Chapter 11 CAPITAL FLOWS AND THEIR IMPLICATIONS FOR CENTRAL BANK POLICIES IN TAIWAN. by Hsiao Yuan Yu 1

Chapter 11 CAPITAL FLOWS AND THEIR IMPLICATIONS FOR CENTRAL BANK POLICIES IN TAIWAN by Hsiao Yuan Yu 1 1. Introduction Capital flows have significant repercussions for developing countries. In the past decade, most of the countries in the SEACEN region received massive capital inflows due to their rapid economic development and steady export performance. The influx of foreign capital can supply the needed capital to support their economic development but it can also have an adverse impact on the economy and financial system of the recipient countries, if the capital inflows are not properly managed. Whether huge capital inflows create asset bubbles is another important issue for the countries to address. Section 1 of this report highlights the pattern of the capital flows in Taiwan. It analyses the related capital flow policies, capital flow trends in Taiwan, and identifies the possible determinants. In Section 2, an empirical analysis of capital flows is carried out, including the factors affecting capital flows. The consequences of capital inflows and the implications of capital flows for central bank policies are discussed and the conclusions are then presented. 2. General Framework and Capital Flows Management Policies in Taiwan The balance of payment (BOP), reflecting a country s capital flows and trade, consists of three parts: current account, capital account and financial account. Current account usually reflects a country s trade surplus or deficit and is significantly important for small, open economies. Capital flows, on the other hand, are generally captured under the financial accounts of BOP after revision by the IMF, and represent the amount and direction of capital flows into and out of a country. 1. Author is the Senior Economist from Department of Foreign Exchange, Central Bank of Republic of China, Taiwan 327

Taiwan is a small island country and is typical of an open economy. Its economy is traditionally dependent on trade. Its current account was fully liberalised many years ago. The liberalisation of current account could be traced back to the 1980s when Taiwan started accumulating huge foreign exchange reserve. It was liberalised much earlier than the capital account and financial account. The capital account, which used to represent a country s capital flows, plays a very minor role after revision of the IMF BOP standard. The items left in the capital account are capital account credit and capital account debt, which are often relatively small in comparison to the main factors, like FDI, portfolio and public and private loans in capital flows. Today, the focus on capital flows has shifted from the traditional capital account to the financial account. There are three main parts in the financial account. They are: foreign direct Investment (FDI), portfolio investments, and public and private loans. Generally speaking, all these three items are liberalised in Taiwan. Some minor restrictions are imposed on them only under certain specific conditions. Capital inflows and outflows for approved FDI are liberalised. Portfolio investments assets and liabilities are also liberalised under the non-discretionary trust account. Other investment assets and liabilities, including public and private loans, are liberalised in Taiwan as well. Only certain kinds of loans which exceed one year are required to be registered under long-term debt for record purpose. Investments in the financial account without corresponding approval are subject to the following restrictions: (a) Domestic company up to $50 million per annum (b) Domestic resident up to $5 million per annum (c) Nonresident remittance up to $100 thousand per transaction We would like to introduce the major capital flow policies of Taiwan in the following two ways: New Taiwan Dollar (TWD) exchange rate regime and the capital flow deregulations. 2.1 New Taiwan Dollar (TWD) Exchange Rate Regime Trading USD/TWD, EUR/TWD, JPY/TWD, GBP/TWD and many other worldwide currencies in Taiwan is quite easy because the Taiwan foreign exchange market is a highly free market. The TWD exchange rate regime basically is a managed floating regime system. In principle, the TWD FX price is mainly determined by market supply and demand. The Central bank will 328

intervene in the foreign exchange market when two exceptions occur. One of the exceptions is seasonal interruption and the other is the abnormal factors, i.e., large flows of hot money. To maintain the orders of our foreign exchange market and reduce fluctuations of the TWD, the central bank may step in to manage the TWD in the FX market. Under the managed floating regime system, the US dollar/twd is stablised in a relatively smooth pattern. Figure 1 depicts the quarterly data of USD/TWD from 2000 Q1. Figure 1 Trend of USD/TWD 2.2 Deregulations on Capital Flow Management Capital inflow and outflow for individuals and companies are generally very free in Taiwan. Only few capital flow restrictions are imposed on short-term TWD conversions and they are: (a) Domestic company up to $50 million per annum (b) Domestic resident up to $5 million per annum (c) Nonresident remittance up to $100 thousand per transaction In addition to the previous few capital flow restrictions, the following major policies enlarging the Taiwan capital market and enhancing market efficiency are currently being implemented: (a) Loosen restrictions on foreign investment in domestic securities. (b) Promotion of the internationalisation of the domestic capital market. (c) Allow nonresident foreigners to take up TWD loans from local banks. 329

