Foreign Portfolio Investors and Financial Sector Stability: Lessons from the Asian Crisis

Under asymmetric information and imperfect contract enforcement, foreign portfolio capital flows inevitably entail the interplay of benefits and risks. Given the considerable advantages foreign investors offer, however, a country cannot afford simply to walk away from global capital markets by imposing strict capital controls and/or severely limiting the activities of foreign portfolio investors within its borders. The best way to maximize net benefits is to keep the door open to global capital flows while minimizing the risks they pose to financial sector stability by attacking unwanted distortions at their sources. The Asian crisis demonstrated that major weaknesses in the domestic financial system can magnify risks to the extent that host economies eventually incur a financial crisis. Problems that intensify risks are: (i) inconsistent and shaky macroeconomic management; (ii) severe asymmetric information problems (e.g. inadequate accounting, auditing, and disclosure practices) in the financial and corporate sectors; and (iii) inadequate prudential supervision and regulation of domestic financial institutions and markets. The Asian experience also suggests that short-term foreign debt poses special problems for the maintenance of financial sector stability.