Hot and Cold Money

There may be a general misunderstanding about two issues regarding capital mobility that emerged this week. The first involves how East Asia is coping with the deluge of foreign investment flowing into the region’s equity markets. The second is the apparent Iranian decision to move their investments out of Europe for fear that if sanctions are implemented, the funds could be frozen.

Foreign investors have flocked to East Asia and their buying helped fuel sharp gains in most of the regional bourses until this week. The foreign inflows have tended to push up regional currencies and expand monetary conditions, even though several central banks in the region are in a tightening mode. Since China’s currency regime changed six months ago on 21 July 2005, most currencies in the region have appreciated and by much more than the 0.6% that the yuan has advanced.

The Philippines peso and the Thai bhat have both appreciated by almost 6% over the past six months. The Indonesian rupiah has appreciated by nearly 4%, while the South Korean won has risen by more than 3% and the Singapore dollar has gained 2%. Given the meager rise of the yuan and the outright decline (3.3%) of the Japanese yen, these countries could see their competitiveness eroded.

Officials also need to be concerned that the hot money will distort price signals for investors and policy makers. Central banks throughout the region are in the process of raising interest rates to either normalize money market conditions or to ward off future inflation. Yet the currency appreciation being experienced has steadied the official hands. Thailand is the exception to this generalization as the central bank hiked the official rate 25 bp this past week to 4.25%. But in recent weeks, Indonesia, the Philippines, South Korea, Malaysia and Taiwan took a pause within the rate hiking cycles.

Many observers suspect officials have intervened to try to slow their currencies rise. Since the Chinese revaluation, the Federal Reserve’s custody holdings, which includes Treasuries as well as agencies, have risen by about $86 bln, The market does not know which central banks utilize the Fed’s custodial services, but there are strong suspicions that Asian central banks are good clients.

The US, the G7 and the IMF have been encouraging East Asia to liberalize its capital markets. There seems to be a general reluctance to do so and the dramatic swings in the equity markets and the knock-on impact on the currency market will likely reinforce this reservation.

Indeed, from the point of view of a policy maker sitting in emerging Asia, the global capital markets are fraught with risk and appear at times to be whimsical. This seemed to have been the general disposition even prior to the 1997-1998 financial crises, but that experienced reinforced that sense. And the recent price action confirms the correctness of that view.

The liberalization of the capital markets was partly sold on the basis that the price of financial variables, like interest rates and currencies can act like shock absorbers for the strains and stresses that a modern economy generates. Interest rates and currencies could be the burden so that the real economy doesn’t have to. Clearly the violent boom-busts of that culminated in the Great Depression of the 1920-1930 threatened the very basis of liberty and representative government. Those countries that have developed capital markets also appear to be able to better manage the business cycle. Yet one lesson that senior US policy makers, like former Treasury Secretary Robert Rubin took from the Asian financial crisis was that the volatility of the capital market themselves could threaten the very system that the capital markets were to help protect and stabilize in the first place.

All too often, market observers do not fully appreciate that liberalization of the capital markets requires more than simply a government dropping prohibitions and restrictions or “getting out of the market’s way”. Strong capital markets require strong supervision and regulation. It requires transparency and a conflict resolution process. As the Tokyo Stock Exchange apparently has had to learn more than once, strong capital markets require technological advances to handle the occasional spikes in turn-over.

Strong capital markets also require strong financial institutions. This is true not only because financial institutions are significant and active market participants, but also because the role of financial institutions change under a regime of liberal capital markets. Specifically, the role of banks as lenders to business may become what economists called “disintermediation”. That is to say that the capital markets can fulfill some of the function of banks. For example, for every dollar that Corporate America borrows from the bank, it gets two from the markets directly by selling bonds or equity. In Europe, it is almost ratios are almost the exact opposite. The Assistant Governor of the People’s Bank of China recently revealed that nearly 88% of Chinese corporations’ external financing is derived from bank loans.

It is not only developing countries that are vulnerable to the speed at which capital moves. From time to time, some European officials have expressed sympathy for the old “Tobin-Tax” named for the economist James Tobin who argued that the movement of capital was too fast and that policy makers should consider throwing some sand into the works. The sand would take the form of a small tax on short-term capital movement. Of course, such proposals typically receive more derision than support, but despite that and some practical difficulties, the idea does not die. As developing countries get a larger voice at the international forums do not be surprised to see the issue get more attention.

That said, capital movement may not always be what it seems. Frustrated with the Iran’s decision to proceed with its nuclear research, there may be some attempt on the part of the US and Europe to sanction the country. Part of the sanctions could include a freeze of Iran’s assets. Iran has let it be known that it has begun to shift its assets out of Europe. Details are sparse, but some market participants concluded that this would entail the liquidation of their foreign assets as they repatriated their funds.

While possible, this does not seem like the most likely scenario. Suppose you are an asset manager and you have already constructed your portfolio. The owner of the building that you office is in calls you and tells you that he is not renewing your lease at the end of the month. When you move your office, would you change the investments in your portfolio? Probably not and neither should we assume that the Iranians will either. Indeed there is little reason to believe the contrary. Surely the rally in gold, the sell-off in global equities and bonds this week cannot be laid at the feet of the Iranians.

Maybe Thomas Friedman is right: the world is flat. Geography doesn’t matter. As market participants, we should be indifferent to which country or city investors (e.g. Iran) operate from or where their securities are held. It is far more important what they have invested. Iran, like many other developing countries, does not disclose, for example, the amount or composition of their reserves. What we do know is that Iran is a significant exporter of oil and therefore have probably accumulated US dollar denominated assets.

We also know that the US has in the past frozen other countries assets in the US. So it would seem likely that Iran holds US dollar denominated assets but not in the US. We also know that OPEC as a whole has been has been net buyers of US Treasuries in recent months. Between July and November 2005, OPEC bought about $15 bln worth of US Treasuries and at $67.8 bln in total appears to be the highest on record. This likely understates OPEC’s dollar exposure as a recent BIS paper found that a quarter of the world’s dollar reserves are not kept in US Treasuries, agencies or corporate bonds. Nor are they deposited in US banks. Rather, this part of official reserves appears to have been invested in the US dollar denominated obligations sold by many foreign countries and triple-A rated companies.

When thinking about this issue, one should be aware of an important legal precedent. Several years ago, the US froze Libya’s assets. Libya has placed some deposits with a branch or subsidiary of a US bank in London. Libya asked the branch/subsidiary for their funds and was told that the bank could not comply because of the freeze. Libya sued on the grounds that this was a case of extraterritoriality—or the attempt to enforce US laws where the US did not have jurisdiction. Libya argued that the office in London was not subject to US laws but the laws of the country that it was operating in. One thing led to another and several years passed as the case made its way though the UK legal system. Eventually the highest court in the UK ruled in favor of Libya and the US ordered to make Libya whole and pay a penalty to boot.