(d) Keep approving applications on overseas securities investment. (e) Revise regulations to enhance capital movements. (f) Simplify RMB exchange business. (We opened RMB exchange business on July 1 2008) 3. Trends in Capital Flows in Taiwan During the past decade, the current account, capital account, and financial account all recorded significant growth in Taiwan. We saw our current account continually soaring, capital account running in a breakeven position and financial account shedding. By and large, our BOP recorded large surpluses between the years 2000 and 2003, reaching a peak in 2003 at US$37,092 million, but declined after 2003. In 2007, the BOP of Taiwan was about US$4,020 million. Figure 2 illustrates the trend of capital flows in the past 23 years. Figure 2 Trend of BOP (Taiwan) Unit: US$ million In regard of the current account, we saw steady increases in both exports and imports. In 2007, good and service exports reached US$277,736 million while good and service imports reached US$251,156 million. This brought to our current account a surplus of US$32,881 million in 2007. It can be noticed in Figure 3 that both the volume of exports and imports in value terms have doubled over the last decade. 330

Figure 3 Current Account Trend (Taiwan) Unit: US$ million The position of Taiwan s financial account is very interesting and is totally in the opposite direction as the current account. With the increased liberalisation of the capital market in Taiwan, the domestic residents and companies moved to diversify their portfolios in different countries and currencies instead of in the traditional TWD assets. This swelled the deficit in the financial account recently, especially after 2005. The negative figure in the financial account helped balance the surplus in the current account to stabilise the TWD trend. We have portfolio investment asset worth about US$44,993 million while only US$5,218 million portfolio investment liability in 2007. The financial account deficit reached a record high negative of US$37,100 million in 2007. Figure 4 depicts the recent financial account trend of Taiwan. Figure 4 Financial Account Trend (Taiwan) Unit: US$ million 331

Further, taking a look at the three main components of financial account - FDI, portfolio investment and public and private loans - they tell different stories about capital flows in Taiwan. Figure 5 plots the net FDI, net portfolio investment, as well as the net public and private loans from the period 1985 to 2007 in Taiwan. First of all, the FDI moved in a relatively smooth path during the period. Net FDI was typically negative in Taiwan during the past 23 years. Only in the years 1985, 1986, 1987 and 2006 had Taiwan recorded a positive net inflow but the magnitudes were relatively smaller. For instance, net FDI in Taiwan 2006 was +US$25 million while it was US$2,946 million in 2007. Second, turning to net portfolio investment assets and liabilities, the situation is a little different from the previous net FDI. There were huge magnitudes of portfolio investment assets and liabilities in Taiwan, especially the absolute amounts of portfolio investment assets. However, substantial capital outflows in portfolio investment assets appeared after 2005 due to a significant difference of interest rate between Taiwan and abroad. This caused the negative net portfolio investments to reach a record low of US$39,775 million in 2007. Finally, net public and private loans in Taiwan behaved in a very volatile manner and told a totally different story than net portfolio investment. Before 2001, the net public and private loans behaved in a most volatile as compared to the other two components of capital flows; the capital inflows were positive in some years but in the other years they were negative. The net public and private loans mounted drastically after 2002 and sustained at a high level for almost four years until 2005. This was mainly driven by the expectation of TWD appreciation during that period. This was also the main factor contributing to the positive capital inflows in the financial account between 2002 and 2005. However, the financial account balance declined dramatically after 2005 as a result of significant capital outflows in net portfolio investments. After comparing the trends of capital flows, Figure 6 summarises some statistics of net FDI, net portfolio investment, and net public and private loans. In our sample period, the mean values of the net FDI and net portfolio investment were negative at -US$2,287.3 million and US$3,620.3 million, respectively. On the other hand, the net public and private loans was positive at US$2,188.7 million. Their corresponding medians are US$1,773 million, -US$902 million and US$285 million, respectively, and show similar signs with the mean values. Notice that the mean value of net FDI (-US$2,287.3 million) was larger than the mean value of net portfolio investment (-US$3,620.3 million) but their corresponding medians (-US$1,773 million vs. US$902 million) were in the opposite directions. This tells us that the distributions of net portfolio investment behaved in a much more volatile manner than net FDI. This can be verified in Figure 5 and in the statistics of their corresponding standard deviations as well. 332

