Capital Flow Volatility and Contagion: A Focus on Asia

Abstract

This paper documents four trends in Asia: (1) the increase in the magnitude of gross capital inflows and outflows; (2) the larger magnitude of gross capital inflows relative to outflows in some countries; (3) the increase in the volatility of these capital flows; and (4) the steady increase in the comovement between equity markets over time. It then uses results from recent academic research to evaluate ways in which Asian economies can best mitigate risks from large and volatile capital flows. The analysis suggests that the best approach involves attention to the form of these capital flows and strengthening the domestic financial system rather than directly reducing total capital flows. For example, supporting capital flows in the form of equity, instead of debt, provides natural risk sharing and reduces domestic vulnerabilities. Supporting outward capital flows by domestic investors can provide an important form of stability, as domestic investors often “retrench” and bring money invested abroad home during periods of heightened risk. Finally, one of the most potent methods to stabilize economies against capital flow volatility is to reduce leverage in domestic banking systems. Recent increases in leverage in Asian banking systems suggest that this could be a source of increased vulnerability in the future.

Keywords: international capital flows, contagion, capital flow volatility, Asia, surges, stops, leverage, retrenchment

JEL Classification: F3, F4, F2, G01, F02