Mervyn Davies: Capital inflows are not always good news

Emerging markets need capital to develop and grow, says Mervyn Davies. But there is a marked distinction between “good” and “bad” capital. Policy-makers must ensure that the right environment exists for international investors and companies – and that capital inflows benefit rather than harm their developing economies –

Global capital flows to the emerging markets are still well below the levels of the early 1990s. According to the Washington-based Institute of International Finance, capital flows to emerging markets reached $123 billion in 2002 and are expected to rise to $151 billion in 2003. These may sound like large numbers, but flows are still well below the annual 1990s average of $187 billion.

As a share of GDP, net private capital inflows have fallen from nearly 4% of GDP in 1992 to 2% in 2002. During the golden age of financial globalization in the late 19th and early 20th centuries, flows to emerging markets as a proportion of global GDP were actually larger than they are today.

It is not just the size of the flows that matters, though. Asia showed ahead of the 1997 Asian crisis that there is a very powerful distinction between “good” and “bad” capital flows.

This may sound like a strange concept, but if we look at what happened in Asia, its meaning becomes clear. Ahead of 1997 capital surged into Asia. Then it left just as quickly as it had arrived. This footloose, speculative, short-term money caused significant disruption to Asian economies, as we remember all too well.

Remarkably, since the 1997 crisis, Asia has been an exporter of capital. And the bulk of its savings have gone to the industrialized countries, especially the US. The US has become the destination for international capital – as speculative investors have sought to gain from the stock market boom and as longer-term investors hoped to benefit from the “new economy”. As a result, the US was the main importer of capital at the expense of growing economies in the emerging markets.

These flows helped the US immensely, enabling it to finance its growing trade deficit as Americans went on a spending spree. The US current account deficit has already reached 5% of GDP, or 10% of the total stock of world savings. But this is not sustainable.

China has just displaced the US in terms of investment attractiveness. But other emerging countries need capital, too.

There is a strong argument that economies that are catching up with the developed world should be the recipients of investment, and in the longer term this may well be the case. However, for this to happen, structural changes need to be made to the institutions within emerging economies in order to boost the quality of policy-making.

Policy-makers have a crucial role to play in boosting the attractiveness of their economies to international investors. This is a key step in enabling developing countries to harness domestic demand-led growth. This would reduce their vulnerability to the global economic cycle and improve living standards.

In such circumstances, stronger growth in Asia would lead the region to enjoy a current account deficit – as a sign of economic growth. This would then justify further capital inflows.

One of the main causes of reduced capital flows over the past year has been the global slowdown. Growth this year should recover from last year but it will still be modest. Within this global picture it is Asia that is set to be a global outperformer, just as it was in 2002. And there is a good case for the prediction that Asia will become a key driver of world growth.

However, much of Asia’s current growth is still heavily reliant on exports, something that needs to change to reduce its vulnerability to the global economic cycle.

Current patterns in capital flows

Last November in Beijing Andrew Crockett, general manager of the Bank for International Settlements, highlighted the fact that east Asia is exporting “safe capital” while importing “risky capital”. That sounds bad. But what exactly does it mean?

Risky capital consists, among other things, of foreign direct investment (FDI) and the purchase of portfolios of bad loans. This contrasts with the “safe” investments made by east Asians overseas, which have gone more into bond and money markets in the major economies.

One problem with this is that the flows from Asia that are deepening the US bond market are taking away funds that could have been used instead to deepen the Asian bond market.

Even though China recently overtook the US in terms of its attractiveness as a destination for FDI, the total amount of capital flows into east Asia is still below the levels seen in the early 1990s after taking account of inflation.

China currently accounts for 80% of the total FDI flow into east Asia. The main shift in recent years for east Asia has been the rise in flows directly into equity markets. Stock markets in southeast Asia have only recently attracted more attention from foreign investors.

From a regional standpoint, capital flows to Latin America have suffered the most because of domestic economic and political instability. Net financial flows fell to $29 billion in 2002 from $46 billion the previous year.

Although Latin America has suffered, emerging Europe is gaining. But flows to the region are still quite small, amounting to about $24 billion in 2002. Privatization inflows and convergence plays have had a major role in this.

The region with the greatest long-term potential is Africa, which for a long time has had the highest return from FDI of any region. In 2002 the Africa and Middle East region attracted $10 billion of net private capital flows to emerging markets. This is just under 7% of the total flows.

