Determinants of volatility of net capital inflows to thailand

a risk of a sudden reversal of capital flows indicates that perhaps the driving forcebehind the flows has not changed even after several post-crisis reforms.Since the data on inflows are

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DETERMINANTS OF VOLATILITY

OF NET CAPITAL INFLOWS TO THAILAND

by

Pakinee Banchuin, Author

Professor Peter Pedroni, Advisor

A thesis submitted in partial fulfillment of the requirements forthe Degree of Bachelor of Arts with Honors in Economics

WILLIAMS COLLEGE

Williamstown, Massachusetts

May 19,2008

This thesis would not have been possible without the generosity of my advisor,Professor Peter Pedroni, who devoted time and patience to guiding me through theprocess I would also like to thank my second reader, Professor Savaser, who took hertime to read my draft and give me useful comments

Special thanks go to my friends whom without them, the thesis would have notprogressed to this point: Troung Pham Hoai Chung and Aom Kitichaiwat for insisting onreading my drafts, providing constructive comments, and motivating questions; PabloCuba and Cid Vipismakul for assistance in computer programming and miscellaneoushelp; Megan Brankley and Tengjian Khoo for proofreading my drafts Athikaset Thongves for your helpful overview of Thai economy; and last but not least, Nora Wongfor working through late night weekends with me and your wonderful help on the poster

1 Introduction

Financial integration allows capital to move across countries without anybarriers Capital flows across national boundaries to maximize return on investmentsand diversify investors' risks In tum, the free movement of capital increases theavailability of funds in emerging economies, enabling these countries to finance theirdevelopment One type of capital inflows is foreign direct investment (FDI) Wheninvestors build new factories, they usually bring in advanced technology, leading to atransfer of knowledge On the other hand, capital inflows do not always generatepositive effects on local economies More inflows can mean higher demand on thenational currency, which induces an appreciation in the exchange rate Thisappreciation hurts the country's export competitiveness Consequently, the inflowsincite economic growth in the short run, but since they might hurt export-led growth,the inflows could harm the country's growth in the long run Capital inflows can alsocause inflation Moreover, the flows place a threat on macroeconomic stability because

of a possibility of a sudden reversal of capital flows A sudden reversal of capital flows

is when there is an abrupt stop in capital inflows following by a large increase incapital outflows Reversals thus drain liquidity in the economy, freezing funds forinvestment and destroying investor optimism

Ideally, financial integration should maximize the efficient use of resources andthe transnational flows equate prices and returns on traded assets in the integrated areas

In reality, there are other factors that affect prices and returns on assets, and theallocation of funds There are some literature tries to answer these questions but many

of these studies use data from the United States and Western European countries which

have strong economies, more developed rules of law, and better structured financialmarkets These fundamentals are different from those of East Asian countries Themajority of East Asian countries opened their countries to international finance at thesame time as developing their capital markets and deregulating their banking sectors.For some of the countries, especially Indonesia, South Korea and Thailand, opening uptheir capital accounts when their banking systems and financial markets did notmeasure up to Western standards led to the 1997 economic crisis Due to the extensivescope of this issue and limited time, this paper only features one developing country.

We choose Thailand because it has experienced rapid changes, both an impressiveboom and devastating bust, over the last 20 years The other reason is that someeconomic literature claims that if it Thailand had not triggered the 1997 economiccrisis, the crisis might not have happened at all

One of the causes of the economic crisis was a sudden reversal in capital flows.Nine years later, the Bank of Thailand claimed that Thailand is on the verge of anothersudden reversal in capital flows One signal for the sudden reversal is that after takinginto account of all known factors, the Thai Baht still appreciated at a significantlyhigher rate than those of the regional countries This implies that the high level ofinflows might be because of speculation To prevent a sudden reversal in capital flows,the Bank launched a 30% capital control to discourage any inflows with the purpose ofspeculation Whether those high inflows were hot money for speculation, no one willknow for certain, but the actual effect of the capital control was a plunge in Thailand'sstock market and an uncertainty in investing in Thailand due to the fear that the Thaigovernment could launch even more extreme policies The fact that Thailand still faces

a risk of a sudden reversal of capital flows indicates that perhaps the driving forcebehind the flows has not changed even after several post-crisis reforms.

