Information about Asia and the Pacific Asia y el Pacífico

Chapter 10. Capital Flows: A Prospective View

Ratna Sahay, Cheng Lim, Chikahisa Sumi, James Walsh, and Jerald Schiff
Published Date:
August 2015
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Edda Zoli, Sergei Dodzin, Wei Liao and Wojciech Maliszewski 

Main Points of this Chapter

  • During the past two decades capital flows to Asia have been large and volatile, creating both opportunities and challenges for regional policymakers.

  • In the period following the Asian financial crisis, net capital flows to the region were mainly driven by domestic GDP growth, which was high in comparison with U.S. growth, U.S. interest rates, and investor risk appetite.

  • In both the short and long terms, additional factors will also shape the size and composition of capital flows. These factors include quantitative and qualitative monetary easing in Japan, capital account liberalization (most notably in China), increasing financial integration and development, and changes in saving patterns driven by demographics.

  • All of these factors will contribute to capital flow volatility, requiring sound macroeconomic and microprudential policies as well as macroprudential policies to build resilience and mitigate risk.


The past two decades have seen waves of large capital inflows sweeping through Asia. The first wave started in the early1990s and ended abruptly with the Asian financial crisis in 1997. The second one began in the early 2000s and came to a halt with the global financial crisis. The third wave started in mid-2009 and ended in May 2013, when the U.S. Federal Reserve signaled plans to exit from its quantitative easing (QE) program. Capital inflows delivered economic benefits, but they also posed significant challenges for policymakers because of their potential to generate overheating, loss of competitiveness, and increased vulner-ability to crises.

Against this background, this chapter takes a prospective look at capital flows to and within Asia, and explores the factors that will shape their size and composition in the short, medium, and long terms. Important policy changes and structural transformations, which are under way in the region and globally, will affect capital flow movements in Asia. Such changes include, in the short to medium term, monetary policy normalization in the United States and quantitative and qualitative monetary easing (QQE) in Japan. In the medium to long term, they include capital account liberalization—most notably in China—increasing financial integration and development, and changes in saving patterns driven by demographics.

First, the chapter reviews stylized facts about past capital flow cycles, capital flow composition, and geographical origin and destination, and presents a new empirical analysis of the main drivers of capital flows to Asia after the Asian crisis. This empirical evidence is then used to discuss the outlook for capital flows in the short to medium term. Then, the chapter focuses on the possible impact of Japan’s QQE, China’s capital account liberalization, and other structural changes in capital flows to and within Asia.

Although the full implications of all of these factors on future capital flows cannot be predicted, it is clear that volatility of cross-border capital flows will persist, creating significant policy challenges. Therefore, Asian economies need to continue building resilience to confront these challenges. Sound macroeconomic and microprudential regulation and supervision will be essential tools. In addition, macroprudential policies—which have already been used extensively in the region—can provide supplementary instruments to mitigate systemic risks. Hence, the final section of the chapter reviews Asia’s experience with macroprudential policies, and also highlights how the existing framework could be further strengthened to enhance resilience and improve the response to economic fluctuations. Because capital flows can bring important benefits to Asia, the final section also reviews policy measures that can help channel capital flows to productive uses.

Capital Flows in Retrospect

Stylized Facts on Capital Flows to Asia

Capital flows to Asia have been highly volatile since 1990. After a significant surge in the early 1990s, they saw a massive reversal with the Asian financial crisis. Since the middle of the first decade of the 2000s, capital flows have resumed, but remained volatile, recording a boom from the fourth quarter of 2006 to the third quarter of 2007, followed by a sharp decline during the global financial crisis, and another upswing from the third quarter of 2009 to the third quarter of 2011 (Figure 10.1). Although the pattern of capital flow movements was similar for both advanced Asia (comprising Australia, Japan, and New Zealand) and the rest of Asia, the latter experienced larger shifts in flows, especially in the 1990s and in 2012–13.

Figure 10.1Nonresident Non-FDI Inflows to Asia

(Four-quarter moving average, percent of GDP)

Sources: IMF, International Financial Statistics and World Economic Outlook databases; and IMF staff calculations.

Note: AUS = Australia; JPN = Japan; NZL = New Zealand. FDI = foreign direct investment.

1 Other Asia comprises China, Hong Kong SAR, India, Indonesia, Korea, Malaysia, the Philippines, Singapore, Taiwan Province of China, Thailand, and Vietnam.

Net capital flows were also volatile, particularly in Asian economies other than China. This volatility was due to their composition. Flows to Asia, excluding China, have been dominated by portfolio and other investment, mainly bank loans (Figure 10.2). Both are volatile sources of funding: portfolio investment is considered more mobile than are other flows, and bank loans are typically short term. Both types of flows are also highly sensitive to external financial conditions, particularly in advanced economies. Similarly to the most recent surge in inflows, flows to Asia in the run-up to the Asian financial crisis were related to a declining trend in interest rates in the advanced countries and to a search for yield.

Figure 10.2Asia: Capital Flows, Net

(Billions of U.S. dollars)

Sources: IMF, Balance of Payments Statistics; and IMF staff calculations.

Capital flows to China have been dominated by more stable foreign direct investment (FDI), but in 2012 the “other investment” flow category started to become more volatile. A gradual liberalization of exchange rate restrictions contributed to this additional volatility. The liberalizing of surrendering requirements in 2012, together with changes to near-term perceptions about currency appreciation, produced a shift to foreign deposits. This shift caused a large negative swing in the “other investment” category, which was partly reversed in 2013.

Capital flows to low-income Asian countries have been small compared with those to the rest of the region, but they have been increasing, especially since the global financial crisis. FDI has been the major component of capital flows to this country group, also reflecting greater investment in natural resource sectors following the spike in commodity prices after 2005. FDI inflows have increased rapidly especially in low-income Asian countries with significant natural resources, such as Mongolia, and to a lesser extent, Lao P.D.R. China was the source of part of these FDI flows.

