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					                                                                                                      2011-E-1
                                                                                                    2004-J-1



                      Inflows to
               Capitalタイトル Emerging Countries and Their Reflux to the United States
                          ~サブタイトル(ある場合のみ)~
                                                                    Shun Kobayashi 又はグループ名
                                                                 執筆者名・執筆者名 and Koichi Yoshino
                                                                         Financial Markets Department
                                                                                                2004 年 4 月
                                                                                                January 2011


Under the prolonged accommodative financial environment in developed countries, incentives to search for
yield have increased among investors. This has prompted capital inflows to emerging countries with high
growth prospects (high expected returns) in recent years. In these circumstances, the correlation coefficients
of changes in asset prices among emerging countries have reached an unprecedentedly high level, reducing
the benefits of internationally diversified investment. Concurrently, many of the emerging countries, faced
with a significant amount of capital inflows, appear to be intervening massively in the foreign exchange
market to keep their currencies from appreciating sharply. The accumulated foreign reserves resulting from
the interventions have tended recently to be invested increasingly in longer-term U.S. Treasuries, and it is
possible that this tendency is putting downward pressure on U.S. long-term interest rates. The decline in
these rates may cause an acceleration of capital inflows to the emerging countries by further encouraging
investors to search for yield. The recent international capital flows suggest that a "feedback loop" is
operating between developed and emerging countries, and therefore careful attention should be paid to future
developments, including the possibility of a reversal of capital flows.


Introduction                                                there is an indication of accumulated financial
Based on the strong expectation that economic               imbalances. In what follows, we first provide an
expansion in emerging countries will continue in the        overview of the characteristic aspects of recent capital
future, a massive amount of capital continues to flow       flows from developed to emerging countries, and the
into the emerging countries. 1 At the same time,            policy responses taken by emerging countries that are
emerging countries receiving capital inflows are faced      faced with pressures on capital inflows. We then
with problems such as the rising pressure of currency       review the recent reflux of foreign reserves of
appreciation.     To     keep   their   currencies   from   emerging countries to the U.S. Treasury market and
appreciating sharply, many emerging countries are           conclude by discussing risks and vulnerabilities
introducing or strengthening their capital control          pertaining to the recent international capital flows.
measures. In addition, they appear to be intervening
massively in the foreign exchange market. 2 Their           Capital Flows from Developed to Emerging
foreign       reserves    accumulated      through    the   Countries
interventions have tended to reflux to developed            On a gross basis, capital flows from developed to
countries mainly in the form of investment in U.S.          emerging countries have recently been on an
Treasuries.                                                 increasing trend, after having decreased temporarily
          This paper aims to give an overview of the        due to the Lehman shock (Chart 1). Looking at the net
current state of international capital flows by drawing     purchases of major emerging market equities by
on various data, and to tentatively evaluate whether        foreign investors to see more detailed movements of

                                                            1                          Bank of Japan January 2011
                Chart 1: Capital Flows to                                       Chart 2: Net Purchases of Major Emerging
                         Emerging Countries                                              Market Equities by Foreign Investors
              bil. U.S. dollars                                                             bil. U.S. dollars
    1,400                                           Estimates
                                                                                      40
    1,200                                                                             30

    1,000                                                                             20
                                                                                      10
      800
                                                                                       0
      600
                                                                                     -10
      400                                                                            -20
      200                                                                            -30
         0                                                                           -40
        CY 95 97 99 01 03 05 07 09 11                                                      Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10
 Notes: 1. Chart 1 exhibits the aggregate amount of the capital and financial account on a gross basis of 30 emerging countries. The figures for
            2010 and 2011 are estimates by the Institute of International Finance.Inc (the figure for 2010 partially reflects the actual results).
        2. Net purchases in Chart 2 are the sum of the figures of Brazil, India, Indonesia, the Philippines, South Korea, Taiwan, and Thailand. The
           latest data are as of October 2010.
 Sources: Bloomberg; CEIC; The Institute of International Finance. Inc, "Capital Flows to Emerging Market Economies."

