How will policymakers react to the liquidity that has been flooding into Asia since late last year? Freya Beamish and Shweta Singh at Lombard Street Research find most countries try the âhave-your-cake-and-eat-itâ approach.
Liquidity has been scudding back into Asia since late last year. How are Asian policymakers dealing with it?
They could allow currency appreciation but suffer the hit to exports and the potential for bursting existing bubbles, such as property in Hong Kong.
Or they could intervene, cut interest rates and slam on the capital brakes to hold down the currency but risk overheating and a sharp reversal of funds if it all goes pear-shaped.
For China, there is another option: releasing the controls on capital outflows. Pursuing this would change the face of investment not only for China but globally. Once they have decided the rate of currency appreciation is too fast, most countries try the “have-your-cake-and-eat-it” option: intervening to prevent currency appreciation and “sterilising” to avoid overheating.
They purchase foreign exchange, injecting liquidity into the domestic system and then attempt to sterilise the effects through issuing bonds to soak up that liquidity. This can work for short periods, but it sows the seeds for its own demise.
Sterilising means greater bond issuance, which has the effect of depressing their prices and keeping yields higher, thus preserving or exacerbating the spread that was probably a large factor in causing the inflows in the first place. As foreigners buy more of the newly-issued bonds, the sterilisation is less effective.
Indonesia and Malaysia have seen a massive rise is foreign holdings to more than 30% of the total outstanding bonds. This makes them more likely to turn to restrictions of foreign purchase if they want to carry on sterilising.
Meanwhile, the operation is not costless. It has a fiscal cost in the form of the spread between the yield paid on the local bond and that received on the foreign asset. In China’s case, because of the size of these operations, it has been a major factor in driving down the yield on US treasuries in the first place. In the past, these high costs have turned central banks off sterilisation.
Now, the costs are not at all insignificant for most Asian countries, precisely because of the yield that attracts funds to Asia in the first place.
Only Japan and Hong Kong can borrow more cheaply than the US, with Singapore and Taiwan able to access relatively cheap finance. India is more exposed to this source of pressure with higher spreads and government deficits, although Indonesia also has high costs of sterilisation.
“Surprise” rate cuts are another option, although in the context of competitive devaluation, they ought not to catch us completely off-guard. Korea was the latest to join the fray, with the governor Kim Choong-soo stating: “[We] needed to have a more accommodative condition in response to the recent moves by other global central banks”.
This is code for everyone else is doing it and our interest rate was beginning to stand out. The Bank of Korea’s reticence to cut rates for fear of stoking household debt ratios higher is probably misplaced in this climate. Korea is possibly one economy with the most room to cut in Asia, but this would not help address the economy’s structural imbalances.
China is in a tight spot in terms of reducing its interest rate differential. For six quarters till the fourth quarter of last year, China was suffering capital outflows of roughly $300 billion on an annualised basis. The third round of quantitative easing then coincided with the Chinese authorities’ encouragement of capital inflows but not outflows so that capital again flooded in.
This has pushed an already overvalued renminbi yet higher, exacerbating the profit squeeze on Chinese enterprise by forcing them to cut prices. In these circumstances, the authorities would love to cut rates but they are the ones on a knife-edge.
Cutting rates could risk reigniting the flight from deposits either into the shadows within China, driving up risky debt and fuelling bubbles or out of the country altogether, especially as Chinese growth is now on the wane. China’s creaking banking system is not well equipped to deal with this.
For many of the Association of Southeast Asian Nations countries, the option of cutting rates to stem inflows is restrained by positive output gaps. The inflows themselves stoke inflation and cutting rates would exacerbate this.
The overvaluation of the renminbi could lend a hand in this sense, exerting a knock-on deflationary effect through the Asian supply linkages, especially in the context of weak global demand for the rest of this year.
The final option is outright capital controls and administrative measures. Hong Kong, for lack of options other than the obvious of relaxing the currency board peg, has been forced down the road of administrative control, in an unsuccessful bid to tame the property market.
With its long-standing problem of short-term borrowing from abroad to finance long-term lending for currency hedging, Korea has already taken steps to reinstate controls on banks’ forward foreign exchange positions. These kinds of measures are likely to proliferate if capital inflows continue.
For China, slamming the controls back down on capital inflows just after they have been trying to talk them up does not look good. At this stage it is hard to tell whether the more proactive talk of allowing capital outflows is just an attempt to talk down the renminbi.
The optimistic way of looking at it is that the pain of overvaluation has meant that they have cottoned onto the fact that opening up the capital account would probably mean substantial net capital outflows and a politically scot-free depreciation of the renminbi.
If that is the case, hopefully they will have a plan for the carnage that may ensue in the banking system, otherwise Chinese capital’s brief bid for freedom is likely to be short-lived.
Freya Beamish and Shweta Singh are economists at Lombard Street Research in Hong Kong
©2013 funds global asia