EC331 Assessment 1 ID: 1327532

Project outline

Objective: To find a relationship between speculative foreign capital flows into debt in
Emerging Market Economies (EMEs) and financial instability in the region.

Throughout history, cases of bubbles that eventually lead to crisis in EMEs can trace
their origins to a period of excessive capital inflows. The premise behind this being that
an abundance of funds in the form of foreign lending leads to an exuberance fueled
credit boom. A prosperous period of skyrocketing stock and real estate prices would
inevitably ensue and, in the face of economic instability and inevitable adverse shocks,
the realities of crisis eventually kick in, deteriorating the economy. With the economic
and social consequences of crisis deep in mind, I endeavor to identify a causal
relationship between speculative foreign capital flows and financial instability. If
successful, my findings can hopefully act as a crude warning system for crisis in EMEs.

The measure of choice for foreign speculative flows will be foreign ‘portfolio’
investment (FPI). Though structurally FPI shall only include short-term lending (debt
with maturities less than one year) to focus this investigation on speculative
investments, the term ‘portfolio’ is retained to reflect the passive nature of short-term
investment into debt. This is in contrast to foreign direct investment (FDI), which solely
measures investments that involve acquiring controlling stakes. My interpretation of
FPI reflects the so-called ‘hot money’ investments that dispassionately chase short-term
returns and are prone to quick flow reversals (inflows to outflows).

Financial instability shall be defined in accordance to Hyman Minsky’s Financial

Instability Hypothesis (FIH). Minsky purports that increasingly financially unstable
economies experience a migration of its borrowing population into so-called ponzi and
speculative groups. These groups are highly leveraged relative to their cash flow and as
such groups become more prevalent, an economy faces a growing risk towards shocks
that trigger widespread default and crisis. Adhering to Minsky’s hypothesis, the
measure Debt Service Coverage Ratio (DSCR) shall be used as the sole component in
estimating financial instability. DSCR is a measure of the cash flow available to pay
current (not total) debt obligations (e.g. interest and principal due by the end of the
fiscal year). Formally: DCSR = Net Operating Income / Total Debt Service. Therefore a
DSCR greater than 1 means the entity has sufficient income to pay its current debt
obligations and a DSCR less than 1 means it does not. To reflect the migration of the
borrower population as Minsky described, I shall use the proportion of corporate
entities in the emerging market sample that have DSCR less than one as the dependent
variable measured over time.

As DSCR is essentially a measure of borrowing, it is essential that I control for other

economic factors that influence borrowing behavior. For one, the interest rate (cost of
capital) in which corporate debt can be issued at is expected to have a significant
EC331 Assessment 1 ID: 1327532

bearing on borrowing decisions. I predict an inverse relationship between cost of

capital and the proportion of companies with DSCR less than one. Furthermore, I shall
control for the effect of domestic credit that is made available to the private sector. Very
much like easy access foreign capital, an abundance of domestic credit helps fuel credit
booms. The importance distinction to be made, however, is that domestic credit, unlike
my definition of portfolio investments, should not be interpreted as wholly speculative.
It is an aggregate metric for lending in an economy and hence includes long-term loans
that are naturally less speculative.

Similar to including domestic credit, there is consideration to control for non-

speculative foreign portfolio flows in the model. I assume that long-term investments
(i.e. loans with maturities in excess of a year) are less speculative than short-term loans.
After all, the defining features of ‘hot money’ are that they chase quick returns and are
prone to quick reversals. I anticipate that issues of multicollinearity may arise between
speculative and non-speculative foreign debt as crude data show that they move
similarly. Only regression analysis could tell, however.

Another important factor to consider is business confidence, which can be measured

using OECD’s business confidence index (BCI). Companies make investment (and
correspondingly financing) decisions based on economic outlook. This is nothing more
than a game of expectations – how optimistic or pessimistic companies are with regards
to future profits. As business confidence in the economy grows I expect companies to be
more comfortable in taking more debt to finance investments. Analogously, I regard
past GDP growth to have significant influence on business expectations. I expect a
positive relationship between GDP growth and leverage. The main consideration to
make here is whether BCI as a standalone variable inherently and sufficiently
incorporates the influences of GDP growth. Should this be the case, including both
variables in my model may again give rise to multicollinearity issues, which may
potentially make coefficient readings inconclusive.

