Capital Flows during Quantitative Easing and Aftermath

30 Pages·2014·1.06 MB·English

Capital Flows during Quantitative Easing and Aftermath
Experiences of Asian Countries
The US Quantitative easing (QE) triggered massive expansions of capital flow into developing Asia, raising
concerns about financial instability consequences. The paper examines the effect of QE on capital flows
and scrutinizes factors that influence the effect of QE tapering on financial instability. The findings suggest
that QE did lead to large capital inflows which, with credit expansion, magnified the effect of the QE tapering
announcement on the region’s financial instability. While there is no evidence that macroprudential policies
directly reduced the effect of QE tapering, they can nevertheless be useful preemptive measures.
CApitAl Flows During
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Donghyun Park, Arief Ramayandi, and Kwanho Shin
adb economics
no. 409
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ADB Economics Working Paper Series

Capital Flows during Quantitative Easing and Aftermath:
Experiences of Asian Countries

Donghyun Park, Arief Ramayandi, Donghyun Park ([email protected]) is a Principal
and Kwanho Shin Economist at the, Economics and Research Department
of the Asian Development Bank (ADB). Arief
No. 409 | 2014 Ramayandi ([email protected]) is an Economist also
in the same department. Kwanho Shin
([email protected]) is Professor of the Department of
Economics at Korea University.

The authors would like to thank Kristin Forbes for
sharing the data on macroprudential measures and
Poonam Gupta for helping them replicate her empirical
results. They would also like to thank Jisoo Kim, Jina
Lee, and Aleli A. Rosario for their excellent research
assistance.

ASIAN DEVELOPMENT BANK
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© 2014 by Asian Development Bank
September 2014
ISSN 2313-6537 (Print), 2313-6545 (e-ISSN)
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Printed on recycled paper
CONTENTS

TABLES AND FIGURES iv

ABSTRACT v

I. INTRODUCTION 1

II. CAPITAL FLOWS INTO DEVELOPING ASIA DURING QUANTITATIVE EASING (QE) 1

III. EXPERIENCES OF INDIVIDUAL ASIAN COUNTRIES 8

IV. IMPACT OF QE TAPERING 11

V. CONCLUDING OBSERVATIONS 19

APPENDIX 21

REFERENCES 23
TABLES AND FIGURES

TABLES

1 Gross Financial Inflows, Q1 2000–Q2 2013 5
2 Financial Inflows by Type, Q1 2000–Q2 2013 6
3 Financial Inflows by type (Asia dummy included), Q1 2000–Q2 2013 7
4 Correlation Between Exchange Rates and Stock Price Indices, 2005–2014 11
5 Factors Associated with Exchange Rate Depreciation, April–August 2013 12
6 Factors Associated with Exchange Rate Depreciation (capital flows during each
QE episode included), April–August 2013 15
7 Factors Associated with Exchange Rate Depreciation (different types of capital flows
included), April–August 2013 17
8 Factors Associated with Exchange Rate Depreciation (macroprudential policies
and capital controls included), April–August 2013 18

FIGURES

1 Quarterly Capital Inflows, Q1 2000–Q2 2013 2
2 Cumulative Capital Inflows before the Global Financial Crisis
and during Quantitative Easing 3
3 Quarterly Capital Inflows to Six Asian Countries, Q1 2000–Q2 2013 3
4 Cumulative Capital Inflows to Six Asian Countries before the Global Financial Crisis
and during Quantitative Easing 4
5 Exchange Rate Index in Asia 6: 2005–2014 9
6 Foreign Reserve Holdings in Asia 6: 2005–2014 9
7 Stock Price Index in Asia 6: 2005-2014 10
8 Individual Economic Factors Associated with Exchange Rate Depreciation 14
9 Capital Flows and Exchange Rate Depreciation 16
ABSTRACT

A potentially important side effect of quantitative easing (QE) by the United States (US) Federal
Reserve System (the Fed) is the expansion of capital flows into developing countries. As a result, there
is widespread concern that QE tapering may trigger financial instability in those countries. The central
objective of our paper is to empirically investigate this important issue by (1) examining the effect of
QE on capital flows into developing Asia, and (2) analyzing the different factors which influence the
effect of QE tapering on financial instability in order to identify the most significant factors. We find
that QE1 had a bigger impact on capital flows than QE2 and QE3, and credit expansion and capital
inflows magnified the effect of QE tapering on financial instability. While there is no evidence that
macroprudential policies directly reduced the effect of QE tapering, they can nevertheless be useful
preemptive measures.

