How Capital Flows in the Midst of Excess Savings Affect Macrofinancial Vulnerability

Abstract

In contrast to the period prior to the 1997/98 Asian financial crisis, emerging East Asia today is a region with excess savings, particularly corporate savings. Beginning in the mid-2000s, liquidity was further amplified by massive capital flows, particularly bank-led flows, and subsequently by debt-led flows following the introduction of quantitative easing in the United States. Both types of inflows are critical for bank-dependent Asia in need of long-term financing for infrastructure development. Yet, these two types of capital flows are also the most volatile. The surge of inflows in the midst of excess savings helped raise liquidity and growth, but also posed serious challenges to financial stability. As revealed by flow-of-funds data, the risk-taking behavior of economic agents and their preferences toward financial assets increased. Bank-led flows increased noncore liabilities and caused a credit boom, elevating the risk of procyclicality, while debt-led flows raised the vulnerability to a reversal of flows. These inflows also lowered the effectiveness of monetary policy, underscoring the need to supplement standard measures with a more effective macroprudential policy.