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May 1, 2010

Asia drags its feet

Asian financial markets began the year with an impressive tailwind behind them. They had mostly clawed back the losses of 2008. Economic growth had recovered impressively and, more importantly, the feel-good sentiment had returned to most countries in the region.

Sustaining this was going to be a challenge. With interest rates at record low levels in the developed world and with the prospect of faster growth and wealth creation in Asia, capital flows would—like in 2007—again pose a problem of plenty. Second, commodity prices had begun to rise in the course of 2009. Among the factors that caused this, four stand out. The first was the weakness of the US dollar. The second was robust demand from China. Third, commodities had become securitised and hence were behaving as financial assets, rising or falling in tandem. Fourth, commodities are also in favour as real assets with potential shortages down the road.

Now that one quarter of the New Year is behind us, it is good to ask for Asia’s monetary policy report card. The report is, at best, mixed and, at worst, a disappointment. Asia is still running the risk of a boom and bust outcome to its economies and asset markets. Soft-landing outcomes for both are not yet in the bag.

In response to the global financial crisis of 2008, developed nations resorted to unprecedented monetary and fiscal stimulus. Asian governments added their own set of massive stimulus measures even as they claimed that they were relatively unaffected by the troubles in the industrialised world. They then held on to these measures even as their asset prices spectacularly rebounded from the lows of 2008. There is some inconsistency in their claims and behaviour. If Asia believes that it is capable of economic growth independent of the prospect for the same in the West, its economic policies must also become independent.

In other words, if Asian economies were indeed going to be seriously hurt by the crisis and the repair in the West, then they should have signalled to investors that there was no justification for asset prices to start rising steeply again. On the other hand, if they believed that their economies were capable of levitating on their own, they should have de-coupled their monetary and fiscal policies earlier.

They are scrambling now to contain the possibility of another economic and asset price boom turning into a bust, consigning Asia to the case of a region with potential that is never fully realised. It is a replay of 2007 with just minor changes to the underlying dynamics. Then, Asian economies were in denial about inflation and overheating economies. They thought that they could ignore the rise in the price of crude oil by citing moderate core inflation rate that excluded the price of energy. Simultaneously, they also ignored warnings from overpriced asset markets. Eventually, when they could no longer ignore both signals, they began to tighten but they did so into the global financial storm. Asian economies and asset prices came down to earth with a thud.

This time around, the policy response has been the same—put off dealing with asset price booms until it is too late. Let us examine closely two countries—India and China—that stand for Asia’s future tremendous potential.

Administrative measures only
Recently, China’s State Council got the message from the red-hot first quarter GDP growth numbers and announced further tightening measures on the property sector. There was a hint of panic and desperation in the measures announced.

As is well known by now, ‘financial repression’ in China (administered interest rates, restricted investment choices for the public) has not only resulted in huge household savings rate but has also limited households’ investment options, pushing them into real estate and stock market speculation. They do it to augment their savings and incomes, given very low interest rates available on bank deposits and inability to take their money out of the country. This has resulted in frequent boom-and-bust cycles.

Extremely low official nominal interest rates encourage those that have access to such funding to use those funds for speculation. Those that do not enjoy such access pay extremely high interest rates in the black market. This is unsustainable. China needs to act immediately. It has to set its exchange rate free. That would, in turn, set its interest rate regime free. The central bank would then be able to better manage asset price booms. But China has refrained from raising its interest rates this year. It has relied on administrative measures.

Ultimately, what discourages speculation is cost of capital. Administrative measures are easier to evade than paying higher interest rates. The reluctance to administer the interest rate medicine to the economy and to its financial markets will hurt China.

RBI falls behind
The Reserve Bank of India (RBI) raised its repo rate, the reverse repo rate and the cash reserve ratio on April 21. The interest rate hikes followed a similar hike in March and the cash reserve ratio has gone up a full percentage point in the New Year. On the face of it, these may appear to be proactive and aggressive. The problem is that inflation has proven to be a lot stickier than thought. The consumer price inflation rate is in double-digits. As of February, the rate was 15 percent.

It is possible that food price inflation has peaked and that a good monsoon could bring it down further. But, as RBI acknowledges, the real rate is too negative and that it risks creating a spiral of raising inflation expectations. Yet, it is focused on ensuring that the government completes its borrowing programme to finance its high fiscal deficit. RBI fears that its rate hikes would raise the government’s cost of funding.

This is problematic at many levels. First, it does not put a brake on the government’s profligate tendencies. Second, it aligns monetary policy with fiscal policy. They are loose or too tight together. Policy becomes pro-cyclical and exacerbates business cycles. Third, letting fiscal policy considerations take precedence over inflation runs the risk of entrenching inflation expectations that the central bank is concerned about. Eventually, to restore its credibility, RBI might be forced to raise interest rates steeply to bring down inflation and inflation expectations. That could result in policy overkill with adverse implications for economic growth. In the process, the Indian rupee exchange rate would become highly volatile, hurting foreign trade by raising hedging costs, among other things.

Learning to be important players
In sum, what is becoming evident is that Asian governments are still grappling with their elevated economic stature and the policy challenges that come with it. Both India and China run the risk of losing control of their near-term economic trajectories even as medium growth prospects are underpinned by their sizes, demographics and catching up. If they accept short-term growth pains and asset-price declines, they will have truly decoupled from the ways of the West.


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