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The Positive Side Of Capital Inflows

International | May 02 2007

By Chris Shaw

A few days ago Chinese authorities lifted bank reserve requirement ratios in a continuation of recent attempts to limit the growth in liquidity the economy is experiencing as capital continues to flow into China in unprecedented amounts.

A report by ANZ Bank senior economist Katie Dean shows it is not just China dealing with these inflows but the entire region as net private investment inflows into Asia as a whole reached US$163bn last year, the third highest amount on record. Of this total, around US$70bn took the form of direct foreign investment.

Of course China was the primary destination, accounting for around US$116bn of the total, but the area generally has seen an ongoing increase in recent years. According to Dean the trend is no surprise given the combination of strong economic growth at the same time as inflation remains under control and economic policy throughout the region is becoming more credible.

This is providing a boost for corporate profits, which in turn is increasingly attracting the attention of global investors. The impact of the money flowing in is seen most clearly in a strengthening in local currencies, while at the same time it is providing a boost to liquidity levels. China is the perfect example of this, as the central bank has made a dozen adjustments in the past year in an attempt to stem excess liquidity, so far with little success.

Dean notes the response to the changing conditions by many countries in the region has been to liberalise exchange rate regimes and loosen previous capital account regulations, though Thailand is an example of an opposite reaction in that its government has tightened controls in an attempt to limit inflows.

China’s response has been to let the currency appreciate but very slowly, preferring instead to build up its international reserves, which now stand at something in excess of US$1trn. This represents an annual rate of increase of 39% over the past five years, more than double the region’s average of about 16%.

Dean expects the inflows to continue though it is unlikely to be at the same pace as now as global economic growth is likely to moderate a little in coming years given a tougher economic growth outlook in the US. Assuming the inflows do continue there are some implications for economic management, as many markets and economies in the region remain highly regulated by Western standards.

Included in this regulation is the use of dirty floats (where China is something of an example given the currency is widely considered undervalued yet Chinese authorities are progressing very slowly in terms of allowing it to appreciate) and closed capital accounts, but even these measures have not proven to be enough to fully sterilise the impact of the inflows.

This means domestic liquidity levels are increasing, which Dean notes presents a potential problem in that it in turn puts pressure on inflation. On the plus side the inflows will mean markets in the region will develop further and deregulate faster than may have otherwise been the case, which in turn will prove beneficial for the efficiency of capital allocation between Asia and the rest of the world.

This more efficient use of capital should generate increased productivity in the region, while at the same time allowing policy makers a greater range of options in terms of responding to the economic cycle and any unexpected developments. This should be good for development generally throughout the region and is likely to result in ongoing appreciation of the region’s currencies.

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