If you are in charge of monetary policy in an up-and-coming Asian economy (say India, China, or Korea), you have a problem.
The world’s financial markets have decided that Asia is rebounding more quickly than most other parts of the world, and capital is rushing to get into those countries before asset prices rise too much.
The monetary policy authorities know this and – given what we have all seen over the past few years (or is that two decades?) – they are rightly worried about new “bubbles” of various kinds that can destabilize their financial systems and undermine their economies.
What should these central banks do? If you fear that your economy is growing too fast, and thus inflation is on the rise, responsible central bank mantra dictates that you should raise interest rates. The same mantra was, in the era of Alan Greenspan, less clear on whether interest rates should be increased to forestall unsustainable financial bubbles. With the puncturing of the Great American Bubble, including the fall of Greenspan as an icon, most central bankers are quietly quite willing to tighten monetary policy if they see real estate prices take off like a rocket.
But this is exactly where the problem lies.
If you raise interest rates in an economy open to capital flows, at the same time as the world’s money centers have low or almost zero interest rates, what happens?
Almost certainly, you will attract more capital from overseas. This capital inflow will likely feed into your domestic credit boom and further the run-up in asset prices, housing construction, and other bubble-related phenomena.
Some of these consequences can be offset if you let your currency appreciate, i.e., rise in value as the capital comes in. But most Asian countries, most particularly China, generally resist such appreciation, in order to protect their export industries; so this “feedback” or dampening mechanism is removed. And the more you resist appreciation by accumulating foreign exchange reserves, the more investors believe they will make money on a future rise in the value of your currency. So the more they want to pile into your markets.
What should Asian central bankers do and why should we care?
One view, increasingly part of the mainstream consensus, is that these central banks should tighten up on lending standards and otherwise lean on banks to lend less as capital comes in. This is not a terrible idea – the US, of course, loosened lending standards during its real estate boom, and we know how that ends.
But are such ad hoc adjustments around the edges of the regulatory system likely to be enough, given the scale of capital inflows?
Much more likely is what is now being whispered about in the corridors of financial power – begin to consider ways to tighten capital controls, i.e., limit the amount of capital that can come into a country, or force investors to commit to stay in the country for longer periods of time.
Such capital controls are unlikely to be announced explicitly, but watch for tightening the rules around inflows. And expect discussion increasingly at the level of the G20 about the extent to which various kinds of capital controls can now be considered “best practice.”
The US has historically pushed the view that all capital controls are bad and should be abolished – in fact, this was a major international policy initiative of the Clinton administration, led in this regard by Messrs. Summers and Geithner (who both came up through the international side of Treasury).
But given our more recent record of mismanaging financial markets and dealing with instability, as well as new retrospectives on the string of international financial crises we have experienced since the 1980s, the Obama administration is not in a strong position to block further moves towards capital controls.
For better or worse, we are likely heading towards a world in which capital no longer flows so freely across borders. Look for the start of this in Asia.
By Simon Johnson
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