in high sterilization costs, and the government had to tighten fiscal policy to dampen the economy.

Malaysia and Thailand liberalized their capital accounts during the 1980s and attracted large amounts of FDI. They have been able to absorb these flows effectively without exchange rate appreciation through a combination of policies that liberalized imports and tightened their fiscal stances. But these two countries have also been exposed to market pressures that have called for judicious intervention by the authorities.

The Philippines began liberalizing capital flows in the 1970s, but it was caught with excessive debt levels in the 1980s because it had been less successful than its neighbors in promoting growth and exports. It was the only East Asian country to go through a formal debt workout with commercial banks, which delayed its development for nearly a decade.9 It is now beginning to recover and is continuing its capital market liberalization program. The Republic of Korea has been much more cautious, opening its capital account and market to foreigners only after it had achieved a relatively high per capita income. It encouraged the development of its domestic capital markets before opening those markets to foreigners.

China has undergone the greatest adjustment. It has been reforming and liberalizing its capital markets while engineering a transition to a market-based economy. Its capital account is porous, if not open. The reform process, although not entirely smooth, has a clear and positive direction.

Countries in earlier stages of development should encourage high domestic saving and investment habits and concentrate on attracting FDI for competitive (not protected) markets. Once domestic capital markets and their regulatory structures have had a chance to take root and promote effective capital allocation, there is more scope for liberalization of portfolio investment. It is to the credit of policymakers in East Asian countries that they have learned from experience while continuing to liberalize and have developed a network for sharing experiences.

Macro- and Microeconomic Effects of Capital Flows

Large inflows of capital can create pressures that lead to inflation, real appreciation of the exchange rate, lower domestic saving, and a reduction in the domestic interest rate or the cost of capital generally. The impact depends on the volume of flows, the macroeconomic policy framework, the microstructure of the flows, and incentives in the financial sector. The more the economy can direct capital flows into increased productive investment, the less effect the flows will have on interest and exchange rates. Governments can also sterilize the flows through monetary intervention, although usually at some cost. This practice has generally proved difficult to sustain, but it can provide some leeway during which other policies can be put in place.

The balance between monetary and fiscal policy is a critical factor in managing capital flows. One long-run option that several countries have adopted is to mobilize greater public savings. This approach reduces demand pressures on domestic resources and allows an easier monetary stance and lower interest rates, lessening the pull of high interest rates on short-term capital inflows. That governments have not typically run sustained deficits in East Asia has contributed to a favorable climate for foreign investment. An increase in public saving influences the level of public expenditures, particularly public investment. The demand for infrastructure in the region is large, and, despite expectations that private sources will provide a large part of the required funding, governments will still have to finance the bulk of infrastructure investment. Governments will need to develop long-term strategies to manage capital flows, taking into account the sectoral and distributional aspects of the flows, as well as the aggregate macroeconomic effects on both monetary and fiscal policy. In recent experience, a tighter fiscal stance has proved more effective than tight monetary policy (high interest rates) in managing capital flows in the medium term.10 This approach has also been consistent with high rates of domestic saving and investment.

The capital flows themselves are not monolithic but represent a variety of different instruments, maturities, and risks to the country. The substantial changes in the kinds of instruments underlying these flows have important implications for policymaking. East Asia has traditionally been a major recipient of FDI, and there have been large flows between countries within the region. More recently, FPI has surged. Experience has shown that direct investment is more likely than investment to go into new projects, increasing demand in capital goods markets and for capital imports. The pressure to appreciate the exchange rate will be eased if the current account is allowed to run a larger deficit to effect the real transfer of resources, which may be facilitated by further trade liberalization.

Portfolio investment poses its own problems, which vary depending on whether the instrument is placed abroad or in the domestic capital market. Portfolio investment placed abroad may act more like direct investment if the resulting inflow is used for new investment. But firms seeking financing abroad may undermine domestic monetary policy, and large inflows may disturb a country's capital markets in other ways. Portfolio investment that goes directly into the domestic capital market may be more worrisome, as it can lead to asset inflation and thus tend to reduce domestic saving rather than to increase investment. It is also more likely to affect the exchange rate and to be volatile because it is much more liquid and more sensitive to short-run external factors such as interest rate movements. Portfolio investment therefore adds urgency to regulatory and prudential reform programs. Well-functioning domestic capital markets make managing portfolio flows easier. Although these phenomena are too new to permit hard conclusions, recent experiences in East Asia and Latin America indicate that portfolio flows can be disruptive and that governments may be forced to take strong short-term action.

The fundamentals justify both FDI and FPI in East Asia, supporting the belief that the increase in flows is structural and that fluctuations are transitory. Nevertheless, market perceptions can change rapidly, requiring continual vigilance to ensure that domestic policies remain sound. Even if a country's own policies are exemplary, external events can trigger sharp market reactions, as witnessed by the fallout on East Asia from Mexico's problems. The issue is not whether capital flows are good or bad; the challenge is to conduct both macro- and microeconomic policy so as to ensure that the additional resources provided by foreign capital inflows are used to promote growth and development.

