Asian nations are in a bind. Currency traders are closing in on the kill. Monetary policy in the export-dependent region has made a valiant effort since 2002 to suppress appreciation in the real, or inflation-adjusted, exchange rate as capital inflows grow.
With each passing day, however, the fight is getting tougher. Gross capital inflows into Asia—China, India, Hong Kong, Indonesia, South Korea, Malaysia, Singapore, Thailand, Vietnam, Pakistan and the Philippines—have now risen back to the record highs registered before the financial crisis of 1997.
These flows are causing Asian assets—from stocks to real estate—to boil over. Limiting foreign capital to more manageable levels requires a reduction in Asian interest rates, something that isn’t possible any time soon because of inflation. And that’s an opportunity for currency traders.
“Inflationary pressures are high in Singapore, Taiwan and India,” says Stephen Jen, Morgan Stanley’s global head of currency research in London. “The Singapore dollar and the Indian rupee have been permitted to appreciate. The Taiwanese dollar could catch up.
Asian nations don’t want their currencies to become one-way bets for appreciation against a falling US dollar because of concerns about what that might mean for their exports.
“The rupee is in a zone which is not comfortable for us,” India’s finance minister Palaniappan Chidambaram said in New Delhi last week. The Indian currency has risen almost 13% this year against the dollar, the second highest gain in Asia after the Thai baht.
Central banks in Asia resist appreciation in the nominal values of their currencies by buying dollars. China has added $367 billion (Rs14.4 trillion) to its foreign currency reserves this year; India has amassed $73 billion.
The accumulation of reserves, however, is no free lunch, and it can’t be continued in perpetuity. Monetary authorities have to sell local bonds to mop up the excess liquidity released in the process of buying dollars. The purpose of the bond sales is to keep local interest rates from collapsing, so as to prevent frenzied lending by banks and asset-price inflation.
There’s still one drawback: As long as money market interest rates are high, the incentive for inflow of more overseas capital remains. Besides, most emerging market central banks pay more on local debt than they make on their low-risk, foreign assets. Thus, the strategy works out to be an expensive one.
It might also be quite useless in preventing the loss of currency competitiveness, a recent International Monetary Fund (IMF) study says. Roberto Cardarelli and other IMF economists have investigated 109 episodes of large capital inflows into emerging markets since 1987 to see what policy response works, and more importantly, what doesn’t.
“Resistance to nominal exchange rate appreciation has generally not been successful in preventing real appreciation and has often been followed by a sharper reversal of capital inflows, especially when these inflows have persisted for a longer time,” Cardarelli and his colleagues note.
The other approach is to impose controls on capital inflows. Thailand tried it when it introduced a lockup rule on short-term overseas funds. In August this year, India and Korea restricted local companies from borrowing in foreign currencies. According to the IMF analysis, tinkering with capital controls isn’t a good idea. “Restrictions on capital inflows have in general not facilitated lower real appreciation,” the economists say.
Much of what Asian central banks have done to cope with capital inflows since they began building up in 2002 is quite useless.
So what does work? Moderation in public spending may be the best strategy to deal with surging capital inflows.
“Expenditure restraint helps reduce upward pressure on both aggregate demand and the real exchange rate and facilitates a soft landing,” the IMF study says.
Politicians, however, are more easily persuaded to bolster demand when it’s weak than to contain it when it’s strong. Averting a disaster gets zero votes. BLOOMBERG
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