          Chart 3: Capital Flows to Major Regions                            stems basically from (1) their good fundamentals and
              bil. U.S. dollars                                              (2) investors' more intensive search for yield due to
     800
                  Others                                                     the prolonged accommodative financial environment
     700                                            Estimates
                  Middle East & North Africa                                 in developed countries. A comparison of returns
     600
                  Central & Eastern Europe
     500                                                                     (1-year rolling returns) on stocks and bonds in
                  Latin America
     400          Emerging Asia                                              developed and emerging countries indicates that stock
     300
     200                                                                     returns in emerging countries have exceeded those in
     100                                                                     developed countries for the past several years (Chart
       0
                                                                             4). Although bond returns in emerging countries
    -100
    -200                                                                     temporarily plummeted immediately after the Lehman
        CY 90 92 94 96 98 00 02 04 06 08 10                                  shock, they surged from the second half of 2009 and
 Note: Sum of the capital and financial account on a net basis of 150        have recently exceeded those in developed countries.
       emerging countries. The figures for 2010 and 2011 are
       estimates by the International Monetary Fund (the figure for          Financial assets of emerging countries that showed
       2010 partially reflects the actual results).                          high investment returns have attracted investors in
 Source: International Monetary Fund, "World Economic Outlook."
                                                                             developed countries who are increasingly searching
capital, we see that the trend of a large net long                           for as high a yield as possible under the prolonged
position has continued with fluctuations since the                           accommodative            financial      environment         in    their
second quarter of 2009, after a huge decrease caused                         countries. As a matter of course, risks of financial
by the Lehman shock (Chart 2). Next, examining                               assets should be taken into consideration when
capital flows on a net basis by region, it can be seen                       evaluating the investment returns. In this regard, the
that in 2010 a massive amount of capital continued to                        difference in returns between emerging and developed
flow mainly into emerging Asian and Latin American                           countries is significantly smaller on a risk-adjusted
countries with high economic growth (Chart 3). As for                        basis, reflecting the higher volatility of investment
Central and Eastern European countries, capital                              returns in emerging markets (risk-adjusted returns are
inflows remained at a high level before the Lehman                           returns divided by the standard deviation of returns). It
shock, but their pace of increase decelerated from                           should also be noted, however, that investment returns
2009.                                                                        on emerging market assets may be heightened by
                                                                             considering the exchange rate fluctuations.
(Search for Yield by Investors in Developed                                                In general, investment returns may be
Countries)                                                                   increased by (1) making use of leverage, (2) extending
The increase in capital inflows to emerging countries                        the maturity mismatch (taking on liquidity risk), and


                                                                            2                                   Bank of Japan January 2011
                                                                                           Chart 4: Investment Returns on Stocks and Bonds
                                                                 Stock Return (Before Risk Adjustment)                   Bond Return (Before Risk Adjustment)
                                                             %                                                                                         %
                                                   80                                                                                             50
                                                   60                                                                                             40
                                                   40                                                                                             30
                                                                                                                                                  20
                                                   20
                                                                                                                                                  10
                                                    0                                                                                              0
                                -20                                                                                                              -10
                                                                         Emerging countries                                                                       Emerging countries
                                -40                                      Developed countries                                                     -20              Developed countries
                                -60                                                                                                              -30
                                         CY 05                         06           07           08          09              10                   CY 05         06           07        08         09        10

                                                                     Stock Return (After Risk Adjustment)                                                      Bond Return (After Risk Adjustment)
                                                             %                                                                                         %
                                                   8                                                                                              8
                                                   6                                                                                              6

                                                   4                                                                                              4

                                                   2                                                                                              2

                                                   0                                                                                              0

                                                   -2                   Emerging countries                                                        -2                 Emerging countries
                                                                        Developed countries                                                                          Developed countries
                                                   -4                                                                                             -4
                                                                                                                                                 CY 05          06           07        08         09        10
                                                   CY 05               06          07            08          09              10
                                 Note: Returns are calculated as 1-year rolling returns. Risk-adjusted returns are returns divided by the 1-year rolling standard deviation of returns.
                                       The latest data are as of the end of October 2010.
                                 Sources: MSCI for stock data; JPMorgan's EMBI (emerging countries) and GBI-Global (developed countries) for bond data.


