Click here to learn more. Subscribe to our summer-only newsletter to get great reads in your inbox once a week during July and August. Subscribe Magazine Newsletter. Login Sign up Search. Subscribe Login Sign up. Foreign Policy. Download Audio. A foreclosed home in Stockton, California, May As a result, non-resident holdings as a percent of market capitalization have reached unprecedented levels, ranging between 20 and 50 per cent compared to 15 per cent in the US.
This has made the emerging economies highly susceptible to conditions in mature markets. Since emerging economies lack a strong local investor base, the entry and exit of even relatively small amounts of foreign investment now result in large price swings. Third, they have also sought to reduce currency mismatches in balance sheets and exposure to exchange rate risk by opening domestic bond markets to foreigners and borrowing in their own currencies.
As a result sovereign debt in many emerging economies is now internationalized to a greater extent than that in reserve-currency countries. Whereas about one-third of US treasuries are held by non-residents, this proportion is much higher in many emerging economies, including in Asia. Unlike US treasuries this debt is not in the hands of foreign central banks but in the portfolios of fickle investors.
Although opening bond markets has allowed the sovereign to pass the currency risk to lenders, it has led to loss of autonomy over domestic long-term rates and entailed a significant exposure to interest rate shocks from the US. This could prove equally and even more damaging than currency exposure in the transition of the US Fed from low-interest to high-interest regime and normalization of its balance sheet.
Fourth, there has been extensive liberalization of the capital account for residents. Corporations have been encouraged to become global players by borrowing and investing abroad, resulting in a massive accumulation of debt in low-interest reserve currencies since They have also borrowed through foreign subsidiaries.
These are not always repatriated and registered as capital inflows and external debt, but they have a similar impact on corporate fragility. Hence the reduction in currency mismatches is largely limited to the sovereign while private corporations carry significant exchange rate risks. Fifth, limits on the acquisition of foreign securities, real estate assets and deposits by resident individuals and institutional investors have been raised or abolished.
A main motive was to relieve upward pressures on currencies from the surge in capital inflows. Thus, liberalization of resident outflows was used as a substitute to restrictions over non-resident inflows. Although this has led to accumulation of private assets abroad, these would not be readily available at times of capital flight. Sixth, banking regulations and supervision have no doubt improved, restricting currency and maturity mismatches in bank balance sheets.
However, banks now play a much less prominent role in the intermediation of international capital flows than in the s. International bond issues by corporations have grown much faster than cross-border bank lending directly or through local banks and a very large part of capital inflows now goes directly into the securities market. These measures have failed to prevent credit and asset market bubbles in most countries in the region. Increases in non-financial corporate debt since in Korea and Malaysia are among the fastest, between 15 and 20 percentage points of GDP.
At around 90 per cent of GDP Malaysia has the highest household debt in the developing world. One of the first steps taken was to move to more flexible exchange rate regimes. However, unlike other emerging economies which used monetary policy primarily for inflation targeting and left the currency to the whims of capital flows, most East Asian economies avoided significant currency appreciations despite strong surges in capital inflows.
Korea used such measures to such an extent that the won became one of the weakest currencies in the aftermath of the crisis when there was a strong surge in capital inflows.
However, it should be kept in mind that while Thailand and Malaysia had moderate real appreciations in the run-up to the crisis, this was not the case in Korea and Indonesia. Second, East Asian economies, like many others, made strong efforts to build self-insurance by accumulating large amounts of international reserves. Unlike most other emerging economies, in East Asia reserves did not just come from capital inflows. An important part has been generated by current account surpluses — that is, they are earned reserves rather than borrowed reserves. All countries hit by the crisis made significant progress in the management of their current accounts in the new millennium, running sizeable surpluses or moderate deficits.
They also sought to strengthen regional cooperation in contingency financing by extending and multilateralizing the Chiang Mai Initiative. Third, in order to reduce vulnerability to external debt crises, East Asian economies, like several emerging economies, have sought to move from debt finance to equity finance on grounds that equity liabilities are less risky and more stable.
