RISKS AND POLICY SPACE
Despite these developments locally and regionally, questions still remain about whether relying on these tools can provide lasting relief or whether they simply buy time. One view is that they can buy time to allow the metaphorical storm to pass, or can buy time while other more effective policy measures can be deployed to address the underlying economic and financial forces at work. In these respects, it is important that the bought time be prudently used to strengthen the economic, fiscal and financial system fundamentals. In the fullness of time, we will be in a better position to evaluate the effectiveness of these measures. So far, so good.
The putative success in managing the risks of stop-go capital flows in Asian emerging markets also raises the question of whether the risks were initially overestimated. We will never have a definitive answer but there are good reasons to suggest that the region benefited from some good luck during this period: capital flows in the region were challenging at times but never amounted to the fear from ‘the mother of all carry trades’. One reason this worst-case scenario was avoided can be traced back to the rolling crises casting a pall over sentiment about the global economy. Since 2007, economic and financial turmoil in various corners of the globe have had significant spillover effects that sapped confidence. The intensification of the international financial crisis in late 2008 and early 2009 and then the European sovereign debt crisis were two of the more important shocks to the global financial system that had far-reaching effects.
For Asian emerging markets, the muted confidence had important consequences for capital flow dynamics. Figure 5.4 illustrates the negative relationship between risk perceptions as captured by credit-default swap (CDS) spreads and the strength of capital flows. Higher CDS spreads reflect greater generalized risk aversion amongst international investors. This, in turn, kept a lid on risky capital flows to Asian emerging markets. Looking forward, however, one cannot rule out the possibility that, as the prospects of a global recovery brightens and pessimism shifts to optimism, the risks of stop-go capital flows could materialize. In other words, the good luck story for the capital flow pressure issue could come to an end and a new, less benign chapter in management of stop-go capital flows could begin.
This perspective takes on even greater importance now with the policy space in Asian emerging markets shrinking. Low policy rates for the past few years have helped to support a recovery in Asian emerging markets but these rates are increasing the odds of overheating and of credit-asset price boom scenarios (see Figure 5.5). Moreover, the modest widening of interest rate spreads between domestic interest rates in Asian emerging markets and US dollar interest rates is already encouraging a pickup in cross-border US dollar lending inside the region - which not only helps to reduce the effectiveness of domestic monetary policy and boosts asset prices but also creates potential currency mismatches. These mismatches can show up on the balance sheets of banks or of the private sector, or both. All told, the accommodative monetary policies that have helped to discourage capital inflows may become a less attractive option going forward.
Figure 5.4 CDS spreads and net capital flows in Asia (Q1 2007 - latest)
Figure 5.5 Monetary policy, credit growth, housing prices and inflation in Asia
At the same time, the policy room for manoeuvre on the exchange rate front is also shrinking. The central banks of Asian emerging markets have accumulated large foreign reserve positions. The carrying costs of these reserves are high and rising. As pointed out by Filardo and Yetman (2012) the foreign reserve asset accumulation poses a number of financial stability risks. The primary risks come from the ways in which the central banks sterilize Fx intervention. In emerging-market economies, banks have seen their reserves held at the central bank and their holdings of central bank securities rising. In the short run, the increase in the holdings of central bank securities tends to crowd out private sector investment. So, any cessation in the trend of ever-increasing foreign exchange reserves that need to be sterilized would by itself add to the stimulative lending environment. In addition, banks’ holding of an increasing amount of low interest rate assets (‘lazy’ assets) could provide incentives for banks to fuel future lending booms (Filardo and Grenville, 2012).