                                                         Chart 5: Relationship between Stock Returns                                       Chart 6: Relationship between Stock Index and
                                                                  and the Exchange Rate                                                             Foreign Currency Index of Emerging Countries
                                                                 %
Change in exchange rate against the U.S. dolla r




                                                        40                                                                                         %                                                              %
                                                                                    Brazil                                                 30                                                                         80
                                                                                                                 Indonesia
                                                        30                                                                                                                                                            60
                                                                                 South Korea                                               20
                                                                                                Hungary                                                                                                               40
                                                        20                          Poland           Thailand                              10
                                                                                                                  Turkey                                                                                              20
                                                                         Malaysia
                                                                                        Mexico Russia
                                                        10                                                                                  0                                                                         0
                                                                                             Philippines India
                                                                                   China
                                                                                                                                                                                                                      -20
                                                        0                                                                                  -10
                                                                                                                                                                                                                      -40
                                                                                                                                                               Change in foreign currency index
                                                                                                                       Argentina           -20
                                                    -10                                                                                                        Change in stock index (right scale)                    -60

                                                                                                                                           -30                                                                        -80
                                                    -20
                                                                                                                                           CY 02          03    04      05        06    07      08     09    10
                                                             0              50                100                150               200 %
                                                                                   Change in stock index

                                   Notes: 1. Chart 5 exhibits the rate of change in the stock index (denominated in local currencies) and the exchange rate against the U.S. dollar
                                             from January 2009 to October 2010.
                                          2. Chart 6 exhibits the rate of 1-year rolling change in the stock index and the currency index against the U.S. dollar of emerging
                                             countries.
                                   Sources: Bloomberg; MSCI.


(3) adding other risk factors to the underlying risks.                                                                                           following the Lehman shock. Consequently, the
Of these methods, the first two are difficult for                                                                                                relative appeal of the third method (adding other risk
financial institutions to apply, due to a trend in which                                                                                         factors to the underlying risks) has been rising. For
tightened financial regulations require them to                                                                                                  example, in the case where the underlying risk is the
decrease leverage and hold ample liquidity buffers                                                                                               price fluctuation risk of equities or bonds, the addition


                                                                                                                                             3                                         Bank of Japan January 2011
                                  Chart 7: Correlations between Asset Prices of Major Countries/Regions
    (1) Correlations of Stock Prices between Regions                                       (2) Correlations of Stock Prices between Countries
             correlation coefficient                                                               correlation coefficient
   1.0                                                                                      1.0
                                                                                                           Brazil vs China          Brazil vs India
                                                                                                           Brazil vs Thailand       Brazil vs Indonesia
                                                                                            0.8
   0.8                                                                                                     Brazil vs Russia         Brazil vs Malaysia
                                                                                                           Brazil vs Turkey
                                                                                            0.6
   0.6
                                                                                            0.4
   0.4
                                                                                            0.2
                                       Emerging Asia vs Latin America
   0.2
                                       Emerging Asia vs Eastern Europe & Middle East        0.0
                                       Emerging Asia vs developed countries
   0.0                                 Latin America vs Eastern Europe & Middle East        -0.2
                                       Latin America vs developed countries

  -0.2                                                                                      -0.4
   CY 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10                            CY 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10


Chart 8: Contribution Ratio of the First Principal Component
         for Stock Price Changes in Major Emerging Asian Countries
             %
   80
                                                                                           Notes: 1. Chart 7 (1) and (2) exhibit linear correlation coefficients of
   75                                                                                                the monthly return over the past two years calculated
   70                                                                                                based on MSCI indices of each country/region. The latest
   65                                                                                                data are as of the end of October 2010.
   60                                                                                             2. Chart 8 exhibits the contribution ratio of the first principal
                                                                                                     component for the comovements of seven major emerging
   55                                                                                                Asian countries (China, India, Indonesia, Malaysia, the
   50                                                                                                Philippines, South Korea, and Thailand). Principal
   45                                                                                                component analysis is conducted for each 3-year interval
   40                                                                                                by using the MSCI index of each country.
                                                                                           Source: MSCI.
   CY        95 96 97 98 99 00 01 02 03 04 05 06 07 08
             -97 -98 -99 -00 -01 -02 -03 -04 -05 -06 -07 -08 -09 -10

