Comment on: Philiippe Bachetta and Eric Van Wincoop, who in this paper aim is to assess the impact of financial liberalization in emerging markets on the dynamics of capital flows to these countries. By positing a cost of absorbing these flows, the authors explain how liberalization can give rise to an “overshooting” of capital inflows and asset prices. In addition, the authors examine whether incomplete information can give rise to a high degree of volatility in capital flows as well as to contagion. They also suggest that deviations in capital inflows from their steady-state levels can be used as a potential signal of future crises.Capital flows liberalization investment volatility asset price bubbles

Reinhart, Carmen

English

Research Papers in Economics

  1
Capital Flows to Emerging Markets: Liberalization, Overshooting and Volatility 
by Philippe Bachetta and Eric Van Wincoop 
in Sebastian Edwards, ed. Capital Flows and the Emerging Economies: Theories, 
Evidence, and Controversies 
(Chicago: University of Chicago Press for the NBER, 2000), 98-103. 
 
Comment Carmen M. Reinhart 
University of Maryland, NBER, and CEPR 
 
 
The aim of this paper is to assess the impact of financial liberalization in 
emerging markets on the dynamics of capital flows to these countries. By 
positing a cost of absorbing these flows, the authors explain how liberalization 
can give rise to an “overshooting” of capital inflows and asset 
prices. In addition, the authors examine whether incomplete information 
can give rise to a high degree of volatility in capital flows as well as to 
contagion. They also suggest that deviations in capital inflows from their 
steady-state levels can be used as a potential signal of future crises. 
These are important questions to ask in light of the close linkages between 
capital flows and financial crises. Furthermore, financial crises, particularly 
in,the domestic banking sector, seem to be closely entwined with 
financial liberalization and asset price bubbles (see Kaminsky and Reinhart 
1999). The Asian crises of 1997-98 certainly attest to the relevance of 
these issues. Financial liberalization, full or partial, did appear to help 
explain the cycle of capital inflows and the prolonged lending boom that 
left these economies highly leveraged and, thus, vulnerable to financial 
crises. During the boom phase of the capital flow cycle, the ex post evidence 
is also consistent with an asset price overshooting of the type discussed   2
in this paper. 
In what follows, I will suggest that the analytical framework presented 
in this paper is extremely useful in understanding foreign direct investment 
(FDI) and portfolio equity flows to emerging markets in the 1990s. It is 
also useful for delineating how efforts to liberalize capital markets may 
have contributed to the boom phase of the capital flow cycle and its ultimate 
overshooting. The model also provides insights into FDI’s compar- 
ative resilience vis-a-vis other types of capital inflows following periods 
of turbulence. This resilience was evident following the Mexican crisis of 
1994-95 and the recent Asian crisis as well. This framework, however, is 
less well equipped to explain the surge in short-term capital flows, be these 
short-maturity bonds (as in Mexico or Indonesia) or bank loans (as in 
Korea and Thailand) and their links to financial liberalization. Hence, the 
framework presented in this paper is, in my view, a very relevant but partial 
explanation of the capital flow episode of the 1990s. 
I will divide my comments into two broad areas. The first briefly deals 
with the stylized facts alluded to in the paper, while the second focuses on 
the theoretical model. 
 
