Asian central banks should 'keep calm and carry on'
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Asian central banks should 'keep calm and carry on'

Originally published in the Nikkei Report.


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Executive Summary

These are truly extraordinary times for monetary policy the world over, but particularly in Japan, where the International Monetary Fund appears to have finally given up on the ability of monetary policy -- whether conventional or unconventional -- to rescue the economy from deflation.

The IMF instead suggested in a recent report that the authorities should directly engage in raising wages in the hope that this would be reflected in increased prices and consequently trigger a sustained bout of inflation. Meanwhile, the Bank of Japan has explored the frontiers of monetary policy with negative policy interest rates, quantitative easing and repeated assurances that the 2% inflation target will be met.

How should policymakers in the rest of Asia react? They might see what is happening in Japan as signs of ad hoc desperation, with all the old monetary policy certainties abandoned. The proper response, however, is to "keep calm and carry on." All very well, as the rest of Asia is not facing the same set of deep-seated problems that confronts the BoJ. Inflation has fallen in nearly all Asian countries, but none comes even remotely close to the Japanese experience of persistent deflation.

For some, especially China, India and Indonesia, the deflationary pressure being felt globally is an opportunity to reduce their underlying inflation from previously high levels to a rate comparable to regional peers and close to the 2-3% which was the traditional norm in advanced economies. If these countries can lock in world-parity price stability by lowering inflation expectations, this period of subdued growth could be counted as a success.

Just as important, none of these countries has been forced to resort to unconventional monetary policies of quantitative easing, negative policy interest rates, or "forward guidance" of making specific promises on future actions. "Helicopter money," the financing of fiscal expenditure using the central bank's balance sheet, is not even being discussed in the rest of Asia.

Adhering to orthodox monetary policy, such as retaining the beautiful simplicity of inflation targeting, is a big advantage in a world where the uncertain nature of unconventional monetary policy can leave financial markets puzzled over what authorities will do next.

Volatile capital flows

The rise of unconventional monetary policy in many advanced economies, however, has complicated one aspect of monetary policy for Asian central banks. Foreign capital flows have become much more volatile, resulting in rapidly fluctuating exchange rates.

The story began in 2010, when low interest rates in advanced economies in the aftermath of the global financial crisis encouraged capital flows into emerging economies, which offered higher yields. In many Asian countries, this capital inflow pushed exchange rates uncomfortably high, weakening international export competition and widening current account deficits.

The capital inflows also boosted credit expansion and asset price inflation. These countries were then whipsawed by capital outflows in May 2013, when fears the U.S. Federal Reserve might start tightening its monetary policy (the so-called "taper tantrum"), set off a scramble to retreat from risk. The resulting sharp falls in exchange rates put policymakers in Asia on edge.

Since then, Asian economies have learned to cope better with this volatility. When the Fed finally raised interest rates last December, there was almost no effect on financial markets around the world.

Nevertheless, Asian central banks find themselves in a more uncertain world. They watch with some trepidation attempts in advanced economies to find policy responses to address demand deficiency and ineffectual monetary policy. They note that in advanced economies, the usual domestic channels of monetary policy -- principally through credit expansion -- are blocked by the prolonged process of restructuring balance sheets which were overextended in 2007. In addition, banks are not lending because their own balance sheets need to be strengthened and regulatory requirements are tightening.

As an alternative, policymakers in the advanced economies are quietly welcoming any currency depreciation to help boost domestic activity. Not only does a weaker currency help exporters, but resulting higher import prices is a step toward achieving inflation targets. But one country's currency depreciation represents currency appreciation for trading partners. This "beggar-thy-neighbor" strategy can result in disruptive currency wars.

As a result, Asian central banks outside Japan are on high alert for signs of big disruptive capital inflows into their economies that would appreciate their currencies. What would Asia's central banks do if Japan adopted the policy suggested by Professor Lars Svensson, the Swedish monetary guru, for increasing inflation by imposing a controlled depreciation of the yen? To work, it would have to be a big and sustained depreciation, more than the 30% fall in value that occurred when Prime Minister Shinzo Abe took office in late 2012 and which failed to get inflation back on track.

Currency wars

Such a huge yen depreciation would cause outrage in China, which has received a lot of foreign criticism that it is artificially depreciating its exchange rate. South Korea, competing with Japan in many export markets, would see this move as a currency war declaration.

What lies ahead? No one knows which country will next try negative policy rates. Will some country try the bizarre adventure of helicopter money, in which fiscal expenditure is financed directly from the central bank's balance sheet?

When quantitative easing comes to be unwound, this will mark unexplored territory for central banks. Low interest rates have encouraged greater risk-taking and have inflated asset prices. When bond yields eventually rebound from their current flat yield curves, there will be big capital losses for bond holders worldwide. Asia's central banks know that their defenses against such disruptions are frail, but there is not much they can do about it in an increasingly globalized world.


Stephen Grenville is a nonresident fellow at the Lowy Institute for International Policy in Sydney and a former deputy governor of the Reserve Bank of Australia.

Areas of expertise: Regional economic integration; Australia's economic relations with East Asia; international financial flows and the global financial architecture; financial sector development in East Asia