As in the early 2000s, most portfolio inflows to Asia continued to originate from the United States and advanced Europe, exposing Asia to spillovers from those regions (Figure 10.3). Intraregional portfolio investment has grown somewhat since then. The share of portfolio investment of Asian origin increased from about 15 percent to about 24 percent between 2001 and 2012, reflecting, in part, a deepening of domestic financial markets such as local currency bond markets. Portfolio outward investment within Asia also grew, from 10 percent to 18 percent, over the same period. As of 2012, about 70 percent of direct investment originated within the region, and most of Asian FDI was directed toward the region.

Figure 10.3Asia: Regional Composition of Portfolio and Direct Investment

Sources: IMF staff calculations; Coordinated Portfolio Investment Survey; and Coordinated Direct Investment Survey.

Asian economies also have been the recipients of bank loans from Europe and the United States (Figure 10.4). European banks have been important sources of both direct and indirect credit to the region. The banks’ direct lending has been to private sector agents in the region through cross-border transactions and through lending by local subsidiaries and branches. Direct lending has included the area of trade finances. Indirectly, banks have played a role in the wholesale funding of regional banks, particularly in Australia, Hong Kong SAR, Korea, New Zealand, Singapore, and Taiwan Province of China (IMF 2012b). European banks reduced their lending to Asia in the aftermath of the global financial crisis, with credit from euro area banks not fully recovering to precrisis levels. The impact of European banks’ deleveraging has been partly offset by regional banks, especially those in Japan, that have stepped in (see Box 10.1 below).

Figure 10.4Consolidated Foreign Banks’ Claims on Asian Economies

(Billions of U.S. dollars, on immediate borrower basis)

Source: Bank for International Settlements.

Drivers of Capital Flows to Asia in the Post–Asian Crisis Period

To gain a sense of the drivers of capital flows to Asia in the post–Asian crisis period a model of net capital inflows was estimated using a panel of 14 Asian economies from 2000:Q1 though 2013:Q4.1 (See Annex 10.1.) The results suggest that domestic GDP growth, U.S. short-term interest rates, the U.S. QE program, and investor risk appetite—proxied by the Chicago Board Options Exchange Market Volatility Index (VIX)—have been key determinants of net inflows to the region.

The analysis found that U.S. monetary policy was a more important driver of net capital flows to Asia than was domestic monetary policy. In fact, a 1 percentage point increase in U.S. short-term interest rates was estimated to reduce the ratio of net capital inflows to GDP by 0.3 percent after one quarter (Figure 10.5). Conversely, domestic short-term rates were found not to have a significant impact on net capital inflows. The coefficient associated with the QE dummy variable was estimated to be positive and significant in some model specifications, suggesting that the Federal Reserve’s QE programs may have boosted net capital flows to the region. In contrast, dummies for quantitative easing operations conducted in the United Kingdom and Japan were found not to be significant.

Figure 10.5Asia: Quarterly Response of Net Capital Inflows to Domestic and External Variables


Source: IMF staff estimates.

Note: VIX = Chicago Board Options Exchange Market Volatility Index.

Domestic GDP growth has also been an important determinant of net capital inflows, with a 1 percentage point increase in growth estimated to boost the ratio of net capital inflows to GDP by 0.2 percent after a quarter. U.S. GDP growth by itself was not found to be a significant factor in explaining net capital flows to Asia, but in an alternative model specification, the growth differential between Asian economies and the United States was found to be a significant driver of capital inflows to the region. Investor risk appetite also plays a part in explaining net capital flows to Asia. A 1 percentage point rise in the VIX—indicating an increase in uncertainty and a decline in global risk appetite—is associated with a reduction in net capital inflows by close to one-tenth of a percent of GDP after a quarter. Institutional country characteristics, although not explicitly modeled, played a role in explaining cross-country differences in the net capital flow movements, as indicated by the high significance of cross-section fixed effects. Similar findings were obtained when net inflows excluding FDI were used as a dependent variable, instead of total net inflows.

A model of gross capital inflows to Asia over the same period was also estimated (Annex 10.1).2 Results indicate that gross capital inflows are not very sensitive to U.S. short-term interest rates, and that, instead, they mostly respond to domestic growth, U.S. growth, or the differential between the two growth rates—as well as to the VIX and a dummy for U.S. QE.

Prospective Capital Flows: What Will Shape Capital Flows to and Within Asia?

The empirical analysis provided some insights on what explained net capital flows to Asia in the past. Now, however, the relevant question is: What is the outlook for capital flows? Because Asia is expected to remain a global growth leader, it will very likely continue to receive large capital flows. Nevertheless, a number of global and regional factors will affect interregional and intraregional flows, and most likely will also contribute to capital flow volatility. In the short to medium term, the Federal Reserve’s exit from unconventional monetary policy and the normalization of global interest rates will likely play a role. The Bank of Japan’s (BoJ’s) QQE program could also have an impact on capital flows to and within the region. Beyond the medium term, capital flows to and within Asia will be largely shaped by capital account liberalization, most notably in China. Other factors, such as financial integration within and outside the region, financial development, and savings patterns—in turn driven by demographics—also are expected to shape capital flow movements, including within the region. These aspects are discussed in the next section of this chapter.

Factors Shaping Capital Flows in the Short to Medium Term

Monetary Policy Normalization in the United States

Since May 2013, expectations of a gradual unwinding of QE by the Federal Reserve have led to significant portfolio adjustments on the part of global investors. As a result, capital flows to Asia reversed sharply. The QE program ended in 2014, and U.S. policy rates are expected to start rising in 2015. Given the sensitivity of Asian capital flows to those U.S. policy rates, a rate hike in the United States could lead to a temporary reversal of capital flows in Asia. However, solid domestic GDP growth, especially compared with that of the United States and other advanced economies outside of Asia, will likely continue to attract capital flows to the region in the short to medium term.

Quantitative and Qualitative Monetary Easing in Japan

The BoJ initiated its QQE program in April 2013, as part of Prime Minister Abe’s three-pronged strategy to exit deflation and lift growth. The BoJ’s plan to double the monetary base by about ¥130 trillion (27 percent of GDP) in two years—coupled with concerns about increases in U.S. interest rates—could trigger capital outflows from Japan to other countries in and outside Asia in the short to medium term.

