Monetary Policy Frameworks in Asia: Experience, Lessons and Issues

ADBI Working Paper Series

Monetary Policy Frameworks in Asia:

Experience, Lessons, and Issues

Peter J. Morgan

No. 435

September 2013

Asian Development Bank Institute

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Morgan, P.J. 2013. Monetary Policy Frameworks in Asia: Experience, Lessons, and Issues

ADBI Working Paper 435. Tokyo: Asian Development Bank Institute. Available:

http://www.adbi.org/working-paper/2013/09/27/5902.monetary.policy.frameworks.asia/

Please contact the authors for information about this paper.

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Peter J. Morgan is Senior Consultant for Research at ADBI.

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ADBI Working Paper 435 Morgan

Abstract

This paper analyzes the evolution of East Asian monetary policy frameworks over the past two

decades, chiefly in response to shocks from the Asian financial crisis of 1997–1998 and the

global financial crisis (GFC) of 2007–2009. The Asian financial crisis showed the importance of

exchange rate flexibility and credible policy frameworks, leading to increased central bank

independence, greater focus on inflation policy and more flexible exchange rates. A key lesson

of the GFC was the importance of containing systemic financial risk and the need for a

“macroprudential” approach to surveillance and regulation that can identify system-wide risks

and take appropriate actions to maintain financial stability. Emerging economies face particular

challenges because of their underdeveloped financial systems and vulnerability to volatile

international capital flows, especially “sudden stops” or reversals of capital inflows.

The paper reviews the history of East Asian monetary policy frameworks since 1990; describes

current monetary policy frameworks, including issue of price versus financial stability for a

central bank and the policies a central bank can use to manage financial stability; the monetary

policy transmission mechanism based on financial linkages and financial deepening; assesses

policy outcomes including inflation targeting and responses to the “Impossible Trinity”; and

makes overall conclusions. The paper finds that East Asian central banks have generally

managed inflation and growth well over the past decade, but the difficulties faced by central

banks of advanced countries in the aftermath of the GFC suggests that not all problems have

been solved yet.

JEL Classification: E52, E58, F31, F32, G18

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Contents

1. Introduction ..................................................................................................................... 3

2. History of policy frameworks since 1990 ......................................................................... 3

3. Policy objectives and frameworks ................................................................................... 5

3.1 Price stability ....................................................................................................... 5

3.2 Financial Stability and Systemic Risk .................................................................. 7

3.3 Need for Stronger Macroprudential Policy in Asia ............................................... 8

3.4 Role of a Central Bank in Financial Stability ........................................................ 9

3.5 Financial Stability Mandate versus Price Stability Mandate ................................. 9

3.6 Current Situation of Central Bank Financial Stability Mandates ..........................10

3.7 Tools for a Central Bank Can Help Achieve Financial Stability ...........................11

3.8 Monetary Policy Tools ........................................................................................12

3.9 Currency and Capital Flow Management ...........................................................14

3.10 Macroprudential Policy Tools .............................................................................14

3.11 Architecture for Financial Stability ......................................................................15

3.12 Regional Cooperation ........................................................................................16

4. Policy transmission mechanism based on financial linkages and deepening .................17

4.1 Financial openness in Asian emerging economies .............................................17

4.2 Capital flow composition ....................................................................................18

4.3 Domestic financial development .........................................................................20

5. Assessments of policy outcomes ...................................................................................21

5.1 Effectiveness of inflation targeting ......................................................................21

5.2 Policy frameworks have multiple tools ................................................................23

5.3 Monetary policy and the trilemma ......................................................................23

5.4 Recent experience of advanced economies shows problems remain.................25

6. Conclusions ...................................................................................................................

References ...............................................................................................................................28

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1. INTRODUCTION

East Asian monetary policy frameworks have evolved substantially over the past two

decades, chiefly in response to shocks from the Asian financial crisis of 1997–1998 and

the global financial crisis (GFC) of 2007–2009. The Asian financial crisis showed the

importance of exchange rate flexibility and credible policy frameworks, leading to

increased central bank independence, greater focus on inflation policy and more flexible

exchange rates. A key lesson of the GFC was the importance of containing systemic

financial risk and the need for a “macroprudential” approach to surveillance and regulation

that can identify system-wide risks and take appropriate actions to maintain financial

stability. Emerging economies face particular challenges because of their underdeveloped

financial systems and vulnerability to volatile international capital flows, especially “sudden

stops” or reversals of capital inflows.

The paper is organized as follows. Section two reviews the history of monetary policy

frameworks since 1990.

2. HISTORY OF POLICY FRAMEWORKS SINCE 1990

Section three describes current monetary policy frameworks,

including issue of price versus financial stability for a central bank and the policies a

central bank can use to manage financial stability. Section four examines the monetary

policy transmission mechanism based on financial linkages and financial deepening.

Section five provides assessments of policy outcomes including inflation targeting and

responses to the “Impossible Trinity,” and Section 6 concludes the paper.

Monetary policy is to a large extent constrained by the exchange rate regime. Prior to the

Asian financial crisis, most East Asian economies aside from Japan had their exchange

rates relatively fixed relative to the US dollar, and tended to focus on controlling monetary

aggregates. In the absence of foreign exchange controls, this implied no independence of

monetary policy, and, indeed, the easing of capital controls during the period created the

conditions leading up to the Asian financial crisis. Table 1 shows the classification of Asian

monetary policy regimes in Stone and Bhundia (2004) for the period spanning the pre-

Asian-crisis and post-crisis period. In the pre-crisis period, only the People’s Republic of

China (PRC), the Philippines, and Thailand were classified as having fixed exchange rates,

but those of Indonesia, Republic of Korea (henceforth Korea), and Malaysia were not far

off. Hong Kong, China’s monetary regime, although not included in the table clearly

remained an exchange rate peg (XRP) over the period. Taipei,China’s monetary regime is

not included either, but may be regarded as being a monetary aggregate anchor (MoA).

This paper covers the monetary policy frameworks of the People’s Republic of China; Hong Kong, China;

Indonesia; Japan; the Republic of Korea; Malaysia; the Philippines; Singapore; Taipei,China; and Thailand.

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Table 1: Monetary Rule Classification in East Asia

Country

1995 1996 1997 1998 1999 2000 2001 2002 2003

People’s Republic

of China

XRP XRP XRP XRP XRP XRP XRP XRP XRP

Indonesia ITL ITL ITL ITL ITL ITL ITL ITL ITL

Japan IIT IIT IIT IIT IIT IIT IIT IIT IIT

Republic of Korea MoA MoA ITL ITL ITL ITL FFIT FFIT FFIT

Malaysia ITL ITL ITL XRP XRP XRP XRP XRP XRP

Philippines XRP XRP ITL ITL ITL ITL ITL FFIT FFIT

Singapore IIT IIT IIT IIT IIT IIT IIT IIT IIT

Thailand XRP XRP ITL ITL ITL FFIT FFIT FFIT FFIT

XRP = exchange rate peg; MoA = monetary aggregate anchor; ITL = inflation targeting lite; FFIT = fully

fledged inflation targeting; IIT = implicit price stability anchor; CPI = consumer price index.