Since the data on inflows are not available for all needed time periods, thispaper will use the data on net capital inflows (foreign liabilities) instead This will alterthe scope of the study Instead of investigating the determinants of volatility of theinflows, we will examine the determinants of the fluctuations of the net inflows SinceThailand has a significantly higher risk of capital flows than developed countries, it isinteresting to compare the conclusions on determinants of net capital inflows inThailand to that data from Western European countries and the States

Thailand experienced high growth rates in the late 1980s and the early 1990s.Asset price bubbles and inadequate bank regulation led to strong capital inflows.Unlike some of its neighboring countries, the majority of its inflows were in the form

of bank loans rather than foreign direct investment Due to the belief that the Thaigovernment would keep the exchange rates fixed, these banks and financial companiesdid not cover the risk of foreign exchange rates in their loans Moreover, they usedthese foreign liabilities to finance long-term projects Therefore, when there was asudden reversal of capital inflows in 1997, these firms faced a credit crunch, whichfinally led to the 1997 East Asian economic crisis A little over a decade since thecrisis, Thailand's economy has recovered to some extent After the inflows plummeted

to the lowest point at negative 15 percent of GDP in the first quarter of 1999, capitalinflows slowly bounced back and were at about 5 percent of Thailand's GDP in2005(Ahuja, Chuenchoksan, and Thaicharoen 2007)

The distribution of the flows' components between the pre- and post- crisisperiods is different After the crisis, the main component of capital inflows shiftedfrom bank loans to equity investments Foreigners' holding of Thai equity reached65% of total liabilities (Ashvin et al 2007) Since Thailand and the rest of the worldhave experienced some rapid and drastic changes over this past decade, it is worthinvestigating what are the determinants behind the flows which lead to the change inthe flows' distribution Since the volatility of capital flows is associated negativelywith macroeconomic stability, knowledge about the determinants of fluctuations in theflows will lead to a better monitoring of macroeconomic stability.

To understand the dynamic relationship between capital inflows' volatility andtheir determinants, this paper will use two Structural Vector Autoregressions (SVAR).The remainder of the paper contains five sections: Section II summarizes the relevant

context of Thailand by using quarterly data from Thailand's economy from 1984-2007.Section IV establishes identification matrices to use in VAR Section V analyzes theempirical results and section VI concludes with key findings

2. Literature Review

2.1 Conceptual Issues

This paper will categorize the determinants of capital inflows into two groups,

"push" and "pull" factors "Push" and "pull" factors are classified by their origins

"Push" factors reduce the attractiveness of lending to developed-country debtors Acommon "push" factor is a decrease in rates of return on assets whose fluctuations areusually caused by cyclical factors Since the rates of return in developed countriesfluctuate in response to business cycles, capital inflows motivated by such returns have

total inflows, the country is at risk of a sudden reversal of capital inflows (Montiel andReinhart 1999) Examples of these kinds of "push" factors are the burst of assetbubbles in Japan in the late-1980s and an interest cut in the United States in response

to the 1990-91 recession These two events were concurrent with high level of capitalinflows in emerging Asian countries Two other common "push" factors are growth in

an investor base and a need for portfolio diversification The number of investors hassignificantly grown, and these investors, particularly of mutual and pension funds,want to diversify their investments, so they put some of their money in developingmarkets (Taylor and Sarno 1997) Since "push" factors are created outside developingcountries, the governments of developing countries cannot curb the factors directly.The government can only implement cautious domestic policies

The other determinants of inflows are "pull" factors, which are country-specific.They improve the risk-return characteristics of assets issued by developing-country

market in emerging countries draw foreign investors Removing distortions that have

created gaps between social and private rates of return can induce some capital inflows.For instance, in a heavily-indebted country, a debt-overhang problem discouragescapital inflows, acting as a tax on the country's investment and growth Debt-overhangs establish a gap between social and private rates of return The Brady Planagreement provides a solution to a misalignment between social and private benefitsfor some of the most indebted developing countries i.e Mexico and Brazil (Montieland Reinhati 1999) The agreement convinced private banks to participate in debt-reduction schemes Since without the agreement, giving debt relief is a worthy solutiononly from a social perspective, the agreement made the banks incorporate socialbenefits into their decisions Debt relief increases a country's creditworthiness,attracting more foreign inflows which promote economic growth Another group of

