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Changes in the International Flow of Funds and the Role of Japan

SUMMARY

Changes in the International Flow of Funds and the Role of Japan

-Japan's Response to the Diversification of Asia-



By the Subcommittee on International Financial Transactions, of the Committee on Foreign Exchange and Other Transactions

 

Preface: New Developments in Asian Countries

Three new developments are emerging in Asia. First, Asian countries have recently come to take greater initiative in liberalizing trade and investment, and strengthening development cooperation within the region. Second, as capital flow to developing countries increase in the 1990s, the need to carefully assess the conditions of individual countries has heightened, particularly since the Mexican currency crisis of late 1994. As a result, it became one of the most important challenges for Asian countries to secure appropriate and stable funding. Third, recent appreciation of the yen and expansion in Japanese direct investment in Asian countries has increased interest in the investment environments within these countries. At the same time, the recent volatile movement on foreign exchange markets has bolstered interest in stabilizing exchange rate and internationalization of the yen as a way to cope with the situation.
These developments point to the importance of viewing Asia not as a single, monolithic entity, but as a group of diverse countries requiring measures that are custom fitted to their respective situations.


I. Changes in the International Capital Flow and the Conditions in Asian Countries


1. Changes in the international capital flow

Changes during the 1990s

While the flows of funds to developing countries came to a standstill following the debt crisis of the early 1980s, they have since made a strong recovery in the 1990s, with private-sector capital posting a particularly sharp rise. In addition to the strong direct investment, capital inflow in the form of portfolio equity and bond investment is growing very rapidly.

The surge in private capital flow, particularly to Asian countries, can be traced to the fact that their continued growth has made them appealing international investment targets. Other factors include improving investment environments of the region, due to the growth of the private sector and the development and liberalization of domestic financial / capital markets. The increase of direct investment from the developed countries is underpinned by the expansion of international trade and the globalization of production, sourcing, and sales activities by industrial countries' corporations. The growth in securities investments during the 1990s, meanwhile, can be traced to continued low interest rates in developed countries.

 

Outlook for the future

The Mexican currency crisis of late last year prompted concerns about the sustainability of capital flow to developing countries. However, the flow of funds to developing countries is expected to continue over the medium term for the following reasons; 1) direct investment is increasing as a result of structural shifts in the world economy, 2) funds are flowing to developing countries from more diverse sources, and 3) the countries of Asia and elsewhere are expected to achieve higher growth than developed countries.

 

2. The Flow of Funds to Asian Countries

Capital inflow to Asian countries has surged during the 1990s. The influx of private-sector fund has been particularly strong, with direct investment accounting for as much as 40 percent of the total. The capital flow in the form of portfolio investment has also grown sharply. Portfolio equity investment has been expanding since 1992, and bond investment is also up due to the increase in bond issues by Asian countries on international securities markets.
Investments by the NIEs and more recently by the ASEAN countries in their neighbors have been on the increase in step with the economic development of Asian countries. The overseas Chinese are thought to play an important role in these investment activities. Traditionally, overseas Chinese have confined their investments primarily to relatively small-scale and short-term instruments, using only funds on hand, but more recently they have begun to tackle larger and more long-term investments as well.

The Mexican currency crisis that broke out at the end of last year had a temporary gyrating effect on the foreign exchange and equity markets of some of the emerging economies of Asia. The conditions in Asian countries differ from that in Mexico, however, in that their current account deficits are relatively small and most capital inflow takes the form of direct investment rather than portfolio investment. Nonetheless, the possibility remains that they could be exposed to short-term swings in incoming funds.

 

II. Conditions in Diversifying Asian Countries

While Asian continues to grow as a whole, there are nevertheless major disparities not only in respective economic conditions, income levels, and stages of development of financial / capital markets, but also in the speed at which economic liberalization is proceeding and in the underlying social frameworks of each country. This chapter examines in some detail the funding needs and fund-raising conditions of four countries in different situations.