Keywords: Asia, capital flows, financial stability, global financial crisis, macroprudential measures,
quantitative easing, tapering

JEL Classification: F32, F44, G01
I. INTRODUCTION

The global financial crisis drove the central banks of advanced economies to adopt unconventional
monetary expansions to support financial stability and economic growth. In particular, the US Federal
Reserve launched three rounds of quantitative easing (QE) policies, which involved massive purchases
of United States (US) government bonds. While QE was targeted for the US economy, policymakers in
emerging economies have expressed concerns over its spillover impact on global liquidity and hence
their financial stability. In fact, a number of studies uncover a tangible impact of QE on capital flows
into emerging economies. For example, Cho and Rhee (2013) found that QE, in particular QE1,
significantly contributed to the recovery of capital inflows to Asian countries. Lim, Mohapatra, and
Stocker [LMS] (2014) found that emerging markets outside Asia also experienced a surge of capital
flows after QE. In addition, Chen, Filardo, He and Zhu (2012); and Moore, Nam, Suh and Tepper
(2013) found that QEs had a significant impact on asset prices in emerging markets.

Financial market volatility suffered by Asian countries in May 2013, when the Fed Chairman
Ben Bernanke first hinted at QE tapering, underlines the vulnerability of developing Asia to shifts in the
monetary policy of the advanced economies. In particular, India and Indonesia, two countries with
sizable current account deficits, experienced significant turbulence in their financial markets, although
both have subsequently stabilized. Of central interest to policymakers in the region at the time is the
spillover effect of a more concerted QE tapering on financial stability. The central objective of our
paper is to empirically investigate this important issue by (1) examining the effect of QE on capital
flows into developing Asia, and (2) analyzing the different factors which influence the effect of QE
tapering on financial instability in order to identify the most significant factors. The spillover impact of
QE tapering will depend on the impact of QE on capital flows, which is why it is meaningful to address
the first question.

The rest of this paper is as follows. In Section II, we analyze the impact of QE on capital flows
into developing Asia during QE. For a more systematic analysis, we apply the methodology of LMS
(2014) and distinguish between different types of capital flows. In Section III, we take a closer look at
the country-specific experiences of six Asian countries—India, Indonesia, Republic of Korea, Malaysia,
Philippines, and Thailand. In Section IV, we investigate the role of various factors in determining the
impact of QE tapering on financial stability. While our basic empirical framework is that of Eichengreen
and Gupta [EG] (2013), we extend it in a number of important ways. Section V concludes our paper.

II. CAPITAL FLOWS INTO DEVELOPING ASIA
DURING QUANTITATIVE EASING (QE)

In this section, we examine the behavior of capital flows, particularly into developing Asia, during QE. We
look at capital flows as a whole as well as four different types of capital flows—bank loans, bonds, equity,
and foreign direct investment (FDI). Our sample includes the developing economies covered by LMS
(2014) and adds other emerging economies analyzed by EG (2013). We drop Hong Kong, China and
Singapore since they are high-income financial centers. We also dropped some other economies for data
availability reasons. We end up with the final sample of 62 economies listed in Appendix A1. The data
sources for most economies are World Development Indicators (WDI), International Financial Statistics
(IFS), and Datastream. Appendix A2 lists the definitions and sources of the variables we use in our
empirical analysis. While we are interested in the impact of QE on emerging markets in general, our
primary focus lies in Asian countries. Our sample includes six Asian countries—India, Indonesia, Republic
of Korea, Malaysia, Philippines, and Thailand (hereinafter referred to as Asian countries).
2 | ADB Economics Working Paper Series No. 409

QE was implemented by the Fed as an extraordinary response to the extraordinary shock of
the US subprime crisis which morphed into the global financial crisis. But one of its side effects was a
marked expansion of global liquidity and global financial flows. Rey (2013) argues that large global
capital flow cycles, which are often misaligned with individual emerging market’s macroeconomic
conditions, emerge due to lax monetary conditions in the US or the European Union. Figure 1 presents
capital flows into developing countries by four asset classes—FDI, portfolio equity, portfolio debt, and
loans1—from Q1 2000 to Q2 2013. The figure shows a big surge of capital flows during QE periods
after they collapsed during the global financial crisis (GFC). Our QE dates follow those of LMS (2014),
who define QE1 as Q1 2009–Q3 2010, QE2 as Q4 2010–Q2 2011, and QE3 as Q4 2012–Q2 2013.

