Where is the liquidity coming from? Capital inflows have received a lot of attention lately. Financial capital is flowing into Asia, attracted by the continent’s relatively good economic prospects. More important, for most economies, is a dramatic easing of domestic monetary conditions since late 2008 that has fueled domestic liquidity.
In part, the easing of monetary conditions in Asia was deliberate, a policy response to sharp weaker growth. However, some of the easing of monetary conditions was not deliberate. Economies with an exchange rate somewhat or completely fixed to the US dollar and fairly open capital markets are “importing” the loose US monetary policy. In some economies, those imported monetary conditions sit oddly with domestic economic conditions. In many Asian economies, spare capacity is much smaller than in the US and cyclical unemployment much lower.
Against this backdrop, prominent policymakers in Asia have warned of the threats posed to financial stability by US monetary policy. The head of the China Banking Regulatory Commission, Liu Mingkang, has warned that the FED’s low interest policy is fueling “arbitrage speculation and thus global asset prices, speculation in stock and property markets and created new, real and insurmountable risks to the recovery of the world economy”. This followed earlier similar comments – but focused on Asia – from Hong Kong’s Chief Executive Donald Tsang Yam-Kuen.
The US monetary policy stance itself does not seem inappropriate, given the depressed state of the US economy, with unemployment at over 10 percent. Moreover, there is no credit growth in the US at the moment. The main problem for Asia is the importation in a globalized world of US monetary conditions via fixed or managed exchange rate regimes to economies in very different economic circumstances. The worries expressed by these policymakers underscore the tensions that this state of affairs generates at the moment.
What should governments do to mitigate these risks? Governments in several Asian economies have tightened up prudential regulation and used other administrative measures. They have increased loan-loss coverage ratios and minimum down payments for mortgages and restricted lending to property developers. China’s government also took steps to try to avoid new lending going to the stock market and increase the supply of stocks by allowing IPOs again. Taiwan banned foreign investors from putting money into Taiwanese fixed-term deposits. But, except for Australia, Asian governments have so far refrained from tightening overall monetary policy.
Looking ahead, more prudential and other administrative measures can be taken, such as more increases in loan-loss and minimum down payment ratios and higher reserve requirements.
Administrative measures may not be enough, though. Adjustments to monetary and exchange rate policy may be needed. To decide what to do in this area, in my view policymakers should first determine what the main problem is: capital inflows or (too) rapid domestic liquidity creation. And, if too rapid domestic liquidity creation is the main problem, to what extent is this because of loose monetary conditions imported via the exchange rate regime?
If capital inflows are a big problem, compared to domestic liquidity creation, countries cannot rely too much on higher interest rates to dampen financial risks, because the increase in capital inflows due to the higher interest rates may outweigh the impact on domestic liquidity. This may especially be the case in some of the smaller, financially more open economies in Asia. If the openness of their capital market creates such big constraints, they should consider measures to control or discourage capital inflows. They can also absorb some of the pressure by allowing their currencies to strengthen. East Asian countries tend to be concerned about losing competitiveness if they let their currency strengthen unilaterally. With so many countries facing the same issue, it would make sense to strive for more cooperation on exchange rate management, formally and informally.
If capital inflows are not a major problem but the cyclical differences vis a vis the US mean that loose monetary policy is very inappropriate for domestic economic conditions, there may be room to tighten monetary policy, including by raising interest rate. In my view, this is the situation in China, where the role of capital inflows compared to domestic liquidity creation is smaller than many think. In my view, policymakers have at times been unnecessarily reluctant to raise interest rates. In the first half of 2009, net financial capital inflows were equivalent to 3.3 % of domestic credit creation. There have been years when this ratio was higher, and it is likely to be higher in the second half. But, net financial capital inflows are likely to remain modest in size compared to domestic liquidity creation. Thus, given China’s capital controls and the relatively small role of capital inflows, the pros of higher interest rates seem to outweigh the cons. This may be the case in other Asian countries as well, particularly if such moves are flanked by tightening capital controls further.
Some are reluctant to tighten monetary policy because of low inflation, the traditional trigger for monetary policy action. However, the recent global financial crisis has shown the dangers of neglecting asset price increases in monetary and financial policy making. With monetary policy in key high income countries traditionally geared only towards inflation, monetary policy was loose for too long, even as asset prices rose to levels deemed worrisome by many.
In all cases, introducing more exchange rate flexibility would also help discouraging inflows. By introducing useful two way risk on the foreign exchange market, a more flexible exchange rate gives monetary policy more independence to be in line with domestic needs.
In addition, opportunistic timing of structural reforms can reduce risks on asset prices and quality. The supply of financial titles can be increased, by financial sector deepening, including in the bond and equity market. Where interest rates on bank deposits are still capped, easing the caps and stimulating the development of more long term saving instruments would help absorb financial surpluses. Finally, opportunistically introducing or increasing capital gains taxes on equity and real estate would reduce pressures as well.
As Asian growth prospects are likely to continue to differ significantly from those in the US in the coming years, this may well be a good time to take the steps needed to make monetary policy more independent, so that the monetary stance can be more in line with domestic economic conditions, and to opportunistically time structural reforms.
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