Wednesday, 19 September 2007

Hot money and the double edged sword

Written by Eston Kimani
19-September-2007: In 1997, Asia attracted almost half of the total capital inflow to developing countries. The Asian countries were experiencing what would come to be known as the Asian economic miracle; sustained economic growth for over 30 years, high income growth, poverty reduction, and improved health.

During this period, the stock exchanges of the Asian countries soared and the high interest rates offered by the governments of these countries resulted in an influx of capital from developed countries.

In recounting this period, Joseph Stiglitz, the former chief economist at the World Bank writes that much of this capital was hot money; the kind of capital that looks for the highest return in the next day, week, or month, as opposed to long-term investment in things like factories.

A lot of the hot money went into the stock markets of the Asian countries and in real estate resulting in a bubble as asset prices significantly appreciated.
Inevitably the stock market and real estate bubbles burst resulting in the Asia financial crisis that not only brought economic ruin but threatened to destroy the social fabric of the Asian countries.

As the stock market and real estate bubbles burst, the hot money was quickly removed from the stock market and real estate. This was done through massive sell offs, which resulted in the stock and real estate prices plummeting.

Then since the hot money had to be reconverted back to foreign currency, the respective currencies of the Asian countries suffered a big setback given that a lot of local currency was being dumped to buy foreign currency.

The devaluation of the Asian currencies had a big negative impact on the Asian economies.

In order to discourage the hot money from leaving and increasing the pressure on the local currencies, many Asian governments responded by increasing the interest rates within the economy to make it attractive for the money to stay within the economy.

However the resulting high interest rates caused more problems as companies with debt obligations went into bankruptcy, as they could not afford to pay the high interest rates.

Additionally the value of stock market and real estate assets had decreased significantly once the bubble burst meaning that those assets that had been acquired through credit could no longer support their debt servicing. In this way, many Asian economies found themselves in a lose-lose situation.

Given the spectacular returns of African stock markets in the recent past, there is growing interest from foreign investors to get into the African market.

Yet, African governments must not let the attention get to their heads. Strategies must be put in place to encourage long term investors through issuance of such instruments such as infrastructure bonds that can be used to raise money for badly needed infrastructure projects.

Additionally, there should be measures in place to guard against hot money that is likely to cause problems in the future. Early exit fees and limits on how much foreign currency is allowed to leave the country within a short period of time are some of the controls that can be used to discourage hot money speculators.
As foreign investors become increasingly interested in the Nairobi Stock Exchange, we have to ensure that we have the controls and well laid procedures that will ensure a win-win situation and built a foundation that will serve us well into the future.

Despite the thrill that is likely to come from an appreciation in stock prices as foreign investors increase the demand for stocks, we have to ensure that we guard the long term well being of the stock market and the economy.

An oft-told story is that of a man who went out to find diamonds and mineral riches. He travelled far and wide in his quest to locate the precious minerals but could never find any. Since he was very determined, he decided that he would sell his land and risk his fortune to find the treasure he was seeking for.
He sought out a buyer and explained that he needed the money to go out in search of mineral treasure. Once the buyer had bought the land, he set out to explore it and to his amazement realised that the man’s land had vast reserves of gold, diamonds and minerals.

The man after treasure had looked over far and wide for minerals but had never even bothered to look at his own land.

As government officials and ministers go in and out of foreign capitals looking for investors they need to remember this story. Given the vast unexploited resources in our country, it is time for us to look inward to find treasure.

We need to shift our attention from trying to convince others to invest in our economy and to focus on helping the Kenyan citizens identify and exploit the opportunities around them. Once we have successfully done that, we will not need to convince anyone to invest in our economy as they will come out seeking for us.

Is it not true that “chema chajiuza kibaya chajitembeza?” Or what good shall it do for us to have a growing economy that we do not own? The economist, Paul Krugman, argues that only growth in total factor productivity and not capital investment can lead to long-term prosperity.

This means that there is a lot can be done if we stop giving the excuse of “lack of funds” for our inaction and focus on developing the country and its people in as many diverse ways as possible.

Kimani is the CEO of Africa Value Investment Partners and is a graduate of the Massachusetts Institute of Technology.

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