Figure 5 Trends of Net FDI, Net Portfolio Investment and Net Loans (Taiwan) Unit: USD million To see the deviations among these three factors, both the net portfolio investment and net public and private loans had significantly greater deviations than the net FDI. The standard deviation and range of the net portfolio investment and net public and private loans were multiple times greater than the standard deviation and range of net FDI. Net portfolio investment was the most volatile factors among the others. Figure 6 Statistics of net FDI, Net Portfolio Investment and Net Loans (Taiwan) Net FDI Net Portfolio Net Public and Investment Private Loans Mean -2,287.3-3,620.3 2,188.7 Median -1773-902 285 S.D. 1,783.4 9,376.9 8,959.0 Range 5,610 49,111 31,489 Max 263 9,336 21,258 Min -5,347-3,9775-10,231 Unit: US$ million 333

After comparing the trends of net FDI, net portfolio investments as well as net public and private loans, we next compare the corresponding FDI inflow, portfolio investment inflow and public and private loans inflow. Figure 7 plots the trends of inflows of these three components. The trajectory of the FDI inflow was smoothest compared to that of the other two components, and the pattern is similar as for the net flows in Figure 5. FDI inflow surged after 2005 and reached US$8,161 million in 2007. Both the trends of portfolio investment inflow and public and private loan inflow showed more volatility. The portfolio investment inflow was more volatile than public and private loan inflow. Portfolio investment peaked at US$31,045 million in 2005 but declined sharply soon after. It reached US$5,218 million in 2007 which was the lowest among the three components. On the other hand, the public and private loan inflow did not surge as strongly as portfolio investment inflow after 2000 and dropped to relative low point in 2006. However, it bounced back sharply to US$12,551 million in 2007 and was the largest contributor of capital inflows at that time. Figure 7 Trends of FDI, Portfolio Investment and Loans Inflows (Taiwan) Unit: US$ million In the same way, we also summarise the statistics of FDI inflow, portfolio investment inflow as well as public and private inflow in Figure 8. Likewise, the pattern of FDI inflow was the smoothest, as in Figure 7. It had the lowest average of US$2,112.3 million and median of US$1,445 million among the three components and also the lowest standard deviation (US$2,126.6 million) and 334

range (US$7,939 million). Portfolio investment inflow had a higher average at US$6,926 million than public and private loan inflow at US$5,513.7 million, but a lower median at US$2,729 million than public and private loan inflow at US$4,174 million. This shows that the distribution of portfolio investment inflow was much more skewed than the distribution of public and private loan inflow. In addition, the portfolio investment inflow showed the most volatility and deviations of portfolio investment inflow were the greatest one among the three, with the standard deviation at US$9,591 million and range at US$32,291 million. The numbers are presented in Figure 8. Figure 8 Statistics of FDI, Portfolio Investment and Loans Inflows (Taiwan) FDI inflow Portfolio Investment Public and Private inflow Loans inflow Mean 2,112.3 6,926.0 5,513.7 Median 1,445 2,729 4,174 S.D. 2,126.6 9,591.0 5,474.8 Range 7,939 32,291 19,089 Max 8,161 31,045 17,520 Min 222-1,246-1,569 Unit: US$ million Turning to the scenario of capital outflows in Taiwan, the story is a little different than the previous one(s). The FDI outflow, portfolio investment outflow as well as public and private loans outflow trends are depicted in Figure 9. Obviously, the trajectory of FDI outflow was still the smoothest among the three and reached US$11,107 million in 2007. Public and private loans outflow were more volatile than FDI outflow but more stable than portfolio investment outflow during the relevant period. The movement of portfolio investment outflow was most volatile, after 2002, when it dropped dramatically and reached the record low at US$44,993 million in 2007. The factors attributed as driving the massive portfolio investment outflow were the domestic residents portfolio risk diversification and the popularity of offshore mutual funds in Taiwan. 335

