Derivatives and Global Capital Flows

Four factors in the current financial crisis in Asia have surprised observers. First, although capital flows in Asia appeared stable, the crisis was precipitated by the reversal of the very large proportion of short-term lending. Second, although Asia appeared to be an example of the maxim that capital flows to the region with the highest rates of return, now it appears that risk-adjusted returns were lower in Asia than in other regions. Third, although the foreign lending banks are the most sophisticated operators in global finance, they seem to have had difficulty assessing risk. Fourth, contrary to the belief that foreign equity investors will not liquidate their positions in response to currency devaluation, the equity and foreign exchange markets collapsed together. According to Visiting Scholar Jan Kregel, these four factors may be explained by the role of derivatives contracts in the flow of funds to Asia.