The Stylized Facts 
Section 3.1 of the paper provides some background information on the 
evolution of capital flows to emerging markets in the 1990s. This section 
highlights the increasing importance of portfolio flows to emerging markets   3
and the role of FDI. These and other points made by the authors 
are indeed important, but some qualifications of the stylized evidence, as 
presented in this paper, are in order. 
First, while FDI and portfolio flows did surge in the earlier part of 
this decade, the increase was not universal and much more pronounced 
in Latin America than in Asia. In the years prior to the crisis, short-term 
flows to Asia surged, as Japanese and European banks significantly 
stepped up their lending to this region. Hence, in light of the paper’s goal 
of understanding the role financial liberalization plays in stimulating capital 
inflows, the authors should also consider discussing the role played 
by short-term capital inflows during the period they are analyzing. Other 
papers, which have also modeled the financial liberalization process (see, 
e.g., Goldfajn and Valdks 1995; McKinnon and Pill 1996) have often 
stressed the distinctive behavior of banks during the postliberalization period. 
In particular, it has been shown that, during those periods, banks 
are inclined to acquire short-term offshore liabilities (capital inflows), that 
are then lent at home at substantially higher interest rates and longer maturities 
for a substantial profit. Certainly, the severe liquidity problems 
that some Asian countries have faced in 1997-98 have only served to confirm 
the prominent role played by short-maturity debt; the widespread 
incidence of banking crises have also underscored the central role that 
banks play in intermediating capital inflows. The increasing skewness in 
the composition of capital flows toward the short end of the maturity   4
spectrum has also been linked to the vulnerability of the Asian economies 
of financial crises (see Kaminsky and Reinhart 1998). 
Second, a stylized fact, which is prominently stressed in the background 
discussion and filters through to the analytical framework, is the assertion 
that financial liberalization is primarily a feature of the 1990s. Galbis 
(1993) and Kaminsky and Reinhart (1999) provide detailed chronologies 
of the process of financial liberalization in most of the emerging market 
economies considered here. Financial liberalization was well underway in 
most of these countries by the early 1990s. Among the most documented 
of these financial reforms were the “big bang” liberalizations of the late 
1970s and early 1980s in the Southern Cone. More generally, the removal 
of interest rate ceilings and directed lending was an ongoing process in 
the 1980s for several of the Asian and Latin American emerging markets 
emphasized in this study. 
Third, the authors seem to suggest that financial liberalization has been 
synchronous across the broad range of highly heterogeneous emerging 
market economies in the 1990s, and thus liberalization has been a key 
ingredient in the widespread flow of capital to emerging markets in the 
1990s. While I fully share the authors’ view of the key importance of financial 
liberalization as a pull factor, there is little evidence of such widespread 
cross-country synchronicity of reforms. By the time Argentina and 
Brazil implemented macroeconomic reforms, many of the Asian economies 
now in trouble and Chile had been far advanced in this process.   5
China is particularly difficult to fit in this mold; neither its domestic financial 
sector nor its external accounts have been liberalized by any reasonable 
measure-its currency lacks convertibility and its banking sector 
is bankrupt. A synchronous rise in flows to emerging markets may have 
other explanations than those that are stressed in this paper. Several studies 
that have analyzed the determinants of capital flows to emerging markets 
have found conclusive evidence on the importance of common push 
factors (see Montiel and Reinhart 1999 for a summary of this literature). 
Specifically, the decline in U.S. interest rates in the early part of the 1990s 
and the more dramatic march toward zero of Japanese short-term interest 
rates were clearly forces that helped propel capital toward Asia and 
Latin America. 
 
The Theoretical Model 
Let us recall that this paper aims to assess the impact of financial liberalization 
in emerging markets on capital flows to these countries and to 
explain why liberalization can give rise to the “overshooting” of capital 
inflows and asset prices. To do so, the authors begin by modeling financial 
liberalization as the reduction in a tax, which in turn increases the rate of 
return on physical capital in emerging markets. This approach seems quite 
sensible, since even in the absence of explicit policy decisions, one can reinterpret 
the reduction in this tax as the decline in transactions costs associated 
with new “information-age’’ technology. Furthermore, some countries   6
(like Chile and China) have gone to great lengths to encourage FDI 
through tax breaks and other forms of preferential treatment while shunning 
short-term and portfolio flows. 
In what follows, my discussion of the model will mainly focus on why I 
think that this type of model is better suited to explain the behavior of 
FDI and equity flows than the broader capital flow dynamics that the 
authors discuss in the introduction. This is not to suggest that explaining 
FDI and equity flows is a trivial feat, since both FDI and portfolio equity 
flows showed marked increases in the 1990s. Also, while the authors do 
not actually interpret and exploit some of their findings in this light, this 
framework also allows us to understand in an intuitively appealing manner 
the problem of “overinvestment” that characterized many of the Asian 
economies on the eve of crisis. 
The model, however, would have to be substantially amended to shed 
light on the issue of bond flows and other short-term flows, which were 
also extremely important in explaining the capital flow surge of the 1990s 
as well as its subsequent volatility. To understand these other types of 
flows, some of the assumptions that are made will have to be relaxed. For 
example, it is assumed that capital outflows from emerging markets are 
not possible-investment is assumed to be “irreversible.” Table 3C. 1 
clearly highlights that reversibility of capital flows is a major issue for 
emerging markets. Nor is this issue a new one, as the experiences of the 
early 1980s shown in the table highlight. However, it is true that not all   7
capital flows are equally vulnerable to these abrupt reversals. Indeed, the 
kind of physical capital flows that the authors model in this paper (FDI) 
appear to be relatively resilient following the Mexican 1994 crisis and the 
Asian crises of 1997-98. Bond flows and foreign bank loans, which are 
not included in this model, appear to account for the bulk of the observed 
reversals. 
 