Source: Stone and Bhundia (2004).

Singapore managed the exchange rate as an intermediate target, a monetary policy

framework that had been in place since the early 1980s. Singapore’s high import rate

and its role as a price-taker in international markets made the country highly

susceptible to imported inflation. Thus, Singapore considers the exchange rate to be a

more effective tool than the interest rate for stabilizing inflation. Its monetary policy

framework, however, can be considered a variant of inflation targeting.

As most emerging Asian economies moved toward more flexible exchange rate

regimes after the crisis, most monetary policy frameworks in the region have changed

accordingly to allow more monetary autonomy, with inflation-targeting policies

becoming a popular option. Table 1 shows that, after the crisis, the number of East

Asian countries using fixed exchange rate regimes decreased while the number of

countries using the inflation-targeting (IT) monetary policy frameworks increased. The

PRC also moved away from the exchange rate peg beginning in 2005, although it was

temporarily reinstated during the GFC, so its regime probably can be regarded as

implicit price stability anchor (IIT). Japan’s regime, which is characterized as implied

inflation targeting, did not change a lot, although the Bank of Japan has made the link

of policy with inflation more explicit over time.

Along with this development, many central bank in the region gained increased

independence so that they could focus on controlling inflation. Ahsan et al (2008)

constructed indices of central bank governance and independence (CBGI) using 27

variables to capture different aspects of governance and independence, including legal

independence, political independence, independence to focus on price stability,

independence of exchange rate policy, freedom from requirements to finance

government debt and transparency and accountability. Figure 1 shows the overall

indices in 1996 and 2005. The CBGI indices in 2005 increased in all East Asian

countries, especially in Indonesia, Japan, and Thailand.

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Figure 1: Central Bank Independence Has Generally Increased

PRC = People’s Republic of China

Source: Adapted from Ahsan et al (2008).

3. POLICY OBJECTIVES AND FRAMEWORKS

3.1 Price stability

As mentioned in the previous section, most central banks in East Asia region have

chosen to pursue price stability as at least one principal objective of monetary policy.

Based on information contained on their websites, the monetary authorities of Japan,

Korea, the Philippines, Singapore, and Thailand currently aim for price stability as an

overarching objective. Three central banks—the People’s Bank of China, Bank

Indonesia, and Bank Negara Malaysia—state their goal as maintaining the stability of

the value of the currency, which could mean either the internal value in terms of goods

and services—i.e., the price level, the external value, namely the exchange rate—or

some combination of the two. Bank Indonesia, for example, makes it explicit that the

term refers to both aspects. The Bank Negara Malaysia states that an adequate supply

of credit to the economy is also an explicit goal of the central bank. The Hong Kong

Monetary Authority puts exclusive emphasis on exchange rate stability (vis-à-vis the

US dollar) and pursues this goal by means of a currency board arrangement.

Strategies adopted to achieve the objectives are quite diverse. Four central banks are

self-proclaimed inflation targeters—Bank Indonesia, Bank of Korea, Bangko Sentral ng

Pilipinas, and Bank of Thailand. These central banks are relative new-comers with

Korea starting in 1999, Indonesia and Thailand in 2000, and the Philippines in 2002.

The Bank of Japan has adopted an innovative “two-perspectives” monetary policy

framework that blended views of a more conventional nature with views of a less

conventional nature (e.g., especially those associated with high impact, low probability

events). The other central banks employ a range of eclectic strategies generally

reflecting a set of policy tradeoffs, not least being those associated with the targeting

inflation, sustainable growth, and exchange rate stability.

With respect to policy instruments, the majority of the institutions carry out their policy

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by means of targeting a short-term interest rate (Table 2). The principal exceptions are

the Monetary Authority of Singapore, which, as already noted, uses the nominal

effective exchange rate as an intermediate target, the Hong Kong Monetary Authority,

which intervenes in the foreign exchange market to keep the exchange rate vis-à-vis

the US dollar within a pre-specified constant target zone, and the People’s Bank of

China (PBC). The PBC has adopted growth rates of monetary aggregates as

intermediate targets and typically employs several instruments in the implementation of

its monetary policy—exchange rate, required reserve ratio, interest rates, and open

market operations. Existing controls on the domestic financial system and on

international capital flows arguably makes it possible for the PBC to use several

instruments somewhat independently of each other, an option less feasible in

jurisdictions with more liberalized and efficient domestic financial markets and with

more open capital accounts.

Table 2: Institutional Frameworks for Monetary Policy in East Asia

Economy

Targeting Arrangement

Formal Policy

Rate

Formal Operating

Target

PRC

Reference to money growth targets

1-year deposit and

loan reference

rates

Excess reserves

Hong Kong,

China

Currency board: target range centered

on HKD 7.8 = US$1

USD/HKD spot rate

Indonesia

Inflation targeting: inflation target for

2012–2014 is 4.5±1%; for year-on-year

CPI inflation

BI rate (= target

rate for 1-mo. SBI)

1-month SBI rate

Japan

Medium- to long-term price stability

expressed in terms of year on year rate

of change in the CPI (approximately

between 0 and 2%).

Uncollateralized

O/N call rate

target

O/N call rate

Republic

of Korea

Inflation targeting: target range of 3±1%

in terms of annual headline CPI inflation

(2010–2012)

O/N call rate

target

O/N call rate

Malaysia

Overnight policy

rate

Avg O/N interbank

rate

Philippines

Inflation targeting: target range of 4±1%

(2011–2014) for the avg year-on-year

change in the CPI over the calendar

year.

O/N repo and

reverse repo rates

No formal target

Singapore

As of mid-2012, modest appreciation of

the undisclosed Singapore dollar NEER

policy band

Policy band for

Singapore dollar

NEER

Singapore dollar

NEER

Taipei,China

Intermediate target for M2 growth: 2.5%–

Rediscount rate

Thailand

Inflation targeting: target range of 0.5%–

3% for quarterly average of core

inflation.

1-day repo rate

BI = Bank Indonesia; CPI = consumer price index; HKD = Hong Kong, China dollar; IT = inflation targeting;

NEER = nominal effective exchange rate; O/N = overnight; PRC = People’s Republic of China; SBI = Bank

Indonesia promissory notes.

Sources: Bank for International Settlements (2009); national central banks websites.