Japanese investors have often been net purchasers of foreign assets (mostly foreign bonds and notes) in the past decades, with an average of about ¥12½ trillion (less than 3 percent of GDP) in purchases per year and never exceeding ¥25 trillion (about 5 percent of GDP) per year. QQE will likely have an impact on Japanese capital outflows through the following channels (IMF 2012c, 2013b):

  • Firms expanding abroad—Japanese firms have increasingly moved abroad, often to the Asian region, to reduce production costs and exploit local markets, with a positive impact on destination countries’ growth. A rise in domestic inflation from QQE, accompanied by depreciation of the real effective exchange rate, could slow the rising trend of outward FDI flows.3 However, outward FDI is a long-term trend, because firms aim to locate where demand is growing and take advantage of cost differentials. Therefore, a reversal of increasing overseas production or FDI abroad is unlikely, given the relatively high rates of return on these investments.

  • Rebalancing of portfolio flows—QQE and a sustained difference in monetary policy stance between the BoJ and other major central banks are expected to trigger a shift in the portfolio composition of Japanese investors—especially financial institutions—away from domestic government bonds and into riskier financial instruments, including foreign assets.

Portfolio rebalancing of Japanese financial institutions is progressing. Domestic banks have reduced their holdings of Japanese government bonds since April 2013 and increased outward portfolio investment. But they have also accumulated significant excess reserves at the BoJ, which could be used for further foreign portfolio investment in the future. Holdings of foreign securities have picked up somewhat for public pension funds, but only modestly for insurance companies and private pension funds (Figure 10.6). Nevertheless, the following factors suggest that more capital outflows could take place in the coming years:

Figure 10.6Japan: Outward Portfolio Investment and Foreign Security Holdings

Sources: Bank of Japan; and IMF staff estimates.

Note: QQE = quantitative and qualitative easing.

  • Insurance companies have announced a gradual diversification toward foreign securities in the medium term in their investment plans, although few insurers intend to substantially unwind their Japanese government bond holdings.

  • Japan’s Government Pension Investment Fund—with total investment assets of about 27 percent of GDP—has revealed plans to gradually diversify toward emerging markets for higher yields in the medium term. Benchmark limits on investment in risky assets, which have constrained the acquisition of foreign bonds and equities, were eased in June 2013, resulting in an increase in foreign security holdings (Figure 10.6).4

  • Households in search of higher yields could reallocate more of their savings toward foreign assets, which currently represent only 2½ percent of household financial assets.

Bank Lending Abroad

As QQE encourages financial institutions to shift away from government bonds, Japanese banks will likely increase domestic lending as well as foreign lending, especially to other Asian economies, to boost profits. Overseas activity of Japanese financial institutions has already risen significantly since the middle of the first decade of the 2000s (Box 10.1), and access to ample liquidity under QQE is likely to provide a further boost to cross-border expansion.

An illustrative scenario analysis assuming that Japanese investors broadly maintain the current portfolio composition in their overseas investment strategies suggests that potential capital outflows could be $80 billion to $100 billion (1.6 to 2.0 percent of GDP—IMF 2014a). This analysis takes into account the easing of benchmark limits for the Government Pension Investment Fund, rising interest rate differentials with the United States, domestic credit demand growth, and banks’ large excess reserves. If Japanese investors were to change their strategies, that is, if they were to more aggressively rebalance their portfolios toward foreign securities, capital outflows could be higher, as much as $260 billion (about 5 percent of GDP). A large portion of rebalancing would likely be toward North America and Europe, which historically have been the recipients of about 70 percent of both Japanese portfolio and bank lending flows. Although Asian emerging markets would likely receive a smaller share, the estimated potential capital flows to these economies could be as much as $30 billion—more than half of their peak reserve loss during 2013.

Factors Shaping Capital Flows in the Medium to Long Term

Capital Account Liberalization

Financial accounts in Asia are less open than they are in other regions (Figure 10.7). Based on the Chinn-Ito index,5 although the capital account openness of some Asian economies (Hong Kong SAR, Japan, New Zealand, and Singapore) is comparable to that in the euro area and North America, other countries maintain considerable capital flow restrictions. For low-income economies in particular, capital account liberalization would likely induce further FDI inflows, given their growth prospects and recent trends.

Figure 10.7The Chinn-Ito Index of Financial Openness, 2012

(Index number)

Source: Chinn and Ito (2006).

Note: Em. Europe/CIS = emerging Europe and the Commonwealth of Independent States.

Box 10.1.Cross-Border Activities of Japanese Financial Institutions

Cross-border activities of Japanese financial institutions have risen since 2005, particularly to the Asian region, with a temporary decline during the global financial crisis. Cross-border consolidated claims of Japanese banks abroad reached nearly $3 trillion (about 30 percent of total banking and trust assets) in December 2013—growth of 40 percent since 2005. Claims on Asia have more than doubled since the global financial crisis and now account for about 10 percent of total foreign consolidated claims (Figure 10.1.1).

Figure 10.1.1Consolidated Foreign Claims for Japanese Banks

(Billions of U.S. dollars)

Source: Bank for International Settlements.

Japanese banks expanded their overseas networks through various forms of ownership. Besides setting up local branches and subsidiaries, banks have sought to expand their customer bases and business functions through business alliances and investments in overseas financial institutions. They have also sought to exploit different ownership structures tailored to local markets. As a result, major Japanese banks have attained an important global and regional presence, especially in the areas of syndicated lending and project finance, and now overseas gross profits account for about 30 percent of total gross profits. At the same time, major brokerage firms and life insurers have sought acquisitions or strategic partnerships overseas, especially in Asia.

Empirical analysis indicates that limited domestic credit demand owing to stagnant growth has created incentives for Japanese banks to seek opportunities abroad (Lam 2013). Also, abundant yen liquidity, supported by a stable deposit base, and strengthened capital ratios have allowed Japanese banks to take on more foreign exposure. Large financing needs for infrastructure in emerging Asia, increasing outward foreign direct investment and trade links of Japanese firms, robust growth in Asia, and European bank deleveraging in the region have offered new business opportunities abroad for Japanese banks. Higher interest rates in destination countries have provided an additional incentive to expand overseas.

