The region is no stranger to the consequences of an asset bubble. But will it have the political will to bite the bullet and impose capital controls that staunch the flow of easy money into its capital and property markets?
The economic success of the Asia-Pacific, its vibrant outlook and resilience have been key factors in attracting large flows of capital from the West and in fuelling optimism across the region. But regulators, including central bankers, have grown concerned that the US Federal Reserve’s policy of quantitative easing will result in more US dollars circulating outside the US in search of assets with the potential of providing a positive yield. When that wall of liquidity finds its way to Asia through investments in stocks, bonds and property, it could sow the seeds of a major asset bubble.
Capital controls become an option
McLaughlin: Positive about Asia's medium-term prospects
The region is familiar with the consequences of asset bubbles. In view of the amounts of money in circulation around the world, Andrew McLaughlin, the chief economist at the Royal Bank of Scotland (RBS), warns against countries naively relying on money which they know is hot. “A failure to address asset bubbles,” he explains, “will have damaging consequences that could severely affect the medium- to long-term prospects of regional economies.” The level of vulnerability differs.
“Some countries that are receiving the largest amounts may well suffer the most,” notes McLaughlin, “as soon as such inflows are held back and capital starts fleeing to other shores.” Korea is one such country that is extremely leveraged and too reliant on foreign capital. This has prompted the Korean government to pursue policies aimed at reducing leverage. The Philippines too has reported experiencing at least US$1 billion of inflows monthly in recent months. McLaughlin readily acknowledges that monetary authorities in the region still enjoy much leeway in monetary sterilization and other measures that mitigate the impact of hot money flows. In view of the magnitude of global liquidity flows into Asia, imposing capital controls has become a real option.
Erik Lueth, the senior regional economist for RBS, seconds this view. “Even the International Monetary Fund has moderated its hard-line stance against capital controls in the aftermath of the global financial crisis,” Lueth observes. “Its economic orthodoxy eased somewhat and Asia’s experience in the late 1990s was particularly instructive.” Lueth is referring to the Asian financial crisis of 1997-1998, when Malaysia and Korea, two of the countries that were most affected, fended off speculative attacks on their currency and stockmarkets by imposing capital controls and as a result were among the first to recover from the crisis and to begin posting strong growth.
Not without risk
HSBC economists Frederic Neumann and Kim Song-yi argue that hampering capital flows has turned into an attractive option for policy-makers in the region. They point out in a report that capital controls that had been relaxed in recent years in much of the region – with the notable exception of China – are being re-evaluated. In recent months, Thailand, Korea, Taiwan, and Indonesia, have tinkered with various regulations and guidelines for foreign investors to stem inflows.
Neumann: Re-evaluating capital controls
“While these do not amount to full-blown capital controls, such policies are clearly aimed at slowing inflows,” Neumann notes. “More regulations are forthcoming, if only because without some form of capital control measures, it is hard to see a clear way out of Asia’s dilemma of surging currencies and asset bubbles. Raising the cost of money to stifle domestic demand will not do, because the higher rates would attract more inflows from outside, especially if capital controls have been relaxed.”
The prime motivation for capital controls is to discourage speculative activity and prevent excessive currency appreciation, notes the HSBC report. The most common measure seen across different regions is the imposition of taxes and investment limits.
It is worth noting, Neumann says, that capital control measures may relate to the liberalization of outflows. In order to ease upward pressures on the domestic currency, some countries choose to encourage outflows instead of curbing inflows, especially foreign direct investment inflows that could fuel economic growth and development. “Over the years, in a number of Asian economies, including Korea, the Philippines, and Thailand, the authorities have sought to offset strong inflows with greater outflows of local investor capital,” Neumann points out. “While this makes sense, on balance it is questionable whether capital outflow liberalization in itself is enough.” Neumann feels that the potential pool of investment capital awash across borders is infinitely greater for inflows than outflows.
Unintended side-effects
Still, even capital control proponents warn that imposing stringent capital controls can have unintended consequences that could dissuade monetary authorities from pursuing them. In 2006, for example, Thailand’s measures had a harsher-than-intended impact, while Brazil’s tax on inflows, at least initially, left markets entirely unimpressed.
Second, regulatory leakage may render these measures ineffective. For example, imposing taxes on certain kinds of inflows could redirect flows to other avenues, leaving the aggregate amount of capital pouring in unaffected. In fact, even economies with tight capital controls have been unable to stop the inflow of black money, as investors – or, perhaps more correctly, speculators – diligently drill holes into the regulatory wall.
Unlike rate hikes or even a managed exchange rate appreciation, Neumann notes, the impact of capital controls is hard to calibrate and therefore policy-makers have had little experience with such measures, and could easily overshoot or undershoot their goal of curbing excessive inflows.
Emerging bright spot
While the strict measures that Malaysia took in 1998 – effectively halting the ringgit convertibility – immediately come to mind when mentioning capital controls, McLaughlin points out that different ways exist in which capital controls can be imposed. China, for instance, has imposed tougher reserve ratio requirements for its banks. “By increasing the reserve requirements, the Chinese government raised the cost of the movement of capital and was able to keep the pricing mechanism in place. “I don’t think that some measure of capital control will undermine the efficacy of the market.”
Leuth: Even the IMF has moderated its stance
Lueth says the strengthening of the emerging market economies will continue. In the next 10 years, he opines, emerging markets are the place where investors need to put their money. McLaughlin too is positive about Asia’s medium-term prospects – in contrast to the uncertainty in the developed world. “The only exceptionally bright spot at present seems to be Asia and this explains why the region is feeling it is enjoying an autonomous growth engine. For the first time in a global cycle, people feel that Asia is not simply a play geared towards the US consumer.”
Yet, despite the malaise gripping the US economy, McLaughlin sees the US corporate sector as particularly robust. “The corporate sector, with the exception of real estate companies, has been remarkably well-behaved and corporate balance sheets show a fair number of them are enjoying huge financial surpluses. When the US corporate sector saw how bad the outlook was for the global economy – in light of the failure of demand to pick up – it was the first one to bite the bullet and pursue aggressive cost-cutting adjustments and clearing of inventory.”
This was filed in October but only published in the December 2010 issue of The Asset
The Asset website is at http://www.theasset.com
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