 

1. Continued growth in ASEAN countries as seen in Thailand

The rapid economic growth Thailand has experienced in recent years can be attributed to export-oriented industrialization based on the active importation of foreign capital. Recently, however, Thailand's export competitiveness has been blunted and its incoming direct investment slow to grow. Against this background, the government is promoting the development of more sophisticated industries, which it sees as a key factor in the achievement of sustainable growth. Since rapid economic growth has rather highlighted the shortages in the country's economic infrastructure, Thailand plans to actively incorporate private-sector funds to advance enormous infrastructure development programs.

Thailand's domestic savings have risen sharply as a result of economic growth and reforms of the financial system. This has in turn brought steady expansion of financial / capital markets. However, Thailand cannot meet booming demand for funds entirely from domestic sources and is increasingly relying on overseas funds to make up the shortfall. Likewise, Thai companies are also diversifying their fund-raising efforts to meet the booming demand for funding. Not only increasing their borrowings from commercial banks, but also Thai companies are raising more money on the equity market and international financial / capital markets.

The recent inflow of funds to Thailand reflects these developments. In 1993, in particular, the country saw sharp growth in incoming portfolio investment, especially in equities. Commercial banks are also expanding their borrowings from overseas, which is the primary reason behind the increase in the influx of short-term funds.

 

2. India's economic liberalization

The open and market-oriented economic reform in India since 1991 catalyzed a strong economic recovery in 1994 that is expected to feed a healthy demand for funds over the short term. Infrastructure enhancement has traditionally been the province of the public sector, but in recent years the private sector has begun to be involved because of the fiscal constraints on the public sector.

Domestic savings in India are rising, but are still low compared to the countries of East Asia. Financial / capital markets have seen certain progress, such as liberalization of deposit interest. However, many regulations affected by earlier socialist policies remain and have impaired financial institutions from being as efficient as they could be. Since 1992, Indian companies have actively turned to the domestic capital markets to meet their fund-raising needs, and capital markets are expanding rapidly.

The open door policies adopted by India in 1991 and subsequent improvements in economic conditions have expanded the inflow of funds in the form of both direct and portfolio investment. Of particular note is the active fund-raising by major Indian companies on international financial / capital markets and the surge in private-sector portfolio investment resulting from the increase in equity purchases in domestic Indian markets by foreign investors.

 

3. China's reforms and open door policies

China embarked on its reform and open door program in 1978 and has posted rapid economic growth since 1991. A surge in fixed asset investment as a result of economic growth puts a squeeze on the supply of operating funds and has exacerbated inflation. This situation has led Chinese companies to shift their fund-raising for fixed asset investment away from public investment and loans to equity finance and borrowings from banks. More recently, market-based fund-raising, including equity listings and bond flotations on both domestic and foreign markets, have also picked up. High economic growth has underscored the shortages of infrastructure. The government of China continues to actively finance investment in infrastructure through policy financing. At the same time, it has begun to draw on low-interest loans from international financial institutions and foreign governments, and on importation of foreign private sector capital.

China's domestic savings are high at about 40 percent of GDP, but these savings have not been invested in an efficient manner yet, due to the deficiencies in the financial / capital markets. The financial system has been progressively revised in line with the economic reform and open door policies, and a major overhaul of the legal system in 1994 was aimed to improve the functions of the financial system. Of note are People's Bank of China Law of 1995, which boosts the monetary policy-making capacity of the central bank, and the Commercial Bank Law, which strengthen the Central Bank's regulatory oversight on commercial banks. Reforms in insurance system is also under consideration.

The flow of funds into China, primarily from the private sector, has expanded rapidly since 1992. In 1993, China became the largest recipient of funds among developing countries. Direct investment accounted for 59 percent of the total influx of funds in 1993. Portfolio investment in equities and bonds are also on the increase, reflecting the diversification of fund-raising techniques used by Chinese companies.

