Derivatives and Global Capital Flows: Applications to Asia

There are four factors involved in the current financial crisis in Asia that have caused surprise. Since the Latin American debt crisis was thought to have been aggravated by the dominance of syndicated private bank lending, borrowers were encouraged to increase private direct investment flows. The stability of capital flows to Asia was used as an example. Yet, the Asian crisis appears to have been precipitated by the reversal of short-term private bank lending. Second, the flows of capital to Asia have been used as example of the benefits of free international capital markets in directing resources to the most productive uses. Yet, in the aftermath of the crisis it appears that total returns on equity investments in Asia have in fact been lower than in most other regions throughout the 1 990s. Third, it appears that in a number of Asian countries, the majority of the international lending was between foreign and domestic banks. It has been suggested that the major cause of the crisis is unsafe lending practices by the Asian banks permitted by inadequate national prudential supervision. Yet, these economies were the most advanced on the road to market liberalisation. One of the cardinal principles of financial liberalisation, formed in the aftermath of the Chilean crisis, is that the creation of institutional structures ensuring the stability of the financial system should precede financial market liberalisation. Indeed, many countries were following this advice. It is interesting to note that the lending banks were generally large, global banks who employ highly sophisticated risk assessment procedures. Yet, they appear to have continued lending well after the increased risks in the region were generally apparent. This suggests that even the most sophisticated operators in global financial markets have difficulties in assessing risk, and that their regulators were no more successful in imposing prudent limits. Finally, private portfolio and direct investment flows were considered to be preferable to syndicated bank lending because they were thought to segregate the problem of foreign exchange instability from asset market instability. Syndicated lending was denominated in the currency of the lending bank, and the exchange rate risk was borne by the borrower; but direct equity investors purchase foreign financial assets denominated in foreign currency and thus bears the currency risk. It was suggested that in a crisis the foreign investor would suffer first from a fall in asset prices, and second from a decline in the exchange rate, which would discourage him from liquidating the investment and reduce selling pressure in the foreign exchange market. Yet, the linkage between the collapse in exchange rates and equity markets appears to have been even closer in Asia than in other experiences of financial crisis.