From Rich to Poor: A Plan for Stabilizing Investment Markets in Developing Countries

by Michael J. Johnston and Peter Wilamoski for the Caux Round Table. Compliments of the Papousy Endowed Chair in Business Ethics at Southern New Hampshire University.

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Section 1

Section 3

Section 4

Ethics, Whose Values?

Where Did The Seven Trillion Dollars Go?(English) (Greek)

2. The "hot money problem"

The benefits of foreign equity portfolio investment by developed nations in developing nations are widely acknowledged. With foreign portfolio investment, however, comes a persistent problem: the risk of "fickle" or "hot money," the flight of investment capital when it is needed most. Every investor remembers what occurred in Asia starting in 1997 (and became known as the Asian contagion), and later affected Latin American markets and the Russian market.

The heavy foreign portfolio inflows to emerging markets which built gradually throughout the 1990s, quickly and hugely reversed in many Asian countries and Latin American countries in 1997 and 1998. The period of inflows created some of the seeds of the later market collapse. Capital inflows helped to create overvalued currencies, and as local stock prices climbed, the higher values fueled excessive speculation in both the economy and the markets, some of it funded with debt. The overvalued currencies dampened export possibilities, and when the trade balances turned down, declining currencies turned the tide on the markets, and eventually economic growth turned down.

Asian countries, in particular, followed the postwar Japanese model of high debt ratios. But as economic growth turned negative, the debt which had fueled expansion became unmanageable, injuring both borrowers and lenders.

Further, foreign portfolio investors began to sell stocks in emerging countries even though many of these countries had not developed economic and market excesses. That which started in Southeast Asia, gradually moved to Latin America. Often, the reason for selling was only the fear of others selling. Consequently, many countries without major fundamental problems suffered a degree of the same fate of declining markets -- hence the term "contagion."

Confusion, blame, and, predictably, calls for reform have followed. This paper has compiled and assessed many of these ideas for with reform. The question we must focus on is: What practices allow us to retain the benefits of foreign portfolio investment, while reducing or mitigating its potential for sudden and large capital flight?

Many needed reforms, such as banking system reforms, have no direct bearing on foreign portfolio flows. However, they are essential in order to provide more economic stability, which indirectly improves the climate for greater stability from portfolio investment.

The Asian contagion

During the Asian contagion, foreign investors, responsible to the investors they represented, sold their holdings when faced with declining currencies, markets and corporate results. And after selling, they typically exchanged the currency and pulled their capital out of the host country. Although the companies whose stock was sold did not suffer an outflow of capital, as would have been true with the removal or forced repayment of a bank loan, nevertheless the resultant decline in the currency and stock market amplified the problem of repaying foreign, hard currency loans. And large declines in stock prices impacted business and consumer confidence, and created problems for those who might have speculated in stocks with borrowed money. As these processes unfolded, foreign portfolio capital fled, and the "vicious circle" continued.

Malaysia attempted to stop this process by invoking capital controls, prohibiting investors from withdrawing capital from the country. Investors responded by strenuously objecting to the sudden change in the rules, claiming not only that it was unfair but that it would also create an atmosphere of mistrust for future investment in the country. And in some instances portfolio investors sold holdings in other countries out of fear that capital controls might also be imposed there. Or they sold merely to reduce exposure to their foreign portfolio holdings of emerging country stocks.

In the Asian contagion, even though the forces of bank loans not rolling over and foreign portfolio investment withdrawals reinforced each other's negative impact, direct investment actually remained quite stable. And various supra national sources of funds stepped forward to ease the crises. Having multiple sources of foreign capital and the flexibility to utilize them throughout the different phases of economic growth cycles will be very important to emerging countries.

Clearly, capital flows from all sources tend to be stable and available during growth phases of emerging economies. In fact, the excessive availability of capital from debt sources, both domestic and foreign, creates its own set of problems during periods of economic slow down. The same can be said, to a lesser extent, about excessive foreign portfolio investment. During economic bad times, reforms should be focused on mitigating capital flight, both debt and equity. This means addressing the conditions under which capital flows in during the good times.

While foreign portfolio flows provide a source of capital for private economic development, surges in capital flows to developing nations raise several difficult issues for the country's policymakers. First, capital inflows that are large relative to national saving and economic growth can lead to appreciation or overvalued exchange, and a potentially inflationary rise in money supply growth. Second, any change in domestic economic conditions, which leads to a reversal of investor perceptions can lead to capital outflows and trigger an economic "crisis."

