RUSSIAN STATE PEDAGOGICAL UNIVERSITY BY HERZEN

Economic faculty

Department of applied economy

Course work on theme:

ATTACTION OF FOREIGN INFLOWS IN EAST ASIA

Student of the third course

_________________

Superviser of studies,

Candidate of economic science,

Senior lecturer

Linkov Alexei Yakovlevich

St. Petersburg

2000 y.

Plan

1. Integration, globalization and economic openness- basical principles in attraction of capital inflows

2. Macroeconomic considerations

3. Private investment:

1. Commercial banks

2. Foreign direct portfolio investment

1. Problems of official investment and managing foreign assets liabilities

2. Positive benefits from capital inflows

International economic organizations (IEOs), such as the World Bank, the World Trade Organization (WTO), and the International Monetary Fund (IMF), have bun promoting economic openness and integration, centered on free trade and capital flows. as not a complement but a substitute for national development strategy.

Investment efforts in South Korea and Taiwan were underwritten by active government strategy, including subsidies, promotion, tax incentives, socialization of risk, and establishment of public enterprises. Singapore’s economic growth was also predicated on a high investment strategy implemented by the government, even though Singapore relied relatively more on foreign investors than the other East Asian countries did.

Regionalism is likely to remain an important factor in global economic relations in the foreseeable future, as countries continue to strive for greater access to foreign markets and for solutions to economic problems and disputes that in many cases might be resolved only through regional cooperation.

Managing large and perhaps variable capital inflows- or, more aptly, managing the economy in such a manner as to effectively and productively absorb these flows- is a major challenge for East Asian countries. Each country has embarked in its own financial markets, following initiatives in trade liberalization. Until recently, the bulk of capital inflows in East Asia has been FDI and project- related lending, both official and private. At the relativly lower levels of a decade ago, these flows could be readily accomodated. The overall impact of foreign investment on growth and exports has been very positive. As the capital flows have increased, they have created macroeconomic pressures on exchange rates, domestic absorption, investment policies, and the capacities of domestic capital markets. The more recent expansion of portfolio investment implies much more integration into global capital markets and a corresponding increase in exposure to international market discipline- refferred to by some as market- conditionality- that will circumscribe policy options and limit the range of possible deviation from global norms on a number of variables.

The increased complexity of these poses serious policy challenges to authorities, whose primary objective is to promote real sector growth in economies in which the industrial and financial sectors are still rapidly evolving.

Achieving sustainable, rapid growth with open capital accounts and active capital markets my will be more difficult than was true with the more closed financial structures that used to be the norm in East Asia. Indeed, concern about losing control of domestic policy contributed to some governments reluctance to liberalize their financial sector and capital accounts in the past, and contributes to their willingness to stop the process if they see it getting out of hand. However, capital controls are becoming more porous, the pressures to liberalize stronger, and the benefits from more open financial sectors more compelling Government preferences and market forces are liberalization. East Asian countries can continue their rapid growth only if they achieve the efficiency gains that result from further liberalization. Furthermore, less distorted markets provide fewer opportunities, for sent-seeking behavior and resource misallocation caused by price and other market distortions.

As capital, domestic and foreign, to seek the highest rate of return in only market. Investment levels in countries that offer strong growth potential can be augmented by flows of foreign saving. At the same time, sophisticated investors have expanded opportunities to seek short-term gain from exploiting market imperfections, implicit guarantees, and price fluctuations.

These latter activities and the extent to which they influence other portfolio investments are more worrisome because of their volatility and their potential impact on long-term policy. They may or may not be responding to fundamentals. Theoretically, speculation and arbitrage are believed to contribute to efficient markets and to impose few net costs overall. Market forces represented by these speculative flows have generally, but not always, created pressures toward needed corrections, either of fundamental policy unbalances or of unwarranted implicit guarantees or distortions.

However, short-term traders can exert a great deal of influence on specific markets as specific times, with can work against government policy objectives. It is argued that short-term traders would do this only if policies were wrongheaded, but in practice market forces make no judgments as to the inherent value of a policy- only as to whether a profit can be made from expected market movements. Market agents have been known to err and overshoot (although policymakers probably anticipate or perceive more errors than are likely to occur). Nevertheless, it is not generally wise policy to try to resist market pressures on the theory that they may be wrong. They are not often wrong, and resistance can be expensive, since today private international markets can mobilize vastly larger sums than even industrial country governments. When market forces do err or overshoot, they correct themselves usually quickly enough to avoid much lasting harm. In fact, quick policy reaction when the market is applying pressure in response to some perceives profit opportunity often sends a signal that large gains are unlikely and mitigates the flow, whereas digging in against market trends may set up an easy win for speculators at the government’s expense. Moreover, where policy failures contribute to market pressures, resistance to adjustment can be vary expensive. The burden is on governments to manage their economies so that easy arbitrage opportunities are not readily available and official policies or actions do not give rise to implicit guarantees or other distortions that markets can exploit to the detriment of public objectives. Consistent application of sound policy and clear direction goes a ling way toward reducing the likelihood of overreaction by markets. In addition, policymakers can blunt short-term flows that pose dangers to the economy through a variety of instruments that reduce speculative short-term gains.

