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Capital Flows and Implication for Central Bank Policies in The SEACEN Countries

Choon-Seng Lim, Vincent and Min Shrestha ()

in Research Studies from South East Asian Central Banks (SEACEN) Research and Training Centre

Abstract: The SEACEN economies have liberalised their external accounts and domestic financial markets. The current account is fully convertible in all the countries in the SEACEN region while the capital account is by and large fully convertible in the majority of these countries. Since early 1990s, net capital flow to the SEACEN countries increased steadily until 1996 due to the massive increase in total capital inflows. However, after the financial crisis of 1997, total capital outflows have outweighed total capital inflows resulting in a negative net capital flow. Both domestic factors such as attractive economic growth, attractive interest rates and large current account deficits and external factors such as low world interest rates are responsible for the increased capital inflows in the region. However, determinants of short-term capital inflows vary from that of the total capital inflows. Notably, short-term capital inflows are found to be inversely associated with domestic economic growth. The effects of push and pull factors on capital flows vary across the countries. Recent experiences of SEACEN countries indicate that the US sub-prime mortgage crisis has led to slower capital inflows in the region while domestic political climate, further liberalisation in overseas investment; and, encouragement to invest abroad have accelerated capital outflows. The SEACEN region has benefited significantly from the increased capital inflows mainly in terms of increased investment, higher economic growth, favourable external accounts and developed financial markets. However, capital flows have also led to challenges for monetary and financial stability. The recent experience of SEACEN countries shows that capital flows can create asset price bubbles and induce sharp increases in bank credit while outflow of capital results in lower equity prices and depreciation of exchange rates. Short-term capital inflows are highly volatile and prone to sudden reversals. After 2003, the share of short-term inflow started to become increasingly dominant in the total inflow in the SEACEN region, resembling the pattern of capital flows before the 1997 crisis. Due to the larger share of highly volatile shortterm foreign capital, SEACEN economies are again, facing the risk of massive capital reversals. In order to prevent a repetition of the same problems in the future, SEACEN countries need to encourage more long-term capital inflows rather than short-term ones. To safeguard the financial system and the economy from speculative attacks, authorities need to implement more prudent regulations and cautiously monitor potential areas of such attacks. In order to maintain a conducive monetary stability environment, central banks need to sterilise inflows with appropriate intervention measures. Freer exchange rates allow for more capital flows in and out of the country. However, in the time of distress, the countries that have a free floating exchange rate regime may suffer from larger capital reversals. Therefore, a managed floating exchange regime may be more advantageous during a crisis. The financial markets and economies of the SEACEN countries are currently affected by the global financial crisis, due mainly to external factors. In order to minimise further negative impacts of the crisis on various sectors of the economy including capital flows, to speed up the recovery process, and also to explore the possibility of inventing new economic drivers within the region, coordinated policy measures need to be implemented at the national as well as regional levels.

Date: 2009
ISBN: 983-9478-75-3
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