The expansion trend overseas is likely to continue under the quantitative and qualitative monetary easing framework. Ample liquidity in the domestic market will act as a push factor for banks’ lending activity both domestically and abroad. Japanese financial institutions would benefit from a more diversified income base as they expand abroad, although they may want to use a gradual and cautious approach in overseas strategies given that they will need to maintain adequate capital ratios under the global regulatory reform agenda (for example, Basel III). Furthermore, rapid expansion could lead Japanese financial institutions to buy foreign assets at high prices or enter into unfamiliar local markets. This could, in turn, lead to heavy losses as occurred in the late 1980s and 1990s. Higher overseas exposure may add to risks that would require continued close monitoring by supervisory authorities, which would be accompanied by an increase in cross-border supervision challenges.

China and India are the largest Asian economies, and they have relatively closed financial accounts. Their liberalization could have a significant impact on capital flows to and within the region in the medium to long term. Existing evidence, however, suggests that capital account liberalization in India would not have a very large global effect, given that restrictions have already not been truly binding, and the scale of potential flows is lower (Ma and McCauley 2013; Bayoumi and Ohnsorge 2013).6 For this reason, this section focuses on developments and implications of capital account liberalization in China.

According to both de jure and de facto measures, China’s capital account is still relatively closed. Besides scoring low for financial openness according to the Chinn-Ito de jure index, China ranks 138th in its ratio of international assets and liabilities to GDP, a widely used index of de facto financial openness. Moreover, the spreads between implied returns on currency forwards in China and the offshore renminbi markets—another measure of de facto financial openness—have been persistently high, indicating that capital flows have remained restricted despite the increasing share of foreign assets and liabilities in GDP (Ma and McCauley 2013).

Some gradual steps toward liberalization have already been taken (Box 10.2), and capital account liberalization has been listed among the key reforms in the authorities’ blueprint announced in 2013. Steps, yet to be defined, will likely include further expanding the list of qualified domestic and international investors for outward and inward foreign portfolio investment transactions, and gradually increasing quotas. The Shanghai Free Trade Zone has been launched, and a pilot program loosening certain restrictions in the zone is being rolled out. In parallel, the Chinese authorities are actively promoting the internationalization of the renminbi for transactions among nonresidents.7

Size of Potential Flows

How large could the potential flows from further capital account liberalization in China be? The adjustment in the gross investment position could potentially be very large. Chinese assets abroad and foreign assets in China are currently much smaller than what would be expected given the scale and characteristics of the Chinese economy, and also in light of other countries’ experiences (He and others 2012; Bayoumi and Ohnsorge 2013).

Estimates point to a potentially large expansion in China’s outward portfolio position, and a smaller increase in its inward portfolio position. These estimates are based on the sensitivity of capital inflows and outflows to changes in capital account restrictions in a sample of emerging markets. The adjustment of Chinese assets abroad—mostly reflecting portfolio diversification—could be on the order of 15 percent to 25 percent of GDP, while the adjustment of foreign assets in China could be on the order of 2 percent to 10 percent of GDP. This would imply a net accumulation of Chinese net international assets of 11 percent to 18 percent of GDP ($1 trillion to $1.5 trillion, or 1.3 to 1.2 percent of the world’s GDP—Bayoumi and Ohnsorge 2013). Other analyses also point to a projected increase in the net outward position of about 10 percent of GDP (nearly $1 trillion, or 1.3 percent of the world’s GDP) by 2020 (He and others 2012). It is difficult to speculate about the destination of such outflows, given that data on the current geographical composition of China’s outward portfolio investment are not available.

Similarly, China’s outward FDI position will likely increase by more than inward FDI. He and others (2012) estimate that the stock of outward FDI could increase by 22 percent of GDP by 2020, while inward FDI could rise by 11 percent of GDP during the same period. This would imply net FDI outflows of 11 percent of GDP ($1 trillion, or 1.3 percent of world GDP). A large portion of flows could be directed to the rest of Asia, which is currently the recipient of 85 percent of China’s FDI. Continuing the trend of the past few years, low-income countries in Asia, especially those with large natural resources, would likely be among the recipients of FDI.

Box 10.2.China: Steps toward Capital Flows Liberalization and Their Impact

China has been taking gradual steps toward liberalizing capital flows.

Inward foreign direct investment (FDI) and its liquidation remain subject to approval requirements, but since early 1990, administrative barriers have been gradually eased. As a result, inward FDI annual flows increased from less than 1 percent of GDP in 1990 to 3.1 percent of GDP in 2012, making China the destination for 18 percent of global FDI and the world’s largest recipient.

Outward FDI has been largely liberalized, even though investments are still subject to administrative regulations and approvals. Although China’s outward FDI stock in 2012 amounted to only 6.1 percent of GDP (compared with 31.3 percent of GDP in the United States), it increased sharply from $64 billion in 2005 to $503 billion in 2012 and it is now the world’s fifth largest (Figure 10.2.1).

Figure 10.2.1Qualified Foreign and Domestic Institutional Investors

(Accumulated approved investment fund)

Source: IMF staff calculations.

Note: QDII = qualified domestic institutional investor; QFII = qualified foreign institutional investor; RQFII = renminbi qualified foreign institutional investor.

Portfolio investment is subject to tight, but gradually increasing, quotas:

  • Inward portfolio investment is channeled through qualified foreign institutional investors, subject to a three-month lock-in period and an aggregate ceiling. In 2011, a Renminbi Qualified Foreign Institutional Investors scheme was established to allow qualified investors to invest offshore renminbi in domestic securities markets, with certain restrictions on asset allocation and subject to an overall ceiling. In 2013 the scheme was further expanded, and restrictions on asset allocation were loosened. In addition, eligible institutions outside of mainland China may invest in China’s bond market, subject to limits but not lock-in periods.

  • Outward portfolio investment is channeled through qualified domestic institutional investors, subject to institution-specific ceilings. Under this program, licensed domestic institutions are allowed to raise funds from domestic investors to invest in foreign capital markets. Since the program was launched in 2006, the investor base has gradually expanded to include banks, mutual funds, and retail investors. The scope of eligible investment instruments has also been broadened.