 

4. Indochina's transition to market economy as seen in Vietnam

The Vietnamese economy has achieved steady expansion under Doi Moi (renewal) policies started in 1986. Since 1992, real growth rates have been in excess of 8 percent. While the industrial sector, comprised mainly of state enterprises, has led the growth, agriculture continues to be Vietnam's main industry. Further growth will require enhancement of infrastructure development in areas like transportation, distribution and electric power.

Vietnam's financial system has traditionally been used as an instrument of fiscal policy, and the people of Vietnam are said to have generally placed little faith in it. Consequently, the financial markets have been unable to efficiently mobilize domestic funds. The government of Vietnam is endeavoring to advance financial reforms, but it will take time before the financial / capital markets are able to absorb domestic savings and efficiently channel them into investment.

With both income and savings low, Vietnam is dependent on the flow of funds from other countries to finance investments it needs to support economic growth. The primary source of incoming funds has so far been official development assistance (ODA). Vietnam has been eyed as a potential site for direct investment, but it will need to further enhance the investment environment.

 

III. Challenges and Advice


1. Efforts required of Asian countries

Higher domestic savings, and their efficient use

Asian countries continue to need significant scale of investment to sustain their economic growth. Meeting this enormous demand for funds will require Asian countries efforts towards the efficiency and stability of fund-raising at home and abroad.

Domestic savings should serve as the primary source of funds for the investment to sustain economic growth. While it is generally important to increase domestic savings, it is essential for Asian countries, where savings rates are already high, to build financial systems able to sufficiently absorb those savings. Reform of financial system must continue so that financial / capital markets can provide the public with attractive savings opportunities. In addition, sound macroeconomic management, including inflation-fighting and currency-stabilizing measures, is prerequisite as well. By the same token, it is important to strengthen function of financial institutions to achieve efficient allocation of absorbed savings. Essential in this will be human resources development, institutional reforms, better accounting systems, information disclosure, and other efforts to improve market transparency and enhance investment environment.

 

Stable importation of foreign capital

Although saving rate of Asian countries is generally higher than other developing countries, importation of foreign capital remains a major challenge. The attraction of private-sector foreign capital requires enhancement of investment environment. This will involve boosting countries' appeal as a direct investment target by creating needed infrastructure and stabilizing policies, and enhancing the environment for portfolio investment and private-sector bank lending, via such steps as the creation of transparent markets that allow foreign investors access to the information they require in order to accurately assess the risks inherent in investments and loans.

International securities investment have become so prevalent that it is relatively easy for a developing country, that has achieved certain level of economic growth, to import foreign capital. At the same time, however, sharp fluctuations in incoming foreign capital puts these fledging market economies at a major risk. The stabilization of foreign funds inflow entails improvements in market transparency through active information disclosure aimed to curtail the factors behind fund fluctuations, diversification of funding sources, and above all, sound and orderly macroeconomic management.

 

Providing funds required for infrastructure development

Though the state of the infrastructure varies from country to country, Asian countries are faced with an urgent need to make steady, large-scale investments. The Asian Development Bank estimates that Asian countries will need to invest some $1,232 billion in infrastructure between 1994 and 2000.

Infrastructure development has traditionally been the province of the public sector and is traditionally carried out with ODA from overseas. However, given the anticipated increases in demand for infrastructure funding, it will be necessary to attract more foreign private-sector funds as well. That, in turn, will require measures to reduce country risks and enhance legal and other institutional frameworks, so as to set proper stage for investment. However, infrastructure is intrinsically a public property, and there are limits to the infrastructure building that the private sector can engage on the basis of market principles.

 

2. What is expected of Japan

(1) Cooperation for the development of Asian financial / capital markets

Support for the development of domestic financial / capital markets

For Asian countries, the development of efficient financial / capital markets is the key to meet their diversifying demand for funds. It is desirable that Japanese public institutions, international institutions, and private institutions should provide training, send experts, and provide other support fine-tuned to conditions in individual countries.