Foreign direct and equity investments offer a degree of risk sharing with foreign investors, with correspondingly higher expected returns. Large volumes of mobile funds seeking profitable investments provide fertile ground for speculators and arbitrageurs seeking to profit from distortions in risk-adjusted yields across markets and countries. This factor imposes a great deal of discipline on national financial markets and their underlying economic policies. The more a country becomes integrated into the international market, the less room it has for distortions in major policy variables (such as interest rates and exchange rates) that deviate from the norms expected by the international financial community.11 Furthermore, there will be pressure toward conformity with international standards for policies and regulations in domestic capital markets and other sectors exposed to external markets. All this should encourage sound overall policy. However, markets can also overreact, and countries must be prepared to protect themselves from specific, short-term runs unrelated to the fundamentals. The difficulty is to know when this is the case and when fundamental adjustment is called for.

Regulatory Implications of Capital Flows

As East Asian countries have become more integrated into global markets, their domestic capital markets have had to adjust to international norms and practices, albeit at varying paces. Moreover, governments are finding that they need to rely to a greater extent on indirect policy tools. Much of the effectiveness of these instruments depends on the sound functioning and the depth of local capital markets. Most capital markets in the region, particularly bond markets, are still in an early stage of development. They lack depth and liquidity and are subject to many imperfections. In addition, domestic capital markets have been largely insulated from international markets and subject to a variety of controls. These markets have been small in relation to global markets, but rapid changes are taking place; equity markets in Korea, Malaysia, and Thailand now rank among the top twenty in the world. As the markets continue to expand, so will the need for more readily available information and for effective prudential regulations that minimize market distortions. Reform and liberalization of these markets will be necessary to promote the orderly absorption of foreign capital, particularly portfolio investment and short-term money market flows.

Direct controls that have been popular in the past, such as those on interest rates or ownership, impede capital flows, may cause flows to be misallocated, and cannot be maintained as capital accounts open. When direct controls are reduced, enhanced disclosure, better accounting standards, and stronger prudential regulation become indispensable partners to the liberalization process. Capital market regulations or practices that amount to implicit or explicit government guarantees or insurance (against sharp declines in equity value, bank failure, or sharp exchange rate changes) tend to encourage uneconomic risk taking and speculation by national and foreign investors that can be costly to governments. Financial sector legislation needs to be designed to encourage and reward prudent behavior by financial agents. Allowing greater portfolio diversification by banks, encouraging contractual saving, and expanding options for other asset holders are important elements of financial sector reform. The development of effective prudential regulations and an efficient transaction infrastructure in capital markets (and in the financial sector in general) is as essential as appropriate macroeconomic policy for managing capital flows.

Toward a Framework

Dealing with substantial flows of foreign capital is a difficult and complex task, particularly when flows are volatile. Industrial countries have been wrestling with the issue for some time, with mixed success. Country strategies will have to adjust to individual situations, using a variety of less-than-perfect instruments. Faced with persistent pressure from external capital markets, developing countries in East Asia will have to adjust their long-term policy frameworks to accommodate flows in a sustainable way. This will involve action on fiscal policy, trade policy, regulation and development of the financial sector, and investment policy, as well as monetary and exchange rate policy. Although the emphasis should be on medium-to-long-term policies, policymakers will also have to consider the management of transitions and short-term surges. These short-term events can threaten long-term strategy and will require nondistorting interventions designed to mitigate their effects without sending mixed signals on policy fundamentals. Such interventions, which should be of short duration, are likely to become less frequent as capital markets mature. The critical objective is not just to react to short-run surges but to manage the economy in a way that will encourage stable long-term flows.12

In assessing the potential impact of large-scale capital inflows, policymakers need to take into account the durability of the inflows so that they can develop and implement policies to manage the flows. Are the flows witnessed in recent years sustainable? (Will the high levels of capital inflows continue for a prolonged period?) Are the flows reversible? (Will they stop coming in, or perhaps flow out again?) And are they volatile?13 (Will the amounts change rapidly up or down?) Because these questions are influenced by global events and decisions in the major economies, the answers lie in part beyond the control of policymakers in East Asia. Authorities therefore must be more sensitive than in the past to external factors and be prepared to react quickly. But they can do much to enhance the durability of beneficial capital flows, both in their macroeconomic policy stance and in a number of microeconomic policy areas that affect the productive allocation of capital inflows. Planning carefully, honing appropriate policy instruments, establishing credibility, and sending clear signals are important in managing capital flows.

Sound macroeconomic policy is, of course, fundamental. That "old-time religion" of low inflation, a balanced fiscal stance, and prudent credit creation regains some of its luster as countries become more integrated into world capital markets. Most of these guidelines were developed in an earlier period of free capital flows under the gold and gold exchange standards (at least for the part of the world that participated), so their relevance is not surprising.