of exchange rate risk is considered as a kind of "carry                                coefficients between emerging countries or regions
trade" in a broad sense, and this kind of investment                                   have increased remarkably. For example, looking at
may have increased recently. In fact, as the stock                                     the historical movements of correlation coefficients of
prices and the value of currencies against the U.S.                                    stock returns between (1) major emerging regions and
dollar have risen simultaneously in many emerging                                      (2) a specific country and another emerging country
markets during the recovery process following the                                      (with Brazil chosen as the specific country in this
Lehman shock, investment in emerging market stocks                                     paper), we see that the degree of comovements has
has performed remarkably well for those holding U.S.                                   shown an upward trend irrespective of the
dollars (Chart 5). It should be noted, however, that a                                 combination and recently reached a historically high
highly positive correlation between the change in                                      level (Chart 7). As an alternative method, principal
stock returns and exchange rates in emerging markets                                   component analysis was conducted for stock price
has been observed from a historical perspective (Chart                                 changes in seven major emerging Asian countries, and
6). This fact suggests that careful attention should be                                the result shows that the contribution ratio of the first
paid to the possibility of a reversal process in which                                 principal component, which implies the degree of
the unwinding of carry trade positions accompanies a                                   comovements, has increased significantly for the past
simultaneous decline in stock prices and exchange                                      several years (Chart 8). This fact suggests a growing
         3
rates.                                                                                 tendency in which stock prices of each country are
                                                                                       driven not by idiosyncratic factors but by common
(Increased Correlation among Countries                                                 factors among countries. As for the background of
/Regions)                                                                              heightened comovements of recent emerging market
A characteristic feature of recent asset price                                         stock prices, one may consider that the influence of
fluctuations in emerging countries is that correlation                                 foreign investors tracking an index for the entire


                                                                                       4                                        Bank of Japan January 2011
    Chart 9: Foreign Reserves of Emerging Countries                              Chart 10: Balance of Payments of Emerging Countries
                                                                                            bil. U.S. dollars
        bil. U.S. dollars                            bil. U.S. dollars           1,200
 450              Brazil
                                                                         3,000                   Capital and financial account          Estimates
                                                                                                 Current account
 400              India                                                              800         Changes in reserve assets
                  Hong Kong                                              2,500                   Errors and omissions
 350              Indonesia
 300              South Korea
                                                                         2,000       400
                  Thailand
 250              China (right scale)
                                                                         1,500         0
 200
 150                                                                     1,000 -400
 100
                                                                         500
  50                                                                                 -800
   0                                                                     0
                                                                                 -1,200
    CY 02           04           06      08         10/1Q      10/3Q
                                                                                     CY 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11
 Note: Chart 10 exhibits the sum of 30 emerging countries. The figures for 2010 and 2011 are estimates by the Institute of International Finance.
       Inc (the figure for 2010 partially reflects the actual results). The balance of payments is constructed according to the principles of
       double-entry bookkeeping and the equation "current account + capital and financial account + changes in reserve assets + errors and
       omissions = 0" is maintained. The increase in foreign reserves means the outflows and is expressed as a negative figure.
 Sources: CEIC; The Institute of International Finance. Inc, "Capital Flows to Emerging Market Economies"; web site of each central bank.

