It is almost 19 years since the tragedy of the Asian financial crisis. It has been 19 years of financial and economic reforms, more flexible currencies, more independent central banks, and a declining reliance on short-term bank lending. Yet, global financial markets seem no safer than before. There was more financial market volatility in 2015 than at any time since 1929, according to the International Monetary Fund (IMF). If it is insane to do the same thing over and over again expecting a different result, maybe it is about time we took a more critical view of the perceived wisdom of how to make the international financial system safer.
Cross-border flows of money have been on a roller-coaster ride. Broadly speaking, private cross-border capital flows rose strongly a few years after the Asian crisis, far outpacing gross domestic product (GDP) growth, fell off a cliff in 2008, and were recovering slowly before the US Federal Reserve's first rate rise in 10 years last month. It is not the total magnitude of cross-border capital flows totted up across countries and long stretches of time that has worried policymakers and others, but their variability and concentration.
Emerging-market policymakers have long complained that this variability and concentration was largely outside of their control. Once they were allowed in, cross-border capital surged and fled in spite of domestic policy, not because of it. The inability of policymakers in emerging markets to reverse tides of private capital is reflected in the negative correlation between flows into emerging economies and the level of interest rates. Cutting interest rates to stop rising inflows or raising rates to stem outflows doesn't work. The positive correlation between rates and flows is to be found in large advanced economies, in textbooks, and the sermons to developing countries given by policymakers of developed countries.
Two salient features of emerging-market crises such as the Latin American debt crisis in the mid-1980s and the Asian financial crisis were the sudden stop and reversal of short-term bank lending and the breaking of exchange rate pegs. The development of local bond markets and greater integration with global financial markets were added to the original pleas to increase exchange rate flexibility and liberalize foreign direct investment (FDI) in the Washington Consensus over what was right for emerging-market countries.
Emerging-market and other developing countries generally followed this path, sometimes kicking and screaming. To encouraging cheers, the large emerging economies have adopted more flexible exchange rate regimes, notably India, Russia, Brazil, and more recently China. International correlations signal that efforts to make emerging-market equity and debt markets more globally integrated have worked. Portfolio debt and equity flows rose from 21 percent of total cross-border flows to emerging economies in the 1980s to 38 percent in the 2000s. Boosted by a relaxation of ownership rules, FDI jumped from 20 percent of private cross-border flows in emerging economies in the 1980s to 32 percent in the 2000s. The share of bank lending in private cross-border capital flows to emerging markets fell from 59 percent in the 1980s to 30 percent in 2000s.
However, despite these changes, net private cross-border flows have become even more volatile over time. Bank lending has typically been the most volatile flow, but portfolio debt flows have turned out to be the least persistent form of capital. Despite the long held views about the stability of FDI and equity flows, differences in the volatility and persistence between different types of flows have been virtually indistinguishable in recent years. The impact of foreign developments on the variability of net capital flows to emerging economies has also increased over time. Moreover, the sensitivity of net flows to shifts in US monetary policy is greater for those countries that have floating exchange rates or those that are more globally integrated.
These observations suggest that while policymakers have focused on the what of international finance—products and exchange rates—equal attention should be placed on the who. The empirical data underscores the role played by investors shifting appetite for risk, a concept I first identified some 15 years ago but is only now part of mainstream analysis (see Pure Contagion and Investors' Shifting Risk Appetite: Analytical Issues and Empirical Evidence by Manmohan S. Kumar and Avinash Persaud).
When risk appetite rises or falls, it is not instruments or exchange rate regimes that determine the size and direction of flows, but where these investors consider home. If flows are provided by overseas investors, who scurry home when risk appetite falls, or step out when they cannot get sufficient yield back home, then it is hard for domestic policy in the recipient countries to influence them. Consequently, one of the fundamental things emerging markets need to do at the same time as improving their global competitiveness is to deepen the capacity of the domestic financial system to mobilize savings for investments so that they are less dependent on passersby.