Figure 9 Trends of FDI, Portfolio Investment and Loans Outflows (Taiwan) Unit: US$ million Figure 10 summarises some of the key statistics of FDI outflow, portfolio investment outflow as well as public and private loan outflow. Public and private loan outflow had the smallest absolute value of the mean at US$3,325 million while FDI outflow recorded a bigger average value than public and private outflow. Again, portfolio investment outflow played the key role in the trend of capital outflow. Besides, portfolio investment outflow had the biggest standard deviation and range than both FDI outflow and public and private loan outflow. This substantiates the finding that the portfolio investment outflow was the most volatile among the three components. Figure 10 Statistics of FDI, Portfolio Investment and Loans Outflows (Taiwan) FDI outflow Portfolio Investment Public and Private outflow Loans outflow Mean -4,400-10,546.3-3,325 Median -4,420-4,136-4,615 S.D. 2,628.3 14,359.4 6,021.1 Range 11,042 44,993 27,554 Max -65 0 11,990 Min -11,107-44,993-15,564 Unit: US$ million 336

4. Determinants of Capital Flows in Taiwan Although we have a moderately neutral BOP recently, it consisted of a huge surplus in current account and a deficit in financial account, which reflected the occurrence of massive capital inflows and outflows simultaneously. From the group discussion at the first SEACEN capital flow workshop, we classify the determinants of capital flow into two parts. One set are the common factors which are at play across the different countries and the other set are the country specific factors which are operative locally and reflect the country s specific situation. The determinants are summarised in Figure 11. Among the common factors of that determine capital flow, both inflow and outflow, we see more capital inflow determinants than capital outflow determinants. Figure 11 Common Factors of Capital Flow Determinants Inflow Common Factors of Capital Flow Outflow Improved investment environment Government policies Quality of infrastructure Political stability Strong economic growth Free trade agreement (FTA) Capital market development External factors US economy recession Global economy slowdown Weak US dollar Government policies on resident capital outflow Risk diversification Alternative investment opportunities 337

Beyond the common factors of capital flow determinants, we provide some other essential country specific factors which also potentially influence capital flow in Taiwan. Possible causes behind the significant capital inflow in Taiwan include: (1) Increasing export (2) Moderate FX policies (3) Sound stock market (4) Expectation of currency appreciation (5) Getting better relationship with China recently On the other hand, the huge negative numbers in the financial account represent huge capital outflow. Possible determinants of capital outflow include: (1) Increasing import (2) Strong resident portfolio diversifications (3) Interest rate difference between TWD, USD and other major currencies (4) Popular offshore mutual funds (5) Political uncertainty Besides the above plausible determinant factors influencing capital inflow and outflow in Taiwan, a simple empirical model is introduced to investigate whether some key factors are significant in capital flow determination. Our empirical model is set up as follows: CF in = α + β 1 GDPGR + β 2 IR + β 3 CAR + δ 1 WGDPGR + δ 2 WIR + ε (1) Equation (1) modeled the relationship between the dependent variable capital flow (CF in ), three internal independent variables (GDPGR, IR and CAR ), two external independent variables (WGDPGR and WIR ) as well as the intercept item (α). The parameters β and δ are the corresponding coefficients of the internal independent variables and external independent variables, respectively. From the first SEACEN capital flow workshop, three internal independent variables in our empirical capital flow model are domestic real GDP growth rate (GDPGR), domestic real interest rate (IR), and current account to GDP ratio (CAR). And the rest of the two external independent variables are world real GDP growth rate (WGDPGR), and world real interest rate (WIR). For a tractable model, we would like to use some proxies here: we use real 12-month time deposit rate as proxy of domestic real interest rate; US real GDP growth rate for world real GDP growth rate and 1-year US LIBOR rate for world interest rate, respectively. 338