Other investment. Foreign borrowing is subject to a ceiling or approval requirements, but lending abroad is largely unrestricted. The holding of cross-border accounts also requires approval. Domestic correspondent banks may offer renminbi financing accounts to banks participating in foreign renminbi operations within certain limits and maturities. Hong Kong SAR and Macao SAR renminbi clearing banks may participate in the domestic interbank market.

However, even though the literature points to a substantial increase in Chinese net foreign assets in the postliberalization equilibrium, arbitrage conditions will likely continue to play a major role in driving capital flows in the short to medium term, for a number of reasons including the following:

  • Non-FDI capital flows to China have been sensitive to arbitrage conditions even under restrictions. Regression analysis confirms that appreciation expectations play a major role in driving these flows, together with U.S. interest rates and growth prospects in China. Appreciation expectations are probably a better proxy for return on investment than are interest rates, which were heavily regulated in the past (Table 10.1).

  • Arbitrage could continue to attract capital inflows after opening up. Projected productivity developments in tradable and nontradable sectors will likely lead to further appreciation pressures of the renminbi in the medium term driven by Balassa-Samuelson effects.8 At the same time, financial market liberalization—another key reform in the Chinese authorities’ blueprint announced in 2013—will likely bring interest rates closer to a “natural” level consistent with relatively high marginal product of capital.9 The correction of exchange rate undervaluation, trend appreciation, and the high natural interest rate all constitute strong incentives for inflows.

Table 10.1Determinants of Non-FDI Capital Flows to China, January 2002 to November 2013
Interest differential10.5610.9830.769**
Standard error0.5480.6020.323
12-month NDF premium2−2.173***−2.544**−2.161***
Standard error0.5811.0080.414
Output growth in China30.875**1.256*0.776***
Standard error0.4230.6720.273
Lagged non-FDI flow0.427***0.405***0.371***
Standard error0.0690.0780.041
Durbin-Watson statistics1.8721.781.745
Source: IMF staff estimates.Note: Heteroscedasticity autocorrelation robust standard errors are reported. ARCH = autoregressive conditional heteroscedasticity; FDI = foreign direct investment; OLS = ordinary least squares.

Interest differential = China one-month repo – U.S. one-month Treasury bill rate.

The NDF premium is measured by the gap between the non-deliverable forward (NDF) on renminbi and the renminbi/U.S. dollar spot rate and defined as 100×(NDF-spot)/spot, capturing appreciation expectations.

Output growth in China—capturing growth prospects—is the monthly growth rate of industrial production.

*p < .1; **p < .05; ***p < .01.
Source: IMF staff estimates.Note: Heteroscedasticity autocorrelation robust standard errors are reported. ARCH = autoregressive conditional heteroscedasticity; FDI = foreign direct investment; OLS = ordinary least squares.

Interest differential = China one-month repo – U.S. one-month Treasury bill rate.

The NDF premium is measured by the gap between the non-deliverable forward (NDF) on renminbi and the renminbi/U.S. dollar spot rate and defined as 100×(NDF-spot)/spot, capturing appreciation expectations.

Output growth in China—capturing growth prospects—is the monthly growth rate of industrial production.

*p < .1; **p < .05; ***p < .01.

The size and direction of flows will depend on the interplay between portfolio diversification and arbitrage flows, with risk premiums playing a major role. Given the large gap between “equilibrium” and the current foreign asset position, incentives for diversification will likely be strong. Moreover, relatively weaker institutional development in China could become an additional incentive for outflows, reducing arbitrage incentives through risk premiums. But these factors could still be outweighed by appreciation pressures and higher interest rates. Given the size of potential flows and the weight of the Chinese economy, potential implications of opening up for the region are significant:

  • Opening up of the capital account could magnify short-term risks. Financial markets in China are still relatively shallow, and the reaction of asset prices to sudden swings in capital flows could be destabilizing. In particular, liberalization could have immediate repercussions for China’s real estate market. Given that real estate has been one of the key drivers of growth, a price correction and a slowdown in the market could affect economic activity, with strong international spillovers. A sharp price correction would have a particularly large effect on Japan and Korea (Ahuja and Myrvoda 2012).

  • Expanding investment opportunities for Chinese households could lead to lower incentives for precautionary savings in the longer term, and possibly result in higher global interest rates (Nabar 2011).

  • Inflows could still dominate at the early stage of liberalization, generating a typical boom and bust cycle. The results of a boom-bust could create strong spillovers, both directly through economic activity and trade linkages, and indirectly through the perception of regional risks.

  • Liberalization would also change the role of the renminbi in the region. Opening up of the capital account and greater exchange rate flexibility will help diversify risks and free monetary policy in China. But the implications for the region would be more mixed. Fixed exchange rates in China proved to be a stabilizing force during times of financial turbulence in the past, for example, by helping crisis-struck countries restore competitiveness faster during the Asian crisis of the late 1990s. Greater renminbi flexibility and potentially large fluctuations related to capital flows could require stronger and faster policy responses in the region. Moreover, significant advances in the internationalization of the renminbi could amplify the transmission of Chinese policy and domestic shocks.

Other Medium- and Long-Term Drivers of Capital Flows

While China’s capital account liberalization process is likely to be the main factor affecting the size and direction of capital flows to and within Asia in the medium to long term, other variables will also be at play, including the following:

  • Financial development—Differences in the speed and pattern of financial sector deepening can create changes in the demand for, and supply of, domestic and foreign financial assets. Residents in Asian economies with less-developed financial markets, and hence limited domestic access to financial instruments, may have high demand for instruments issued in countries with deeper and more diversified financial sectors. However, as local financial markets develop, the pattern of demand for domestic versus foreign assets may change.10 Similarly, foreign investors will likely increase their demand for Asian financial instruments as local markets deepen and become more liquid. For example, foreign holdings of Asian bonds have grown since the middle of the first decade of the 2000s as local bond markets developed (see Chapter 5).

  • Financial integration—A number of initiatives are under way to strengthen regional financial markets and promote integration in Asia. These include regional economic surveillance processes in the Association of Southeast Asian Nations (ASEAN) and ASEAN+3, the Chiang Mai Initiative, the Asian Bond Markets Initiative, and the Asian Bond Fund Initiative. The push for integration is particularly strong in ASEAN (see Chapter 9). The development of cross-border financial regulation and practices will have an impact on the capital flow pattern within the region.