As part of a time-series econometric analysis, I plan to include and test the lags of the
factors listed above to take into account lead times in investment decision making.
Realistically, businesses make investment and financing plans with fixed horizons and
are therefore generally unable to react to economic developments instantaneously.
Furthermore, I shall ensure thorough testing for stationarity in the data set to avoid
spurious regressions, and for cointegrating relationships. Care will also taken to
identify any multicollinearity and endogeneity issues. The set of EME countries I shall
use remains undecided, with the main deciding factor being the availability of data. Data
sources shall be OECD for confidence indicators, and The World Bank and IMF for GDP,
domestic credit, and breakdown of capital flows. DSCR will require manual compilation
of corporate data available through Datastream.
EC331 Assessment 1 ID: 1327532

Literature Review

Capital flow, and subsequently flight, induced crisis is not an unfamiliar phenomenon to
emerging market economies. Though widely debated, many attribute the cause of the
1997 Asian Financial crisis to the massive capital inflows and eventual outflows that
preceded the debacle. Irresponsible use of ‘hot money’ flows into the region lead to
credit booms, consumption binges, and bubbly asset prices. As inflows abruptly shifted
into outflows, banking and currency crisis, called ‘twin crisis’, ensued, and there was
widespread default, bank failures, and massive currency devaluations in the region
(Kaminsky 1999; Reinhart and Kaminsky 1999; Radalet and Sachs 1998). Over the 17-
year period following the crisis, Asian EMEs have strongly recovered and grew at
unprecedented rates. This protracted period of impressive growth that has been
accompanied by persistent inflows of capital (besides a brief hiccup late 2008 and early
2009) is reminiscent of the years that preceded 1997. Though arguably more subtle, the
resemblance to the past is uncanny and alarming.

Though Hyman Minsky’s Financial Instability Hypothesis (Minsky 1992) was not a
paper that delved into international economics, the everlasting theory it embodies
(which serves as the basis of my paper) can nonetheless be placed in the context of
foreign lending. Minsky purported that during periods of economic prosperity,
exuberance would drive excessive borrowing (and correspondingly lending) in an
economy. This movement would continue up to the point of excess that eventually
triggers financial demise following an adverse shock – a “Minsky Moment”.
Dynamically, this cycle unfolds as a transition of the economy from one highly
populated with low risk borrowers, to one dominated by highly leveraged borrowers
that possess significant risk of default due to the low cash flow to debt obligation ratios
of their balance sheets. This transition in the economy leads growing financial stability –
a time bomb.

Moving on to more ‘relevant’ work, Stiglitz (2000) and Stiglitz (2004) suggested that
capital market liberalization is systematically associated with greater instability. With
an emphasis on short-term speculative flows, Stiglitz purported that such flows are
markedly pro-cyclical, and hence exacerbated economic fluctuations when they did not
actually cause them. A slight adverse shock to the economy or a sudden change in the
lender’s perception on “emerging market risk”, could result in sudden and massive
capital outflows, undermining the financial system. In such a scenario, financial
institutions are weakened, often bankrupted, and exchange rates plummeted – leaving
immense burden for institutions that borrowed in foreign currency. Given Stiglitz’s
analysis on how mechanics of capital flow reversals ultimately result in instability, I
would congruently add my take that flow reversals could only do so much damage to
the economy if borrowers nurtured unhealthy and unsustainable balance sheets during
the period leading up to the reversal.
EC331 Assessment 1 ID: 1327532