Strengthening ties between financial / capital markets in the Asian region

The importance of maintaining close ties among the financial / capital markets of each Asian country has increased in step with the acceleration of cross-border movements of funds within the Asian region. Japan should boost the policy dialogue at various levels, at forum such as The (Asia Pacific) Four Markets Meeting and APEC, thereby promoting closer ties among Asian authorities. It should also consider to develop "soft" infrastructure required for Asian financial / capital markets, taking into account the need for international harmonization.

 

(2) Cooperation for stable fund-raising by Asian countries

Development of open, international financial markets in Tokyo

Greater access of Asian countries to the international financial markets in Tokyo will not only contribute to their fund-raising needs, but also offer Japanese investors more efficient investment vehicles. In this context, restrictions have gradually been lifted on non-resident bond issues and equity listings. These improvements in Asian countries' and companies' access to Japanese markets are expected to help them increase their fund-raising activities in Japan. We should also make further efforts to create more attractive offshore markets.

Facilitation of foreign investment, internationalization of the yen

Stabilization of foreign exchange rate and reduction of currency risk is the key to facilitate foreign investment by Japanese private-sector. Given the importance of risk hedge opportunity under unstable condition of a foreign exchange market, environment should be improved so that investors can make full use of a wide range of hedging instruments. Another important step in facilitating foreign investment by the Japanese private sector will be the internationalization of the yen. Improving the environment through deregulation will enhance the internationalization of the yen. This, in turn, will expand the opportunities of yen-denominated investment which carry no foreign exchange risk for Japanese investors, and facilitate foreign investment by the Japanese private sector. In the course of deregulation, it will be important to rigorously apply the principles of self-accountability to private-sector investment.

Support for smaller businesses in Asian countries

The sound development of private-sector companies, especially small and medium sized enterprises is necessary for the sustained development of the high-growth Asian economies. Japan should make active contributions to this by providing two-step-loans through public institutions, utilizing the resources of local private-sector institutions. Besides funding, it is also important to provide technical support related to managerial expertise and other relevant matters by public and private-sectors.

Dealing with the Mexican currency crisis type incident

Emerging markets are one of the world's growth centers. Ensuring their sound development and a stable inflow of funding to them represent an important element in the development of the world economy and stability of the world financial / capital markets. This will require the enhancement of policy dialogues between the IMF and national governments, and the establishment of an international framework for financial support led by the IMF in case of sharp fluctuation of fund movement.

 

(3) Cooperation for infrastructure development by Asian countries

In as much as it forms the basis for sustainable growth, infrastructure development is an urgent priority for Asian countries. It is important that Japan offers continued support for infrastructure development through its public institutions. It has also become important to respond to private capital demands in Asian infrastructure building.

Encouragement of private-sector investments in infrastructure projects

Public-sector support will be an important catalyst for private-sector investments and loans for infrastructure development projects. This support could take the form of technical assistance in the drafting of efficient infrastructure plans, and more directly participating in infrastructure investments with private sector, to help them cover qualitative and quantitative risks involved. An important complementary step that the public sector can make in qualitative terms would be to undertake political risks that the private sector would find hard to accept. This will involve active use of the guarantee services of the Export-Import Bank of Japan. Depending on the project, it would also be effective to use the guarantee services of the multilateral development agencies or public institutions in other countries. At the same time, the complementary steps that public institutions can offer, in quantitative terms, should not be overlooked.

Establishment of an investment fund in infrastructure projects

It is essential to raise core equity funds for infrastructure projects to obtain lending from private financial institutions. One way to do so would be to set up a Japan-led infrastructure investment fund that facilitates equity fund raising and catalyzes infrastructure projects utilizing abundant financial resources of Japan. From the standpoint of contributing to appropriate infrastructure building it is hoped that Japan's public institutions will play an active role, in encouraging the participation of the private sector, and opening new venues of policy dialog with recipient countries.