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Capital Flows to Asia Revisited: Monetary Policy Options

Capital flows into emerging Asia should be high on the ‘watch list’ for policymakers in the region. But, perhaps, not in the way we had previously anticipated.

Twelve months ago our policy antennae were keenly attuned to the risks posed by the foreign capital that flooded into Asia from mid-2009 onwards. What was remarkable about this was the speed of the rebound after the massive drop during the global financial crisis. Within just 5 quarters, net inflows rose from their early 2009 trough to their mid-2010 peak—a mere one-fifth of the time that typically elapsed between troughs and peaks in the cycle of capital flows during the pre-Asian crisis period.

Another twelve months on, what we’re seeing is not really all that “exceptional”—a point often overlooked in the current debate on capital inflows to emerging markets.

In our latest Regional Economic Outlook, we put the current situation into historical perspective. Our analysis confirms that, with the recent surge, net overall capital flows to emerging Asia (as a share of GDP) have not surpassed the peaks reached in past episodes of large inflows to the region. Also, it is reassuring that signs of risks from asset valuations and corporate indicators remain largely muted, and that external buffers are large.

Of course, that’s not to say it's all blue skies. The nature of inflows is different this time, and that poses new challenges and risks.

Net portfolio flows—bonds and equity—are now dominating inflows to Asia. And, for a few economies in the region—including India, Indonesia, Korea, the Philippines and Thailand—those inflows are large compared to what their domestic markets can absorb. And, despite the slowdown since late 2010, portfolio inflows to emerging Asia are expected to continue over the next two years.

The earlier rapid surge and continued concentration in potentially volatile portfolio flows raise concerns for a few Asian economies. Given the relatively shallow markets in some countries, asset price bubbles can form quickly and sudden stops remain a real possibility.

This poses risks to financial stability and asset market imbalances, particularly in a context where there are already isolated pockets of concern on overheating, such as credit dynamics in some countries and certain segments of property markets around the region.

Given that large capital flows are seen to complicate the conduct of monetary policy, and the added risks to financial stability, how then should policymakers in the region proceed?

Monetary policy effectiveness

Capital flows can affect the monetary transmission mechanism as they can depress long term bond yields, which tend to be driven mainly by global factors. This in turn means that central banks have relatively limited influence on long-term interest rates.

Despite the important role of long-term interest rates in monetary transmission in other parts of the work, our analysis find that monetary policy in Asia has a strong influence on economic activity, working mostly through short-term interest rates. Indeed, a bulk of bank loans to businesses and mortgages in the region are priced relative to short-term interest rates.

So, when capital inflows are large, conventional monetary policy still has a role to play in countering overheating pressures.

Safeguarding financial stability

But, macroeconomic stability is not sufficient to guard against the risk of financial instability—a point underscored by the global financial crisis.

The upshot has been increased attention of the role of macroprudential measures, as have been introduced by several economies in Asia. These measures aim to reduce the risk of overheating in asset prices and of subsequent busts if capital flows reverse. We find that macroprudential measures can play a useful role in reducing economic and financial instability that could arise from surges in capital inflows.

Changes in both policy rates and macroprudential measures are likely to affect economic activity, as well as financial conditions. However, macroprudential measures differ in some key respects. For example, changes in policy rates are “blunt” instruments that impact all lending activities, whereas macroprudential measures are aimed specifically at markets in which there is an excessive risk of financial instability.

Accordingly, the two instruments are best seen as complements to, and not substitutes for, one another.

Better together

Asia’s economies are now well placed—and have the necessary ‘space’—to tackle overheating concerns with appropriate macroeconomic policies. But that will not be enough to limit leverage and address financial stability risks. Policymakers should be ready to tighten monetary policy together with, but not in place of, macroprudential measures.