Foreign direct investment regimes have been liberalized and overall limits and sectoral caps over direct and portfolio equity inflows have been relaxed or removed. While the Korean equity market is quite deep, coming in among the top 12 globally in capitalization, many emerging economies lack a strong local investor base. Consequently, the entry and exit of even relatively small amounts of foreign investment can result in large price swings.
Even in countries with little foreign presence, such as China, equity prices have thus become highly susceptible to changes in the global risk appetite because local investors now act with a global perspective.
Fourth, since currency mismatches in balance sheets played a central role in crises in emerging economies, governments have sought to reduce their exposure to exchange rate risk by opening local bond markets to non-residents and borrowing in local currencies. In East Asia the development of regional bond markets was also seen as a solution to the problems of currency and maturity mismatches, culminating in the Asian Bond Market Initiative in Governments in several emerging economies have effectively stopped issuing foreign-currency debt in international markets.
A much higher proportion of public debt held by non-residents is now issued locally, denominated in local currencies and subject to local jurisdiction. Domestically issued local-currency debt held by non-residents is not always included in external debt statistics even though according to the conventional definition based on the residency of holders, such debt is part of external debt.
Because of this discrepancy, the external debt of emerging economies is often underestimated. For instance, when the Malaysian central bank started using a new definition of external debt in , including all debt owed to non-residents irrespective of currency and place of issue, total external debt of Malaysia went up from Whether in local currency or dollars, foreign ownership of debt is a key indicator of external vulnerability.
For instance, the US has always been uneasy about foreign holdings of its treasuries. Around one-third of US treasuries are held by non-residents. Sovereign debt in many emerging economies is now internationalized to a greater extent. The proportion is much higher when internationally issued government debt is included. Furthermore, unlike US treasuries, this debt is not in the hands of foreign central banks and other official bodies, but mostly in the portfolios of fickle investors.
Opening local bond markets and borrowing from non-residents in local currency have no doubt allowed the sovereign to pass the currency risk to lenders. However, it has also led to a significant exposure to interest rate shocks and loss of autonomy in controlling domestic long-term rates and heightening their sensitivity to fluctuations in debt markets of major advanced economies.
This could prove equally or even more damaging than currency exposure in the transition of central banks of major advanced economies from low-interest to high-interest regimes and normalization of their balance sheets. Fifth, most emerging economies have also shifted from cross-border borrowing to local borrowing from international banks by opening up their banking sector to them. There has been a sharp increase in the share of foreign banks in emerging economies in the new millennium even though the crisis in the US and Europe resulted in a certain degree of withdrawal of their banks from these economies.
In Indonesia half of banks are foreign. Korea had no foreign banks in , but their number increased rapidly in the new millennium. Local lending by foreign banks in all currencies, including foreign currencies, is now greater than their cross-border lending. As seen during the eurozone crisis, foreign banks tend to act as a conduit of financial instability in advanced economies, transmitting credit crunches from home to host countries, rather than insulating domestic credit markets from international financial shocks.
Sixth, in East Asia banking regulations and supervision have improved, promoting more prudent lending and restricting currency and maturity mismatches in bank balance sheets. However, banks now play a much less prominent role in the intermediation of international capital flows than in the s. International bond issues by corporations have grown much faster than cross-border bank lending directly or through local banks. More importantly, a very large part of capital inflows now go into local securities markets, bypassing the banking system.
Seventh, the opening of domestic asset and credit markets to non-residents has been accompanied by extensive liberalization of the capital account for residents in East Asia and elsewhere. Since the global crisis, there has been a massive accumulation of debt in dollars by non-financial corporations, mainly through international bond issues. In major emerging economies, such issues have also been made though foreign subsidiaries. These are not always repatriated and registered as capital inflows and external debt, but they have a similar impact on corporate fragility.
In East Asia, dollar debt accumulation is particularly notable in Indonesia and Korea. This means that the reduction in currency mismatches in balance sheets is largely limited to the sovereign while private corporations have been building up debt in low-interest reserve currencies very much in the same way as in the s.