Asia: The Challenge of Capital Inflows

By Anoop Singh

As I have highlighted in previous posts, Asia has been leading the global recovery and it is expected to continue doing so in the near term.

Not only has Asia’s rapid growth helped output return to pre-crisis levels relatively quickly, it has attracted large capital inflows into the region. Foreign capital has poured in, attracted by Asia’s strong fundamentals and bright growth prospects. Portfolio and cross border banking flows have rebounded sharply as financial conditions normalized.

Looking ahead, our growth projections suggest that Asia is expected to outperform advanced countries. As a result, the region is likely to continue to attract significant capital inflows, assuming that fallout from the euro zone sovereign debt crisis is contained and that the recent spike in global risk aversion abates.

So is there a downside risk to this deluge of foreign capital? History has shown that persistent and large capital inflows can be a double edged sword. While they bring with them numerous benefits, they do pose risks and policy dilemmas. Continued large capital flows pose, for example, the risk of overheating and runups in asset prices that may subsequently render the region vulnerable to outflows and asset price busts.

Asset prices

So far, while capital flows have boosted asset prices, we find the runup in such prices to be generally contained. Indeed, it appears that stock prices are not out of line with historical norms in most countries, based on using price-to-earnings ratios as a measure of valuation. But there is a concern that equity analysts may be overly optimistic regarding future earnings growth. Turning to property markets, there are lingering concerns that property prices have been rising too fast, especially in China and Hong Kong SAR. But these trends have been seen in localized pockets in specific countries, and don’t appear to be a nationwide phenomenon.

However, there is a need to remain vigilant to the buildup of bubbles, as they take time to develop. Analysis in our Regional Economic Outlook finds that it can take 11 quarters for a stock price bubble to develop and burst and even longer for a property price bubble. Furthermore, inflationary pressures have emerged in some countries, and inflation expectations have increased. Also it is worrying that excess liquidity has been rising across Asia, in part fueled by the strong inflows and resistance in many countries to letting exchange rates appreciate.

Prudential measures

Policymakers in the region have already stepped in, appropriately in my view, to put in place prudential measures to slow the runup in asset prices, particularly in the property market. These measures are already beginning to work. Policymakers also have at their disposal other tools, including allowing more exchange rate flexibility to slow down capital inflows.

While the recent inflows pose short-term macro management challenges, over the medium term capital inflows to the region could help to boost much needed infrastructure development and develop service sectors. Along with reforms aimed at improving the investment climate—such as increasing product and labor market competition, leveling the playing field for foreign investors, ensuring contract enforcement, and reducing administrative bottlenecks—they could help to increase foreign and domestic investment in key sectors. In this way, they could also support the package of policies that is needed in many Asian countries to rebalance the economy toward domestic demand in order to maintain medium-term growth momentum.

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  1. [...] Asia: the challenge of capital inflows [...]

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