Governments should naturally exercise caution in opening financial markets to international flows. Liberalization needs to be predicated on (a) developing an appropriate regulatory framework and supervisory system, (b) ensuring that the resulting incentives promote prudent behavior, and (c) adopting a macroeconomic policy structure that is consistent with open financial flows. Policies need to promote both domestic and international equilibrium, be flexible enough to respond to disturbances from the capital markets, and include safety features to activate in periods of crisis. Even with such precautions, the world is a highly uncertain and unpredictable place. There can be no assurances against unforeseen crises, even with the best of policies. This is part of the price of open market economies. The point is not to stifle an the economy in order to avoid crises but to ensure that the economy is sufficiently flexible and robust to weather the crises and continue to develop and liberalize despite such interruptions.

The basic the theoretical framework for analyzing the impact of external capital flows derives from the pioneering work done by Flemming (1962) and Mundell (1963) on open- economy stabilization policies. Their relatively simple models have been revised as the issues addressed have become more complex. Policy guidelines have become more complicated and much more dependent on a host of other factors that affect economic activity, including expectations, which can be hard to pin down. The theory provides a useful backdrop and guide for appropriate policy responses, but practical policymaking requires a thorough understanding of the characteristics of the economy in question, the exact nature of the capital flows, and the range of available policy options and tradeoffs. East Asian policymakers have been adept at pursuing reform until difficulties arise, then slowing or even backtracking a bit to reassess and make corrections before moving ahead once more. This pragmatism has proved its worth, as these countries have generally avoided major crises.

The basic theoretical models were initially developed to study the relative effects of monetary and fiscal policies in achieving domestic stabilization. Impacts on the external equilibrium were viewed as results and perhaps as constrains. Critical to the analysis if the exchange regime- fixed or floating- and the openness of the capital account (or the degree of substitutability between domestic and financial capital assets).

Under most conditions, the models indicate, that given a fixed nominal exchange rate regime, fiscal policy is relatively more powerful than monetary policy in affecting domestic output. Expansionary fiscal policy increases demand for domestic goods but also tends to raise interest rates as additional public borrowing is required. Higher interest rates attract more foreign capital, increasing reserves. The increase in domestic resources to that sector. The current account balance deteriorates, partly absorbing the increased capital flows. Real currency appreciation occurs as domestic prices rise, even though the nominal rate if fixed.

Conversely, monetary policy has a greater effect on the external account. Raising domestic interest rates attracts foreign capital and builds reserves, the amount depending on the substitutability of foreign and domestic assets. Attempts to stimulate domestic demand by lowering interest rates are diluted, as capital flows overseas to seek higher rates there, reducing any effect on domestic demand. The more substitutable foreign and domestic assets are, the less the interest rate change required for a given effect. Increased substitutability of assets leads to other problems, however. Where governments try to constrain domestic demand by raising interest rates, capital flows in, to benefit the higher rates, and counteracts the restraint. If sterilization is attempted- if, for example, governments sell bonds (tending to further increase domestic interest rates) to absorb the increase in the money supply associated with the influx overwhelm the authorities’ ability to continue to issue bonds to purchase foreign exchange. In such circumstance, it is hand to prevent a real currency appreciation.

For an economy dependent on export growth, as most East Asian countries are, the dangers of expansionary fiscal policy, combined with monetary constraint to keep inflation under control, are evident. East Asian countries generally adopt more conservative fiscal stances than Latin American countries.

Under a floating-rate regime, the additional exchange rate flexibility dampens some of these effects, but at the cost of loss of control over the nominal exchange rate. Fiscal policy becomes relatively lass effective in influencing domestic output. The increase in demand from expansion leads to an appreciation of the nominal (and, consequently, the real) exchange rate, increased imports and lower exports, and less demanded for money and bonds.

Interest rates rise, but less than in the fixed-rate case, and the floating rate keeps the external accounts in balance. The increase in capital inflows offsets the higher current account deficit. Under most reasonable assumptions, output rises, but less than under a fixed exchange rate for a given increase in expenditures. By contrast, monetary policy can have a more compelling effect. An expansionary action, such as open market purchase of domestic bonds, increases output through the effects of money supply on demand. It also leads to a depreciation, which shifts resources to the tradable sector and decreases the current account deficit, offsetting the outflow of capital brought about by the more perfect substitutability of assets, although the interest rate change will be smaller.

These models can also be used in reverse to examine the effects of a change in external variables on the domestic economy. What are the implications when we look at the effect on domestic policy of increases in foreign capital inflows? For a regime with a fixed nominal exchange rate, an increase in foreign inflows tends to reduce the domestic interest rate and increase domestic demand. This, in turn, leads to an increase in domestic prices that will bring about a real appreciation through higher domestic inflation. Reserves tend to accumulate, although by less than the capital inflows, as the current account also deteriorates. Monetary policy action to absorb the capital inflows through, for example, open-market sales of bonds (sterilized intervention) could offset the impact on demand. But such an action would tend to increase interest rates, which could well attract more capital inflow. It is not likely to be effective in the long term if there are practical limits on how many bonds can be issued, and it could be costly (because of negative carry on the reserves accumulated). The more substitutability there is between domestic and foreign assets, the less variance is possible between domestic and foreign interest rates before increase in the domestic interest rate become self-defeating. Fiscal contraction would offset the increase in demand and perhaps allow a reduction in interest rates, which would diminish the attraction of domestic assets to foreign investors. A fiscal response would take longer to orchestrate than a monetary response, however, become public budgets are hard to cut in the short run.