Too much money is as bad as too little. Foreign capital inflows can be of poor quality. And emerging financial systems are often unable to absorb the shock of such an influx. They can act as a trampoline, bouncing the cash straight into a domestic spending boom.
One barometer of domestic economic excess - and of the sustainability of growth - is the fundamental balance. Paying attention to this barometer reading could warn when an investment bonanza is heading for trouble.
The fundamental balance is defined as the sum of a country's current account position plus its total net receipts of foreign direct investment (FDI), less any scheduled foreign debt repayments. It represents the long-term demand for a currency.
Because currency values are determined by the interaction of supply and demand, countries that run fundamental surpluses (ie, strong demand) and impose relatively tight monetary policies (ie, limited supply) - such as Japan and Germany in the 1980s - enjoy long-term currency strength. Those that follow the opposite path - such as the UK and the US in the 1970s - suffer currency weakness.
The domestic counterpart of the fundamental balance is the gap between domestic savings and investment by indigenous firms. A fundamental surplus clearly indicates that domestic savings are in excess of local financing requirements. Consequently, the economy is unlikely to face a major overheating problem. On the other hand a fundamental deficit suggests domestic savings are insufficient. In short, over-consumption is being fed by inflows of volatile hot money.
Chart 1 ranks countries according to their average fundamental balances between 1989 and 1996. We have found that currency crises typically occur when the fundamental deficit exceeds around 3.5% of annual GDP. Not surprisingly, Thailand, Mexico, the Philippines and Pakistan all feature.
This explains why Mexico's economic problems in 1994 were far worse than Malaysia's, even though both had similar current account deficits. The current account balance does not tell us whether imports are of consumer goods by domestic companies (bad) or of capital goods by multinationals (good). The fundamental balance does. Thus Malaysia could still boast a fundamental surplus because of massive net FDI. On the other hand, Mexico's deficit consisted largely of consumer imports which had to be financed by volatile and unreliable inflows of hot money. The rest is history.
The fundamental balance tells us about the quality of currency inflows and about an economy's competitiveness. If a country has a current trade surplus then it must have a current competitive advantage in production. Similarly, if multinationals invest in plant and build factories, they must consider that there is also some future competitive advantage.
Flows of portfolio investment (which are excluded from the definition) go largely into financial markets and create volatility. FDI (which is included) goes into the real economy and creates growth. In short, the quality of capital is more important than quantity.
Chart 2 shows the stark difference between the poor quality of flows to Latin America and the higher quality of flows to Asia-Pacific countries. Between 1989 and 1996 both regions enjoyed a net increase in foreign exchange reserves. But Latin America's rise came solely from inflows of volatile hot money. Worryingly, it suffered a net outflow of "good" capital, measured by the fundamental deficit. Asia enjoys a surplus of "good" (growth-creating) capital. Latin America suffers from too much "bad" (volatility-creating) capital.
Admittedly, this regional picture misses much at the local level. For example, within Latin America, Chile looks more like an Asian economy. Thailand and Indonesia are more like Latin economies in Asia. What's more, as the chart shows, eastern Europe and Russia are close to the Asian model, whereas the other emerging markets, such as India and Africa, are in the Latin American mould.
Latin America's real economic problem can be identified from its large fundamental deficits. Asia's fundamental surpluses obscure deeper financial problems, however. Economies with good fundamental balances can still have too much of a good thing. In these cases, the quality of flows becomes secondary: there is just too much foreign money for the economy to absorb. The result is excess spending, which leads to a crisis.
The problem is that many emerging financial systems act as trampolines rather than shock-absorbers. When global capital pours in, its effects are magnified many times. The result is either a consumer boom and a swelling trade deficit, or a long period of over-investment that culminates in severe debt and banking problems. But the outcome is always a currency crisis. Every major emerging market crisis of the past 10 years has started as a currency crisis.
The explanation, put simply, is that many emerging markets have insufficient domestic financial instruments, and their domestic financial markets are too shallow to sterilize the effects of large foreign inflows. Because foreign currency is a reserve asset of the domestic banking system, it can then be leveraged up several times, forcing domestic credit growth to soar.
This problem can also be explained in terms of a clash between free, footloose private capital and governments' centralizing instincts. The clash creates fissures in financial markets because government controls promote the uneven development of the real economy and the financial sector. Many Asian governments have refused to let financial markets function freely, while their Latin American counterparts have typically imposed or sanctioned controls on the free working of real goods and labour markets. This uneven development led first to the Mexican peso crisis in 1995, and more recently to the 1997 Asian and eastern European currency crises.
This is how it happened. Multinationals and foreign pension and mutual funds poured new investment into the emerging economies during 1993-95. Because of the trampoline effect, the foreign portfolio capital inflows exaggerated the domestic spending booms. Latin America - notably Mexico - with its higher propensity to consume, quickly blew these funds on imported consumer goods. This resulted in swelling current account deficits, and in Mexico's case a plunging peso.
Asia's solution to the excess was different, given its bias towards investment spending. Typically, over-investment became most pronounced among the lower value-added producing countries in east Asia. Thailand was by far the worst culprit, directing a whopping 43% of GDP into fixed investment, on average, over the three years to end-1995. Thailand just edged out Korea and Singapore which recorded investment rates of 37% and 36% respectively. Meanwhile, five years on, Japan was still adjusting to a similar glut of capacity left over from the late-1980s. An economy can only productively use investment equivalent to between 18% and 27% of GDP annually. The rest is likely to be wasted (see chart 3).