The Search for a Framework
ADBI series on Asian Economic Integration and Cooperation
Edited by Masahiro Kawai and Mario B. Lamberte
Chapter 1: Managing Capital Flows: Emerging Asia’s Experiences, Policy Issues and Challenges
Masahiro Kawai and Mario B. Lamberte INTRODUCTION 1.1 Capital inflows provide emerging market economies with invaluable benefits in pursuing economic development and growth by enabling them to finance needed investment, smooth consumption, diversify risks, and expand economic opportunities. However, large capital flows, if not managed properly, can expose capital-recipient countries to at least three types of risks (Kawai and Takagi, Chapter 2, this book). The first is macroeconomic risk. Capital inflows could accelerate the growth of domestic credit, create economic overheating including inflation, and cause the real exchange rate to appreciate, thus affecting macroeconomic performance in a way not consistent or compatible with domestic policy objectives such as sustainable economic growth with price stability. The second is risk of financial instability. Capital inflows could create maturity and currency mismatches in the balance sheets of private sector debtors (particularly banks and corporations), push up equity and other asset prices, and potentially reduce the quality of assets, thereby contributing to greater financial fragility. The third is risk of capital flow reversal. Capital inflows could stop suddenly or even reverse themselves within a short period, resulting in depleted reserves or sharp currency depreciation. About 15 per cent of the large capital inflow episodes over the past 20 years ended in crisis, with emerging Asia experiencing proportionately more episodes of hard landings (Schadler, Chapter 4, this book), the most devastating of which occurred in 1997–98. Thus emerging Asian economies (EAEs)1 need to manage these risks well to fully enjoy the benefits of...
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