Responding to external shocks: what has changed since the crisis in the mid-1990s?
Introductory remarks by Malcolm D Knight, General Manager of the BIS, at the 39th SEACEN Governors Conference, Colombo, 12 February 2004.
Let me explain why I believe that the topic for this conference - responding to external shocks - is timely. It is not because Asia is at present particularly vulnerable to external shocks. On the contrary, there are good reasons for thinking that central banks in Asia are better able to respond to shocks than they were in the mid-1990s. The reasons for this improved performance are well known: macroeconomic policy frameworks are now much more robust; the financial systems in most countries have been greatly strengthened; and most countries in emerging Asia have reduced short-term debt and built up large foreign exchange reserves. In short, the vulnerabilities that beset the Asian economies in the 1990s have been largely removed.
Unfortunately the story does not quite finish with this reassuring conclusion. One reason is that global external current account imbalances are large and growing. No one knows how or when these imbalances will eventually be adjusted. Nor does anyone know what might be the consequences. Another reason is that some of the actions that Asian governments have taken to reduce vulnerability to external shocks may at some point create new challenges of their own. It is therefore wise to think ahead about potential problems.
In this spirit, I would like to put before you three interrelated questions:
(1) What has changed since the mid-1990s?
(2) Have exchange rates been sufficiently flexible?
(3) What are the challenges created by large holdings of foreign exchange reserves?
1. What has changed?
Most observers would agree that policy reforms following the 1997-98 crisis have led to the emergence of a more resilient Asia. Let me mention two elements of domestic policy in emerging markets that are particularly relevant for central banks. First, many countries have introduced credible reforms to make price stability the dominant objective of monetary policy, often within an inflation targeting framework. This has laid a solid foundation for monetary stability and has helped to anchor long-term inflation expectations.
A second crucial element has been reforms to strengthen domestic banking systems. Over the past few years, Asian banks have been recapitalised, problem loans have been reduced, and prudential regulations have been strengthened. At the same time, governments have taken steps to develop domestic bond and stock markets. By helping to diversify risks and reduce currency mismatches, these steps have meant that external shocks are now less likely to be magnified by a banking system crisis.
External policies have also undergone significant changes since the 1997-98 crisis. First of all, many countries have adopted more flexible exchange rate regimes - not necessarily free floating, of course, but nevertheless more flexible. The advantages of greater flexibility are well known. A flexible exchange rate can act as a shock absorber when prices and wages are sticky. Any required change in the real exchange rate can take place more quickly. Day-to-day movements in the exchange rate can give banks and firms a powerful interest in managing exchange rate risk properly. In the past, under fixed rates, banks and corporations often borrowed excessively in foreign currency in the confident belief that the fixed rate would be maintained. When the exchange rate did fall - sometimes very suddenly - they then expected to be bailed out.
Another second external element of policy has been much increased holdings of foreign exchange reserves, which has enhanced the ability of countries to manage their exchange rates. Now it is of some interest to note that these two elements could appear contradictory. If there is greater exchange rate flexibility, why hold larger reserves?
2. Have exchange rates in Asia been sufficiently flexible?
You are, of course, well aware that there is a perception that exchange rates in Asia have not moved enough given the region's large trade surpluses and inflows of capital. According to this view, the recent accumulation of official reserves has impeded or slowed the appreciation of Asian currencies against the dollar, implying significant depreciation in nominal effective terms. There is also some evidence that the month-to-month volatility of many exchange rates has been remarkably low given the scale of the shocks over the past couple of years.
On the other hand, it can be argued that confidence in emerging economies is much more dependent on exchange rate stability than it is in industrial countries. Four reasons why this might be so were noted by various central bank governors at a recent meeting at the BIS.
Let me briefly summarise.
(1) Foreign exchange markets in emerging economies tend to be relatively thin and illiquid - features that expose them to disorderly exchange rate fluctuations.
(2) Emerging markets face a higher degree of uncertainty with regard to capital flows than is the case for industrial countries. This makes them vulnerable to exchange rate under- or overshooting, with an associated risk of financial instability.
(3) Large exchange rate movements may be incompatible with the central bank's inflation and growth objectives. An appreciation of the home currency may be resisted because the tradable sector's capacity to absorb exchange rate change is limited. This can be a major consideration when there is a risk of deflation. And in certain conditions central banks may resist depreciation because they fear overshooting of the inflation target.
(4) Exchange rate fluctuations can easily raise concerns about debt sustainability in countries with high levels of foreign currency debt.
These are very persuasive arguments for limiting exchange rate movements - particularly for very open economies such as those here in Asia. For instance, it is entirely understandable that when policymakers are concerned that their country is on the verge of deflation - as some countries in Asia were last year - they would be reluctant to accept an appreciation of their currency.
Yet there are also several well known counterarguments. What are the potential risks from significant and prolonged currency misalignments? Does resistance to market pressure increase vulnerability, much as it did before the Asian crisis? What are the implications for the conduct of monetary policy and for the financial system?
Many would argue that it is virtually impossible to resist underlying long-run exchange rate movements. Holding down the nominal exchange rate would eventually increase demand and prices so that a real appreciation would be brought about by higher inflation. Expectations of future currency appreciation may just lead to large inflows of short-term speculative capital, driving up equity and bond prices to unsustainable levels. The subsequent adjustment can be very disruptive. In short, attempts to hold one price constant almost always have spillover effects in other markets.
A second risk is that an undervalued exchange rate can generate over-investment in some tradable sectors that would not be viable at a realistic exchange rate. If banks lend heavily to such sectors, the financial system can be weakened once the exchange rate is corrected.