emerging market with high expected returns is                                     financial account surplus earned are mirrored by
increasing, as well as that convergence of indices                                reverse flows abroad in the form of a significant
referred to as a benchmark is proceeding. Among                                   increase in foreign reserve assets due to the
other factors, it is possible that increased correlations                         interventions (Chart 10).
among commodity prices have led to stronger
comovements of stock prices of countries that produce                             Reflux of Capital                       from   Emerging           to
different types of commodities. In any case, as the                               Developed Countries
increase in comovements among asset prices in                                     (Purchases of U.S. Treasuries by Emerging
emerging       countries           reduces    the      benefits          of       Countries)
internationally diversified investment that were
                                                                                  In general, foreign reserves are invested in safe and
originally expected from the indexing investment
                                                                                  liquid assets (typically U.S. Treasuries), as they are
approach, 4 the probability of entering a phase of
                                                                                  also regarded as reserves for claims. Most of the
simultaneous adjustment of, for example, stock prices
                                                                                  foreign reserves accumulated through the
has also been increasing.
                                                                                  interventions by the emerging countries are also
                                                                                  considered to flow back into the U.S. government
(Responses by Emerging Countries)                                                 bond market. In this regard, by checking the recent
Due to the massive amount of capital inflows, most                                developments in U.S. Treasury holdings by foreign
emerging countries are faced with upward pressure on                              investors, we can see (1) a remarkable increase in
their local currencies. They are also concerned about                             purchases of U.S. Treasuries by foreign official
the "trilemma of international finance," that is, the                             institutions, and (2) by country and region, an increase
quandary that it is impossible to achieve (1)                                     in purchases by Brazil and emerging Asian countries
stabilization of the foreign exchange rate, (2)                                   such as China (Chart 11). We can also see a strong
independent monetary policy, and (3) free capital                                 negative correlation between the rate of change in
mobility at the same time.                                                        holdings of U.S. Treasuries by foreign official
            In reality, several emerging countries appear                         institutions and that in the U.S. dollar's effective
to be intervening massively in the foreign exchange                               exchange rate for about one year (Chart 12). (Here, as
market to keep their currencies from appreciating, as                             a proxy for the amount of U.S. Treasuries held by
well as introducing or strengthening capital control                              foreign official institutions, the amount held in
measures in succession5 (Chart 9). As a result, the                               custody at the Federal Reserve Bank of New York is
balance of payments of emerging countries shows that                              used.) This chart could imply that emerging countries
the current account surplus and the capital and                                   have been increasing their holdings of U.S. Treasuries

                                                                                 5                                     Bank of Japan January 2011
                                                  Chart 11: Foreign Holders of U.S. Treasuries
                           (1) By Sector                                             (2) By Country/Region
           bil. U.S. dollars                                                           bil. U.S. dollars                      bil. U.S. dollars
3,500                                                                        600                                                                  1,000
                                                                                                   Brazil
3,000                    Foreign official institutions                                                                                            900
                                                                             500                   Russia
                                                                                                   Emerging Asia                                  800
2,500                    Private sector                                                            Latin America                                  700
                                                                             400
2,000                                                                                              China (right scale)                            600
                                                                             300                                                                  500
1,500                                                                                                                                             400
                                                                             200                                                                  300
1,000
                                                                             100                                                                  200
  500                                                                                                                                             100
       0                                                                          0                                                               0
      CY   93 95 97 99 01 03 05 07 09                           10/3Q            CY     02        04         06          08   10/1Q 10/3Q
  Notes: 1. In Chart 11 (1), figures up to 2009 are based on the annual data of the Bureau of Economic Analysis. Figures for 2010 onward are
            calculated by summing up the quarterly Treasury International Capital (TIC) data.
         2. In Chart 11 (2), figures for emerging Asia are the sum of Hong Kong, India, Malaysia, the Philippines, Singapore, South Korea,
             Taiwan, and Thailand. Figures for Latin America are the sum of Chile, Colombia, and Mexico. Figures for emerging Asia and Latin
             America exclude China and Brazil, respectively.
  Sources: Bureau of Economic Analysis, "International Investment Position"; U.S. Department of the Treasury, "Treasury International Capital
           System."

      Chart 12: Relationship between Holdings of U.S. Treasuries by Foreign Official Institutions and the U.S.
                Dollar's Effective Exchange Rate
       %                                                                               correlation coefficient
15                                                                                1
                        Rate of change in the amount of
                        U.S. Treasuries held in custody                         0.8
10                      Rate of change in the U.S.                              0.6
                        dollar's effective exchange rate
                                                                                0.4
 5                                                                              0.2
                                                                                  0
 0                                                                              -0.2
                                                                                -0.4
 -5                                                                             -0.6
                                                                                -0.8
-10                                                                              -1
  Mar-03 Mar-04 Mar-05 Mar-06 Ma r-07 Mar-08 Mar-09 Mar-10

 Notes: 1. The left-hand chart exhibits the 3-month rate of change in the U.S. dollar's effective exchange rate and the 3-month rate of change in the
           amount of U.S. Treasuries held by foreign government and international organizations in custody at the Federal Reserve Bank of New
           York. The latest data are as of the end of September 2010.
        2. The right-hand chart exhibits the 12-month rolling correlation coefficient between the "rate of change in the U.S. dollar's effective
            exchange rate" and the "rate of change in the amount of U.S. Treasuries held in custody."
 Sources: Bank for International Settlements, "Effective Exchange Rate Index"; Federal Reserve Bank of New York, "Factors Affecting Reserve
           Balance."

