Über die Autorinnen und Autoren

"Masahiro Kawai is dean of the Asian Development Bank Institute. From 1998 to 2001, he was chief economist for the World Bank's East Asia and the Pacific Region, and he later was a professor at the University of Tokyo. Eswar S. Prasad holds the New Century Chair in International Economics at the Brookings Institution and is also the Tolani Senior Professor of Trade Policy at Cornell University and a research associate at the National Bureau of Economic Research. They are also the editors of Financial Market Regulation and Reform in Emerging Markets."

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Asian Perspectives on Financial Sector Reforms and Regulation

BROOKINGS INSTITUTION PRESS

Contents

Chapter One

In the period before the financial crisis, the prolonged period of low real interest rates in advanced economies led to financial imbalances in these economies. The outcome was a search for yield that resulted in carry trades and the increased financialization of commodity markets, which led to volatility in capital flows and exchange rates as well as to escalating commodity prices. These developments had a bigger impact on emerging market economies (EMEs) than they did on advanced economies. However, low interest rates and the search for yield, combined with dubious financial innovations, also led to an excessive and substantially misdirected expansion of credit and asset price bubbles in a number of advanced economies.

In response to the crisis, unconventional policies adopted by the advanced economies have again pushed interest rates to very low levels, even lower than before the crisis. No doubt these interest rates were appropriate when the economies were looking into the abyss of depression, but the longer they are maintained in the current circumstances the greater the potential that they will once again lead to imbalances similar to those seen before the crisis. Only this time they are likely to affect the EMEs more than the advanced economies.

In particular, this chapter discusses how the search for yield combined with optimism about the growth prospects of Asian EMEs could lead to increased capital inflows into these economies. The outcome is likely to be an appreciation of regional exchange rates, increasing asset prices, and rising commodity prices. If sustained, such trends could lead to imbalances that could undermine growth in some of these economies at a time when the world is looking at EMEs to lead the global economy out of the recession. This chapter looks at the issues from the perspective of EME policymakers. It discusses the policy measures already undertaken by policymakers in Asia as well as those that could potentially be undertaken.

Introduction

Following the bursting of the Internet bubble in 2000, real policy rates trended downward globally (figure 1-1). What is even more striking, though, is that the real policy rate in the United States was below 1 percent from about the second quarter of 2001 right through to the second quarter of 2006, or a period of five years. It was in fact persistently negative for four of those years—that is, from about the fourth quarter of 2002 to the fourth quarter of 2005. Real interest rates in other industrial countries, while never turning negative, were also very low, falling below 1 percent around the end of 2002 and remaining below that level until the third quarter of 2006. In contrast, policy rates in Asian EMEs were considerably higher, being at the level of those in advanced economies only briefly in 2004. In Latin America real policy rates were even higher than those for other economies for almost the entire period. Therefore, there was a sustained period of very low interest rates in the advanced economies during the last decade and also a significant divergence in interest rates between the advanced economies and the EMEs.

While these interest rates were possibly appropriate for these countries given the monetary policy frameworks adopted by them, the sustained period of low real interest rates in the advanced economies and the divergence in interest rates relative to those in EMEs set off a chain reaction of developments that culminated in the current crisis. As we emerge from the current crisis, EME policymakers are again confronted by conditions that are creating risks to monetary and financial stability in their economies. In this chapter I explore three of these policy issues.

The first has to do with the implications for EMEs of the easy monetary policy conditions in advanced economies, specifically the unconventional monetary policies adopted. The volatility and distortions in the financial markets are creating risks for EMEs in a number of areas. Most important, the potentially large capital flows into EMEs can lead to volatility of exchange rates, which could create difficulties for open, trade-dependent, economies. They can also lead to significant volatility in bond and equity markets, as large volumes of foreign funds move in and out of these markets.

The second policy issue is the potential impact of capital flows driven by carry trades and the search for yield on the valuation of EME assets. Asset price bubbles have affected a number of the economies at the epicenter of the current crisis. In the period since the crisis, asset prices are likely to be again stoked; only this time there is a high risk that those bubbles will be in the EMEs. Large capital inflows will amplify such distortions. In managing these bubbles, central banks will have to overcome the current intellectual stalemate regarding the role of central banks in managing asset price bubbles. Asian central banks may need to adopt a proactive approach, even if many central banks in the developed countries have preferred not to play an active role.

The third and final policy issue has to do with the growing role of commodities as an asset class for investors. In a period of low global interest rates and ample liquidity, commodity prices are again on the rise, and this could potentially have more dire consequences for the EMEs than for the more advanced economies.

Effect on Emerging Market Economies of Unconventional Monetary Policies in Advanced Economies

The rapid growth in capital flows between advanced and EMEs has been significantly influenced by the monetary policies of the advanced economies. Research by the Institute of International Finance notes that since the 1970s there have been three major upswings in net private capital flows to EMEs. As a percent of GDP, each peak in the up cycle has been higher than the previous one. It also notes that, based on the resumption of flows in 2009, the fourth upswing could be just beginning. There are compelling reasons to believe that EMEs could once again see a surge of capital inflows.

There is the expectation that economic and financial conditions in EMEs would be better than in the advanced economies. It has also been noted that, following the crisis, many EMEs are in better fiscal positions than a number of large advanced economies and are, therefore, better able to support growth. Furthermore, it is generally agreed that policy interest rates in the advanced economies would have been close to zero for most of 2010 and possibly into 2011. While there has been talk of policy exit in the countries that have undertaken quantitative easing, this is within the context of the unwinding of the vast liquidity support facilities and not in terms of increasing interest rates off the floor. EMEs in Asia also dropped their interest rates in 2008—09 in response to concerns about the deflationary impact of developments among their advanced trading partners.

However, unlike in advanced economies, financial systems in Asia have remained largely functional, and banks have continued to provide financing. This means that the monetary transmission mechanism in the Asian economies continues to work and that the central banks in the region have not had to adopt the quantitative easing adopted by their...