A third danger is that monetary policy objectives could be compromised. The more the public perceives that a central bank is too concerned about the exchange rate, the greater is the probability that this emerges as a benchmark for market expectations of inflation. This obviously reduces the role of inflation targets as credible nominal anchors. For all these reasons, central banks should constantly ask themselves: "How does the market view intervention in forex markets? Is there a risk of distorting private sector choices or decisions?".
This brings me to my third question.
3. What are the challenges of large foreign exchange reserves?
The 1997-98 crisis nurtured the perception that Asian economies needed to build up much larger official foreign exchange reserves to survive in a world of mobile international capital. This view was reinforced by the recommendations of international financial institutions and of credit rating agencies, which often rewarded countries holding large reserves with better credit ratings. Building up higher levels of reserves therefore became an important policy priority.
Many of the earlier vulnerabilities have now dissipated and policy frameworks are much stronger. Nevertheless, the pace of reserve accumulation in Asia has not abated. In some countries, current reserve levels exceed what would be required from summing up all the needs arising from conventional indicators - months of imports, the coverage of short-term foreign currency debt, and so on. There is, of course, no obvious upper limit on reserve levels, as central banks have an unlimited supply of their own currency with which to buy foreign currency. But large and growing international reserves can still create risks for an economy - even if such risks are hard to quantify.
One is the risk of a weakening of monetary control. At first, interventions can be fully sterilised. But as reserves grow it becomes harder and harder to sterilise successive increases. For example, central banks can exhaust their holdings of the domestic government securities used in sterilisation operations. And the public will be willing to hold larger and larger volumes of domestic debt securities only at higher interest rates. Countries with shallow and illiquid financial markets are likely to reach such limits faster than those with liquid and deep bond markets.
If reserve accumulation does indeed result in monetary expansion, it can set off an unsustainable credit boom, or contribute to inflated equity and property prices. Such developments could expose the financial system to substantial risks. Banks with excess liquidity may be tempted to take on riskier and riskier assets. At the same time, extremely low interest rates and easy access to credit prompt individuals and firms to borrow and accumulate debt. In the past such booms have often been accentuated by capital inflows, making the subsequent bust all the more severe.
How to judge at what point reserve accumulation could begin to cause such problems is, of course, a major challenge for policymakers. At present here in Asia there are some grounds for reassurance on this score. Even though international reserve levels in a number of Asian countries have grown to several times the monetary base, trends in domestic credit and broad monetary aggregates do not appear to be an immediate cause for concern. Nor is there any evidence of a generalised increase in domestic price pressures.
Yet there are also grounds for vigilance. Inflows of foreign currency are rising strongly throughout Asia. Many countries have recently seen a sharp narrowing of their interest rate differentials vis-à-vis dollar paper, large short-term capital inflows, and a rise in unhedged corporate debt levels. Equity prices have also increased rapidly, and there is some anecdotal evidence of strongly rising property prices. In addition, the sheer pace of the expansion of domestic bank lending to households in many Asian countries in the past few years raises questions. Finally, recent sharp increases in global commodity prices underline possible inflation risks for the future. The current situation, therefore, requires close monitoring.
A second risk is that ever higher international reserve levels not only create a balance sheet risk for central banks - in the sense that local currency liabilities are funding foreign currency assets - but also oblige central banks to confront difficult investment choices. During much of the period since 1999 or so when the large accumulation of international reserves began, official purchases of US Treasury and other high-rated dollar securities have been seen as a good investment - with yields declining and the dollar strong. Experiences over the past year or so have been rather different. As a higher proportion of a country's external assets comes to be held as foreign exchange reserves, the managers of those official reserves could be forced to consider high-yield alternatives to the assets that central banks normally purchase. This creates new challenges for the managers of official reserve portfolios - challenges that can begin to stretch the mandate of a central bank. This raises the question: "How far does a greater attention to considerations of what assets to hold in the international portfolio undermine the achievement of other objectives of the central bank?". Some countries have addressed this problem by effectively hiving off a portion of external assets owned by the official sector to an institution with a more explicit mandate for portfolio management.
Two final thoughts before concluding. First, I would say that the way in which Asia responds to the challenges posed by the current global conjuncture is of great importance, not only to the countries of the region but also to the rest of the world. One dimension of this is Asia's role - as the major surplus current account area - in reducing international imbalances. Moreover, although the dollar has fallen by around 20% in effective terms from its peak in 2001, the main counterpart to this movement has been a strong appreciation of only a few currencies: mainly the euro and the Canadian, Australian and New Zealand dollars. As the dynamism of domestic demand in the economies of Asia becomes more firmly established, and as stronger global growth eases concerns about deflation, the case for accepting currency appreciation will become stronger - not so much to offset a lack of international adjustment elsewhere in the world, but rather to forestall domestic inflationary pressures. It goes without saying that policy adjustments outside Asia will also be necessary.
The second dimension is that Asian central banks have become increasingly important investors in dollar paper, notably US Treasuries. Such purchases have prevented disorderly exchange market conditions and have helped to smooth the adjustment of the dollar. But these developments entail risks. A sudden shift in the behaviour of a large official investor can lead to abrupt changes in prices. "Herding" by other investors can reinforce such movements and lead to increased financial market volatility.
Let me conclude by reiterating what I said at the start. Asia is now better able to respond to and resist adverse shocks - at least of the type seen in the late 1990s. The macroeconomic policy framework is much more robust than it was before the 1997-98 crisis. And the financial systems in the region have been strengthened. Yet the current situation poses difficult challenges for central banks. New developments require vigilance and a willingness to constantly reassess the effectiveness of current policies. I have tried to outline the various dilemmas and to suggest that there are no easy answers. I believe this conference will help all of us to understand and analyse the issues more clearly. I am very much looking forward to hearing what you have to say.