In the early 1990s, transition economies relied more on official capital than on private capital to finance the transformation from a centrally planned to a market economy. Over time, greater access has been gained to private markets, first short-term financing, including repatriation of flight capital, and in the last few years medium-term and long-term financing. Indeed, several of these economies now have international credit ratings, and have recently successfully issued eurobonds and obtained medium-term syndicated loans. In terms of foreign direct investment, however, transition economies still lag behind. During the past five years, cumulative foreign direct investment inflows amounted to 4 percent of GDP in transition economies against 6 percent in Latin American countries and as much as 13 percent in East Asian developing countries.
2. Benefits from financial globalization
The benefits of financial globalization are well-known: it facilitates the transfer of savings across borders allowing savings to finance productive investment, promoting growth and job creation, as well as portfolio diversification. At the same time, the process of integration also injects healthy competition to the domestic banking system.
Just like integration of trade is promoted by liberalized trade regimes, financial integration is also facilitated by limited restrictions and controls on capital movements. However, there is an important question as to the appropriate speed by which countries that presently have capital controls should abolish them, a topic to which I will shortly return.
One of the clear lessons from the past decade of increased financial integration is that such integration tends to accentuate the benefits of good policies and the costs of bad policies. Foreign capital tends to be attracted to countries that enjoy macroeconomic stability characterized by prudent fiscal policies and monetary policies aimed at low inflation rates and a stable political situation. While capital can provide a valuable source of foreign savings, it also poses challenges to the policy makers. Large inflows attracted by relatively high interest rates might cause the money supply to expand thus endangering the inflation target. It might also be difficult for an embryonic banking system to efficiently channel large inflows to productive investments.
III. The recent currency and financial crisis and its lessons
Let me turn to the most recent currency and financial market crisis in Southeast Asia and discuss in this context the policy requirements for globalization of financial markets. It is useful to bring the crisis into perspective. First, let us not forget that the Southeast Asian countries—the so-called Asian Tigers—have displayed very strong economic performance for years exemplifying the advantages of globalization of trade and financial markets. There is no reason why—with appropriate economic policies—their performance should not continue to be strong in the medium term.
Second, this crisis is not an isolated event. In fact, the other two "worlds" referred to in the title of this conference have also witnessed a currency crisis in recent years: Europe in the context of the European Monetary System in 1992-93 and Mexico in 1995. In each of the three instances, the crisis was blamed on the financial markets, but the origin could be traced to imbalances in the economy and weaknesses in domestic policies. With each crisis, it is becoming increasingly evident how globalized financial markets have become. It is truly "one world."
What went wrong in the Southeast Asian economies?
The economic situation and problems differ in each of the countries although some of the features are common. In the case of Thailand, where the crisis began, macroeconomic warning indicators had been flashing for some time. Massive capital inflows had led to a significant increase in bank lending, in part invested unwisely in the property sector. A large part of the inflows were of short-term nature, and the Central Bank had sizeable short-term forward obligations in foreign exchange.
At the same time, the external current account deficit had increased to 8 percent of GDP, partly reflecting a slowing of export growth and real effective appreciation of the baht, which was pegged to the U.S. dollar. There is no magical number for a sustainable deficit across all countries. However, in general current account deficits above 5-8 percent of GDP deserve close monitoring. When the authorities finally tightened economic policies and the currency depreciated, the crisis was already in full swing. Investors—both domestic and foreign—were pulling funds out of the country and the exchange rate and equity prices fell precipitously.
What separated this currency crisis from currency crisis in many other countries was the extent of its contagion effect. The crisis quickly spread to other Southeast Asian economies, including the Philippines, Indonesia, Malaysia, and Hong Kong SAR. These economies shared some of the economic weaknesses of Thailand although their economic situation differed. But the crisis was not confined to the region. By the second half of October, the unrest became global, and markets in North America, Latin America, Europe, the Baltic states, and Russia all joined in. This is one of the first instances when a crisis in an emerging market has had world-wide financial implications on a significant scale.
Another feature of this crisis was that it hit severely a country like Indonesia that had macroeconomic indicators that did not provide warning signals of an imminent balance of payments crisis. For instance, the fiscal and external current account deficits were relatively small and short-term external debt was less of a problem than in Thailand. However, the strong overall performance masked a number of underlying structural weaknesses that made it vulnerable to adverse external developments. And once the contagion spread, markets began focusing on these weaknesses, including the health of the financial sector.
Besides financial markets, the Asian events are likely to slow foreign trade and economic growth in the short term, in particular in Japan, and to a more limited extent in Canada and the United States, to mention a few. Given the policy adjustments that are being undertaken, however, with support from the IMF, the World Bank, the Asian Development Bank and bilateral official creditors, hopefully the downturn in economic activity in Southeast Asia will be short-lived and growth resumed at the strong rate of the past.
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