Asia has accumulated most of the world's foreign exchange reserves, and plenty of hubris to boot. Now, fears have been raised that too much foreign cash could distort financial markets.
Illogical? Surely foreign investors pumping money into the region is an unambiguous vote of confidence. Witness Thailand's global roadshow for a bond offering that is neatly diverting attention from its deep-set economic problems.
When the IMF warns excessive cash inflows pose danger to financial stability it means short-term funds chasing the high returns offered by regional currencies.
Unlike foreign direct investment, portfolio funds are inherently fickle, leaving the potential for whiplash currency movements. The idea finds expression in nature when limiting friction, keeping an object stationary, is overcome giving way to an exaggerated movement Similarly, stable fixed currency systems persuade investors the risk of devaluation is low causing them to accept a lower risk adjusted rate of return.
This has been the Southeast Asian experience where most economies have run US dollar-linked currency regimes, supported by relatively high interest rates. Strong underlying economies and significant direct investment has made the game easy for traders who borrow funds in US dollars and invest in Asian currencies.
Every day, banks and foreign funds bet massively on small movements in currency and interest rate levels. Much of the activity is conducted via swap transactions where counter parties trade fixed and floating interest liabilities. Banks earn big bucks guessing changes in yields and arbitraging mis-priced bonds where deep variance still exists.
