2nd OECD-AMRO Asian Regional Roundtable

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. OECD-AMRO Joint Asian Regional Roundtable (19 July 2013)
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Portfolio Investment Flows and Capital Controls
Comments for Session 1 Roundtable Discussion
Takuji Kinkyo
Kobe University
The risk of Financial Contagion
After the Asian financial crisis of 1997-98, there were two noticeable changes in Asian
economies’ exchange rate regimes. These economies did not return to dollar pegs even
after the currency market regained stability. Instead, they shifted towards more flexible
exchange rate regimes, particularly managed floating. As shown by Kinkyo (2012a), the
degree of flexibility in the crisis-hit Asian economies has increased substantially.
Although the authorities continue to intervene in foreign exchange markets to prevent
large fluctuations and excessive volatility, few have explicit or rigid exchange rate
targets. A notable example is China, which maintains a de facto adjustable peg against
the US dollar. The increased flexibility in exchange rate regimes has rendered Asian
economies less vulnerable to a currency crisis triggered by speculative attacks. In
addition, as the proposition of Impossible Trinity suggests, the greater exchange rate
flexibility creates more room for monetary policy autonomy despite these Asian
economies’ higher degree of integration with global capital market (Kinkyo, 2013).
While East Asia’s economic integration has been led by foreign trade and FDI,
Asia’s economic integration through intra-regional financial transactions is lagging.
However, East Asian equity markets are showing greater integration with global
markets, as well as with the region. For example, the estimated conditional correlation
of equity returns increased significantly within the ASEAN throughout the 2000s
(Kinkyo, 2012b; Kinkyo and Hamori, 2013). There is also a tendency for the levels of
correlations to converge among ASEAN countries. Although it is not obvious whether

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the observed convergence is caused directly by the intra-regional integration or
indirectly by the integration with global markets, it is conceivable that both factors have
contributed to the convergence. The increased correlation of equity returns indicates that
financial shocks can be rapidly transmitted across Asian markets. The risk of financial
contagion will be greater if foreign investors fail to differentiate between ASEAN
equities and treat them as one asset class due to market imperfections, such as
asymmetric information and costly enforcement.
A Guideline for Capital Controls
There is a growing consensus that some forms of capital controls are effective in
maintaining external stability when they are used for prudential purposes. In particular,
restrictions on short-term capital inflows can be helpful to reduce the risk of financial
contagion. Examples of restrictions on short-term capital inflows are taxes on inflows
and unremunerated reserve requirements. These measures were introduced by a number
of emerging economies, including Brazil, Chile, Columbia, Russia, and Thailand (Ostry
et al, 2011). By contrast, the restrictions on capital outflows tend to be ineffective and
even harmful when they are used as a substitute for required policy adjustments, such as
fiscal consolidation and monetary tightening.
Capital controls can be used as a temporary measure to prevent and mitigate the
adverse impact of financial contagion. However, unilateral imposition of such controls
could distort cross-border capital flows and exert harmful spill-over effects on financial
stability in neighbouring countries. To avoid this, it will be desirable to develop a
regional guideline for capital controls. The guideline will help Asian countries to avoid
the adverse impact of unilateral actions by outlining prerequisites and procedures for the
imposition of macroprudential controls (Kinkyo, 2010). AMRO can play a leading role
in developing such a guideline in close collaboration with other relevant international

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organisations, such as the IMF and OECD.
Capital Market Development
At the same time, it should be emphasised that capital controls must be used as a
short-term measure and should not be an obstacle to the long-term development of
domestic capital markets. The empirical evidence indicates that the presence of capital
controls could have detrimental effects on financial development in the long-run (Chinn
and Ito, 2002). Limited market liquidity is one of the key challenges facing Asian
capital markets. Greater foreign participation in domestic capital markets will lead to
better price discovery and less price volatility by improving market liquidity and
exerting pressures for better corporate governance (Prasad and Rajan, 2008). Deep and
liquid capital markets can not only better absorb external shocks, but also serve as a
spare tire in the event of severe disruption of the bank financing channel (Felman et al.,
2011).
In a similar vein, broadening the base of domestic institutional investors, such as
pension funds, insurance companies, and mutual funds, is important to improve market
liquidity. Although the asset size of domestic institutional investors remains relatively
small, there is a substantial scope for increasing the coverage of pension and insurances
in most emerging Asian countries. In addition, regulations on the investment of pension
funds and insurance companies are generally conservative, limiting the scope for
diversifying investment allocations. The government can promote the development of
institutional investors by adopting international best practices for these regulations.
Remittances
For many developing countries, workers’ remittances are becoming a major
component of capital inflows and they could significantly impact macroeconomic and

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financial stability. There is empirical evidence that remittances contribute to economic
growth through their positive impact on consumption, savings, or investment. However,
a surge in inflows of remittances could have adverse effects on long-term growth by
causing Dutch Diseases through the real exchange rate overvaluation and the associated
de-industrialisation. It is therefore important to closely monitor the cross-border flows
of remittances and assess their impact on macroeconomic balances. However,
monitoring the flows of remittances is not straightforward because a substantial part of
their funds are often channelled through informal financial systems in developing
countries. Such informal financial systems are not under the effective control of
financial supervisors in these developing countries. Bearing in mind the growing
importance of remittances, Asia’s regional economic surveillance should pay more
attention to the economic impact of remittances and promote cooperation to better
monitor the intra-regional flows of remittances.
References
Chinn, M. and Ito, H. (2002) “Capital Account Liberalization, Institutions and Financial
Development: Cross Country Evidence,” NBER Working Papers, No. 8967, Cambridge, MA:
National Bureau of Economic Research.
Felman, J., Gray, S., Goswami, M., Jobst, A., Pradhan, M., Peiris, S., and Senevirante, D. (2011)
“ASEAN5 Bond Market Development: Where Does It Stand? Where Is It Going?” IMF
Working Paper WP11/137, Washington, DC: International Monetary Fund.
Kinkyo, T. (2010) “Policy Reponses,” in Rosefielde, S. Kuboniwa, M. and Mizobata, S. (eds) Two
Asias: The Emerging Postcrisis Divide. Singapore: World Scientific Publishing.
Kinkyo, T. (2012a) “De Facto Exchange Rate Regimes in Post-Crisis Asia,” Economics Bulletin, 32,
pp. 2155-2165.
Kinkyo, T. (2012b) “Securities Market Integration in East Asia,” Journal of Economic & Business
Administration, 206 (4), pp. 63-78 (in Japanese).
Kinkyo, T. (2013) “Coordinating Regional Financial Arrangements with the IMF: Challenges to Asia
and Lessons from the EU.” In: Christiansen, T., Kirchner, E., and Murray, P., (eds.) Handbook
on EU-Asian Relations. Basingstoke: Palgrave Macmillan.
Kinkyo, T. and Hamori, S. (2013) “Exchange rate Flexibility and Securities Market Integration in
East Asia,” (unpublished manuscript).

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Ostry, J.D., A.R. Ghosh, K. Habermeier, L. Laeven, M. Chamon, M.S.Qureshi, and A. Kokenyne
(2011) “Managing Capital Inflows: What Tools to Use?” IMF Staff Discussion Note, SDN/11/06,
Washington DC: International Monetary Fund.
Prasad, E.S. and Rajan, R.G. (2008) “A Pragmatic Approach to Capital Account Liberalization,”
Journal of Economic Perspectives, 22, pp.149-172.