  • Savings and demographics—A high share of economically inactive dependent population is typically associated with lower national savings, with an impact on current account balances and capital flows (Higgins 1998; IMF 2008). Aging trends within Asia are expected to become more diverse, with population aging projected to intensify, especially in China, Japan, and Korea (see Chapter 8), with possible implications for capital flow movements.

Policy Implications: Building Resilience and Reaping the Benefits of Capital Flows

Several important factors will shape the size and composition of capital flows to and within Asia in the short to long term. Although it is not possible to predict how all of these drivers will interact and what the final outcome will be, Asia is likely to remain the recipient of large capital flows, given the prospects of sustained strong regional growth, increasing financial openness, and deepening capital markets. It is also clear, though, that significant changes in capital flow movements may occur, and volatility is likely to persist. Although these flow movements could bring important benefits to Asia by providing new financing for productive uses, they will also create challenges.

Abundant inflows can inflate asset prices and fuel credit booms and imbalances in some sectors. These inflows can also generate strong exchange rate appreciations, eroding competitiveness and possibly creating currency risks in firm and household balance sheets. In addition, capital flow volatility can contribute to boom-bust cycles (IMF 2011). Therefore, a range of policy tools is needed to build resilience against these risks, while reaping the benefits of capital flows.

Sound macroeconomic policies will be essential to build resilience as well as to manage capital flow volatility. Strong microprudential policy, including effective supervision and enforcement, will also be crucial to contain and address vulnerabilities in individual financial institutions. However, in the past these tools have proved to be insufficient to contain systemic risk. Therefore, policymakers in Asia and other regions have increasingly used a range of policy tools that explicitly focus on system-wide vulnerabilities—macroprudential policies. Have these measures been effective in Asia? And can they help in the future?

Asia’s Experience with Macroprudential Policy

Zhang and Zoli (2014) analyze a sample of 13 Asian economies and 33 economies from other regions since 2000 and find that Asia has made extensive use of housing-related macroprudential measures—especially loan-to-value caps. In fact, Asia has done so to a larger degree than has other regions. Changes in reserve requirements on local currency deposits have also been quite common, both in Asia and elsewhere, probably reflecting their use as a monetary policy tool.11 However, other liquidity tools, such as credit limits, dynamic provisioning,12 restrictions on consumer loans, and capital measures, have been rarely used in Asia. Measures to discourage transactions in foreign currency have been deployed less frequently in the region than they have been in Central and Eastern Europe and the Commonwealth of Independent States—where foreign-exchange-denominated or indexed loans were widespread—and Latin America. Residency-based capital flow management measures have been employed only to a small extent in Asia.

There is significant cross-country heterogeneity in the tools that have been used in Asia since 2000, because Asian economies had to confront different potential threats to financial stability. New Zealand introduced a minimum requirement on core funding and has revised its macroprudential framework to introduce countercyclical capital buffers, overlays to sectoral capital requirements, and loan-to-value restrictions. Hong Kong SAR and Singapore have predominantly relied on housing-related tools. Korea, in addition to housing measures, imposed a levy on bank non-deposit foreign currency liabilities and a ceiling on bank foreign exchange derivative positions. China and India have been heavy users of reserve requirements (as a monetary policy tool). Among ASEAN economies, domestic prudential tools and reserve requirements on foreign exchange deposits have been used. Capital flow measures have been adopted in Indonesia and Thailand, including minimum holding periods for central bank bills in the former, and withholding taxes for nonresident investors in the latter.

To get a sense of how macroprudential and capital flow management policies evolved and built up over time in Asia and other regions, two aggregate indices were constructed—one for macroprudential policies and one for capital flow measures.13 Based on these indices, there appears to have been a structural tightening of the macroprudential policy stance that is particularly pronounced in Asia (Figure 10.8). Macroprudential policies were most heavily used in the precrisis boom period during 2006–07, and then again after the crisis, as capital flowed back into the region and asset prices inflated. By contrast, Asian economies have tightened residency-based capital flow measures or instruments to discourage transactions in foreign currency less frequently than have other regions.

Figure 10.8Use of Macroprudential Policies and Capital Flow Management Measures by Region

Source: IMF staff calculations.

Note: CEE/CIS = central and eastern Europe and Commonwealth of Independent States.

1 Index summing up housing-related measures, credit measures, reserve requirements, dynamic provisioning, and core funding ratio. Simple average across countries within country groups.

An empirical investigation of the effectiveness of macroprudential and capital flow management measures in Asia from 2000:Q1 through 2013:Q1 suggests that housing-related macroprudential instruments contributed to the reduction in credit growth, house price inflation, and bank leverage in the region (Zhang and Zoli 2014).14 Housing-related instruments that have been particularly effective include loan-to-value ratio caps and housing tax measures. On average, a tightening in housing-related tools is estimated to have reduced credit growth in Asia by 0.7 percentage point after a quarter and by 1.5 percentage points after a year. The impact of these instruments on housing price inflation has been larger: a tightening in housing-related measures is estimated to have lowered house price growth by 2 percentage points after one quarter.

Other non-housing-related domestic macroprudential tools, measures to discourage transactions in foreign currency, and residency-based capital flow management measures have not had a significant impact on lending, leverage, housing price growth, or portfolio inflows in Asia. Nevertheless, these policies may have affected the distribution of risks in the financial system and the resilience of the system to systemic pressures. For example, foreign-exchange-related macroprudential policy can contain currency, maturity, and liquidity mismatches within the banking system, without having a strong impact on loan growth and asset prices. Indeed, foreign-exchange-related measures have helped mitigate vulnerabilities from short-term foreign borrowing in Korea (Box 10.3). However, it has to be recognized that macroprudential policy also entails costs, mainly arising from higher intermediation charges and their effect on long-term output (Arregui and others 2013).