Following the guidelines of the SEACEN capital flow research workshop, we adopt quarterly data from 1985 to 2007 which include complete data of 92 quarters in capital flow, domestic real GDP growth rate, domestic real interest rate, current account to GDP ratio, US real GDP growth rate and 1-year US LIBOR rate. In order to carefully build up our empirical model, we have to investigate the stationary of every variable and to check whether some of the variables have the unit root properties first. The augmented Dickey-Fuller unit root test (no constant approach) will be adopted. Our test results suggest that only capital inflow data is stationary overtime while other domestic real GDP growth rate, domestic real interest rate, current account to GDP ratio, US real GDP growth rate and US real interest rate are non-stationary overtime. However, the five independent variables become stationary after first order difference. The augmented Dickey-Fuller unit root test results are summarised in Figure 12. Figure 12 Augmented Dickey-Fuller Unit Root Test Results Source: Bloomberg and Aremos database. * denotes significant at 95% confidence interval. After investigating the unit root test, we should rebuild our empirical model to cover stationary variables instead of previous non-stationary variables. Thus, our empirical model would become the following equation (2). CF in = α + β 1 GDPGR + β 2 IR + β 3 CAR + δ 1 WGDPGR + δ 2 WIR + ε (2) Different from previous equation (1) is that we adopt first order difference of five independent variables instead of those independent variables themselves. This correction is due to the fact those independent variables are non-stationary overtime in previous unit root test. The regression empirical results of our model are summarised in Figure 13 below. Parentheses in the Table denote the standard deviation (S.D.) of the corresponding variables. 339

Figure 13 Capital Inflow Empirical Model Results Source: Bloomberg and Aremos database. * denotes significant at 95% confidence interval. According to the results of our empirical model in Figure 13, both constant and the first independent variable, difference of domestic real GDP growth rate are significant. The estimate of constant term is 3,714.24 with standard deviation 512.64 and t-statistic 7.25 which is significant at 95% confidence interval. Among the three internal variables and two external variables, only difference of domestic real GDP growth rate is significant in our empirical model. The estimate of difference of domestic real GDP growth rate is 652.57 with standard deviation 302.85 and t-statistic 2.15. Other two internal variables, difference of domestic real interest rate and difference of current account to GDP ratio, and two external variables, difference of US real GDP growth rate and difference of US real interest rate are not significant during this sample period in our empirical model. Please note that empirical results might be different in other sample periods or in other kinds of models. Based on the previous capital inflow empirical model, we substitute capital outflow data in place of original capital inflow data and repeat the empirical model. The augmented Dickey-Fuller test shows that capital outflow data are stationary overtime in our sample; other variables behave stationary as well after first order difference. The statistic of capital outflow in the augmented Dickey-fuller test is -6.80. Then we have the empirical model as following equation (3). CF out = α + β 1 GDPGR + β 2 IR + β 3 CAR + δ 1 WGDPG + δ 2 WIR + ε (3) The results of the empirical model of capital outflow show that only the constant item is statistically significant under 5% level. The first order difference of domestic real GDP growth rate, domestic real interest rate, current account 340

to GDP ratio, world real GDP growth rate as well as world real interest rate are all insignificant in our sample. The summary of the capital outflow empirical results are presented in Figure 14. 5. Capital Flows and Monetary Policies The recent capital flow liberalisation had significant impact on our financial account and balance of payment. Massive capital inflows in public and private loans brought in much capital to the Taiwan capital market while significant capital outflows in portfolio investment contributed to much capital flowing abroad Figure 14 Capital Outflow Empirical Model Results Source: Bloomberg and Aremos database. * denotes significant at 95% confidence interval. as well. The net effect of capital inflow and capital outflow was increased slowly and then dropped drastically during the past five years. This net effect of financial account also dominated the development of balance of payment which resulted in a minor negative BOP in 2007. This trend could be seen from Figures 2 and 5. Observing the trends of FDI inflow, portfolio investment inflow as well as public and private loans inflow during past five years in Figure 7, it is obvious that massive amount of capital had flowed in, especially in portfolio investment after 2002 and in public and private loans after 2001. The huge amount of capital inflow in the portfolio investment item was mainly attributed to the liberalisation of restrictions on foreign institutional investors and the globalisation of Taiwan capital market. With the liberalisation of many restrictions on foreign investors, most caps of Taiwan listed companies were amended to 100%, as to compared to less than 50% previously. This policy helped attract more and more foreign investors, including investors of institutions and natural persons, in moving capital to invest in the Taiwan stock and bond markets in recent years. Portfolio investment inflow reached a record high at US$31,045 million in 2005. This 341

