How Asian economies can avoid asset bubbles
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Just as Asian economies started to recover from the global recession, policymakers and markets began worrying over unwarranted asset price increases. While the worries are global, especially in the case of stock markets, the risks of asset price bubbles seem particularly high in Asia, where abundant liquidity is driving up prices of all sorts of assets from real estate in the Hong Kong Special Administrative Region (SAR) and Singapore to Chinese art.
Where is the liquidity coming from? Capital inflows have received a lot of attention lately. Financial capital is flowing into Asia, attracted by the continent's relatively good economic prospects. More important, for most economies, is a dramatic easing of domestic monetary conditions since late last year that has fueled domestic liquidity.
In part, the easing of monetary conditions in Asia was deliberate, a policy response to sharp weaker growth. But some of the easing of monetary conditions was not deliberate. Economies with an exchange rate somewhat or completely fixed to the US dollar and fairly open capital markets are "importing" the loose US monetary policy. In some economies, those imported monetary conditions sit oddly with domestic economic conditions. In many Asian economies, spare capacity is much smaller than in the US and cyclical unemployment much lower.
Against this backdrop, prominent policymakers in Asia have warned of the threats posed to financial stability by the US monetary policy. I would not put it that way. The US monetary policy stance seems about right, given the depressed state of the US economy, with unemployment at around 10 percent. Moreover, there is no credit growth in the US at the moment. The main problem for Asia is the importation of US monetary conditions under fixed or managed exchange rate regimes to economies in very different economic circumstances. But the worries expressed by these policymakers underscore the tensions that this state of affairs generates at the moment.
What should governments do to mitigate these risks? Governments in several Asian economies have tightened prudential regulation and used other administrative measures. They have increased loan-loss coverage ratios and minimum down payments for mortgages and restricted lending to property developers. The Chinese mainland has taken steps to try to avoid new lending going to the stock market and to increase the supply of stocks by allowing IPOs again. Taiwan has banned foreign investors from putting money into the island's fixed-term deposits. But, except for Australia, other economies in the region have so far refrained from tightening their overall monetary policy.
Looking ahead, more prudential and other administrative measures can be taken, such as increasing loan-loss and minimum down payment ratios and higher reserve requirements. Administrative measures may not be enough, though. Adjustments to monetary and exchange rate policy may be needed. To decide what to do in this area, in my view policymakers should first determine what the main problem is: capital inflows or (too) rapid domestic liquidity creation. And, if too rapid domestic liquidity creation is the main problem, to what extent is this because of loose monetary conditions imported via the exchange rate regime?
If capital inflows are a big problem, compared to domestic liquidity creation, economies cannot rely too much on higher interest rates to dampen financial risks, because the increase in capital inflows owing to higher interest rates may outweigh the impact on domestic liquidity. This may especially be the case in some of the smaller, financially more open economies in Asia. If the openness of their capital market creates such big constraints, they should consider measures to control or discourage capital inflows. They can also absorb some of the pressure by allowing their currencies to strengthen. East Asian economies tend to worry about loosing their competitiveness if they let their currencies strengthen unilaterally. With so many economies facing the same problem, it would make sense to strive for more cooperation on exchange rate management, formally and informally.
If capital inflows are not a major problem but the cyclical differences vis-a-vis the US mean that loose monetary policy is very inappropriate for domestic economic conditions, there may be room to tighten monetary policy, including raising interest rate.
In my view, this is the situation on the mainland, where the role of capital inflows compared to domestic liquidity creation is smaller than many think. Policymakers have at times been unnecessarily reluctant to raise interest rates. In the first half of 2009, net financial capital inflows were equivalent to only 3.3 percent of domestic credit creation. Given the mainland's capital controls and the relatively small role of capital inflows, the pros of higher interest rates seem to outweigh the cons. This may be the case in other Asian economies as well, particularly if such moves are accompanied by tightening capital controls further.
Some are reluctant to tighten the monetary policy because of low inflation, the traditional trigger for monetary policy action. But the global financial crisis has shown the dangers of neglecting asset price increases in monetary and financial policymaking. In key high-income economies traditionally geared only toward inflation, the monetary policy was loose for too long, even as asset prices rose to levels deemed worrisome by many. In all cases, introducing more exchange rate flexibility would help discourage inflows. By introducing a useful two-way risk on the foreign exchange market, a more flexible exchange rate gives monetary policy more independence to be in line with domestic needs.
In addition, opportunistic timing of structural reforms can reduce risks on asset prices and quality. The supply of financial titles can be increased, by deepening the financial sector, including in the bond and equity markets. In places where interest rates on bank deposits are still capped, easing the caps and stimulating the development of more long term saving instruments would help absorb financial surpluses. Finally, opportunistically introducing or increasing capital gains taxes on equity and real estate would reduce pressures as well.
As Asian growth prospects are likely to continue to differ significantly from those in the US in the coming years, this may well be a good time to take the steps needed to make monetary policy more independent, so that the monetary stance can be more in line with domestic economic conditions.
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