East Asia’s On/Off Switch

In 2009 and the first half of 2010, low interest rates and an uncertain global outlook led to strong, volatile capital inflows into some of Asia’s most promising economies. Policymakers in these places—which include, among others, Hong Kong, Taiwan, Singapore, South Korea, Indonesia and India—have searched for the best ways to control the on/off switch, to prevent volatility from undermining their economic growth. We examine this trend in a recent analysis, available to RGE clients, which surveys the measures implemented in each of the countries noted above.

In 2011, capital flows could turn even more volatile if investors begin reversing carry trades in anticipation of G3 rate hikes. With growth risks derailing emerging Asia’s monetary tightening schedule, more and more policy makers will battle credit and asset bubbles and inflows that create external vulnerabilities, like short-term private and sovereign debt inflows, to reduce the threat from capital outflows to liquidity, currencies, asset markets and capex financing. However, the region’s capex financing needs, weakened current account balances and elevated sovereign and corporate debt issuances will tie policymakers’ hands and prevent them from imposing punitive capital controls or taxes.

The root cause of volatile capital flows is debatable: Low interest rates abroad and expectations of domestic currency appreciation attract carry trade and external borrowings, but domestic conditions may be exacerbating emerging market (EM) Asia’s inability to cope with heavy, volatile short-term capital flows.

Several regional economies currently are characterized by less liquid FX and capital markets, inadequate asset market diversification for foreign investors, partial capital account convertibility, weak business climates for FDI, inadequate sterilization and monetary and exchange rate policies that encourage speculation. Since structural reforms to enable flexible exchange rates and deepen financial markets can be implemented only in the medium term, prudential measures are becoming Asia’s short-term policy tool of choice to cope with capital inflows.

Macroprudential measures could reduce volatility from speculation in the very specific asset markets they target, but their long-term effectiveness in containing total capital inflows, currency appreciation and general volatility might be limited. This is especially true for regulations targeting equity and bond inflows.

Empirical evidence from Asia suggests that measures targeting corporations’ and domestic and foreign banks’ FX and derivative positions could somewhat reduce short-term capital inflows, external debt and associated vulnerabilities such as maturity and currency mismatches and systemic risks in the banking sector.

The experiences of South Korea and Indonesia, for instance, show that advance warnings and gradual implementation can reduce negative market reactions to such restrictions. But regulations only will be effective if the countries’ targeted inflows account for a large share of total capital inflows and if investors perceive the measures to be permanent and are unable to shift to other short-term asset classes within the country. Plus, the costs of inflow regulations must be far higher than foreign investors’ expected returns, as well as interest and exchange rate arbitrage for external borrowings of domestic banks and companies.

Tighter real estate regulations, especially those related to mortgage lending, have tempered the surge in prices and/or sales in several countries and eased risks of asset bubbles or sharp market corrections in the event of capital outflows. However, home prices and sales in the luxury sector continue to be driven by capital inflows and speculation, suggesting a need for further regulatory tightening. Rate hikes by Asian policy makers could contain equity market bubbles, but they also could attract more inflows related to bonds and external borrowings.

Nonetheless, our analysis leads us to conclude that many Asian economies need to tighten monetary policy sooner rather than later. New inflows from the rest of the world might prove problematic, but at present low or negative real interest rates seem to be fueling speculative investment by domestic players, and that too is a dangerous dynamic.

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