AMANDO TETANGCO: Watch out when fighting capital inflows

The surge of capital to emerging market economies is a major consequence of the global financial crisis. The easy monetary policy and risk appetite in advanced countries are “pushing” money out of their markets, and the favourable macroeconomic prospects of and interest rate differential with emerging market economies are “pulling” in the funds. Since 2010, emerging market economies have been receiving more than a trillion dollars of capital flows a year, with emerging Asia getting about half of the flows.1

While the potential benefits of capital flows are well recognized, the size and volatility of these flows create risks to financial stability. They also present challenges to the conduct of monetary policy. In most of the emerging economies, the amount of capital exceeds the absorptive capacity of the economy. Liquidity management becomes a huge hurdle to monetary authorities. Subsequently, there is a risk of build-up of financial imbalances due to rapid credit growth and rising asset prices.2 Outside the formal financial system, there could also be a build-up of another kind of risk. Shadow banking creates additional credit. The excess liquidity in the economy could be bolstering credit intermediation by institutions outside the supervisory ambit of the central bank.

The reversal of flows is the other side of this risk. The eventual recovery in advanced economies and the exit from accommodative monetary policy could trigger sudden stops and, finally, capital reversals. There is no doubt these may have a destabilizing impact on emerging market economies.

What are the broad contours of the policy responses of emerging Asia in the face of strong capital inflows? Primarily, emerging Asian economies have put a premium on structural reforms to improve the capacity of their economies to absorb capital inflows and channel them to productive investments. In the financial sector, reforms are in progress. These reforms are aimed at deepening domestic bond and equity markets, developing financial products in a prudent manner, and strengthening financial regulation and supervision. As a result, financial intermediation has improved, as much as the transmission of monetary policy has been strengthened.

Disciplined macroeconomic policies have been an important part of the toolkit of emerging Asian countries. Their macroeconomic policy tools have encompassed fiscal policy, monetary policy and exchange rate policy. Their policy mix has differed depending on, among other things, the state of their economy (how close their economy is to potential growth), their level of reserves, and the scope to allow the local currency to strengthen (whether the currency is already overvalued or still undervalued). 

At the Philippines Central Bank (BSP), we have always tried to make effective use of monetary policy instruments – we were able to reduce policy rates because of the benign inflation environment, and we have rationalized our reserve requirements. In general, Asian currencies have appreciated as a consequence of the flows. Sterilized interventions were mainly to temper volatility of currency movements, although these actions have resulted in rising costs of stabilization. In the case of the Philippine peso, the appreciation has been at 9% since 2009.

Emerging Asian countries have also used macro-prudential and capital account measures to manage capital inflows and contain the build-up of excesses in specific sectors and in the banking system. They have employed macro-prudential policies as the first line of defence against financial stability risks, especially since the relatively shallower nature of their financial markets means that asset price bubbles could form rather quickly. At the BSP, we look to macro-prudential measures to help maintain stability in the financial system while we work on the further development of the financial market.

However, it is important that policymakers are circumspect in the use of macro-prudential measures. The nexus between macro-prudential and monetary policies should be duly considered. For example, macro-prudential restrictions on borrowing may affect expenditures in other sectors and, subsequently, economic output. They may also weaken the transmission of monetary policy by influencing credit supply conditions. Monetary policy, in turn, may impinge on financial stability. Policy rates affect the cost of borrowing with subsequent impacts on how market agents decide on leverage and composition of assets and liabilities. Efficiency dictates that we should have a clear assignment of tools to policy objectives – monetary policy should be focused on ensuring price stability, and macro-prudential tools should be used to manage potential build-up of systemic risks. In many instances, both policies can be mutually reinforcing, such as when they both lean against the business and financial cycles.

There have also been instances of capital flow management measures that have been implemented by some emerging Asian economies. A number of these economies have undertaken measures to liberalize the regulatory environment on capital outflows as a safety valve to balance the flows coming in. Nonetheless, prudential and capital flow management measures implemented by emerging Asian countries have not substituted for warranted macroeconomic adjustments. Finally, emerging Asia has been an active advocate for multilateral coordination. There is a central role for communication and coordination among capital-receiving economies to help ensure that they do not pursue beggar-thy-neighbour policies that would simply re-route the unwanted surges to each other.

Amando Tetangco is Governor, Philippines Central Bank

1. “Capital flows to emerging market economies”, January 2013

2. IMF Regional Economic Outlook–Asia and Pacific, April 2013

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