Emerging markets should allow their currencies to strengthen to fight inflation and reduce the risk of a sharper correction in asset prices at a later date, the Bank of International Settlements (BIS) said yesterday. The BIS also warned in its annual report that, although risk premiums had risen in recent weeks, they had come from very low levels. Interest rates should therefore continue to rise to rein in excessive liquidity.
“Financial markets may have become ‘irrationally exuberant’ and containing inflationary pressures seems to require further tightening in most jurisdictions,” the BIS cautioned in its annual report. Freeing exchange rates to appreciate could “mitigate inflation risks, attenuate the price and income effects of high commodity prices for exporters and reduce pressures on capacity for countries experiencing strong demand.”
Malcolm Knight, General Manager at the BIS and author of the report, told Emerging Markets that small economies with open capital accounts have seen their currencies appreciate as their terms of trade have strengthened.
“These countries recognise that it is very difficult to stop appreciation by purchasing foreign exchange because it is difficult to stop the domestic money stock from rising rapidly. So whether they like it or not, they realise they cannot sterilise,” said Knight.
By contrast, the BIS issued a warning to those emerging markets that have sought to depress exchange rates through FX intervention and loose monetary policy. (For full details, click here)
“It has proven increasingly difficult to forestall rapid monetary and credit expansion and asset price rises, which could be aggravating vulnerabilities to financial strains and future inflationary pressures. The efficiency of the domestic financial system could also be compromised by these developments.”
The Swiss-based BIS in particular urged China to follow suit in allowing its currency to appreciate, which would help combat global imbalances. The report noted that China’s exchange rate policies have deep implications for neighbouring Asian states. “They are linked to China through production networks and demand for their exports to China is set to grow. To avoid imbalances or overheating, these economies therefore have an incentive to allow their currencies to appreciate along with the renminbi.”
Uncertainty over commodity prices poses a further inflationary risk, according to the report, and the BIS advocated prudent surveillance of commodity price trends. “A supply-induced doubling of prices would boost inflation in emerging Asia by as much as 1.4% above baseline,” said the report, while noting that the current account surpluses of many Asian countries mean they are well positioned to weather this risk.
However, although recognizing the need for tighter monetary policy, the BIS also expressed concern that the increased exposure of investors to emerging markets through derivatives and the greater globalization of financial flows made it more difficult to predict the impact of tightening credit conditions in developing economies.
“Too little is known about the strength and nature of the financial and psychological linkages in an increasingly globalized world...An important lesson from the May-June 2006 episode of market volatility is that both inflation and inflation forecasts can suddenly spike upwards and breach targets,” the report concluded.
Known as the central banks’ central bank, the BIS holds 6% of the world’s currency reserves, researches global finance, and provides central bank policymakers with a forum for discussion.