Because macroprudential policies appear to have helped mitigate the buildup of financial risks in Asia, they can play an important role in the future in managing systemic risks from capital flow volatility in the region. But how can the region’s existing macroeconomic policy framework be further enhanced? One relevant issue is how macroprudential policy could be used in the event of asset price declines, slowing credit growth, or capital flow reversals. Although macroprudential policies have sometimes been loosened in a countercyclical fashion, most notably in 2008–09 as the global financial crisis unfolded, more experience needs to be gained on whether and how these instruments should be recalibrated when the financial cycle turns. Nevertheless, theory suggests that a loosening of macroprudential policies should be considered to prevent excessive deleveraging in the downward phase of the financial cycle.15

Box 10.3.Foreign-Exchange-Related Macroprudential Policy in Korea

Korea has traditionally been highly vulnerable to capital flow reversals, mainly owing to short-term borrowing in the banking sector that creates maturity mismatches and foreign exchange liquidity problems. The aggregate short-term external debt of Korean banks reached $160 billion in 2008:Q3—a sharp increase from the $60 billion level it reached in 2006:Q1. However, in the four months following the Lehman Brothers bankruptcy, nearly $70 billion left the country. The volatility of capital flows was higher in Korea than it was in other economies during the global financial crisis (Ree, Yoon, and Park 2012).

To mitigate vulnerabilities from short-term foreign borrowing, Korea adopted a series of macroprudential policies beginning in June 2010, including a ceiling on banks’ foreign exchange derivatives positions and a macroprudential stability levy on noncore foreign exchange liabilities. The former measure was intended to reduce maturity and currency mismatches. The ceiling is designed to be adjusted depending on the credit cycle. The stability levy is a tax on banks’ noncore foreign currency liabilities. It is also adjustable and can be used as a countercyclical tool when capital flow surges seriously threaten financial stability, with the maximum rate of 50 basis points. Its proceeds flow into the Foreign Exchange Stabilization Fund, which is separate from the government budget and can be used as a buffer in the event of a financial crisis. Other important measures include limits on foreign currency bank loans and prudential regulations to improve the foreign exchange risk management of financial institutions.

While Korea’s experience in the use of these tools is limited, preliminary evidence suggests that the tools have been effective in containing overexposure to funding shocks and putting a brake on procyclical lending. Indeed, banks’ short-term net external debt, including that of foreign bank branches, declined steadily from $153 billion in June 2010 to $126 billion in December 2012, and the short-term external debt ratio fell continuously, reaching 30.6 percent by the end of 2012, after peaking at 51.9 percent in the third quarter of 2008 (Figure 10.3.1). The sensitivity of capital inflows to global conditions fell after the imposition of the levy, relative to a comparison group of countries (Bruno and Shin 2012). Rollover risks for domestic banks also fell because their external debt maturities lengthened (IMF 2012a). The sensitivity of exchange rate volatility to changes in the Chicago Board Options Exchange Market Volatility Index (VIX) declined, too, reflecting lower foreign exchange liquidity mismatches (Ree, Yoon, and Park 2012).

Figure 10.3.1Korea: Macroprudential Policy and Bank Foreign Exchange Liabilities

Sources: Bank of Korea; and IMF staff calculations.

Against this background, consideration could be given to the adoption of countercyclical capital requirements and dynamic provisioning, which, at present, barely exist in Asia.16 These could be helpful instruments in a context of high volatility, because they are specifically designed to build buffers during the upswing phase of the cycle that can be used during a downswing (Ghilardi and Peiris 2014; IMF 2014c). Even though there is little empirical evidence about their effectiveness, these instruments seem particularly useful in increasing resilience, as well as the predictability of regulatory changes through the cycle.17

In addition to macroeconomic policy and micro- and macroprudential measures, other policy initiatives can strengthen Asia’s resilience to shocks and its ability to cope with the volatility of capital flows. Continuing ongoing efforts to develop local currency bond markets would further reduce the use of short-term—and, hence, more volatile—inflows from outside Asia to finance long-term investment projects. Enhancing cooperative mechanisms, such as the Chiang Mai Initiative, making them more operational, and strengthening regional surveillance from within the region would also improve Asia’s resilience and ability to respond to funding shocks.

Channeling Capital Inflows to Productive Use

In spite of the policy challenges they create, capital flows can bring important benefits to Asia. They can help finance domestic productive investment projects, contribute to the development of financial markets, enhance international risk sharing, facilitate technology transfer (for example, through foreign direct investment), promote trade, and contribute to greater consumption smoothing.

Capital flows could also provide financing to address two important issues in the region, namely financing constraints for small and medium-sized enterprises and shortfalls in infrastructure. The channeling of capital flows to productive uses could be facilitated by measures to further develop bond and equity markets. These measures would include enhancing and streamlining disclosure requirements for bond and equity issuances; improving transparency about issuers, for example, through standardized reporting and wider credit scoring; enhancing central clearing counterparties to reduce counterparty risks; and strengthening the legal and regulatory framework as well as corporate governance (Chapter 5).


Since 1990, capital flows to Asia have been large but volatile, creating opportunities as well as significant challenges for policymakers. In the period following the Asian financial crisis, net capital flows to the region were mainly driven by high domestic GDP growth (which was also high in comparison with U.S. growth), U.S. interest rates, and investor risk appetite. These factors will likely continue to play a role. U.S. monetary policy will probably have an impact in the short to medium term. In the same time frame, the BoJ’s QQE program will also affect capital flows to and within the region, mainly through its impact on portfolio rebalancing and bank cross-border lending. In the medium to long term, China’s capital account liberalization could have significant implications for capital flow movements, although views differ on whether net capital inflows or outflows to the country will prevail. Financial market development, financial integration, and changes in savings patterns will also likely continue to affect capital flows to and within Asia.

All of these factors will contribute to capital flow volatility, requiring policymakers to take preemptive measures. Macroeconomic and microprudential policies will be essential tools for strengthening resilience, but macroprudential policy can also help mitigate systemic risks. Indeed, empirical evidence shows that Asia’s experience with macroeconomic policy has been positive. The existing macroprudential toolkit could be further enhanced in the future with the adoption of countercyclical requirements and dynamic provisioning, which appear to be suitable instruments to strengthen resilience and respond to volatility. Policy measures to foster the development of bond and equity markets could help channel capital flows to their most productive uses.

