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Asian Perspectives on Financial Sector Reforms and Regulation
BROOKINGS INSTITUTION PRESSCopyright © 2011 ASIAN DEVELOPMENT BANK INSTITUTE THE BROOKINGS INSTITUTION
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Chapter OneMonetary Policy Challenges for Emerging Markets in a Globalized Environment SUKUDHEW SINGH
In the period before the financial crisis, the prolonged period of low real interest rates in advanced economies led to financial imbalances in these economies. The outcome was a search for yield that resulted in carry trades and the increased financialization of commodity markets, which led to volatility in capital flows and exchange rates as well as to escalating commodity prices. These developments had a bigger impact on emerging market economies (EMEs) than they did on advanced economies. However, low interest rates and the search for yield, combined with dubious financial innovations, also led to an excessive and substantially misdirected expansion of credit and asset price bubbles in a number of advanced economies.
In response to the crisis, unconventional policies adopted by the advanced economies have again pushed interest rates to very low levels, even lower than before the crisis. No doubt these interest rates were appropriate when the economies were looking into the abyss of depression, but the longer they are maintained in the current circumstances the greater the potential that they will once again lead to imbalances similar to those seen before the crisis. Only this time they are likely to affect the EMEs more than the advanced economies.
In particular, this chapter discusses how the search for yield combined with optimism about the growth prospects of Asian EMEs could lead to increased capital inflows into these economies. The outcome is likely to be an appreciation of regional exchange rates, increasing asset prices, and rising commodity prices. If sustained, such trends could lead to imbalances that could undermine growth in some of these economies at a time when the world is looking at EMEs to lead the global economy out of the recession. This chapter looks at the issues from the perspective of EME policymakers. It discusses the policy measures already undertaken by policymakers in Asia as well as those that could potentially be undertaken.
Following the bursting of the Internet bubble in 2000, real policy rates trended downward globally (figure 1-1). What is even more striking, though, is that the real policy rate in the United States was below 1 percent from about the second quarter of 2001 right through to the second quarter of 2006, or a period of five years. It was in fact persistently negative for four of those years—that is, from about the fourth quarter of 2002 to the fourth quarter of 2005. Real interest rates in other industrial countries, while never turning negative, were also very low, falling below 1 percent around the end of 2002 and remaining below that level until the third quarter of 2006. In contrast, policy rates in Asian EMEs were considerably higher, being at the level of those in advanced economies only briefly in 2004. In Latin America real policy rates were even higher than those for other economies for almost the entire period. Therefore, there was a sustained period of very low interest rates in the advanced economies during the last decade and also a significant divergence in interest rates between the advanced economies and the EMEs.
While these interest rates were possibly appropriate for these countries given the monetary policy frameworks adopted by them, the sustained period of low real interest rates in the advanced economies and the divergence in interest rates relative to those in EMEs set off a chain reaction of developments that culminated in the current crisis. As we emerge from the current crisis, EME policymakers are again confronted by conditions that are creating risks to monetary and financial stability in their economies. In this chapter I explore three of these policy issues.
The first has to do with the implications for EMEs of the easy monetary policy conditions in advanced economies, specifically the unconventional monetary policies adopted. The volatility and distortions in the financial markets are creating risks for EMEs in a number of areas. Most important, the potentially large capital flows into EMEs can lead to volatility of exchange rates, which could create difficulties for open, trade-dependent, economies. They can also lead to significant volatility in bond and equity markets, as large volumes of foreign funds move in and out of these markets.
The second policy issue is the potential impact of capital flows driven by carry trades and the search for yield on the valuation of EME assets. Asset price bubbles have affected a number of the economies at the epicenter of the current crisis. In the period since the crisis, asset prices are likely to be again stoked; only this time there is a high risk that those bubbles will be in the EMEs. Large capital inflows will amplify such distortions. In managing these bubbles, central banks will have to overcome the current intellectual stalemate regarding the role of central banks in managing asset price bubbles. Asian central banks may need to adopt a proactive approach, even if many central banks in the developed countries have preferred not to play an active role.
