[South Bulletin 55]

These changes in the nature and composition of capital flows have important consequences for the sources of vulnerability of DEEs to boom-bust cycles. Exposure to the risk of instability and crises generally results from macroeconomic imbalances and financial fragility built up during the surge in capital inflows mainly in three areas. First, surges in capital flows can produce or support unsustainable exchange rates and current account deficits. This is quite independent of the composition of capital flows. A surge in FDI would have the same effect on the exchange rate, exports and imports as a surge in portfolio investment or external borrowing. If such imbalances are allowed to develop, sudden stops and reversals would produce sharp declines in the currency and economic contraction unless there are adequate reserves or unlimited access to international liquidity.     

Second, financial fragility arises because of extensive dollarization of liabilities, and currency and maturity mismatches in balance sheets. This would be the case when borrowing is in foreign currency and short-term. When capital flows dry up and the currency declines sharply, mismatches could result in increased debt servicing difficulties and defaults. 

Finally, capital surges can produce credit and asset bubbles. Credit expansion can occur when banks borrow abroad to fund domestic lending, currency market interventions cannot be fully sterilized or inflows lower long-term interest rates. The link between capital flows and asset markets strengthens with greater presence of foreigners in domestic markets. Not only portfolio investments but also many types of capital inflows that are traditionally included in FDI, such as acquisition of existing firms and real estate investment, can create asset bubbles. Reversal of capital flows could then create credit crunch and asset deflation with severe macroeconomic consequences.

The growing denomination of external liabilities of DEEs in their own currencies changes the nature of the risks associated with borrowing from non-residents. It no doubt reduces currency mismatches in balance sheets, which played a key role in most past episodes of crises in DEEs, and transfers the currency and interest rate risks to international lenders and investors. However, it also enhances the impact of instability in capital flows on domestic securities markets and increases the risk of exposure to international contagion. The exposure is also amplified by growing international portfolio diversification by the residents of DEEs through investment abroad. Indeed, evidence suggests that stock prices in DEEs are now closely correlated with net private capital flows, more so in Asia than in Latin America, and the correlation between global and emerging-market equity returns has been rising in recent years with increased two way traffic in capital flows between emerging and mature economies (IIF, October 2007; BIS, 2007).

In previous booms it was the debtors who were highly leveraged, taking both currency and interest rate risks by borrowing short-term in foreign currencies. Now international lenders and investors have become highly leveraged by borrowing in their own currencies and investing in local currency instruments of DEEs. Thus, tightened credit conditions in AEs can lead to a rapid withdrawal by highly leveraged investors from DEEs, causing asset and currency declines, as observed after the collapse of Lehman Brothers. Furthermore, with increased foreign presence, domestic bond markets may no longer be relied on as a “spare tyre” for private and public borrowers and provide an escape route at times of interruptions to access to external financing (Jara, Moreno and Tovar, 2009).   

Still, on the basis of past experience, many DEEs consider that exposure to instability and crises associated with borrowing in local currency is considerably less serious than exposure resulting from liability dollarization that proved fatal during the 1997 crisis. Mitigating currency and maturity mismatches in financing is indeed one of the main rationales of the Asian Bond Market Initiative introduced by ASEAN+3 governments in 2003. The same considerations also explain why several other countries such as Korea are so keen on broadening foreign participation in bond sales as a way of cutting crisis risk (Seo, 2011).