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UPDATED: May 31, 2010 NO. 22 JUNE 3, 2010
Crisis Focus: Alert Over Capital Inflow

Emerging Asia's capital markets have posted rapid gains as the pace of economic recovery in the region has increased, drawing massive investment from overseas. Governments in emerging Asia should remain vigilant and be ready to act if volatile capital inflows threaten to destabilize the region's financial markets, said the Asia Capital Markets Monitor, Asian Development Bank's annual assessment of the performance and outlook for the region's capital markets released on May 18. Edited excerpts follow:

Global economic and financial conditions have improved over the past year in part due to the unprecedented policy measures taken in response to the global financial crisis. As a result of the improving external environment and swift policy responses by Asian governments, emerging Asia's economic recovery has gained substantial traction.

Inflation, though rising, remains manageable. The balance of payments across the region remains in surplus as exports rebound and capital inflows surge. External funding conditions for emerging Asia have vastly improved as the global credit environment eases and investors' appetites for risk return. Even the impact of the Greek debt crisis and fears of its contagious effects on Asia's capital markets have been and are expected to remain limited. But the timing and pace of exits from fiscal and monetary stimulus will influence the region's capital markets.

The global economic recovery, very low returns on safe assets in developed countries, and attractive valuations drove the post-crisis rebound in emerging Asian equity markets. Emerging Asian equities delivered lofty returns in 2009 and market capitalization soared, though still remaining below pre-crisis levels.

Despite favorable cyclical development, the strong performance of emerging Asian equities in 2009 limits further gains this year.

The region's strong economic recovery has also led to a surge in capital flows to emerging Asia.

In 2009, emerging Asia's currencies already strengthened to varying degrees against the U.S. dollar. Appreciation pressures on Asian currencies are likely to intensify as capital inflows surge due to the region's improved economic prospects.

This surge in capital inflows has been driven by portfolio equity flows, which created net inflows in 2009, as investors take advantage of widening earnings potential between emerging Asian and mature markets.

While the return of capital flows is welcome, surges in short-term capital inflows could destabilize financial markets and pose a risk to stability.

Managing capital flows requires an array of policy measures including sound macroeconomic management, a flexible exchange rate regime, resilient financial systems, and temporary and targeted capital controls.

The use of capital controls may be appropriate in circumstances where capital inflows are transitory, and are adding undue pressure on exchange rates and posing risks to financial stability; and where the effectiveness of macroeconomic policy measures to counter the inflows and the exchange rate movements are uncertain.

The Asia Capital Markets Monitor covers 11 economies of emerging Asia, including the Chinese mainland, Hong Kong, India, Indonesia, South Korea, Malaysia, the Philippines, Singapore, Taiwan, Thailand and Viet Nam.

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