Annex 10.1. Empirical Analysis of Drivers of Capital Flows to Asia in the Post–Asian Crisis Period

A number of empirical studies have assessed the impact of U.S. interest rates and the Federal Reserve’s QE program on capital flows to advanced economies and emerging markets, but the focus was not specifically on Asia. Among the most recent studies, IMF 2011 finds a negative impact from a hike in the U.S. rate on net capital flows, which is more pronounced when the rate increase is unanticipated. Fratzscher, Lo Duca, and Straub (2013) find that U.S. unconventional monetary policy has had a sizable impact on capital flows to emerging economies, but those effects were relatively low compared with other factors. Ahmed and Zlate’s (2013) empirical analysis indicates that U.S. unconventional monetary policy has not had a significant impact on net flows to emerging markets.

Unlike the existing literature, the model presented in this chapter focuses on Asian economies. The model is a cross-section and time fixed-effects panel.18 The dependent variable is net capital flows as a percentage of GDP. The explanatory variables include the domestic short-term interest rate; domestic real GDP growth; U.S. real GDP growth (or the differential between domestic and U.S. growth); the U.S. short-term interest rate; the VIX, as a proxy for investor risk appetite; changes in the nominal effective exchange rates; and a dummy taking the value of 1 when the Federal Reserve’s QE programs were introduced. Regression results are reported in Annex Table 10.1.1.

Annex Table 10.1.1Regression Results: Determinants of Capital Flows to Asia
Dependent Variable
Net Capital Flows as a Percentage of GDPGross Capital Inflows as a Percentage of GDP
Lagged domestic rates0.
Lagged U.S. short rates−0.3−0.3−0.3−0.2−0.2−0.2
Lagged VIX−0.1−0.1−0.1−0.4−0.4−0.5
QE dummy1.
Lagged domestic growth0.
Lagged U.S. growth0.00.0−0.9−0.9
Lagged growth differential0.21.7
Lagged D(NEER)0.10.0
Source: IMF staff calculations.Note: NEER = nominal effective exchange rate; QE = quantitative easing; VIX = Chicago Board Options Exchange Market Volatility Index.
Source: IMF staff calculations.Note: NEER = nominal effective exchange rate; QE = quantitative easing; VIX = Chicago Board Options Exchange Market Volatility Index.

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Yitae Kim, Raphael Lam, and Jongsoon Shin also contributed to this chapter. The authors thank Jingzhou Meng and Sidra Rehman for excellent research assistance, and Joong Shik Kang, Kwok Ping Tsang, Jerry Schiff, Chikahisa Sumi, and Jianping Zhou for helpful comments.

See Annex 10.1 for background information on the empirical analysis and regression results.

Studies on capital flow volatility emphasize the importance of analyzing gross capital flows instead of just net flows (for example, Forbes and Warnock 2012; Milesi-Ferretti and Tille 2011).

Empirical evidence suggests that, for instance, a 10 percentage point depreciation in the real effective exchange rate would slow the overseas production ratio by 1.3 percentage points.

Under the new policy mix, the Government Pension Investment Fund can invest 12 percent (±5 percent) and 11 percent (±5 percent) of assets in foreign stocks and bonds, respectively.

The Chinn-Ito (2006) index is a commonly used measure of capital account openness, based on the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions.

India’s existing portfolio assets are much lower than are China’s. Indeed, India’s bond and stock market sizes are about one-quarter of China’s (Bayoumi and Ohnsorge 2013).

Trade settlement in renminbi now accounts for nearly 20 percent of China’s total trade, and the renminbi is also widely used for trade financing. At the same time, offshore renminbi markets have been developed in Hong Kong SAR, Singapore, and London, and China has signed currency swap agreements with numerous countries.

Balassa-Samuelson effects refer to increases in productivity and wages in the tradable goods sector that lead to higher wages in the nontradable (services) sector, and appreciation of the real exchange rate.

He, Wang, and Yu (2014) estimate the “natural” interest rate to be about 4½ percent.

Theoretical models on the relationship between financial development and capital flows are presented, for example, in Caballero, Farhi, and Gourinchas 2008.

Reserve requirements are categorized as macroprudential policies in several studies (for example, IMF 2013c).

Dynamic provisioning requires building a cushion of reserves during the upswing phase of the business cycle that can be released when the cycle turns.

To construct these indices, first, changes in macroprudential policies and capital flow measures were coded numerically using a simple binary variable, taking on value 1 for tightening actions and -1 for loosening ones. Then, these dummy variables were cumulated over time since 2000. The macroprudential policy index aggregates housing-related and non-housing-related domestic prudential measures, while the capital flow measure index summarizes policy actions aimed at discouraging transactions in foreign currency as well as residency-based capital flow management measures. This categorization between macroprudential policy and capital flow measures involves some degree of judgment, given the overlap between certain macroprudential and capital flow management measures. Nevertheless, it tries to reflect as closely as possible the broad definitions of macroprudential and capital flow measures discussed in IMF 2012a and 2013b.

A number of empirical studies have tried to assess the effectiveness of macroprudential policies on a sample of countries from different regions, and typically find that some individual macroprudential instruments, such as loan-to-value caps, debt-to-income ratios, and reserve requirements, have been effective in curbing excessive credit and asset price growth (Lim and others 2011; Arregui and others 2013; Kuttner and Shim 2012). Other studies have provided illustrative evidence that macroprudential policy can contain credit booms (Dell’Ariccia and others 2012).

On theoretical grounds, the use of macroprudential policy as a countercyclical tool can be justified in a context in which financial frictions create procyclicality in the financial system, exacerbating business cycle fluctuations (for example, Angeloni and Faia 2013; N’Diaye 2009).

China introduced countercyclical capital requirements in 2010 and New Zealand introduced its countercyclical capital requirements framework in 2013.

Apart from theoretical exercises and assessments that are numerically simulated, empirical studies of how the countercyclical capital requirements mechanism actually works are absent. Jiménez and others (2012) provide some empirical evidence on the effectiveness of dynamic provisioning in Spain.

Cross-section fixed effects were included to control for institutional country characteristics (for example, institutional quality and restrictions on capital flows). Formal tests strongly reject the null hypothesis that these fixed effects are redundant.

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