The “Asset Crisis” of Emerging Economies

BEIJING – In theory, the difference between capital inflows and outflows in developing countries should be positive – they should be net capital importers, with the magnitude of the balance equivalent to the current-account deficit. Since the 1997-1998 Asian financial crisis, however, many East Asian countries have been running current-account surpluses – and hence have become net capital exporters.

Even odder is the fact that while they are net capital exporters, they run financial (capital) account surpluses. In other words, these countries lend not only the money they earned through current-account surpluses, but also the money they borrowed through capital-account surpluses – mainly to the United States. As a result, East Asian countries are now sitting on a huge pile of foreign-exchange reserves in the form of US government securities.

While China has attracted a large amount of foreign direct investment, it has bought an even larger amount of US government securities. Whereas the average return on FDI in China was 33% for American firms in 2008, the average return on China’s investment in US government securities was a mere 3-4%. So, why does China invest its savings so heavily in low-return US government securities, rather than in high-return domestic projects?

One answer lies in the fact that China’s FDI policy over the past 30 years has crowded out Chinese investors from high-return projects, forcing them to settle for less lucrative projects. But there are still potential investors who cannot find any suitable investment opportunities in China, generating excess resources, which in turn are invested in US government securities.