Figure 1: Quarterly Capital Inflows, Q1 2000–Q2 2013

$ billion
500
QE1 QE2 QE3
400
300
200
100
0
–100
–200
–300
Q1 2001 Q1 2003 Q1 2005 Q1 2007 Q1 2009 Q1 2011 Q1 2013
Loans Bonds Equity FDI
FDI = foreign direct investment, QE = quantitative easing.
Note: Cumulative capital inflows are the sum of quarterly capital inflows during the period before the
global financial crisis (Q1 2006–Q2 2008) and during the three QE periods (Q1 2009–Q3 2010, Q4
2010–Q2 2011, and Q4 2012–Q2 2013).
Source: Authors’ calculations based on data from International Financial Statistics CD-ROM,
December 2013.

Figure 1 shows that total capital flows into developing countries during QEs are comparable to
those before the GFC. However, the composition of capital flows is somewhat altered. Figure 2 weighs
cumulative capital flows by type during the pre-crisis period (Q1 2006–Q3 2008) versus the sum of
the flows during the three QE periods. Figure 2 clearly shows that while bank-led flows (i.e., loans)
dominated before the GFC shrank, other flows (i.e., bonds, equity, and FDI) rose after the crisis. This
pattern reflects bank deleveraging to strengthen their balance sheets as the GFC intensified. As a
result, bank-based funding was replaced by funds flowing through direct capital markets. Azis and Shin
(2013) also find this reversal in the pattern of capital flows. Figure 3 and Figure 4 show capital flows
into Asia during the same period. Again, capital inflows into Asian countries during QE periods are
comparable to those before the GFC. We can also observe the same pattern of reversals, i.e., shrinking
bank loans and expanding bonds and equity flows after the GFC.

1 More precisely, loans are collected from the IFS that are classified as “other liabilities” which also include trade credit.
Capital Flows during Quantitative Easing and Aftermath: Experiences of Asian Countries | 3
Figure 2: Cumulative Capital Inflowsbefore the Global Financial Crisis
and during Quantitative Easing

$ billion
1,800
1,600
1,400
1,200
1,000
800
600
400
200
0
Q1 2006–Q2 2008 All QEs
Loans Bonds Equity FDI
FDI = foreign direct investment, QE = quantitative easing.
Note: Cumulative capital inflows are the sum of quarterly capital inflows during the period before the
global financial crisis (Q1 2006–Q2 2008) and during the three QE periods (Q1 2009–Q3 2010, Q4
2010–Q2 2011, and Q4 2012–Q2 2013).
Source: Authors’ calculations based on data from International Financial Statistics CD-ROM,
December 2013.

Figure 3: Quarterly Capital Inflows to Six Asian Countries,
Q1 2000–Q2 2013

$ billion
100
QE1 QE2 QE3
80
60
40
20
0
–20
–40
–60
–80
–100
Q1 2001 Q1 2003 Q1 2005 Q1 2007 Q1 2009 Q1 2011 Q1 2013
Loans Bonds Equity FDI
FDI = foreign direct investment, QE = quantitative easing.
Notes:
1. Cumulative capital inflows are the sum of quarterly capital inflows during the period before the global
financial crisis (Q1 2006–Q2 2008) and during the three QE periods (Q1 2009–Q3 2010, Q4 2010–
Q2 2011, and Q4 2012–Q2 2013).
2. Six Asian countries include India, Indonesia, the Republic of Korea, Malaysia, the Philippines,
and Thailand.
3. Loans, bonds, and equity data for Malaysia cover only Q1 2002–Q2 2013.
Source: Authors’ calculations based on data from International Financial Statistics CD-ROM,
December 2013.
4 | ADB Economics Working Paper Series No. 409
Figure 4: Cumulative Capital Inflows to Six Asian Countries before the Global
Financial Crisis and during Quantitative Easing