as a result of massive interventions in response to the                       maturity of U.S. Treasuries held by foreign official
depreciation of the U.S. dollar against their currencies.                     institutions (Chart 13) shows that their holdings of
                                                                              longer-term bonds have recently been increasing
(Purchases of U.S. Treasuries by Foreign                                      remarkably, while those of short-term bonds have
Official Institutions and Downward Pressure                                   remained more or less unchanged. Looking at the
on the Term Premium)                                                          share of indirect bidders (which are purchasers other
It is possible that the purchases of U.S. Treasuries by                       than primary dealers in the U.S. market and composed
foreign official institutions have exerted downward                           mainly of foreign official institutions) at U.S. Treasury
pressure on U.S. long-term interest rates, as holding                         auctions by maturity (Chart 14), we see that the share
periods of foreign official institutions typically                            of medium- and longer-term bonds held by indirect
following a buy-and-hold strategy tend to be longer                           bidders has been increasing. The share of 10-year
than those of the private sector. A breakdown by                              bonds held by them reached around 40 percent


                                                                            6                                        Bank of Japan January 2011
  Chart 13: U.S. Treasuries Held by Foreign                                            Chart 14: Shares of Indirect Bidders at U.S.
            Official Institutions by Maturity                                                    Treasury Auctions
            bil. U.S. dollars                                                             %
 2,500                                                                               55
                                                                                                  10-year            5-yea r
                                Short-term bonds                                     50
                                                                                                  3-year             1-yea r
 2,000
                                Long-term bonds                                      45           3-month
                                                                                     40
 1,500
                                                                                     35
 1,000                                                                               30

                                                                                     25
   500
                                                                                     20
      0                                                                              15
      CY                                                                               Jan-08    Jul-08     Jan-09   Jul-09    Jan-10     Jul-10


   Chart 15: Relationship between the Term Premium and
             Transactions of U.S. Treasuries
        %                                                                 %
 16                                                                            1.0
                                Rate of change in the amount of
 14                             U.S. Treasuries held in custody                0.9 Notes: 1. In Chart 13, short-term bonds mean T-bills, and long-term
                                                                                             bonds mean T-bonds and notes. The latest data are as of the
 12                             Term premium (right scale)                     0.8
                                                                                             end of September 2010.
 10                                                                            0.7        2. In Chart 14, 12-month moving average data are used
  8                                                                            0.6            because the raw data of shares of indirect bidders are
  6                                                                            0.5            volatile. The latest data are as of October 2010.
  4                                                                            0.4        3. The rate of change in the amount of U.S. Treasuries held in
  2                                                                            0.3           custody in Chart 15 is same as that of Chart 12. As for the
                                                                                             definition of the term premium, see Footnote 6.
  0                                                                            0.2
                                                                                   Sources: Bloomberg; Federal Reserve Bank of New York, "Factors
 -2                                                                            0.1           Affecting Reserve Balance"; U.S. Department of the
 -4                                                                            0.0           Treasury, "Treasury International Capital System."
   Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10


recently, though it used to be low compared with other                            Federal Reserve. Yet, foreign official institutions --
maturities        in     the      past.      Thus,       foreign    official      which in the past tended to become less willing to
institutions in emerging countries have tended to                                 invest in U.S. Treasuries when the term premium (U.S.
lengthen the duration of U.S. Treasury holdings,                                  long-term interest rates) declined -- have recently
because -- like private investors in developed                                    increased investment in U.S. long-term bonds due to
countries -- they are compelled to search for yield                               the recent rise in foreign reserves. As a consequence,
under       the      prolonged            accommodative            financial      their activities might have exerted downward pressure
environment in developed countries.                                               on U.S. long-term interest rates to some extent. Indeed,
              Finally, turning to the relationship between                        recent research shows that purchases of U.S.
the rate of change in the holding amount of U.S.                                  Treasuries by foreign official institutions are more
Treasuries by foreign official institutions and                                   likely to bring about a decline in long-term bond
estimates of the term premium of U.S. long-term                                   yields compared with those by private investors.7
interest rates, we can see negative correlations in the                                         If the reflux of capital from emerging
                                                    6
last several months (Chart 15). Considering that                                  countries to the United States leads to a decline in U.S.
these two variables have generally showed positive                                long-term interest rates, this relationship has a
correlations from a historical viewpoint, the recent                              significant implication for international capital flows
negative correlations suggest that an increase in                                 as a whole. Namely, as mentioned earlier, one of the
purchases of U.S. Treasuries by foreign official                                  important driving forces of recent capital flows to
institutions and a decline in the term premium are                                emerging countries is the prolonged accommodative
occurring simultaneously. It should be borne in mind                              financial environment in developed countries. Under
that estimation of the term premium is based on only                              such an environment, investors have been accelerating
one method and that other factors may be affecting the                            their search for yield and become more eager to invest
term premium, such as the Treasury purchases by the                               in assets of emerging countries that are expected to


