Asia has received sizable capital inflows before the Asian crisis in 1997. Capital inflows are contributed in part by internal factors such as high economic growth, liberalizing the financial system and opening the capital market, and in part by external factors such as low rates of interest in industrial countries, especially the United States. Capital inflows supplied finance needed for a high rate of investment, imports and economic growth. At the same time, capital inflows distorted relative good prices, fed bubbles into real asset markets and inflationary pressure into the economy.

Substantial capital inflows can give rise to microeconomic and macroeconomic policy issues. Especially, capital inflow surges increase the difficulty in managing monetary policy of an open economy under a fixed exchange rate system and with unrestricted trade flows and capital flows. The higher the degree of capital mobility, the more difficult the maintenance of a fixed exchange rate and the control of the money stock.

The main purpose of this study is to empirically explore how the monetary authority in Asia did cope with the surge of capital inflows in the period 1985-1996. It statistically examines the extent to which the massive capital inflows influenced the conduct of monetary policy and the effects of the policy of sterilization and intervention in the foreign exchange market. it provides empirical evidence for what a group of seven selected countries across Asia have done. The seven countries in the group are Indonesia, Korea, Malaysia, Philippines, Singapore, Thailand, and Taiwan( R.O.C.). The regression is estimated using a panel of 84 observations for the seven countries during 1985-1996.

A capital inflow generates monetary expansion and pressure for exchange rate adjustment. It poses an important policy question as to how to deal with capital inflows. It is uncertain whether capital inflows last long or not. Asian countries regarded capital inflows as a transitional phenomenon. As a result, Asian countries decided it was desirable to minimize the impact of capital inflows on the economy.

Asian countries heavily utilized the policy categories of measures to minimize the impact of capital inflows on the money supply and exchange rate. The monetary authority conducted contraction of the domestic source in the monetary base of the central bank, primarily directed to offset the effect on the money supply of an increase in the net foreign assets of the central bank resulting from capital inflows. At the same time, the monetary authority intervened in the foreign exchange market, primarily designed to absorb pressures on exchange rates that are accompanied by capital inflows and to prevent nominal exchange rate appreciation.

The statistical results indicate that the degree of sterilization of the monetary authority is very high and that the sterilization is undertaken to control the money supply rather than to control the monetary base.

Furthermore, the effect of the intervention in the foreign exchange market is estimated to be small. The main statistical finding implies that the monetary authority took the policy of a high degree of sterilization with a low level of intervention in foreign exchange markets. The policy leads for a capital inflow to yield negligible effects on the exchange rate and small positive effects on the money supply and the price level. Consequently, the monetary authority succeeded in keeping exchange rates at desired levels and in limiting increases in monetary growth, despite a surge of capital inflows.
The majority of industrial countries allow their exchange rates to float and unrestricted capital flows. Under the world conditions, the monetary authority in Asian countries could have accepted the view that capital flows are of a permanent nature and that sterilized intervention policies are effective over a short period. If the monetary authority accepted the view, it would have floated the exchange rate. The study concludes that Asian countries could have avoided the financial crisis.

Executive Summary

Ⅰ. Introduction

Ⅱ. Capital Inflows to Developing Countries

Ⅲ. Monetary Policy Responses to Capital Inflows
A. Sterilization
B. Foreign Exchange Market Intervention

Ⅳ. A Model of Monetary Sector

Ⅴ. Estimated Equations and Capital Inflow Effects
A. Sterilization
B. Money Demand
C. Foreign Exchange Market Intervention
D. Effects of Sterilization with Foreign Exchange MarketIntervention

Ⅵ. Conclusions

References

Korean Abstract