Short Term Capital Flows, the Domestic Money Supply, and Bubbles

November 24, 1999

Many writers on the Asian financial crisis write about how short-term foreign capital inflated the domestic money supply causing a bubble economy. Later, when the foreigners withdrew the capital, they caused the domestic bubble to burst. Therefore, they reason, foreign short-term capital movements are responsible for the Asian financial crisis. In this essay, I want to show that this tale is much to simple. It fails to account for the role of the domestic banking system.

Direct Effects of Foreign Capital Investment on Money Supply

Suppose that a foreigner, say an American, wants to invest in the Malaysian stock market. The American has saved many dollars. However, before he can purchase a share of Malaysian stock, he must convert his dollars into Malaysian ringgits. Let us see how this affects the Malaysian money supply.

The Malaysian money supply, in its most basic form, consists of the face value of the paper and metal ringgits in circulation plus the deposits at banks that are available to depositors to be withdrawn or used to purchase goods on demand. When the American buys ringgits from a Malaysian, he does not increase the amount of ringgits in circulation. He merely causes ringgits to be transferred from some Malaysian's account to his own. And when he buys the stock from a Malaysian, he causes his ringgit to be transferred to the seller. This in no way causes the amount of ringgits in circulation to rise. Thus, his transaction does not directly effect the Malaysian money supply.

Indirect Effect: The Role of Banks

There may, however, be an indirect effect. The seller of the ringgit may feel richer because he now owns dollars. As a result, he may mortgage some of his property in order to increase his speculation. In other words, he may transfer ownership of his property from himself to a bank. If the bank merely transfers ringgits that would have been owned by someone else to the mortgager, there is still no change in the money supply. However, if the bank thinks itself richer and decides that it can afford to make loans of new demand deposits, the result is an increase in the Malaysian money supply.

In a similar scenario, a bank may create money for an apparently different reason. Let us suppose that the Malaysian decides to use his dollars to invest in the U.S. So he puts his dollars in an investment fund (or mutual fund), based in Malaysia. The investment fund manager promises to buy a portfolio of U.S. stocks and bonds. As the fund grows, the manager turns to a Malaysian bank in order to help finance advertising. Believing that the fund has a strong foundation in U.S. assets and that it has growth potential, the bank creates new money to lend to the fund.

Finally, a government central bank may perceive that the growth in domestically held foreign assets denominated in foreign currency warrants an increase in its own money supply. So it follows various well-known measures to allow banks to expand their credit and, in so doing, to expand the money supply.

The Central Fact

In each of these cases, we find one central fact. The Malaysian money supply cannot be increased unless Malaysian bankers increase their credit. Moreover, if the bankers were tightly controlled by the Malaysian central bank, there could be no increase in the basic money supply unless the central bank permitted this to occur.

So far, we have been concerned only with the basic money supply. The picture is complicated when we recognize that the presence of near monies like credit cards and time deposits. But the fundamental phenomenon is the same. Unless Malaysians increase their credit on the basis of the transfers of ringgit ownership from Malaysians to foreigners (and/or the later transfers of ownership of short-term securities), the Malaysian expansion of money-credit cannot occur.


There could have been no bubble if Malaysian bankers had not expanded the money supply. It may be true that the bankers were inexperienced and made a mistake in granting the new credit based on what they believed was a larger increase in Asian ownership of assets than in fact occurred. It is evident, however, that flows of short-term capital as between countries cannot, by themselves, cause a financial crisis. The proposition that they can is simplistic and incomplete. It ignores the complexities of international finance in a world where different countries use different currencies.

Gunning’s Address

J. Patrick Gunning
Visiting Professor
U.S. Coast Guard Academy
Management Department
15 Mohegan Avenue
New London, CT 06320

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