$ billion
250
200
150
100
50
0
-50
Q1 2006–Q2 2008 All QEs
Loans Bonds Equity FDI
FDI = foreign direct investment, QE = quantitative easing.
Notes:
1. Cumulative capital inflows are the sum of quarterly capital inflows during the period before the global
financial crisis (Q1 2006–Q2 2008) and during the three QE periods (Q1 2009–Q3 2010, Q4 2010–
Q2 2011, and Q4 2012–Q2 2013).
2. Six Asian countries include India, Indonesia, the Republic of Korea, Malaysia, the Philippines,
and Thailand.
3. Loans, bonds, and equity data for Malaysia cover only Q1 2002–Q2 2013.
Source: Authors’ calculations based on data from International Financial Statistics CD-ROM,
December 2013.

In order to empirically investigate the impact of QE on capital flows into developing countries,
we follow the methodology adopted by LMS (2014). Their baseline specification is a balanced dynamic
panel regression as follows2:

(cid:1832)(cid:1835) (cid:3404) (cid:2025)(cid:1832)(cid:1835) (cid:3397)(cid:2019)(cid:1838) (cid:3397)(cid:2024)(cid:1842)(cid:1828) (cid:3397)(cid:2011)(cid:1829) (cid:3397)(cid:2016)(cid:1843)(cid:1831) (cid:3397)(cid:2010)(cid:4593)(cid:1850) (cid:3397)(cid:2012)(cid:1829)(cid:1844)(cid:1835)(cid:1845)(cid:1835)(cid:1845) (cid:3397)(cid:2009) (cid:3397)(cid:2028) (cid:3397)(cid:2013)
(cid:3036)(cid:3047) (cid:3036)(cid:3047)(cid:2879)(cid:873) (cid:3036)(cid:3047) (cid:3036)(cid:3047) (cid:3036)(cid:3047) (cid:3047) (cid:3036)(cid:3047) (cid:3047) (cid:3036) (cid:3047) (cid:3036)(cid:3047)

where (cid:1832)(cid:1835) is financial flows into country i at t. Financial flows are transmitted via three different
(cid:3036)(cid:3047)
channels: (1) liquidity ((cid:1838) ), (2) portfolio balance ((cid:1842)(cid:1828) ), and (3) confidence ((cid:1829) ). The liquidity
(cid:3036)(cid:3047) (cid:3036)(cid:3047) (cid:3036)(cid:3047)
channel (cid:1838) , is measured by the US 3-month Treasury bill rate. The portfolio balance channel (cid:1842)(cid:1828) , is
(cid:3036)(cid:3047) (cid:3036)(cid:3047)
measured by the US yield spread—difference between yields on 10-year US bonds and 3-month
bills—and the interest rate differential between the developing country vis-à-vis the US. Finally the
confidence channel is measured by the Volatility Index (VIX).

The impact of QE that is not explicitly captured by the three channels is measured by (cid:2016). (cid:1843)(cid:1831) is
(cid:3047)
a dummy variable that takes the value of 1 during the three QE periods and 0 otherwise. In some
specifications, we include individual QE dummies - (cid:1843)(cid:1831) , (cid:1843)(cid:1831) and (cid:1843)(cid:1831) corresponding to QE1, QE2,
(cid:873)(cid:3047) (cid:874)(cid:3047) (cid:875)(cid:3047)
and QE3 periods, respectively. It is important to note that (cid:2016) does not necessarily reflect the full effects
of QE. Insofar as QE affects capital flows through the three channels, the estimate of (cid:2016) represents a
lower bound to the potential effects of QE. The explanatory variables include a vector of additional
time-varying country-specific controls (cid:1850) such as current gross domestic product (GDP) and country
(cid:3036)(cid:3047)
rating, and a crisis dummy ((cid:1829)(cid:1844)(cid:1835)(cid:1845)(cid:1835)(cid:1845) ) that takes a value of 1 between Q3 2008 and Q2 2009 and 0
(cid:3047)

2 We exclude the post-crisis dummy because most post-crisis periods overlap with the QE periods. Interestingly, while it is
included in Lim, Mohapatra, and Stocker (2014), its estimate is not statistically significant.