In today's financially turbulent world, each country has to look out for itself to prevent falling into a financial abyss. The different kinds of foreign capital have to be identified and dealt with. This second article on managing capital flows discusses the need to carefully manage foreign loans, and the need to identify and prevent the kinds of manipulative and speculative funds that caused so much turmoil in Asia and elsewhere.

By Martin Khor

March 1999

Foreign Loans and Credit

Another form of foreign capital flows relates to loans and credit denominated in foreign currencies.

The proper management of foreign credit is vital if developing countries are not to fall into a debt trap.

In the 1970s and 1980s, a lot of foreign loans was given to governments in developing countries. A substantial part of the loans did not go into productive or income-generating projects.

Moreover, the fall in commodity prices caused these countries' export earnings to shrink. This combination of factors meant that many countries were unable to service their foreign loans, and had to request for debt rescheduling.

This was met only if the countries agreed to follow 'structural adjustment policies' devised by the International Monetary Fund and the World Bank. That's how about 80 developing countries, the majority of them being African or Latin American, fell into a debt trap and under the sway of the IMF and World Bank.

Many countries learnt the lesson that governments should not obtain too much foreign loans if they are not good at managing them. But a new assumption was made, that if private companies took on such loans there would not be so much risk as corporations are supposed to be good in financial management since they are commercially oriented.

In the 1990s, many developing countries (including those in Asia) were persuaded to 'liberalise' their financial operations. Thus, countries like South Korea and Thailand that in the past controlled the private sector's foreign loans now relaxed their conditions and in fact encouraged the inflow of foreign-currency credit to local commercial banks and companies.

This was a costly mistake, firstly because a significant part of the foreign loans was also badly managed, as they were channelled to sectors (such as property development and share purchases) that were already bloated.

And secondly, because the unexpected and sharp depreciations of the East Asian countries' currencies meant the borrowers had to pay much more in local currency terms to service their foreign debts.

Many of the loans had been on a short-term basis, and when they matured, the local banks or companies would ask for renewals of the loans, which were thus 'rolled over'.

However, as the Asian crisis broke out, the foreign creditors refused to roll over the loans and asked for repayment. Even some loans that were not yet due were 'called in'.

The failure of private banks and companies to meet their foreign debt obligations was a major cause of the financial crisis in South Korea, Thailand and Indonesia. The private foreign loans had gone out of control, due to policy liberalisation.

There was an exit by foreign creditors as well as a kind of moratorium on providing new loans. This exit by foreign creditors together with the exit by foreign portfolio investors constituted the 'panic withdrawals' so much talked about these days.

In devising a policy for foreign loans, a country has to remember the brutal fact that the loans (whether obtained by the public or private sector) have to be repaid, with interest, in the specified time frame, and in the foreign currency denominated.

This can be done only if the borrower has invested the foreign loan in a project or activity that yields a net revenue sufficient to service the debt.

But whilst making sufficient profit may be enough for an individual company or agency to repay its foreign loan, that's not enough from a national perspective.

That's because the loan has to be repaid in foreign currency. For all the loans to be thus repaid, it implies that the loans as a whole have to be invested in activities that together yield sufficient foreign exchange earnings to enable the debts to be settled.

This is often a tall order. For a government agency or a private company to use the loan wisely enough to ensure its repayment is often hard enough; but for the loans as a whole to earn sufficient foreign exchange to service the foreign loans can be a special rather than a general achievement.

This is why many countries fall into a debt trap: it may be easy to get a foreign loan (at least the first few times!) but it is much harder to be able to service it satisfactorily.

Thus, developing countries have to devise prudent policies on foreign loans. Governments should limit the amount of foreign credit they themselves should get and make sure that a large part of it earns (or helps the country to earn) foreign exchange.

Just as importantly, developing countries should place strict controls over the private sector's foreign loans, and not leave it to each company or bank to decide if and how much it wants to borrow.

The Malaysian Central Bank's ruling that private companies can only take foreign loans to the extent they can show the loans would yield foreign exchange for debt servicing is an example of control that should be considered by other countries.

Highly Speculative Funds

Finally, there is another category of foreign capital that needs especially strict controls: the funds that are used to speculate in and manipulate local financial and capital markets.

These funds are used by institutions (which may include hedge funds, investment banks and even commercial banks and big corporations) to take positions on the currency, money, bond, stock and commodity markets in the expectation that changes in the values of currencies, or in the prices of shares and commodities, or in interest rates, can bring them profits.

Often these institutions (especially the hedge funds) do not even bring in their own capital, but make use of their great leverage to borrow large sums from banks, make use of derivatives and other financial instruments to further expand the value of funds at their disposal, and then make bets on the markets.

Due to financial globalisation and liberalisation, many developing countries have experienced financial turbulence caused by the operations of these big market players. They have been able not only to take advantage of, but to actually instigate and cause swings in, the values and prices of currencies, stocks and interest rates.

The Asian crisis, with all its consequences in currency and output collapses and job losses, was triggered by these kinds of funds and their kind of play.

They do constitute a major part (and probably the most dangerous and poisonous part) of the 'short-term capital flows' that are often talked about these days.

Yet because the activities, modus operandi and even the identities of these players are shrouded in secret, this highly speculative capital flow ('capital play' might be a more appropriate term) is often not considered when the dangers of short-term capital flows are discussed.

But developing countries (and indeed the world community) would only imperil their financial systems and their overall economies if they do not urgently put in place policy and regulatory measures to control, prevent or strictly manage this category of foreign capital.

Some of Malaysia's foreign-exchange control measures introduced last September were aimed specifically at this kind of capital. The moves to deinternationalise the ringgit (by not recognising ringgit sales or trade outside Malaysia) and to fix the ringgit to the dollar were meant to create conditions that made it difficult or impossible for financial speculators to gamble on the ringgit's value.


Foreign direct investment, portfolio investment, foreign loans and credit, and highly speculative funds are the major categories of foreign capital that flow in and out of a country.

Since developing countries like Malaysia are too small to be a big player on the global market, they can be very vulnerable not only to the decisions of the big institutions that determine the volume and timing of the flows, but also to the manipulative activities of some of the global speculative players.

However, developing countries can take some defensive measures, and must urgently formulate a comprehensive policy to deal with the different kinds of capital flows.

Such a framework may include a selective policy towards attracting foreign direct investments of the right type; a careful policy on portfolio investment that welcomes serious long-term investors but keeps out the damaging short-term profit-seekers; a very prudent policy towards public and private foreign loans; and measures that prevent the manipulative and speculative activities and funds in the financial and capital markets.

Even with the best intentions and plans, there is no certainty that a country can be shielded from the adverse turbulent effects of global capital flows and financial operations.

The national policies have to be augmented by international regulatory action, which is still absent. Until that comes about, if ever, each nation should look out for itself in this predatory world. - Third World Network Features

About the writer: Martin Khor is Director of the Third World Network.