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3.2 Financial Stability and Systemic Risk

The GFC raised questions about the adequacy of IT policy frameworks in particular

and the focus on price stability in general, and heightened the awareness of financial

stability and the need for a macroprudential dimension to financial surveillance and

regulation. The International Monetary Fund’s (IMF) analysis (IMF 2009) stated that

“macroeconomic policies … did not take into account building systemic risks” and that

“a key failure during the boom was the inability to spot the big picture threat of a

growing asset price bubble.” It is widely believed the United States (US) Federal

Reserve underestimated the buildup of financial imbalances coming from housing price

bubbles, high leverage of financial institutions, and interconnections among different

segments of the financial market. In addition, Taylor (2009) argued that the Federal

Reserve’s monetary policy stance was too easy, in that it kept the federal funds rate

too low for too long, fueling the housing boom and other economic imbalances,

although Bernanke (2010) disputed this view.

Several excellent reviews of what went wrong in financial regulation (Group of Thirty

2009; Brunnermeier et al. 2009; de Larosiere Group 2009) point to regulatory and

supervisory deficiencies, including inadequate macroprudential supervision. Due to the

propensity to focus on individual institutions (the traditional “microprudential”

approach), supervisors around the world failed to recognize interconnections and links

across financial firms, sectors, and markets due to the lack of a macroprudential

approach. Supervisors only focused on their piece of the puzzle, overlooking the larger

problem. Shin (2009) pointed out that “mis-educated” supervisors and examiners were

focused on individual institutions, without regard to the impact on the system.

Nonetheless, there is no generally agreed definition of financial stability, because

financial systems are complex with multiple dimensions, institutions, products, and

markets. Indeed, it is perhaps easier to describe financial instability than stability. The

European Central Bank (ECB) website defines financial stability as:

…a condition in which the financial system—comprising of financial

intermediaries, markets and market infrastructures—is capable of withstanding

shocks, thereby reducing the likelihood of disruptions in the financial

intermediation process which are severe enough to significantly impair the

allocation of savings to profitable investment opportunities. (ECB 2012)

Further, the ECB defines three conditions associated with financial stability:

(i) The financial system should be able to efficiently and smoothly transfer

resources from savers to investors.

(ii) Financial risks should be assessed and priced reasonably accurately and

should also be relatively well managed.

(iii) The financial system should be in such a condition that it can comfortably

absorb financial and real economic surprises and shocks. (ECB 2012)

Perhaps the third condition is the most important, because the inability to absorb

shocks can lead to a downward spiral whereby they are propagated through the

system and become self-reinforcing, leading to a general financial crisis and broadly

disrupting the financial intermediation mechanism.

In a similar vein, threats to financial stability are considered to pose systemic risks. The

Committee on the Global Financial System (CGFS 2010: 2) defines systemic risk as “a

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risk of disruption to financial services that is caused by an impairment of all or parts of

the financial system and has the potential to have serious negative consequences for

the real economy.”

3.3 Need for Stronger Macroprudential Policy in Asia

In Europe and the United Sates, undetected systemic risks before the GFC arose for

several reasons, including widespread use of sophisticated derivative financial

products to move risks around the system; the development of the unregulated

shadow-banking system; excessive reliance on wholesale funding by banks; under-

capitalization of banks; and lack of understanding of the riskiness of innovative financial

products. These factors on the whole did not apply to Asian financial systems during

the crisis, and this helps to explain why those economies did not suffer financial crises

and recovered relatively quickly. Moreover, in the aftermath of the Asian financial crisis,

Asian economies greatly strengthened their financial systems, reduced foreign debt,

improved their monetary policy and financial regulatory frameworks, and moved toward

greater currency flexibility.

Nonetheless, Asian economies need to strengthen their macroprudential policy

frameworks for several reasons. First, although emerging Asia does not have much of

the shadow-banking system that plagued the financial stability in developed

economies, many financial institutions exist outside the formal banking system,

including real estate finance companies and credit card companies. Finance

companies triggered the Thai financial crisis and merchant banks were behind the

Korean financial crisis, both in 1997. Asian financial systems also show signs of

procyclicality, most notably in the close relation between bank lending, real estate

cycles, and overall economic growth.

Perhaps most importantly, Asian economies are subject to large and volatile

international capital flows. Capital inflows provide emerging market economies with

valuable benefits in pursuing economic development and growth as they enable them

to finance needed investment, smooth consumption, diversify risks and expand

economic opportunities. However, large capital flows, if not managed properly, can

expose capital-recipient countries to at least three types of risks (Kawai and Takagi

2010):

(i) Macroeconomic risk. Capital inflows could accelerate the growth of domestic

credit, create economic overheating including inflation, and cause the real

exchange rate to appreciate, thus threatening sustainable economic growth and

price stability.

(ii) Risk of financial instability. Capital inflows could create maturity and currency

mismatches in the balance sheets of private sector debtors (particularly banks

and corporations), push up equity and other asset prices, and potentially reduce

the quality of assets, thereby contributing to greater financial fragility.

(iii) Sudden stops and/or reversals of capital flows. Capital inflows could stop

suddenly or even reverse themselves within a short period, resulting in rapid

reserve decumulation or sharp currency depreciation.

The Asian financial crisis, as well as other emerging economy crises, highlighted the

systemic risks associated with so-called “double-mismatches” associated with

borrowing short term in foreign currencies and lending longer term in domestic

currencies. It is noteworthy that about 15% of the large capital inflow episodes over the

past 20 years ended in crisis, with emerging Asia experiencing proportionately more

episodes of hard landings (Schadler 2010).

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Asian economies are also exposed to activities of large global banks, which could

become an issue if one or several such banks needed to be resolved. Finally, Asian

financial systems are likely to increase in complexity as they develop, so that issues of

market transparency and interconnectedness of financial firms are likely to become

more relevant.

3.4 Role of a Central Bank in Financial Stability

A country’s central bank is well qualified to play a key role in monitoring and regulating

financial stability from the point of view of its surveillance capacity and the policy tools

at its disposal. This reflects its routine work of monitoring the macroeconomic

developments and financial system conditions and its responsibility for overseeing

payments and settlement systems. As described in more detail below in this section,

central banks have a number of policy tools that can affect financial stability, including

monetary policy instruments and, in some cases, exchange rate and capital flow

management tools and macroprudential policy tools. These tools can be used both to

prevent crises and to mitigate crises when they occur. Nonetheless, there is wide

debate about the consistency of an objective of financial stability with the more

traditional and well-established central bank objective of price stability. More broadly,

the current debate focuses on the appropriate role of a central bank within a broad

architecture of financial stability and macroprudential policy responsibility.

3.5 Financial Stability Mandate versus Price Stability Mandate

The debate has been lively about whether a central bank mandate for financial stability

would conflict potentially with the more traditional mandate for price stability. Some

studies concluded that targeting asset prices directly, as part of an augmented Taylor

Rule, could be potentially destabilizing. For example, Bernanke and Gertler (2000: 46)

argue that:

Given a strong commitment to stabilizing expected inflation, it is neither

necessary nor desirable for monetary policy to respond to changes in asset

prices, except to the extent that they help to forecast inflationary or deflationary

pressures.

However, few proponents of a financial stability mandate actually propose targeting

asset prices; instead they merely support taking asset price movements into account

as a risk factor in setting monetary policy over a longer period of time. Cecchetti,

Genberg, Lipsky, and Wadhwani (2000: xix) conclude that:

A central bank concerned with stabilizing inflation about a specific target level is

likely to achieve superior performance by adjusting its policy instruments not

only in response to its forecasts of future inflation and the output gap, but also to

asset prices.

Similarly, Borio, and Lowe (2002: 20) argue that:

…a slightly modified policy regime, under which the central bank responds not

only to short-term inflation pressures but also, at least occasionally, to financial

imbalances, may ultimately deliver a better combination of monetary and

financial stability.

The crux of the matter is that an environment of low and stable inflation may be

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conducive to the development of financial imbalances, as low interest rates and

profitable investment opportunities contribute to an increasing appetite for risk. This

pattern was described by Minsky (1986), and has been emphasized by Borio and Lowe

(2002), Borio and White (2004), and others. This implies that, in a period of low

inflation, systemic imbalances are likely to appear first in the financial sector and later

in the real sector with a significant lag. This also highlights the need for a longer-term

time horizon for monetary policymaking.

This debate is closely related to the “lean versus clean” debate of whether it is

preferable for the monetary authority to “prick” bubbles before they burst by “leaning

against the wind,” or to wait until after the bubble bursts, and then clean up the mess

via aggressive monetary policy easing. However, the huge costs and lengthy recovery

period following the GFC due to the deleveraging process have severely undermined

the argument in favor of the “clean” approach. This experience highlights the potential

risks of a credit-driven bubble and supports the argument in favor of leaning, rather

than cleaning, to prevent such bubbles. As a result, the consensus has swung strongly

in favor of a central bank paying close attention to financial stability and leaning against

the wind, even if it is not an official part of its mandate.

3.6 Current Situation of Central Bank Financial Stability

Mandates

The specific responsibilities for financial stability vary widely across central banks.

Figure 2 provides a good summary of financial stability mandates of a large number of

central banks of advanced and emerging economies as of 2009, based on a survey of

central banks by the Bank for International Settlements (2011). A darker shade is

associated with a stronger mandate. The survey divides mandates into three major

areas: banking sector, payments system, and financial system. The mandate for the

banking sector varies widely across countries. European central banks are generally

very light in their banking sector responsibilities, while emerging economy central

banks in Latin America and Asia have the strongest mandates, and Japan and the US

fall in between. For the financial system as a whole, relatively strong mandates are

recognized for oversight and suasion and guidance, but few central banks have an

explicit monetary policy mandate for financial stability. Interestingly, all central banks

with such mandates are in Asia. It seems likely that the relative emphasis placed by

Asian central banks on financial stability contributed to their good performance during

the GFC.

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Figure 2: Financial Stability Related Mandates of Central Banks in 2009

(The darker the shading the bigger the mandate)

JP SE AU ECB UK PL CL MX US FR TH MY PH

Regulation making

Licensing

Supervision

Oversight

Suasion/Guidance

Macroprudential reg'n

Regulation making

Designation

Oversight

Suasion/Guidance

MP with finstab objective

Major or full

Banks

Payment

Systems

Financial

Systems

None or very minor

Intermediate

AU = Australia; CL = Chile; ECB = European Central Bank; FR = France; JP = Japan; MX = Mexico; MY = Malaysia;

PH = Philippines; PL = Poland; SE = Sweden; TH = Thailand; UK = United Kingdom; US = United States.

Source: Adapted from Bank for International Settlements (2011).

3.7 Tools for a Central Bank Can Help Achieve Financial

Stability

A central bank has a number of policy tools that can affect financial stability, including

monetary policy instruments and, in some cases, exchange rate and capital flow

managemewnt tools and macroprudential policy tools. These tools can be used to help

prevent and mitigate crises. Monetary policy tools are ordinarily aimed at affecting the

demand for and supply of money, primarily open market operations and reserve ratio

requirements. In a crisis, the lender of last resort function of the central bank can

simply be seen as an extreme version of open market operations. Macroprudential

policy tools are aimed at reducing systemic financial risk, most typically by restraining

bank credit growth.

There has been a good deal of debate about whether capital flow management tools

should be classified as macroprudential tools, or whether they belong in a separate

category. Ostry et al. (2010) represented a sharp break from previous thinking at the

IMF by arguing that emerging economies could and should adopt capital flow

management tools in some cases. However, they argued that capital control measures

should be considered separately from domestic prudential measures, partly because

long-lasting and widespread adoption of capital control measures could distort capital

flows and exchange rates, thereby worsening international imbalances, and therefore

should be used only as a last resort when other policy options are exhausted.

However, in the presence of large and destabilizing capital flows, many observers in

emerging economies believe that this position is too extreme, and that capital control

measures could be used on a more regularized basis. It may be helpful to distinguish

them by arguing that macroprudential measures are aimed primarily at domestic

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balance while capital control measures are aimed mainly at international balance, but

this distinction clearly blurs in practice.

It should also be emphasized that the prime justification for capital flow controls is to

shield shallow and unsophisticated financial sectors from the damaging effects of

capital flow volatility. As financial sectors deepen and become more sophisticated in

line with economic development, their resilience to capital flow volatility should

increase, thereby gradually lessening and eventually ending the need for capital control

measures. In this regard, the openness of capital markets in Hong Kong, China; Japan,

and Singapore provide an endpoint toward which other Asian economies may expect to

evolve.

There is also a fair degree of confusion about the distinction between microprudential

and macroprudential policy tools. For example, loan-to-value ratios were originally

developed as microprudential tools to ensure viability at the level of an individual bank.

But they have been employed as macroprudential tools to control the real estate cycle

in several economies, including the PRC; Hong Kong, China; and Korea. Therefore,

whether or not a policy tool is regarded as microprudential or macroprudential has to

be judged in terms of its broad objective, that is, whether it is used to promote the

health of individual financial firms or to contain financial vulnerabilities in certain sectors

such as the real estate sector. It should be clear that if loan-to-value ratios are modified

in response to the regulator’s perception of the risks of the credit cycle, they should be

regarded as macroprudential policy tools.

3.8 Monetary Policy Tools

In normal times, open market operations are typically conducted with sales of short-

term government paper (a virtually riskless asset) for cash with the aim of raising the

level of short-term money market rates. If the economy falls into a liquidity trap with

zero nominal short-term interest rates, and/or suffers seize-ups in particular markets

that disrupt the normal financial intermediation process, then the central bank can

resort to so-called “unconventional” measures.

Descriptions of central bank balance sheet operations typically distinguish between

quantitative easing and credit (or qualitative) easing—see for example, Bernanke and

Reinhart (2004) and Borio and Disyatat (2009)—although the distinction in practice is

not so clear-cut.

Open market operations can become

unconventional ones if they broaden the types and maturities of assets to be

purchased, the credit rating or equivalent metric of the assets, and the time horizon of

the purchases. The objectives of such purchases can range from lowering long-term

bond yields to easing freeze-ups of specific markets, such as those for interbank

borrowing or asset-backed securities. Lender of last resort operations are just one

example of this.

Such measures are regarded as “unconventional” mainly relative to the standard practice during normal

times of central banks in developed economies, which is almost exclusively to target the short-term

money market interest rate by open market operations. Emerging market economies tend to use a

broader range of operations much more regularly, as did developed economy central banks in earlier

periods.

The aim of quantitative easing is to expand the size of the central

bank’s balance sheet by increasing the size of reserve deposits—current account

balances—beyond the level that is required to bring the overnight funds rate to zero.

Possible channels of impact of such a policy include (i) the permanent, positive effect

See Morgan (2012) for a more detailed discussion.

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on base money and money supply; (ii) the signaling effect of the central bank’s

commitment to keep the policy interest rate low; and (iii) the portfolio balance effect of

money supply increase, that is, the effect of inducing investors’ shift toward other

assets due to the imperfect substitutability of money for other financial assets, thereby

raising their value and stimulating final demand (Morgan 2012).

Credit (or qualitative) easing is aimed at changing the shares of various kinds of assets

held by the private sector, with the expectation that this will lead to changes in their

relative prices, and thereby stimulate real economic activity. For example, a central

bank’s outright (permanent) purchases of long-term government bonds could be

expected to reduce long-term bond yields, stimulate long-term investment and boost

overall economic activity. A central bank’s direct lending to market participants could

reduce credit market spreads and improve the functioning of private credit markets

more generally, when the normal transmission mechanism breaks down. Like

quantitative easing, credit (or qualitative) easing generally involves an increase in the

size of a central bank’s balance sheet, but attempts to change the mix of assets, not

the level of bank reserves (liabilities). Bernanke (2009) provides a detailed description

of the Federal Reserve’s credit easing measures.

In Asian emerging economies, unconventional measures were adopted by the Bank of

Korea, the Monetary Authority of Singapore (MAS), the Reserve Bank of India (RBI),

and the Central Bank of Taipei,China (CBC). Perhaps the most significant

unconventional policy measures in the region outside Japan have been those involving

provision of foreign currency liquidity by central banks via the Federal Reserve swap

arrangements to offset the shortage of US dollars arising from capital outflows.

For example, the Federal Reserve and the Bank of Korea announced the

implementation of a $30 billion swap agreement on 29 October 2008. This appears to

have been effective in easing the shortage of dollar funds in the Korean market. The

spread between the Korean one-year interbank rate and the one-year Treasury bill

rate, a measure of banking sector credit risk, spiked upward from mid-2008 when the

Bank of Korea’s foreign exchange reserve holdings (mainly US Treasuries) dropped

sharply. However, once the foreign reserve holdings began to rise again in December,

as a result of the loan by the Federal Reserve, the spread shrank rapidly again. The

Bank of Korea drew roughly half of the Federal Reserve’s swap line, and total foreign

exchange reserve holdings rose by 40.8 trillion won (roughly $29 billion) during that

period. The Bank of Korea also expanded its won-yen swap agreement with the Bank

of Japan from $3 billion equivalent to $20 billion equivalent, and established a won–

yuan swap with the People’s Bank of China of up to 180 billion yuan, although it did not

make use of these.

The CBC also adopted a number of unconventional measures in September and

October 2008, including expanding the eligible counterparties for its repo operations;

extending the term of such operations from 30 days to 180 days; expanding eligible

collateral to include certificates of deposit; and linking the interest rates on central bank

reserve deposits to market rates (CBC 2008a; 2008b). These operations seem to have

been effective in reducing interbank spreads relative to policy rates by about 30–40

Although the Fed’s large-scale outright purchasing operations of Treasury bonds, agency bonds and

mortgage backed securities in 2009 and 2010 were widely referred to as “quantitative easing” (QE1 and

QE2, respectively), the Fed has not described them as such, instead referring to them as credit easing

measures.

There is some debate about whether such measures can be regarded as unconventional or not.

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basis points during that period.

Central banks can also attempt to influence market expectations by making

announcements about the expected trend of future monetary policy. A large volume of

literature has developed around what generally is referred to as the “commitment” or

“policy duration” effect. The basic idea is simple—even though a central bank may set

the very short-term rate, normally the overnight interbank rate, at zero, the market still

has considerable uncertainty about the future development of monetary policy.

Therefore, if a central bank can persuade the market that it will keep the policy rate

lower than the market would expect otherwise, this should cause longer-term rates to

fall, thereby stimulating the economy. This type of policy has been analyzed

theoretically by a number of authors, including Svensson (2001) and Eggertsson and

Woodford (2003).

3.9 Currency and Capital Flow Management

Capital inflows provide emerging market economies with substantial potential benefits

in pursuing economic development but, if not managed properly, can expose recipient

countries to macroeconomic risks, financial instability, and sudden stops and/or

reversals of capital flows. A central bank’s management of the exchange rate and

capital flows can play a key role in reducing such volatile and potentially destabilizing

capital flows.

Sterilized intervention has been the favorite tool applied by many emerging Asian

economies to prevent nominal exchange rate appreciation and economic overheating.

From 2000 to 2007, intervention in the foreign exchange market was unidirectional, that

is, purchasing the US dollar to prevent domestic currency appreciation against the

dollar, leading to large buildups of foreign exchange reserves across the region. Such

interventions had to be sterilized to prevent overheating of the economy.

In addition to sterilized intervention aimed at stabilizing exchange rates, capital controls

are a common tool for limiting capital inflows in emerging market economies.

Countries that have substantially liberalized their capital account, market-based

controls—such as the Chilean unremunerated reserve requirement imposed on capital

inflows—have been the predominant option in recent years.

3.10 Macroprudential Policy Tools

However, designing and

implementing capital inflow controls is not easy. Administering capital controls requires

highly competent country regulatory authorities as they must constantly watch for

unwanted flows—often disguised—entering through various channels. For these

economies, returning to draconian capital controls or recreating a system of extensive

administrative controls is no longer a viable option.

Some central banks also have macroprudential powers to promote financial stability by

virtue of having responsibility for supervising the banking sector. This enables them to

restrain the buildup of financial imbalances by using tools such as loan-to-value ratios,

In Ostry et al. (2010), however, tools aimed at controlling large capital inflows that may fuel domestic

credit booms are not seen as macroprudential tools per se but rather as measures that can buttress

prudential regulations.

Brazil imposed a tax on fixed-income and equity inflows in October 2009 in response to surges in capital

inflows and, in the following month, imposed another tax on certain trades to prevent circumvention.

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debt-service-to-income ratios, credit exposure limits on specific sectors (especially real

estate), and limits on loan growth, among others. Some of these tools tend to be time-

invariant, while others can be altered in a discretionary way according to the

authorities’ assessment of the economic and financial situation. Many macroprudential

tools have been developed for use as microprudential tools (loan-to-value ratios,

exposure limits, among others.) at a bank level, but can be adapted to macroprudential

used by calibrating them in relation to the macro-financial cycle. If central banks do not

have such powers, they must try to work with the supervisory agencies having those

powers if they believe it is necessary to have them implemented.

Sector-targeted macroprudential tools are used to restrict bank lending and other

financial activity during boom periods. They generally aim to limit the tendency for a

self-perpetuating cycle between asset values and credit growth to lead to an

unsustainable asset bubble. Measures include loan and underwriting standards, loan-

to-value ratios, debt-service-to-income ratios, caps on credit growth, and exposure

limits. Table 3 provides a summary of macroprudential measures in Asia.

Table 3: Asian Experience with Macroprudential Tools

Objective

Tools

Examples

Manage aggregate

risk over time

(procyclicality)

Countercyclical provisioning

PRC; India

Loan-to-value ratios

PRC; Hong Kong, China; Indonesia; Japan;

Republic of Korea; Malaysia; Philippines;

Singapore; Thailand

Debt-service-to-income ratios

PRC; Hong Kong, China; Republic of Korea

Tighter lending criteria

PRC; Hong Kong, China; Republic of Korea;

Malaysia; Philippines; Singapore; Thailand

Credit limits

PRC; Hong Kong, China; India

Tighter supervision

PRC; Hong Kong, China; India; Republic of

Korea; Malaysia; Singapore

Capital requirements

India; Malaysia

Exposure limits on lending to

specific sectors

Republic of Korea; Malaysia; Philippines;

Singapore

Manage aggregate

risk at every point in

time (systemic

oversight)

Capital surcharges for

systemically important banks

PRC; India; Philippines; Singapore

Liquidity and funding

requirements

PRC; India; Republic of Korea; Malaysia;

Philippines; Singapore; Thailand

Loan-to-deposit requirements

PRC; Republic of Korea

FX exposure limits

Republic of Korea; Philippines

Limits on currency mismatches

India; Malaysia; Philippines

PRC = People’s Republic of China; FX = foreign exchange.

Sources: CGFC (2010); Lamberte, Manlagñit, and Prativedwannakij (2010); Sheng (2010).

3.11 Architecture for Financial Stability

The experience of the GFC shows the need for a strong systemic stability regulator that

can make objective assessments of the financial situation and take pre-emptive actions

where needed (Kawai and Pomerleano 2012). However, responsibilities for financial

stability frequently are divided among multiple entities, mainly central banks and

financial regulators. Moreover, other policymakers need to be involved in decision-

making as well, especially the finance ministry, since it is responsible for committing

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public funds in the case of resolution, and the deposit insurance agency, which often

has responsibility for bank resolution. An effective structure for systemic stability

regulation must ensure adequate sharing of information and good coordination of

decision-making and policy implementation.

The relationship between such a systemic stability regulator in charge of

macroprudential policy and a central bank charged with traditional monetary policy is

an important issue. To achieve both price stability and financial stability, there have to

be at least two policy instruments, that is, monetary policy and macroprudential policy.

However, in practice it is often questionable to what extent macroprudential policy tools

can be wielded independently of monetary policy. If monetary conditions are easy and

investments attractive, market participants may try to evade specific macroprudential

regulations and make investments by alternative means, and their ability to evade such

regulations tends to increase over time. This suggests that both monetary and

macroprudential policies should aim in the same direction.

A cooperative effort to regulate financial stability requires that financial system

information be shared fully. However, experience shows that there is a natural

tendency for individual regulators not to share information to the extent needed.

Therefore, there is a strong argument in favor of the central bank having some direct

oversight responsibility for the financial sector, so that it can obtain needed information

about financial market conditions directly rather than having to request it from another

agency.

3.12 Regional Cooperation

The discussion so far has dealt with macroprudential policy in a single country, but the

experiences of the Asian financial crisis, the GFC, and the eurozone financial crisis

show that such crises can be contagious, transmitted by volatile capital flows within a

region. Therefore, regional perspectives on systemic risk regulation are needed as

well. This is particularly so when global systemically important financial institutions are

involved.

Within Asia, existing policy dialogue processes include the ASEAN+3

At the global level, the IMF and Financial Stability Board (FSB) can assist in assessing

risk, while the newly-formed ASEAN+3 Macroeconomic Research Office, which is the

surveillance arm of the Chiang Mai Initiative Multilateralization (CMIM), and the

economic review and policy dialog, could be a counterpart of the IMF and the AFSD

could become the regional counterpart to the FSB.

meeting for

finance ministers and the Executives’ Meeting of East Asia-Pacific Central Banks for

central bank governors. From 2012 central bank governors joined the ASEAN+3

finance ministers meeting for the Economic Review and Policy Dialogue, whereas only

deputy governors had attended previously. However, the development of an Asian

Financial Stability Dialogue (AFSD), as proposed by Kuroda (2008), could enhance

communication about common risk factors and possibly lead to coordinated actions to

reduce systemic risks. The AFSD would include finance ministries, central banks,

financial supervisors, and deposit insurance companies.

Ten member nations of the Association of South East Asian Nations plus the PRC, Japan, and the

Republic of Korea.

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There is no doubt that Asia needs an effective mechanism of intensive policy dialog

and cooperation. The existing policy dialog processes among the region’s finance

ministers described above can play a critical role in fostering the establishment of such

a mechanism, but the development of an AFSD could provide a more complete

platform for such cooperation.

The CMIM has the responsibility to act as a regional financial safety net for its

members (ASEAN+3), i.e., to provide foreign exchange if a member country faces a

balance of payments crisis. A reliable safety net could limit the need for an individual

country to acquire foreign exchange reserves, and thereby reduce the potential impact

of such reserve accumulation on the worsening of global current account imbalances.

However, there are many practical issues that need to be resolved to achieve such

reliability. The biggest stumbling block is IMF conditionality, which is required if a

country needs to draw more than 30% of its quota. However, making the provision of

reserves automatic without conditionality invites the risk of moral hazard. Adding pre-

approved credit lines can help, but, until such issues are solved, Asian countries are

likely to continue to rely on their own foreign exchange reserves as the first line of

defense against capital outflows.

4. POLICY TRANSMISSION MECHANISM BASED ON

FINANCIAL LINKAGES AND DEEPENING

This section discusses the policy transmission mechanism based on financial linkages

and deepening, including global financial linkages and domestic financial deepening.

The former focuses on developments in the size and composition of capital flows, while

the latter includes credits, private bonds, government bonds, equities, corporate

savings, household savings and household balance sheets. It is not possible to go into

detail on every economy, so we focus on sketching the broad outlines.

4.1 Financial openness in Asian emerging economies

Financial systems tend to become more open as economies develop and restrictions in

areas such as capital accounts ease. However, capital account regimes can also

become more restrictive, particularly in countries that experience shocks and crises

from rapid capital inflows or outflows. The Asian financial crisis was a watershed in

Asia in terms of the perceived risks associated with open capital accounts. Financial

openness is not easy to measure. There are two broad approaches—de jure and de

facto. De jure measures assess the restrictiveness of published laws and regulations

regarding foreign exchange and capital account transactions. These are typically based

on the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions

(IMF 2008). Examples of this approach include Quinn (2003) and the Chinn-Ito

Index

(Chinn and Ito 2008).

The degree of openness has ranged widely and has changed substantially in major

Asian emerging economies, according to the Chinn-Ito Index for 1996 and 2009 (Figure

The Chinn-Ito Index is compiled by evaluating four major categories of restrictions on external accounts:

(i) the presence of a multiple exchange rate regime, (ii) the presence of restrictions on current account

transactions, (iii) the presence of restrictions on capital account transactions, and (iv) the presence of a

requirement of the surrender of export proceeds. The index score ranges from -1.84, which indicates

they are fully closed, to +2.48, meaning they are fully open.

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3). Hong Kong, China and Singapore are rated as fully open, consistent with their

status as regional financial centers. Both the PRC and India have maintained relatively

low ratings of -1.15, suggesting they are relatively closed. Indonesia and Viet Nam

have become significantly more open, while Malaysia and Thailand have become less

open, primarily as a result of their experiences during the Asian financial crisis.

Figure 3: Chinn-Ito Indices for Major Asian Emerging Economies

PRC = People’s Republic of China

Source: Chinn and Ito (2008).

However, it is widely recognized that de jure measures may not reliably capture the

effective degree of capital market openness. The alternative approach is to measure de

facto capital market openness, based on estimates of actual capital flows. One of the

main sources in this regard is Lane and Milesi-Ferretti (2006). The essential idea was

that a higher level of external assets and liabilities (relative to GDP or some other

measure) indicated the effective openness of capital markets. The series was updated

to 2009 in Kawai, Lamberte, and Takagi (2012). The external assets and liabilities

ratios generally rose for all Asian economies from 1990 to 2009. Despite the region’s

relatively low overall de jure openness scores, the ratios were close to or exceeded

100% for all but one economy in 2009. The capital accounts of many Asian economies,

therefore, in fact appear to have been quite open on this measure.

4.2 Capital flow composition

Gross capital inflows to emerging Asia

Total for PRC; Hong Kong, China; India; Indonesia; the Republic of Korea; Malaysia; the Philippines;

Singapore; Taipei,China; and Thailand.

have risen rapidly over the past two decades,

although the share of GDP peaked in 2007 (see Figure 4). Direct investment flows

have been relatively stable, with persistent positive inflows. Portfolio flows have been

somewhat more volatile, although there were only two years of actual outflows, which

corresponded to the two crisis years of 1998 and 2008. Other inflows, mainly loans,

have shown by far the greatest volatility, underlining the persistent concern about the

- 1.5 -1 - 0.5 0 0.5 1 1.5 2 2.5

PRC

India

Thailand

Malaysia

Viet Nam

Philippines

Indonesia

Hong Kong, China

Singapore

1996 2009

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risks to financial stability emanating from this category. Nonetheless, the outflow of

other inflows in 2008 was much smaller than in 1998, pointing to the improved

fundamentals of emerging Asian economies at the time.

Figure 4: Gross Capital Inflows in Emerging Asia

Source: CEIC Database Co.

The picture on net inflows is similar, but shows little sign of an upward trend as percent

of GDP over time, as the peak in 1996 was never exceeded (Figure 5). The pattern of

relative stability of direct investment flows is maintained, but both portfolio and other

flows show greater volatility on a net basis, with more episodes of net outflows for both.

The large net portfolio outflows seen in 2006 and 2007 appear to reflect the increasing

role of Hong Kong, China and Singapore as investment intermediary centers.

Figure 5: Net Capital Inflows in Emerging Asia

Source: CEIC Database Co.

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There is a continuing debate about whether gross or net capital flows are a better

indicator of currency and financial stability risks. Net inflows are probably more relevant

for currencies, but gross inflows may be more directly related to financial stability risks,

since they are a function of total transaction volumes.

4.3 Domestic financial development

All East Asian emerging economies showed substantial increases in total private

liabilities relative to GDP from 2000 to 2009, especially the PRC and Viet Nam. As

Table 4 shows, however, there were major differences when it comes to types of

liability. Private bank credit fell in Malaysia, the Philippines, and Thailand in the

aftermath of the Asian financial crisis. Stock market capitalization rose in all Asian

emerging economies, while private bond market capitalization fell only in Singapore.

However, among Asian emerging economies, private bond market capitalization is high

only in Malaysia, which underlines the scope for further development of this sector.

Table 4: Sources of Private Sector Funding as % of GDP

PRC = People’s Republic of China

Local currency bond issuance has generally increased substantially in Asia over the

past two decades. The increase in government debt has been most obvious in the

PRC, Japan, Korea, Singapore, Taipei,China, and Thailand. In many cases, this

resulted primarily from bond issuance accompanying sterilization of foreign exchange

intervention. Private bond issuance has increased mainly in the PRC; Hong Kong,

China; Korea; Malaysia; Taipei,China; and Thailand. However, corporate bond

issuance in general is still substantially lower than government bond issuance.

Life insurance premiums as a percentage of GDP have reached very high levels in

Hong Kong, China, and Singapore, befitting their status as international financial

centers.

Data on assets are not available for most economies.