At a strategic level, managing capital flows becomes an issue for countries that have structured their economies so as to achieve real growth rates which generate real rates of return high enough to attract foreign capital.14 To achieve a desirable and sustainable rate of foreign capital inflows, a country must ensure that interest rates are consistent with international rates adjusted for risk and expected exchange rate movements. The exchange rate is also a function of export promotion policy. Fiscal and trade policy should be set to accommodate the real transfer of foreign capital and limit demand-driven inflationary pressure domestically. This policy framework should seek to promote high domestic saving rates and investment in productive activities, rather than rent-seeking behavior. Trade openness is important, to improve absorption of capital inflows in the short run and to develop foreign exchange earning capacity that will enable eventual repayment. Liberalization and reform of domestic goods and capital markets will be necessary concomitants of adapting to more open capital flows externally and will increase the growth potential of the recipient country. As countries become richer, the scope for nationals to invest abroad should be expanded. This will help balance large capital inflows and increase portfolio yields to nationals. The mix of policies within this strategic framework will evolve over time as the country develops and the external environment changes.

At a tactical level, countries still have to deal with fluctuations and potentially sharp movements in capital flows in response to external shocks. They must also be able credibly to implement changes in their strategic policy stances. To modulate capital flows, countries may resort to sterilization policies, use wider bands for exchange rate interventions, change reserve requirements on foreign deposits, adjust short-term interest rates, or impose a variety of taxes or fees-or even temporary direct controls-on short-term foreign transactions. Because these latter interventions can easily become distorting and can lead to potentially costly evasion, they should be used only in an emergency. If the need for them continues, there is good reason to suspect that more fundamental policy problems must be addressed.

In sum, the challenges for East Asian countries are to manage the transition to more open capital markets and dynamic international capital flows so that capital is used effectively; to develop more efficient domestic capital markets that will absorb foreign investment without excessive risk and volatility; to allow nationals the benefits of participating in the global capital market; and to minimize the pain of transition. In the nineteenth century a massive movement of capital from Europe to America led to a dramatic shift in the center of economic power. The current movement of capital from the Western economic powers to East Asia may signal a similar event at the end of this century.

Notes

1. In this book "East Asia" refers to the developing economies of China, Indonesia, the Republic of Korea, Laos, Malaysia, Mongolia, Papua New Guinea, the Philippines, Thailand, and Viet Nam, which are included in the totals for the region. Hong Kong, Singapore, and Taiwan (China) also play an active role in the region, but neither they nor the industrial countries of Australia, Japan, and New Zealand are included in the regional totals, except as specified.

2. Repeated rescheduling agreements led to some "involuntary lending" to sustain debtors until a more lasting solution could be found. This shows up as new flows in the data on net flows in table 1.1.

A few countries, including Korea, Malaysia, and Thailand, voluntarily accelerated repayments of some debts out of current account surpluses or other capital flows during the late 1980s.

3. The Brady plan (launched in 1989) provided a means for debtors to renegotiate unserviced debt with creditors and convert most of it to bonds with lower face value or interest but enhanced security. Clearance of delinquent debt opened up the possibility for debtors to return to capital markets (although few were expected to do so soon) and generated speculative interest in the Brady bonds themselves. See Cline (1995) for a thorough review of the debt crisis.

4. The more readily domestic currency can be converted into foreign exchange, the easier it is for nationals to acquire international assets. With full capital account convertibility, the distinction between domestic and foreign assets becomes vanishingly small.

5. The largest recipients of private flows were the following (East Asian countries are in italics): China (24 percent), Mexico (12.4 percent), Korea (7.2 percent), the former Soviet republics (7.1 percent), Argentina (6.6 percent), Malaysia (6.0 percent), Portugal (5.7 percent), Brazil (4.7 percent), Thailand (4.0 percent), Turkey (3.3 percent), Venezuela (2.5 percent), Hungary (2.3 percent), Islamic Republic of Iran (2.2 percent), India, Chile, Indonesia, Philippines, and Poland (all between 1 and 2 percent).

6. The exception was the Philippines, which was unable to maintain high growth rates during the 1980s and suffered from the debt crisis. It now appears to be getting back on track.

7. China received more FDI inflows than the United States in 1993 and only slightly less in 1994.

8. The earlier opening of trade policy had similar effects in goods markets but quite positive net effects on growth.

9. Vietnam is currently negotiating a debt workout with commercial banks on debt acquired before it liberalized its economy. Fortunately, its debt burden has not had the debilitating effect on growth experienced by other countries.

10. Changes in short-term interest rates may be effective in curtailing short-term surges of capital in or out, as occurred following the Mexican crisis in early 1995.

11. The recent experiences of the European currencies and the dollar indicate the influence financial markets have on the national monetary policies of even the most industrialized countries.

12. Whatever instruments are traded, the distinction between short term and long term is less an issue of an instrument's nominal maturity than of the willingness of investors to sustain or increase their net exposure.

13. It is useful to distinguish between volatility, which is a measure of short-term fluctuation around a mean or trend, and reversibility, which refers to a discrete cessation of inflow-or even an outflow-in response to a shock of some sort. The former makes short-run management difficult. The latter can cause serious economic disruption if it is unexpected and unmitigated.

14. If a country is experiencing large capital inflows without having high-yield real investment opportunities, this may be a warning signal about the speculative nature of the capital flows and a reason for some kind of control until the economic fundamentals are in better shape.