It is also the case that the authors work with a real model, in which 
there is no money, credit, nor exchange rates. There is also no debt. The introduction 
of a second emerging market asset, be it money, debt, or both, 
would clearly allow for a more comprehensive modeling of the capital 
flows of the 1990s. While there are always trade-offs between tractability 
and breadth, to understand the capital flows of the 1990s we must also address 
the issue of debt and bank lending. As we have seen in the cases of 
Southeast Asia and Korea, bond financing and bank loans accounted for   8
an important share of capital inflows to this region as well as other emerging 
markets. 
A less pressing, but possibly interesting, extension of this framework 
would be to relax the assumption that consumption decisions are taken 
on a period-by-period basis. The reason that this may be a fruitful exercise 
has to do with the authors’ introduction of incomplete information and 
learning. While I very much like their idea of incomplete information as a 
possible source of volatility and contagion, this uncertainty is not (in its 
present form) allowed to feed back so as to affect consumption decisions. 
In sum, if the authors wish to address the links between financial liberalization, 
aggregate capital flows, asset price bubbles, and volatility, I would 
urge them to incorporate other assets, besides physical capital, in their 
framework. An interesting extension of this type of analysis could also be 
to build on the financial liberalization story and incorporate a financial 
intermediary, as in Edwards and Vegh (1997) and Krugman (1998). Of 
course, attempting to do too many of these things in a single model will 
no doubt prove messy but it would be highly complementary to the interesting 
issues that are already addressed in the paper.   9
References 
Calvo, Guillermo A., and Carmen M. Reinhart. 1999. When capital inflows come 
to a sudden stop: Consequences and policy options. In Key issues in reform of 
the international monetary andfinancial system, ed. P. Kenan, M. Mussa, and 
A. Swoboda. Washington, D.C.: International Monetary Fund, forthcoming. 
Edwards, Sebastian, and Carlos Vegh. 1997. Banks and macroeconomic disturbances 
under predetermined exchange rates. Journal of Monetary Economics 40 
(November): 239-78. 
Galbis, Vicente. 1993. High real interest rates under financial liberalization: Is 
there a problem? IMF Working Paper no. 93/7. Washington, D.C.: International 
Monetary Fund. 
Goldfajn, Ilan, and Rodrigo Valdes. 1995. Balance of payment crises and capital 
flows: The role of liquidity. Cambridge, Mass.: Massachusetts Institute of Technology. 
Mimeo. 
Kaminsky, Graciela, and Carmen M. Reinhart. 1998. Financial crises in Asia and 
Liberalization, Overshooting, and Volatility 103 
Latin America: Then and now. American Economic Review 88, no. 2 (May): 
444-49. 
. 1999. The twin crises: The causes of banking and balance of payments 
problems. American Economic Review 89, no. 3 (June): 473-500. 
Krugman, Paul. 1998. Bubble, boom, crash: Theoretical notes on Asia’s crisis. 
Cambridge, Mass.: Massachusetts Institute of Technology. Mimeo. 
McKinnon, Ronald, and Huw Pill. 1996. Credible liberalizations and international   10
capital flows: The overborrowing syndrome. In Financial deregulation and integration 
in East Asia, ed. T. Ito and A. Krueger, 7-42. Chicago: University of 
Chicago Press. 
Montiel, Peter, and Carmen M. Reinhart. 1999. Do capital controls influence the 
volume and composition of capital flows? Evidence from the 1990s. Journal of 
International Money and Finance 18, no. 4 (August): 619-35. 
 

Balance of payment crises and capital flows: The role of liquidity.

Banks and macroeconomic disturbances under predetermined exchange rates.

Bubble, boom, crash: Theoretical notes on Asia’s crisis.

Credible liberalizations and international 10 capital flows: The overborrowing syndrome.

Do capital controls influence the volume and composition of capital flows? Evidence from the 1990s.

High real interest rates under financial liberalization: Is there a problem? IMF Working Paper no. 93/7.

The twin crises: The causes of banking and balance of payments problems.

When capital inflows come to a sudden stop: Consequences and policy options.

Capital flows to emerging markets: Liberalization, overshooting and volatility (a comment)

Capital flows to emerging markets: Liberalization, overshooting and volatility (a comment)

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics