Monetary policy challenges posed by global liquidity
The development of the local currency bond market in Asia stands as an enduring legacy of the Asian financial crisis and a testament to its lesson to avoid the combination of currency mismatch and maturity mismatch. However, mature local currency bond markets in Asia have not insulated monetary policy from the ebb and flow of global liquidity.
Exchange rates affect the economy not only through a trade channel but also through a financial channel. The financial channel goes in the opposite direction to the trade channel: a stronger currency goes hand in hand with looser financial conditions and buoyant investment activity on the back of strong capital inflows. The financial channel works through the bilateral exchange rate against the dollar, rather than the trade-weighted effective exchange rate. Hofmann, Shim and Shin (2017) show that an appreciating currency against the US dollar compresses the risk spreads of sovereign bonds and boosts industrial production; an appreciation in the effective exchange rate dampens it.
Behind the financial channel of exchange rates is a dense matrix of financial claims in dollars. The global economy is a matrix, not a collection of islands, and the matrix does not respect geography. A European bank lending dollars to an Asian borrower by drawing dollars from a US money market fund has its liabilities in New York and assets in Asia, but headquarters in London or Paris.
The financial channel of exchange rates compounds the monetary policy challenges. A stronger currency loosens financial conditions even as pass-through to domestic inflation is subdued, and a weaker currency tightens financial conditions even as inflation rises due to pass-through effects. For this reason, the monetary policy framework has to incorporate the exchange rate as a key element. By extension, monetary policy is an element of a larger policy framework involving macroprudential frameworks.