new issues. To the extent that the new issues fund new investment, the effects would be quite similar would be owned by the domestic issuer rather than the foreign investor. New issues may also be used to recapitalize existing operations. Here the effect would be through the banking system and the rest of the domestic financial market, where debt would be retired by the new equity-generated flows. Although this could ease pressure on the banking system, it would tend to lower interest rates and increase domestic liquidity. That, in turn, would increase aggregate demand and create more pressure on the exchange rate than if the funds had been invested in new equipment with a high import content.
The bulk of equity investment has been into existing stocks in East Asian markets, driving up the prices of equity. the cost of capital drops for those floating new issues, but there are for also strong wealth effects on existing asset holders-as their wealth increases, consumption is likely to go up as well. This will tend to raise domestic prices and appreciate the currency in real terms, Whether these foreign equity, investments increase physical investment depends on the behavior of the other asset holders-those who sold to foreign investors and those whose assets appreciated. If they invest in new projects, physical investment will also increase, otherwise, it will not. It is more likely that domestic savings will fall when there are large portfolio investment flows than when the flows take the form of FDI. In Latin America, which has experienced more portfolio inflows decline, rather than physical investment to increase. In the past East Asia has avoided this result, partly because its overall policy regime has favored investment, partly because of the greater degree of sterilization it has been able to achieve, and partly because the share of portfolio investment has been smaller. Portfolio flows are a very recent phenomenon, and it is still to soon to measure many of their effects in East Asia.
It is particularly worrisome when large private capital flows move into commercial real estate. Experience in many countries, both industrial and developing, indicates the ease with which speculative bubbles can develop in real estate during an investment boom. Asset inflation in this sector can generate very high rates of return-much higher than are available from investment in manufacturing-over a few years. But such rates are not sustainable. When the bottom falls out, as it inevitably does, there are frequently severe repercussions on the banking sector, since domestic banks are usually major financiers of the real estate, and governments often end up bailing out the financial sector. Indonesia faced this problem in 1993; Thailand saw carliev bouts of these bubbles; and they are not unknown in other countries, including the United States and Japan.
The sustainability of flows into stock markets is a complex matt...