                                                                                 7                                   Bank of Japan January 2011
                           Chart 16: "Feedback Loop" of International Capital Flows
                                                             Capital inflows in "search for yield"
                                                             under the accommodative financial
                                                                         environment

                              Developed countries                                                      Emerging countries



                         More accommodative financial
                                                                                            Massive currency intervention to offset the
                                 environment
                                                                                            appreciation pressure on local currencies
                                       ↑
                                                                                                                ↓
                       Downward pressure on U.S. long-term
                                                                                               Accumulation of foreign reserves
                                 interest rates



                              Developed countries
                        (in particular, the United States)                                             Emerging countries

                                                              Reflux of capital in the form of
                                                               investment in long-term U.S.
                                                                        Treasuries


produce high returns based on growth prospects. As                                possible sharp decrease in capital inflows to the
the above analysis implies, if the accumulated foreign                            United States induced, for example, by diversification
reserves of emerging countries have contributed to a                              of foreign reserve management by emerging countries.
decline in U.S. long-term interest rates, this will create                        It may be inferred that emerging countries have a
a more accommodative financial environment in the                                 potential need to enlarge the coverage of invested
United States. Thus, the recent international capital                             currencies in their foreign reserves from the viewpoint
flows suggest the operation of a "feedback loop," in                              of mitigating foreign exchange losses stemming from
which the intensified search for yield among investors                            one-sided investment in the U.S. dollar. It is also
further increases capital inflows to emerging countries                           possible that some emerging countries will allow their
(Chart 16).                                                                       local currencies to appreciate and be driven to
                                                                                  monetary tightening by a large margin if their
Conclusion: Risk Factors for the Outlook                                          economic             growth        accelerates          or   inflation     risk
The current international capital flows outlined in this                          intensifies. In such a case, capital flows from
paper entail several risks and vulnerabilities. First,                            emerging countries to the U.S. bond markets may
there is a risk that excessive risk-taking activities by                          shrink dramatically.
investors will create asset price bubbles in emerging                                                Fundamentally, the increase in capital flows
countries. History shows that it is difficult to judge                            to emerging countries is considered to be based on
whether current situations are bubbles on a real-time                             structural changes such as the expansion of their
basis. Nonetheless, it cannot be assumed that the                                 economy, market developments, and improvements in
current situation -- in which investors increasingly                              market infrastructure. At the same time, we have
take profits on several risk factors at once through the                          observed            that    accompanying                investors'     herding
carry trade -- will continue as it stands. Moreover, the                          behavior, capital flows to emerging countries have
experience following the Lehman shock shows clearly                               increased under the unprecedentedly accommodative
that once reversal of the carry trade begins, the                                 financial           environment            in     developed          countries.
situation can take a sudden turn for the worse. In                                Accordingly, careful attention should be paid to the
addition, as the recent asset price movements in                                  future developments in capital flows, including the
emerging markets have shown a rapid increase in the                               accumulation of financial imbalances.
degree of comovements, it should be borne in mind
that once a phase of adjustment is entered, the
possibility of a simultaneous decline in asset prices
will also increase.
          The second risk concerns a large-scale
adjustment in the U.S. Treasury market, due to a