"pull" factors emerges from the components of a country's financial structure A functioning and deep financial system helps prevent rapid outflows (Nakagawa andPasalida) A bigger and deeper capital market attracts more inflows because it cancushion economic shocks better and offers more investment options Capital accountliberalization and the size and depth of a developing country's capital market alsoimpact the quantity of inflows The financial sector is not the only place that offershigh returns in developing countries; investing in the real resources sector is anotheroption Lower raw materials or labor costs might also allure foreign direct investment

well-If the major determinants of capital inflows are domestic, the government might beable to control the sustainability of capital inflows

government can implement sterilization or fiscal policies to cope with the effect of the

flows Sterilization policies for capital adjust the domestic component of the monetarybase in response to capital inflows so that the total monetary base remains unchanged.The tools used for the sterilization vary from open market operations to wider-bandexchange rate policies and forward exchange market intervention to capital controls

external competitive position, it might use fiscal policies For example, a reduction ingovernment spending can reduce the amount of money supply

On the other hand, if pull factors are responsible for most of the variability incapital inflows, the government response will depend on whether pull factors arenominal or real For real pull factors, fiscal policies such as change in investment taxrate can help control for the size and effects of capital inflows For nominal pull factors,monetary policies such as change in interest rates enable the government to havecertain level of control over the size of inflows

2.2 Suggested Determinants of Capital Inflows

In the last fifteen years, growing capital flows from developed countries todeveloping countries have contributed both to economic growth and to economic crises.The main focus in the literature on this phenomenon is to identify whether "push"factors (external to the representative economy) or "pull" factors (domestic) are themajor determinants of capital inflows

Some findings show that push factors have greater effects on capital inflows.Calvo et al (1993) find that an increase in interest rates abroad leads to a rise in capitaloutflows from Latin America Furthermore, push factors significantly influence themovements of official reserves and real exchange rates, yet the impact of push factorsweakens if there are domestic policy responses to capital flows The origin of interestrates matters Montiel and Reinhart (1999) show that for Asian countries, Japaneseinterest rates are more influential than U.S interest rates The paper by }(jm (2000)also supports the greater influence of push factors on the flows, showing that USinterest rate and the US real GDP are important determinants of capital inflows toChile, Korea, Malaysia, and Mexico, while domestic supply and aggregate demandshocks are not as significant factors

Other empirical results suggest that pull factors are significant determinants ofthe inflows Montiel and Reinhart (1999) identify sterilized intervention, restrictions

on capital inflows, and the size and depth of equity market as factors that alter thecomposition of capital inflows Chuhan et al (1993) suggest that a country's creditrating and the institutional investor credit ration affect the inflows into the group ofAsian countries in their paper Guided by these findings, we will categorize

detenninants of capital inflows to Thailand into push and pull factors After that, wewill try to isolate subcategories of push and pull factors.

2.3 Empirical Method

We use Structural Vector Autoregression (SVAR) developed by Blanchard andQuah (1989) SVAR is an appropriate technique for our study because it allows forendogeneity and enable us to examine unobservable shocks Shocks in SVAR areorthogonal so we can obtain some economic inferences

To obtain an SVAR, we first obtain a reduced form VAR which is a system ofstochastic difference equations We write a reduced form VAR as

p

&t =c+ L,Rp&t-p +Jlt

j=l

Jl trepresents a vector of shocks

R j represents coefficients of lagged values

c represents constants

Since shocks in a reduced form VAR are correlated, we cannot make economicreferences from the results So we transform a reduced form VAR to a structural VAR

Reduced form VAR : R(L)&t =c+Jlt (1)

Reduced form VMA: &t =C+F(L)Jlt (2)

Multiply (2) with F(L)-l and get F(Lfl &t =F(L)+c+Jlt (3)

From (1) and (3) R(L) =F(Lfl (8)

Our goal is to find a matrix that allow us to change from reduced form VMA to

reduced form structural VMA The followings will demonstrate how

(2) and (4)

From the properties of lag operator, we know that

A(L)ct =F(L)f.1t

=F(L)(A(O)A(O)-l )f.1t

=F(L)A(O)ct

A(L)=F(L)A(O) (6)