significant trend could be easily seen in Figure 7. The second largest capital inflow in Taiwan during the past five years was public and private loans. According to Figure 7, massive amount of capital inflow appeared in the years of 2002, 2003, 2004, 2005 and 2007. From an analysis of the public and private loan inflow data, the reasons behind this surge of capital inflow could be attributed to the expectations of TWD appreciation in the private sectors. Private commercial banks would borrow first in foreign currencies and then pay back at the end of year if they have the expectation of home currency appreciation. They could make the profit between the periods of borrowing and repayment, depending on the extent of the appreciation. In years of 2002, 2003, 2004, 2005 and 2007, people expected TWD to appreciate and engaged in borrowing at the beginning of year and then paying back at the end of year. As a result, we saw a massive surge of capital inflow in private loan. Those two factors are the most important reasons explaining for the significant capital inflow in recent years in Taiwan. Based on the previous discussion and statistics, we see an increasing capital outflow trend in the financial account in recent years. This was mainly due to the huge amount of portfolio investment outflow. Clearly there was a significant net outflow effect in the financial account after 2005 and this had a very important impact on Taiwan. As discussed, the residents in Taiwan were eager to look for alternative investment opportunities from the worldwide different asset classes motivated by risk diversification and accelerating globalisation. Domestic portfolio diversification and popular offshore mutual fund in Taiwan were the driving forces behind the outflow of home capital, resulting in big deficits in net of portfolio investment and financial account. The deficit in financial account in recent years slowed FX reserves accumulation making the balance of payment negative in 2007. This helped moderate the huge surplus of current account and deficit of financial account in Taiwan to keep the balance of payment neutral. It is to be noted that Taiwan had a huge surplus in balance of payment after 2000 reaching a peak at US$37,092 million in 2003. Although the surplus in the balance of payment started declining after 2003, it was still positive until 2006. Then in 2007, for the first time in the past decade, the balance of payment recorded a deficit due to the significant deficit in the financial account. For the purpose of managing the current account and financial account, some monetary policies may be adopted by governments to induce capital flows to where they are required. During the past five years, Taiwan recorded significant continuing surplus in its current account. In order to balance the huge surplus in its current account and alleviate pressure of appreciation, facilitating capital 342

outflow appropriately might be one of the solutions. To make a decision in monetary policies is definitely very complicated and many factors have to be taken into consideration. From the perspective of monetary policy results in Taiwan 2, a low-interest-rate environment seemed to work well and helped achieve the goal of managing the surplus level in its current account. The high interest rate differential between Taiwan and the other European countries and US induced Taiwan residents to assign funds offshore. This helped facilitate a moderate portfolio investment capital outflow and thus manage the surplus level of the current account in the past five years. 6. Capital Flow and Financial Stability Capital flow now in Taiwan is quite free, compared to the past. This is also true of the banking system. During the past five years, as we have discussed earlier, private loan inflow brought in to Taiwan massive amount of capital due to the expectation of TWD appreciation. The private borrowing and lending banking behaviors did not have any serious repercussions on the financial stability in Taiwan. Our banking system and FX price did not quiver significantly because of private loan capital inflow. However, the liberalisation of capital flow did have some impact on Taiwan. The most significant is its effect on the financial stability of the stock market. Foreign investors could freely invest in most of the listed companies in Taiwan. It is definitely beneficial for foreign institutional investors and shareholders to invest in Taiwan s listed companies as they may bring in sufficient capital, technology innovation, new research of products and some other management skills. However, in respect of the stock market, the behaviour of stocks which attract foreign investors is usually more volatile than those which not. This is mainly attributed to the short-term nature of foreign capital inflow. As we know, investors often allocate portfolio funds to different categories - long-term portfolio and short-term portfolio. Attracting long-term capital investment in Taiwanese companies is definitely a good thing for its stock market because such capital is not volatile, moving in and out often, be they foreign investment or home investment. In contrast, some of the short-term foreign capital, i.e., hot money, moved into the Taiwan stock market to invest in Taiwanese companies but they bought and sold very often. This short-term capital usually causes wide fluctuations in the stock price and increases the volatility of stocks. Such kind of capital inflows will definitely destabilise our market. 2. This meant that low- interest-rate environment in Taiwan is not necessary for the purpose of balancing surplus in current account. 343