The issue of balance sheet health leads us to literature exploring the destabilizing risks
associated with issuing acquiring foreign debt in foreign currency (FC debt) – a
prevalent practice among Asian EMEs in the 1990s. As Gourinchas and Obstfeld (2012)
put it, issuing debt in a foreign currency, a process often referred to as the ‘original sin’
(Eichengreen and Hausmann 2003), essentially entails the borrower entering into a
short position on the foreign currency in which its debt is issued. Should a sudden
depreciation of the domestic currency occur (which arises when there are large capital
outflows), debt valuations increase, leaving borrowers unable to finance their debt.
What follows is a cycle of default, busts, and falling asset prices. Harvey and Roper
(1999) show empirically that Asian managers, prior to the 1997 Asian financial crisis,
were exacerbating debt risk by leveraging with foreign denominated debt. This
highlights the extent to which foreign debt flows, regardless of whether or not they
were speculative in nature, were inherently unstable when denominated in foreign
currency. A common explanation as to why companies often resort to FC debt is because
it’s cheaper. The supply of funds in international debt markets may be greater than
demand, when compared to local markets, leading to lower interest rates (Williamson
2005). It is worth pointing out that although the use of FC debt has declined markedly
from its predominant use in Asia during the 1990s, FC debt still comprises a fairly
significant share of foreign lending in EMEs today.

As Reinhart and Reinhart (2008) point out, so-called capital inflow ‘bonanzas’ (periods
of large capital inflows) have grown in frequency over the past five decades as
restrictions on international capital flows have gradually relaxed. They emphasize that
such bonanzas were convincingly associated with higher incidence in banking,
currency, and inflation crisis in all but high-income countries. They also stress in that in
more than 60% of the countries analyzed, the probability of a crisis around the dates of
a capital flow bonanza is higher than for the entire sample. Apart from the classic credit
boom and bust argument, Reinhart and Reinhart indicate that the pro-cyclical nature of
fiscal policy in developing countries during capital bonanzas contributes towards the
destabilization of the economy. Policymakers are lulled by persistent capital flows that
eventually become perceived as permanent rather than temporary, prompting full-
fledged expansion in fiscal spending that is inherently destabilizing (Gavin and Perotti
1997). Furthermore the lax spending during the boom phase sets the stage for non-
voluntary fiscal tightening when economic downturn sets in – fundamentally
exacerbating any crisis.

Apparent from the pieces of literature reviewed, I am confident in saying that there
exists consensus amongst researchers in the field that excessive capital flows can, and
do, lead to financial instability, which is often followed by crisis. The transmission
mechanism from capital flow to instability appears to fall under the single umbrella of
excessive risk taking, whatever form or combination that risk may be comprised of (i.e.
excessive lending, foreign denomination of debt, and/or pro-cyclical fiscal policy).
EC331 Assessment 1 ID: 1327532

References

Curbing The Boom-Bust Cycle: Stabilizing Capital Flows To Emerging Markets.

Washington DC: Peterson Institute for International Economics, 2005. Print.

Eichengreen, Barry J, Ricardo Hausmann, and Ugo Panizza. Currency

Mismatches, Debt Intolerance And Original Sin. Cambridge, MA: National
Bureau of Economic Research, 2003. Print.

Gourinchas, Pierre-Olivier, and Maurice Obstfeld. 'Stories Of The Twentieth

Century For The Twenty-First'. American Economic Journal:
Macroeconomics 3.4 (2012): 226-265. Web.

Harvey, Campbell R, and Andrew H Roper. The Asian Bet. [S.l.]: [s.n.], 1999.
Print.

Kaminsky, Graciela L, and Carmen M Reinhart. 'The Twin Crises: The Causes Of
Banking And Balance-Of-Payments Problems'. American Economic
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Kaminsky, Graciela Laura. 'Currency And Banking Crises: The Early Warnings Of
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Minsky, Hyman P. 'The Financial Instability Hypothesis'. The Jerome Levy

Economics Institute Working Paper No. 74 (1992): n. pag. Web.

Reinhart, Carmen M., and Vincent R. Reinhart. 'Capital Flow Bonanzas: An

Encompassing View Of The Past And Present'. NBER International Seminar
on Macroeconomics 5.1 (2008): 9-62. Web.

Stiglitz, J. E. 'Capital-Market Liberalization, Globalization, And The IMF'. Oxford

Review of Economic Policy 20.1 (2004): 57-71. Web.

Stiglitz, Joseph E. 'Capital Market Liberalization, Economic Growth, And

Instability'. World Development 28.6 (2000): 1075-1086. Web.