In structural form YAP, c[ has these following properties

1) The vectors of shocks are i.i.d with zero mean

2) Individual shocks are orthogonal because they are economic shocks

3) Individual shocks can be normalized to scale

=A(O)E(ctct ' A(O)') because A(O)is constant

Q" =A(O)A(O)' (7)

A(L) can be found through two forms of matrices: recursive and recursive A recursive form requires many restrictions which make it difficult to implement We canimpose either short-run or long-run economic restrictions on A(L) In this case, I willshow the case for long-run economic restrictions on a recursive form.

non-Long run restrictions in recursive form

To proceed to the next step, we need knowledge on Cholesky Decompositions

3 Model Construction

Economic literature suggests that determinants of capital flows are from bothloanable funds markets and financial markets We suspect that this might be the casefor determinants of the increased volatility in the flows and furthermore that we canuse the Mundell-Flemming Model to examine the possible determinants

settlement balances ( OSB)

track of how variables of our interest affect changes in CA, we can detect whichvariables are the determinants of the increased volatility of the flows Since Thailand isunder a floating exchange rate regime, the nominal exchange rates respond quickly tobring the balance of payment relationship to its equilibrium point We can look at the

services:

Since the balance of payment equation is kept at its equilibrium by the movement innominal exchange rate, there is no need for the central bank to intervene, resulting in

Assumptions for the Mundell-Flemming Model

When we consider the short run time frame, prices are sticky and aggregatesupply needs not to be equal to aggregate demand at all time

Derivations ofIS curve

the factories can increase the shifts of their workers Therefore in the short run,

For consumption, we assume that consumers consume a constant proportion, c,

marginal propensity to consume and O<c<l.

For tax revenues, the tax rate is decided by the government thus T is exogenous

opportunity cost of borrowing The opportunity cost of borrowing resources isthe price of having something now relative to having it later hence the price isthe real interest rate Ceteris paribus, the greater the cost is, the less likelyinvestors want to invest Correspondingly, the domestic investment is adecreasing function of the interest rate Moreover, independent of the interestrate, investors have periods of either optimism or pessimism During periods ofoptimism, investors are more willing to invest and vice versa for periods of

pessimism We denote the level of optimism by la, and the domestic investment

is an increasing function of investor optimism Since the level of optimism

- +

For government spending, the budget is determined by the government so the

For real exchange rate denoted bye, it can be acquired by the product of the

Prow

For exports and imports, their quantities depend on the relative ability ofconsumers to purchase goods and services in other countries The relativeability is reflected through the real exchange rate When the real exchange ratedepreciates, domestic goods become cheaper for foreigners so they want to buymore On the other hand, when the real exchange rate appreciates, foreigngoods become cheaper for domestic consumers so they will buy more.Correspondingly, imports are an increasing function of e and exports are a

Ceteris paribus, there are factors that affect exports and imports positively

We can depict the above equation in the Keynesian Cross Diagram:

Keynesian Cross Diagram, we can deri ve the slop of the IS curve,

Steps: We shiftE +NXwith respect to r. When r decreases, E+NXshifts upward thus

Derivation ofLM curve

through various functions of money

money as a medium of exchange: people use money in their transaction

+

money as a store of value: the return on holding money is negative and is equal

to the inflation rate (P ) The opportunity cost of holding money is what itcould have earned elsewhere had it been invested in other assets In this case,

both domestic, D, and foreign, F So MS =D +F Since the assets held are nominal, a

equation back to its equilibrium

Putting the IS and LM curves together

Derivation of the effect of variables on the IS curve

new equilibrium So for a given value of r, jXocauses jy Correspondingly, when jXo,

Derivation of the effect of variables on the LM curve

the same techniques, we can derive the effect of a change in other variables on the LMcurve:

- + +

LM(P,D,F).