One action that could boost attractiveness to foreign investors is an increase in the number of countries monitored by rating agencies. At present in sub-Saharan Africa only a handful of countries are rated by any agency: South Africa, Botswana, Senegal and The Gambia.

The catch-22 situation for the other countries in sub-Saharan Africa is that the cost of the rating agencies usually has to be met by the government. There is pressure for this funding to come from international donors instead. Even though these countries are not likely to attain investment grade, a rating would still move them much more into investor focus.

The other key requirement for raising the longer-term potential for capital inflows is to increase the capacity-building capability of the economies. This really means building the capacity of the economy to work efficiently enough for its potential to be harnessed.

This can be done in a number of ways, such as introducing more credible institutions, improving the rule of law and introducing credible economic policies.

Good versus bad capital flows

Emerging markets need capital inflows to grow. The countries that have been most successful in attracting capital flows have also been the ones with sound economic policies.

Attracting large capital inflows for the sake of it is, of course, not the ideal situation. This can be very dangerous, as in the case of the large amount of short-term capital that flowed into east Asia just before the 1997 crisis. In fact 1996 was a record year for inflows to emerging Asia.

There has been a significant increase in the sophistication of the treatment of individual emerging markets. Those with sound economic and monetary policies, structural reforms and privatization programmes have been rewarded with strong capital inflows.

Research at Standard Chartered by our global economists, Gerard Lyons and David Mann, has identified the pull factors that make emerging markets attractive to inward investment. Pull has replaced push as the key issue in investment flows.

No longer is money pushed into developing countries in the search for quick returns. Instead, countries need to be able to pull the capital in. To do this they need solid policies with open, transparent and credible capital markets and a sound legal system.

Policy-makers have a crucial role to play in influencing capital flows. There are three key policies that tend to encourage the right capital flows.

• Restructuring and strengthening the banking system. This has been an important issue across Asia in particular, with special success seen in South Korea and Malaysia. It is important for each country to change at its own pace – one speed is not right for all. Asia should embrace peer reviews. In recent years, Asia has operated effectively in addressing regional issues and it is in Asian countries’ interest to continue to cooperate. Asia’s approach contrasts with that of Latin America, where in many countries there is a perception that reform has been imposed – usually by such institutions as the IMF – and that reform is not necessarily in each country’s best interests. In Asia, it is important, if reform is to succeed, that it be driven from within. Reform must be seen as being in each country’s best interests and it must carry the people with it. The strengthening of banking systems will eventually support domestic demand, which can compensate for any export weakness. The restructuring of overindebted and loss-making institutions is a painful but necessary course. Thailand is another example of a country that has shown a significant turnaround since the Asian crisis. The creation of the Thai Asset Management Company has removed bad loans from the balance sheets and is helping the economy recover.
• Further development of local currency bond markets. Much progress has already been made in Asia on the development of local bond markets but more needs to be done. Even China is making progress towards developing its own domestic currency bond market, and it is right that it should adopt a gradual approach to capital account convertibility. Policy-makers need to ensure that the necessary physical infrastructure for debt capital market transactions is in place. There must also be a strong legal and regulatory framework to increase investor protection.
• Reducing dependence on export-led growth. Reducing dependence on exports would negate the need to have such competitive currencies and back up the requirement to have stronger currencies in order to attract capital inflows.

Reducing dependence on exports is a longer-term trend in Asia, which will come from increasing domestic demand. The consumer in Asia has huge potential to boost spending, and is not constrained by large amounts of debt as in the US.

The increasing use of credit cards will help facilitate this, although it must be done with the right level of monitoring to ensure that levels of debt are manageable. This will continue to ensure that Asia is the global growth outperformer, which should see current account surpluses decline over time and broader capital flows coming in.

There is great uncertainty in the world economy at the moment. But it has weathered many shocks in recent years.

It is important for us all – businessmen, bankers and policy-makers alike – not just to anticipate the risks but to appreciate future opportunities. If we get it right, these opportunities are immense.

Helping emerging countries to develop their capital markets and strengthen their economies will be the surest way of ensuring capital flows to these future economic powerhouses.

Mervyn Davies
Mervyn Davies is chief executive of Standard Chartered Bank.