The third and final policy issue has to do with the growing role of commodities as an asset class for investors. In a period of low global interest rates and ample liquidity, commodity prices are again on the rise, and this could potentially have more dire consequences for the EMEs than for the more advanced economies.
Effect on Emerging Market Economies of Unconventional Monetary Policies in Advanced Economies
The rapid growth in capital flows between advanced and EMEs has been significantly influenced by the monetary policies of the advanced economies. Research by the Institute of International Finance notes that since the 1970s there have been three major upswings in net private capital flows to EMEs. As a percent of GDP, each peak in the up cycle has been higher than the previous one. It also notes that, based on the resumption of flows in 2009, the fourth upswing could be just beginning. There are compelling reasons to believe that EMEs could once again see a surge of capital inflows.
There is the expectation that economic and financial conditions in EMEs would be better than in the advanced economies. It has also been noted that, following the crisis, many EMEs are in better fiscal positions than a number of large advanced economies and are, therefore, better able to support growth. Furthermore, it is generally agreed that policy interest rates in the advanced economies would have been close to zero for most of 2010 and possibly into 2011. While there has been talk of policy exit in the countries that have undertaken quantitative easing, this is within the context of the unwinding of the vast liquidity support facilities and not in terms of increasing interest rates off the floor. EMEs in Asia also dropped their interest rates in 2008—09 in response to concerns about the deflationary impact of developments among their advanced trading partners.
However, unlike in advanced economies, financial systems in Asia have remained largely functional, and banks have continued to provide financing. This means that the monetary transmission mechanism in the Asian economies continues to work and that the central banks in the region have not had to adopt the quantitative easing adopted by their peers in the advanced economies (figure 1-2). Interest rates, although still higher than those prevailing in the advanced economies, were nevertheless at historic lows. This creates the risk that the low interest rate environment, if sustained for too long, could lead to a rapid growth in credit and the disintermediation of deposits (see appendix to chapter). Therefore, there is a need to normalize interest rates among Asia's EMEs. However, if they do, this would lead to widening interest rate differentials between Asia and the advanced economies. This is likely to raise expectations of the appreciation of Asian currencies, which could further increase the attractiveness of Asian assets.
In fact, the signs started emerging in the second half of 2009. Carry trades and the search for yields are back in fashion. Investors are once again funding out of cheap currencies and investing in high-yielding ones. Only this time, instead of the yen being the favorite funding currency, it is the U.S. dollar. These funds are being invested in higher yielding assets globally, but given the higher growth prospects for Asian EMEs, it is conceivable that a substantial portion of these funds will end up in the region (figure 1-3).
The return of capital flows to Asian economies puts an upward pressure on a whole range of Asian assets (figures 1-4 and 1-5). Asian equities have risen to levels that are almost close to the peaks of early 2008. Hong Kong, China and Singapore have had to implement a number of measures to control rapidly rising prices in their property sectors. Renewed flows into EME bonds have also resulted in a sustained increase in bond prices. As a result, Asian currencies have been on an appreciating trend since early 2009 (figure 1-6).
Shifting investor expectations are likely to create volatility in capital flows to EMEs, with consequential volatility in asset prices in these economies. Based on the experience before and during the crisis, we can anticipate that risks will be created as inflows lead to rising asset prices, followed by painful declines in prices as the flows reverse—possibly in response to a rise in interest rates in the United States or in response to the EMEs failing to live up to expectations.
This then raises the question of how EMEs should deal with these volatile capital flows, to avoid significant disruptions of domestic monetary and economic conditions. It remains to be seen whether the regulatory reforms being considered in the advanced economies are helpful in reducing the volume of these flows. From recent experience, we know that quite a significant proportion of the short-term flows into EMEs were backed by high levels of leverage. If the regulatory reforms that are now being contemplated act to limit the leverage that investors can pile up, then this may to some degree help limit the size of these flows.