Derivation of the AS-AD model

Since the AD curve reflects the relationship between P and Y, it is consistentwith short run equilibrium in the money and goods market i.e the equilibrium on theIS-LM curves

Steps: We shift the LM curve with respect to P An increase in P shifts the LM curve

the IS curve respect to the variable that we want to see the effect For example, weshift the IS curve with respect to G An increase in G shifts the IS curve upward

+

variables on the AD curve:

- + - + + - + +

Customizing the model for Thailand's economy

the economy back to its equilibrium Since Thailand is a small open economy,

rate Although the fact that some economic literature has claimed that Thailandtriggered the 1997 economic crisis might seem contradictory to our assumption ofThailand as a small open economy, in fact, it is not Thailand can trigger the economiccrisis while remaining a small open economy In 1997, the crisis in Thailanddeteriorated investment in nearby countries because the economies of the neighboringcountries were also characterized by small open economies and similar growth patterns

to Thailand Therefore, the investors in those countries were worried that the countriesmight face the same risk as Thailand, and thus they moved their capital elsewhere

Although Thailand's interest rate is conditional on the rest of the world'sinterest rate, the two interest rates are not equal due to the risk structure of interestrates The risk structure of interest rates is the relationship among different yields onfinancial instruments of the same maturity The variations in yields result fromdifferences in default risk, liquidity, and tax rates (Daniels and VanHoose 143) Forexample, bonds issued by the Thai government or Thai companies have higher defaultrisk than those by governments or companies in developed countries As a result of thehigher default risk, financial instruments in Thailand with the same maturity havehigher yields Since the financial market in Thailand has a lower trading volume, Thaibonds are less liquid than those issued by governments in developed countries orglobally well-known firms Economists use the term risk premium to refer to

differences in yields that are caused by both differences in degrees of default risk andlevels of liquidity (Daniels and VanHoose) Due to this risk premium, uncovered

viewed as an opportunity cost of using money now versus later

+ -

Customizing the model for the economy ofthe "rest of the world"

Since the "rest of the world" represents the overall picture of the worldeconomy, changes or restrictions imposed by countries with small economies areminimal The economy of the "rest of the world" has economically ideal characteristics

The characteristics of the "rest of the world":

Real loanable funds market equilibrium:

Model Analysis

Possible Detenninants for Capital Flows to Thailand

As stated in the previous sections, "push" and "pull" factors are the two

primary forces that drive international capital flows Although economic literstureincludes other suggested determinants, we only study those that are applicable to

Thailand's case One of the most common "push" factors is the rate of returns on

assets in developed countries Since it is difficult to collect available data on rates ofreturn of all assets, we will use interest rates in our model analysis Interest rates are anappropriate measure because they represent returns on bank deposits and an

opportunity cost of investing in other assets Kim (2000) and Culha (2006) use U.S.interest rates to represent the rest of the world's interest rate, but since Montiel andReinhart's (1999) findings that Japanese interest rates are more influential than U.S.interest rates in Asia, we cannot ignore Japanese interest rates The level of outputproduction could be a "push" factor The economic studies also propose several

premiums induce Thai interest rates to be higher than interest rates in the "rest of theworld" in order to compensate for the higher risk investors face Thus, higher interestrates in Thailand will act as a "pull" factor

In the following part, we will use established economic theories to show howthese determinants could affect the level of capital inflows

I An increase in the interest rate of the "rest ofthe world"

Thailand's interest rate Since there is a risk premium in Thailand, the size of increases

in interest rates in both places need not be equal Depending on their risk preferences,investors might move their capital into or out of Thailand, incurring change in theamount of net capital inflows

II An increase in the output of the "rest ofthe world"

The higher level of production of one type of output leads to an increase indemand for the raw materials used in the production Thus, an increase in the level of

higher level of production exceeds the production capacity of the factories, the factoryowners will seek a new production site If the means to the cheapest cost of production

is available overseas, factory owners might create a new production site there In thiscase, an increase in output leads to an increase in net capital inflows

The corresponding IS-LM equations and diagrams are in appendix A

III An increase in Thai interest rate

Since Thailand is a small open economy, an increase in Thailand's interest ratedoes not induce a rise in the interest rate of the "rest of the world" Higher interest rate

in Thailand will attract more investors to move their capital to Thailand

The proposed determinants of volatility of net inflows from economic literatureand the modified IS-LM model only predict change in capital flows We rely on Thaihistorical data on net inflows for the relative importance and characteristics of eachtype of net inflows to Thailand (Graphs are shown in Appendix B) Thailand slowlyopened up its capital account in the mid-1980s In 1993, Thailand established theBangkok International Banking Facilities (BIBF) The BIBF led to two importantconsequences: the liberalizing of Thai currency trading and a high level of foreignloans Originally, the Thai government planned the BIBF to be a transitional place forloans The government hoped that foreign loans would come to Thailand through theBIBF and that Thailand would be able to reissued loans to its neighboring countries.However, due to high interest rates in Thailand during that time period, foreign loansnever left Thailand In 1993, the net inflows of portfolio investment skyrocketedwhereas the net inflows of other investment continued their upward trends These twotypes of flows maintained their upward trend with wide band of volatility until the

