According to IMF statistics, net capital inflow to emerging markets was less than $ 50 billion a year at the beginning of the decade. By 1996, however, this had increased to $ 235 billion. Asia has received roughly half of this capital inflow. In some Asian economies, net capital inflows have averaged 5% to 8% of GDP over a long period. Contributing to this surge of international capital flows was financial liberalization undertaken by economies which had the foresight to do so, with a view to encouraging financial intermediation, domestically as well as internationally, so that the high savings could be channelled into productive investments, thus promoting economic growth. Meanwhile, there has been continued willingness on the part of the developed economies to export capital, under the influence of sustained economic growth, low inflation and low interest rates. Increasing amount of mutual funds and pension funds of these economies looked for higher returns in the emerging markets. In the case of Japan, sustained large current account surpluses, coupled with the earlier appreciation of the yen, have forced many BIS Review 115/1997  -2-  Japanese firms to relocate their production to the rest of Asia. Thus capital inflows into the Asian region have been large. 7. With financial liberalization and the globalization of financial markets, a substantial part of the capital inflow into Asia has been in the form of foreign portfolio investments directed principally at financial instruments in the form of equity and bonds, and, where available, derivatives thereof.
It is therefore understandable that when the reversal of capital inflows came, it caused the damaging financial turmoil that we have seen in a number of Asian economies. 10. Financial liberalization encourages greater financial intermediation, domestically and internationally, and this obviously is beneficial to economic growth and development. But clearly the risks arising from this worthy process must be identified and managed properly before the long term beneficial effects could be realized. The risks are, nevertheless, not well appreciated, simple as they may be, particularly with the benefit of hindsight. 11. There is, as always, credit risk. Yet it is such a common feature that undue exuberance on the part of investors would push price to earning ratios well beyond fundamentals. Bankers also fail to assess the impact of interest rate hikes on the value of collateral or on cash flows. The result is therefore the usual over exposure of investors and lenders to asset losses. Then there is maturity risk. To say that it is risky to finance illiquid non-tradables, such as property, with short term capital inflows is, I suppose, teaching grandmothers to suck eggs, particularly in this company, but this again has been a common feature underlying financial shocks, not just in Asia but also in other parts of the world. The same with currency risk. Many borrowers, in both the private and public sectors, were keen to borrow foreign currency funds to finance investments that do not generate sufficient foreign exchange to repay the debt. Such debts were also unhedged.