Based on the experience before and during the financial crisis, having a good buffer of reserves would help. In previous episodes, many EMEs intervened to absorb these inflows, which—although not entirely insulating domestic asset prices—greatly mitigated the potential impact on the exchange rate (figure 17). When the flows reversed, they were again offset by central bank intervention, with the consequence that, although reserves fell, a sharp depreciation of exchange rates was avoided. The capacity of a country to use its reserves in this manner would depend in an important way on the overall size of its reserves relative to short-term flows and the composition of those reserves. The reserves level should be sufficient to meet the outflows and high enough to maintain confidence in the country's international liquidity. This implies that there must be an underlying foundation of more permanent reserves built from longer term flows, such as current account surpluses and inflows of foreign direct investment. It also means that reserves picked up off short-term inflows should not be used to fund increased imports, or the country could find itself vulnerable when the inflows reverse.
However, under prevailing conditions, it has become more difficult for EME central banks to use reserves in this manner. This is because the operating environment has changed in an important way. Interest rates in the countries or regions that issue traditional reserve currencies are likely to remain very low, which makes the cost of intervention and sterilization more expensive. Therefore, building up reserves, while minimizing the impact of the inflows on monetary and financial conditions, is now more expensive—not impossible, but certainly more difficult and expensive.
Some would argue that having deeper financial markets would allow EMEs to better absorb these capital inflows. This may or may not be the case. It is not easy for EMEs to develop such deep markets, and even if they do, deeper financial markets are a double-edged sword. While the availability of more instruments and participants may mitigate the extreme volatility seen in shallow markets, it may also be the case that the availability of deep and liquid markets may end up attracting more capital inflows. In that sense, the job of the central bank may be no easier. In fact, with the larger flows, it may be that the central bank would have to hold a higher volume of reserves in order to mitigate the impact of these flows on the domestic financial system.
So what else can countries do? There are a number of options in the literature for dealing with capital flows; these are summarize d in figure 1-8. If the policy measures just discussed prove to be ineffective, then countries may have no choice but to take more interventionist measures to restrict the inflows of short-term capital. First among these would be restrictions on the type of assets that foreign investors can hold and the requirements of a minimum holding period. As noted in box 1-1, countries like Indonesia and Taipei, China have already taken such measures. Alternatives would be to increase the cost for foreign investors to invest in the country or to erode some of their potential gains. Measures such as the tax on foreign portfolio inflows implemented by Brazil in 2009 fall in this category. These tools can be effective in reducing the returns that foreign investors hope to derive from investing in local financial assets and thereby help to reduce inflows of short-term funds. However, the magnitude and pervasiveness of such controls may need to be adjusted depending on how intense and sustained the capital inflows are. As countries increasingly liberalize their capital accounts, measures of this nature may be needed to prevent large capital inflows and outflows from undermining macro-economic and financial stability and to maintain a degree of policy independence.
The instrument of last resort is to place a restriction on inflows and outflows. However, to carry this off successfully requires an efficient mechanism to ensure effective implementation, to minimize inconvenience, and to ensure that it does not hinder real economic activity. In particular, it is necessary to distinguish between foreign direct investment and foreign portfolio investment and to allow normal flows for current account transactions. The authority's ability to do this would depend on the available information systems, the extent to which forex transactions are conducted through the banking system, and the effectiveness of the enforcement mechanism. These controls are best maintained only for short periods and then eased gradually as conditions stabilize. Such controls will be ineffective if used for anything other than managing short-term flows—as for example when controls on outflows are used as a substitute for real policy reform relating to large fiscal deficits, high inflation, current account deficits, or a loss of confidence in the banking system.
Within Southeast Asia, regional cooperation is another alternative, although its efficacy to date remains largely untested. The recent expansion and formalization of the Chiang Mai Initiative among the ASEAN+3 countries is a step in that direction. The next step would be to set up a surveillance mechanism to support the initiative and to develop a regional crisis management framework. There are already ongoing consultations among regional policymakers at the various forums. The addition of a rigorous regional surveillance mechanism could enhance the capacity of these countries to react to potential threats preemptively. There could also be opportunities for regional central banks to cooperate in the formulation and timing of their exit strategies. As an example of this, three Asian central banks—Bank Negara Malaysia, the Hong Kong Monetary Authority, and the Monetary Authority of Singapore—established a tripartite working group in July 2009 to map out a coordinated strategy to exit blanket deposit guarantees in their respective jurisdictions; they successfully completed the exit at the end of 2010
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