                                                                                 8                                          Bank of Japan January 2011
1
   The following issues of Bank of Japan Review Series                Bank of Japan Review is published by the Bank of Japan to
summarize the current developments in and the background of           explain recent economic and financial topics for a wide range
capital inflows to emerging countries and examine their               of readers. This report, 2011-E-1, is a translation of the original
implications for the outlook for emerging economies:                  Japanese issue, Bank of Japan Review Paper No. 2010-J-22,
 • Bank of Japan, International Department, "Shinkoukoku no           published in December 2010. The views expressed in the
    Kokusai Shikin Flow to Shisan Kakaku no Hendo                     Review are those of the authors and do not necessarily
    (International Capital Flows and Asset Price Changes in           represent those of the Bank of Japan. If you have comments,
    Emerging Economies)," Bank of Japan Review Paper No.              questions, or requests for hard copies, please contact Takuji
    2010-J-1, January, 2010 (in Japanese).                            Kawamoto, Financial Markets Analysis Group, Coordination
• Ookawa, Risa, Yoshihiro Takada, Eiichi Tamura, Satoe Aoki,          and Market Analysis Division, Financial Markets Department
  Masato Higashi, and Yasunari Inamura, "Shinkoukoku wo               (Tel: +81-3-3279-1111 [ext. 2713]). Bank of Japan Review
  Meguru Shikin Flow to Keizai Doukou (Flow of Funds and              E-series and Bank of Japan Working Paper E-series can be
  Economic Developments in Emerging Economies)," Bank of              obtained through the Bank of Japan's web site
  Japan Review Paper No. 2010-J-11, International Department,         (http://www.boj.or.jp).
  Bank of Japan, July, 2010 (in Japanese).
2
    Examples of papers referring to the recent currency
interventions by emerging countries are as follows:
• Bank for International Settlements, "International Banking
   and Financial Market Developments," BIS Quarterly Review,
   December, 2010.
• International Monetary Fund, Global Financial Stability
   Report, April, 2010.
• Organisation for Economic Co-operation and Development,
    Briefing on Exchange Rate Developments, October, 2010.
3
  For an analysis of the expansion of the carry trade and its
sharp reversal, see Hiroyuki Shiozawa, Maiko Koga, and
Takeshi Kimura, "Carry Trade to Kawase Rate Hendo -- Kinri
Hendo ga Shijo Sankasha no Risk Ninshiki ni Ataeru Eikyo
(Carry Trades and Movements in Foreign Exchange Rates:
Effects of Movements in Interest Rates on Market Participants'
Assessments of Risks)," Bank of Japan Review Paper No.
2009-J-5, Bank of Japan, June, 2009 (in Japanese).
4
   If the presence of investors who use an indexing strategy
("passive" investors) is small, they enjoy the benefits of
internationally diversified investment as price takers. However,
if the presence of passive investors increases significantly, their
activities may have an impact on the prices (as they become
price makers). In this case, a paradoxical result will presumably
arise in which they do not enjoy the benefits of internationally
diversified investment.
5
    For example, in October 2010 Thailand removed an
exemption from withholding tax for foreigners receiving
income from Thai bonds, and Brazil raised the tax on foreign
fixed-income inflows. South Korea also expressed a plan to
introduce a new measure to curb capital inflows from abroad.
6
    From the viewpoint of monetary economics, long-term
interest rates can be decomposed into (1) the average of
expected short-term risk-free rates and (2) the risk premium
compensating for long-term bond holdings. The risk premium
in this decomposition is called the "term premium." In Chart 15,
term premiums are estimated using yield spreads between
10-year and 3-month bonds based on the methodology
proposed in Don H. Kim and Jonathan H. Wright, "An
Arbitrage-Free Three-Factor Term Structure Model and the
Recent Behavior of Long-Term Yields and Distant-Horizon
Forward Rate," Federal Reserve Board Financial and
Economics Discussion Series, 33, 2005.
7
   Jesus Sierra, in "International Capital Flows and Bond Risk
Premia," Bank of Canada Working Paper, 2010, analyzed the
quantitative impact of purchases of U.S. Treasuries by foreign
investors on bond prices by means of regression analysis using
the instrument variables method. He found that purchases of
U.S. Treasuries by foreign official institutions led to a decline
in long-term bond yields.




                                                                      9                               Bank of Japan January 2011

				
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