In addition, the second effect of the short-term capital was its impact on the FX market. Foreign investors buying or selling domestic stocks must first exchange their foreign currencies for local currencies. For a long-term foreign investor, the capital investment in stocks will stay for the long haul since the investment goal is earning long-term dividends instead of short-term capital gains. Such long-term foreign investors will affect the FX market very slightly due to infrequent currency exchange transactions in the FX market. The situation is quite different for a short-term foreign investor. The target of short-term investors is making money from short-term capital gains, not receiving long-term dividends. This will motivate them to trade very often causing instability to both the stock market and FX market. In order to reduce the impact on the stock market and FX market stemming from the behavior of such short-term foreign investors, the central bank monitors the capital inflows and outflows of foreign investors. The central bank encourages foreign investors to allocate their capital in the right designated underlying assets, i.e., Taiwan stock market. 7. Conclusion Taiwan has liberalised its current account and financial account for many years. The recent trend is that the surplus in its current account has been accumulating significantly, especially after 2000. On the other hand, Taiwan recorded more and more capital outflow due to outflow of private loans and portfolio investment assets in financial account. The reasons behind the capital inflow and outflow are quite different. The two major reasons explaining capital inflows to Taiwan are: liberalisation of restrictions on foreign investment and expectation of TWD appreciation. This brought in significant in foreign capital inflows into Taiwan after 2000. The expectation of TWD appreciation pushed private banks to borrow money abroad in the years 2002, 2003, 2004, 2005 and 2007 and brought in significant capital inflows. The major reason explaining capital outflows from Taiwan is the motivation of its residents looking for alternative investment opportunities and diversifying their portfolio and risks. This brought significant capital outflow after 2002 and dominated the deficit in its financial account recently. In order to investigate how macroeconomic factors influence capital flow, we built up an empirical model based on the first SEACEN workshop. The empirical results suggest that both capital inflow and capital outflow are stationary overtime in our sample. On the other hand, the domestic real GDP growth rate, domestic real interest rate, current account to GDP ratio, world real GDP growth 344

rate as well as world real interest rate are non-stationary overtime in our sample. After adopting first- order difference of those independent variables, our empirical capital inflow regression results indicate that only the constant and difference of domestic real GDP growth rate are significant to capital inflow while other variables are insignificant. Turning to the capital outflow model, only the constant item is significant to our capital outflow data. Other independent variables are all insignificant. Note that the empirical results might be different in other sample periods or models. Two major policy tools of the central bank are FX policy and interest rate policy. From the perspective of balancing the BOP, theoretically, some monetary policy might work under certain conditions. For instance, the central bank may tend to adopt a loose monetary policy to encourage capital outflow when facing a huge surplus in its current account, if the policy target is to balance the BOP. On the other hand, the central bank may adopt a tight monetary policy to attract capital inflow when facing a huge deficit in its current account. In reality, conducting monetary policy is much more complicated than we normally think because there are many constraints and scenarios that have to be taken into consideration. Balancing the BOP is only one of the central banks main targets. There are still lots of other proportionate targets the central bank has to deal with. Finally, it is essential for the central bank to maintain stable capital inflow and outflow, but it is not an easy task. Promoting the inflow of long-term capital inflow could help facilitate economic growth and is beneficial for the recipient countries. Whereas, with short-term capital, the inflow can sometimes cause damage to the capital market and aggravate the volatility of the stock market because of the myopic pursuit of profits. How to manage such kind of shortterm capital flow is an issue and an challenge for the central bank. 345