1997 economic crisis After the crisis, the two net inflows fell below their pre-1993level, but slowly picked up

Net FDI has a different pattern from portfolio investment and other investment.Net FDI increased at a slower rate than those of the net inflows of portfolio investmentand of other investment After the crisis in 1997, the amount of FDI dwindled but stillremained higher than the pre-crisis level The pattern of net FDI resembles moreclosely with the pattern of Thailand's GDP than do portfolio investment and otherinvestment This indicates that the level of FDI reflects the growth of real economy.Considering the pattern of net total inflows, its volatility started to increase since 1990

After the crisis, the level of net total inflows plummeted to the lower level than whereits pre-crisis value was This is similar to the net inflows of other investments andsomewhat close to that of portfolio investment This suggests that the movement of nettotal inflows in Thailand is largely motivated by portfolio investment and otherinvestment Since the characteristics of other investment are difficult to identify andthe mobility of portfolio inflows can easily lead to a sudden reversal of capital inflows,

in this study, we will pay special attention to the net inflows of portfolio investment

4 Empirical Studies

Since capital inflows and their associated variables are dynamic, we use astructural VAR analysis to test the predictions Impulse responses are estimated toinvestigate whether the inflows react to suggested variables After that, variancedecompositions are employed to estimate how much each determinant accounts forfluctuations of the flows The empirical study is composed of two parts In Part I, wewill investigate how total inflows and each type of inflow respond to push-pull factors

We will estimate to what extent the push factors and pull factors influence the

about identifying the influence of each component in pull factors on different types ofinflows

4.1 Influence ofPush-PullFactors on Inflows

We will use short run restrictions about push-pull factors to obtain anidentification matrix

A Push factors

Since capital usually flows from countries with big open econOIllies tocountries with small open economies, it is sufficient to treat the real interest rates ofbig open economies as our real foreign interest rates We categorize push factors into 3groups: foreign real supply shocks, foreign real demand shocks, and foreign nominalshocks These groups correspond to the IS-LM diagram Foreign real supply shocksare shocks that affect the level of output at a steady state Foreign real demand shocksare shocks that affect the IS curve, and foreign nominal shocks are shocks that affect

An increase in productivity is shown in the IS-LM diagrams and equations

In this long run money market, there is no need for price to adjust because the short

run equilibrium point is at the same place as the long run equilibrium point

Effects: Both equations and diagrams show that foreign real supply shock has an effect

on real interest rate

i) Foreign real demand shocks

investors recommend that their factories produce more, the short run output rises Overthe transition period, an increased output will result in leftover inventories, whichsignal factories to produce less The factories will adjust their production level to meetwith the demand for output Since the demand for output does not change, the long runlevel of output will be the same as that before an increase in investor optimism Thus,the long run output remains unchanged

Effects: Both equations and diagrams show that foreign real demand shock has aneffect on real interest rate.

ii) Nominal shocks

as an example When money supply increases, the cost of money is cheaper Aninterest rate decreases which results in lower cost of investing in factories Therefore,more factories are built or expanded, resulting in higher output in the short run Overthe transition period, an increased output will result in leftover inventories whichsignal factories to produce less The factories will adjust their production level to meetwith the demand for output Since the demand for output does not change, the long runlevel of output will be the same as that before an increase in investor optimism Thus,the long run output remains unchanged

Since in the long run, real exchange rate will increase, short run real exchange ratemust decrease

B Pullfactors

By definition, pull factors are shocks that affect the level of inflows

Putting assumptions together into a matrix

From above, we show that in the short run, push factors affect both foreignoutput and the level of any types of inflows to Thailand Pull factors only affect thelevel of inflows to Thailand With these assumptions, we write an equation as

A(O)22 £ pull

In the long run, push factors affect both foreign output and the level of anytypes of inflows to Thailand Pull factors only affect the level of inflows to Thailand.With these assumptions, we write an equation as

ft~ss = A(1)21 A(1)22 £pull

ft~ss =flows at steady state