The origin of "hot money" outflows

Crises have their origins in "the buildup of unsustainable economic imbalances and misalignments in asset prices or exchange rates, often in the context of financial sector distortions and structural rigidities."[1] Unsustainable economic imbalances in the financial markets can be the result of expansionary macroeconomic policy that leads to lending booms followed by excessive debt accumulation and an unsustainable rise in asset prices. Excessive debt accumulation and asset price inflation can also be fueled by weak financial systems, overvalued currencies, and volatility in global financial conditions (e.g., a rise in developed market interest rates). The eventual tightening of macroeconomic policy can lead to a correction in asset prices that leads to rising levels of non-performing loans, threatening banks and fueling a flight to safety that drives the currency's value down. Whether the correction of an imbalance leads to a crisis or results in a soft landing depends on the magnitude of the imbalances and the vulnerability of the nation's financial institutions.

Investment decisions of emerging market corporations have been made in an environment with close, unhealthy ties to government and banks, and a weak system of corporate governance lacking transparency in operations that left minority shareholders out of the loop. These conditions contributed to an environment of risky decision making with little consequence and accountability to foreign lenders. For their part, the foreign lenders had a poor understanding of this environment as well as poor statistical information concerning these nations' financial situations. These conditions manifested themselves in over-investment in property development and certain manufacturing fields, which upon failure signaled an outflow of capital.

Ironically, all these imbalances were the result of foreign investors' initial enthusiasm for the economic prospects of these countries. What caused investors to suddenly change their evaluation and want to get out? Jeffrey Sachs and Steven Radelet (1998A, 1998B) developed a framework that explains why market participants that are aware of "imbalances" suddenly recognize their unsustainability, triggering a reversal in investment. Their framework allows a financial crisis to occur as the result of any of, or some combination of, the following:

  • macroeconomic mismanagement;
  • a financial panic where short-term creditors withdraw their funds from a solvent borrower;
  • a bubble collapse where investors purchase assets at prices above fundamental value, expecting a capital gain, not anticipating a price collapse;
  • moral hazard where banks borrow funds on the basis of public guarantees, and if under-regulated, may invest in risky assets;
  • disorderly workout where risky borrowers provoke a creditor grab race and a liquidation even if the borrower is worth more as an ongoing enterprise.

Externally generated crises

Macroeconomic policies historically have been the cause of externally generated crises. Typically, a crisis has been the result of expansionary monetary or fiscal policy in the presence of fixed exchange rates. In the presence of a fixed exchange rate, expansionary monetary policy leads to inflation and an overvalued currency because it makes domestic goods more expensive than foreign goods. An overvalued currency will lead to a current account deficit that must be financed by foreign borrowing. Fiscal policy that produces a government deficit, which exceeds the domestic economy's financing ability will also require foreign borrowing. If macroeconomic policy requires foreign borrowing on a sustained basis, those financing the deficits may eventually begin to question the nation's ability to repay its debt and stop lending.

It is at this point that a crisis begins. At the current exchange rate, the demand for foreign exchange for purchases of imports will exceed the supply of currency from sale of exports. This excess demand may be satisfied from central bank reserves for a while, but these will eventually be exhausted, forcing a devaluation. Central banks may try to delay this by raising interest rates, making domestic assets more attractive. This action lowers domestic demand for goods and services, and slows growth until the current account deficit declines.

Table 4 Macroeconomic conditions prior to crisis    Source: World Bank


Fiscal surplus (% of GDP) 1996

Current Account to GDP ratio 1996

Credit to private sector

(%of GDP)


Non-performing loans to bank assets


Real estate exposure to bank assets ratio


Change in Real exchange /volatility (1995.6-.97.6)

Interest Rate Spread (Local-LIBOR)


Foreign liabilities to assets (1996)














































The role of macroeconomic policy in the Asian crisis of 1997-98 was very different. In contrast to earlier crises that were often driven by large public-sector deficits, most of the nations in this crisis had a fiscal surplus (see Table 4). Foreign lending was not driven by the financing needs of domestic consumption or government borrowing, but by domestic investment opportunities. The macroeconomic imbalances in the Asian crisis were brought about by structural reforms and liberalization measures in the South East Asian countries that led to sharp increases in investment and, as shown in Table 4, credit growth. Indonesia's ratio of investment to GDP rose from 25% to 32% between 1985 and 1996. For Malaysia and Thailand the ratio rose from the high 20% range to over 40 %. Most of this increase in investment was financed by foreign capital inflows, which reached 10% of GDP in Thailand, and 6% of GDP in Korea and Indonesia in 1996.

Dealing with excessive capital flows

If a nation's monetary authorities wish to keep the exchange rate fixed in the face of capital inflows, it must sell domestic currency in exchange for foreign currency, increasing not only its foreign currency reserves but its money supply, as well. As might be expected, the surge in domestic investment, financed to a great extent by foreign lending and an increase in the nation's money supply, has often led to an acceleration of demand and inflationary pressures.

If the source of monetary growth and inflation are capital inflows, the usual mechanism to tighten monetary growth is to "sterilize" capital inflows. Sterilizing the inflows means monetary authorities lower domestic credit to offset the increase in credit caused by capital inflows, leaving the money supply unchanged. However, sterilization efforts have somewhat surprisingly contributed to additional capital inflows. In raising domestic interest rates, policy makers widened the differential with international rates, and thus the incentive to borrow internationally, encouraging additional capital inflows.

Moreover, with short-term capital flows most responsive to interest rate differentials, this macroeconomic policy alters the composition of growing external liabilities toward short-term unhedged obligations of a size that monetary authorities could not completely sterilize. In Indonesia, foreign assets led to reserve money growth of 37%; without monetary sterilization reserve money growth could have been over 70%. The capital inflows permitted local banks and non-bank financial intermediaries to make loans that domestic sterilization efforts had tried to prevent. The resulting rise in asset prices fueled a consumption boom and contributed to speculative behavior in asset markets.

The failure of macroeconomic policies to stem capital inflows and speculative behavior can be blamed in large part on the failure of lenders and borrowers to act prudently. The failure to act prudently can be explained by the absence of institutional features that support efficient decision-making.

These features include:

  • transparency in the operations of government, firms, and financial institutions;
  • corporate governance that protects the interests of shareholders and creditors;
  • financial regulation that exposes shareholders and creditors to the true underlying risk of their investment and encourages due diligence; and
  • courts which enforce the regulations and laws.

Rational or irrational?

Among the fundamental differences between these causes is whether the crisis is brought about by poor economic fundamentals or by market panic. Pointing to the fact that (a) much of the capital flow to Asia supported productive investments, and (b) there are few signs that the market anticipated a crisis (risk premia spreads were smaller in 1997 than in 1996), with funds continuing to flow into Asia at a substantial level literally until the crisis began, Radelet and Sachs conclude that the Asian crisis was not the result of poor fundamentals, but can be explained in terms of a financial panic and disorderly workout. Prior to the crisis there had been rapid growth of short-term liabilities on the balance sheets of financial institutions and corporations that was not adequately revealed to lenders. As the market became aware of these unexpected liabilities, many creditors reassessed the credit worthiness and pulled back. Analogous to a bank run, in the absence of a lender of last resort it becomes rational for creditors to withdraw if others are doing so.

The triggering event in Thailand was the June 1997 announcement by the Thai government that it would no longer support a major finance company, Finance One, a company it had assured investors for months was in good shape and that the government would stand behind. This announcement signaled that creditors would suffer losses, contrary to previous statements and market beliefs. This shock accelerated the flight of funds that had begun earlier in the year, forcing Thailand to devalue the baht despite earlier claims that it would not do so. This triggered capital flight, forcing the subsequent float and collapse of the baht. The beginning of the end started months earlier with Samprasong Land's missed payment on foreign debt due in February of 1997 following the decline in property prices that began in late 1996. As other financial institutions suffered the same fate, the Bank of Thailand stepped in and lent over $8 billion to distressed financial institutions before withdrawing support as foreign exchange reserves fell.

Once a downturn began, Radelet and Sachs suggest that a number of factors contributed to the spread of the Thai crisis to other nations: the contagion effect. First, given the paucity of information, it was difficult to separate good and bad firms and financial institutions, creating the incentive to flee emerging markets before determining the solvency of debtors. Second, as currencies depreciated and the cost to debtors of servicing debt rose, creditors became reluctant to roll over or extend loans. Undercapitalized Japanese banks and Korean banks, suffering from their own crises, began calling in their loans to Thailand and Indonesia. In part, the fact that Japanese banks dominated lending throughout Asia, exacerbated the negative dynamic. Pressure on Hong Kong's currency board system forced it to increase interest rates. This increase put downward pressure on the currencies of nations in crisis, and made Hong Kong banks reluctant to extend loans to them.


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