Malaysia’s level also is relatively high at 6.3% of GDP. Levels in the PRC

% of GDP

1990 2010 1990 2010 1990 2010 1990 2010

PRC 74.3 120.0 -- 81.0 2.9 21.3 77.3 222.4

Hong Kong -- 168.1 108.5 1207.9 0.2 14.4 108.7 1390.4

India 24.2 49.7 12.2 93.5 0.3 5.7 36.6 148.8

Indonesia 38.1 24.1 7.1 51.0 -- 1.5 45.1 76.6

Japan 168.2 102.8 95.5 74.6 39.8 36.3 303.4 213.6

Rep. of Korea 47.2 98.4 42.1 107.4 28.3 63.0 117.5 268.7

Malaysia 77.0 109.3 110.4 172.6 18.8 43.5 206.2 325.4

Philippines 17.0 29.4 13.4 78.8 -- 1.1 30.4 109.3

Singapore 78.2 96.1 93.1 166.2 14.6 11.4 185.9 273.7

Taipei,China -- 124.5 60.5 175.0 14.7 21.8 75.2 321.4

Thailand 72.3 91.7 28.0 87.1 6.5 17.9 106.8 196.7

Viet Nam -- 109.7 -- 19.7 -- -- -- 129.3

Sources: IFS Dec 2011 CD, CEIC Data Company, BIS Quarterly Review June 2011, WDI.

Private credit by

deposit money

banks

Stock market

capitalization

Private bond

market

capitalization

Total

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and Thailand are relatively close to that of Korea, where premiums equal 4.5% of GDP

and represent a good long-term benchmark. India, Indonesia, the Philippines, and Viet

Nam have further to go.

Asian emerging economies’ asset management sectors are expected to grow rapidly

as a result of rising incomes, high savings rates, and the aging of populations in most

economies. Again, however, there is wide variation in the region. Hong Kong, China

and Singapore have very high shares of assets under management in GDP, followed

by Thailand. Using Korea as a benchmark, where such assets equal around 20% of

GDP, countries such as the PRC and India seem likely to develop further.

5. ASSESSMENTS OF POLICY OUTCOMES

Assessments of monetary policy performance in Asian emerging economies have

generally been favorable. Filardo and Genberg (2012) argue that monetary policy

frameworks in the Asia and Pacific region have performed well since the late 1990s in

terms of inflation outcomes. They cite three main reasons: central banks have focused

on price stability as the main objective of monetary policy; institutional arrangements

have facilitated the successful pursuit of this objective; and other economic policies,

mainly fiscal policy, have supported this pursuit by reducing concerns about fiscal

dominance. We may add to this the availability of a large number of policy tools,

including unconventional policies, macroprudential measures and capital flow

measures that help to deliver financial and economic stability.

5.1 Effectiveness of inflation targeting

Trying to assess the effectiveness of inflation targeting has been difficult. Figure 6

shows that CPI inflation rates fell substantially in both Asian “IT” economies (those

adopting IT frameworks after the Asian financial crisis—Indonesia, Korea, the

Philippines, and Thailand) and in “non-IT” economies (PRC, Japan, Malaysia,

Singapore, and Taipei,China) in the decade after the Asian financial crisis. The degree

of improvement in 2000–2011 relative to the pre-crisis period was about the same for

both groups, about three percentage points. Therefore, this improvement in inflation

cannot necessarily be attributed to the implementation of IT policies. At the same time,

central banks in the region generally gained greater independence, their management

was strengthened, exchange rates became more flexible, and, in a number of cases,

trend growth slowed, which would lead to lower inflation by itself.

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Figure 6: Inflation rates of Asian IT and non-IT countries

IT = Indonesia; Republic of Korea; the Philippines; Thailand

Non-IT = People's Republic of China; Japan; Malaysia; Singapore; Taipei,China

Source: CEIC Database Co.

More sophisticated studies using econometric techniques have not reached firm

conclusions regarding the impacts of IT on macroeconomic performance, including

inflation rates, inflation persistence and output gaps. Optimistic studies (e.g., Mishkin

and Posen, 1997; Neumann and Hagen, 2002; Bernanke et al. 1999) marshalled

evidence that IT is associated with lower rates of inflation, lower volatility of inflation

and output, better-anchored inflation expectations, and reduced inflation persistence.

However, others reached more skeptical conclusions, including Cecchetti and Ehrmann

(1999) and Ball and Sheridan (2003), pointing to other factors such as the general

downward trend in inflation before the adoption of IT policies and the period of the

“great moderation.”

Naqvi and Rizvi (2009) focused on the experience of IT in Asia, analyzing the

performance of four IT economies (Indonesia, Korea, the Philippines, Thailand) against

six Asian non-IT economies (PRC; Hong Kong, China; India; Malaysia; Pakistan;

Singapore). They conclude that economic performance has improved in all Asian

economies in post-targeting period, but IT does not seem to have played any

significant role in this improvement of targeting countries. They also find strong

evidence that all variables showed strong reversion to mean suggesting that improved

performance of variables today is simply relative to poor economic performance in the

past. On the other hand, a more recent study, Gerlach and Tillman (2011), finds a

significant improvement in inflation persistence attributable to IT in a sample of nine

Asian economies with four of them using IT. On the whole, it seems difficult to attribute

significant improvement in inflation and output performance to IT policy in particular,

but the general improvement in currency and monetary policy frameworks and

management during the period should accept a good deal of the credit for this

improved inflation performance.

Ito and Hayashi (2004) note that there are a number of issues specific to the

implementation of inflation targeting in emerging market economies. First, economic

statistics are not as reliable as in advanced countries. Second, structural changes tend

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to be larger, especially in Asian economies, and therefore price bias may be more

serious. Also, modeling the monetary transmission mechanism for use in inflation

forecasting is much more difficult. Fourth, the inflation target needs to take into account

possible Balassa-Samuelson effects in economies that are fast-growing and therefore

have a rising price level, on the one hand, and the Japanese experience of deflation,

on the other. Taking into account all of these factors, they recommend that emerging

market countries set their inflation targets at a higher central rate than in advanced

economies and with a wider band of fluctuation. They also emphasize the need to

achieve a certain degree of currency stability as well.

Inoue, Toyoshima and Hamori (2012) took a somewhat different approach by analyzing

the effect of adopting inflation targeting on the correlation a country’s economy with the

global economic cycle. They applied the methodology of dynamic conditional

correlation to analyze the degree of synchronization of the four Asian IT countries—

Indonesia, Korea, the Philippines, and Thailand. They found some signs of increasing

synchronicity in these countries after the adoption of IT. However, they did not compare

this with the results for a control group of non-IT countries, so it is difficult to interpret

the results.

5.2 Policy frameworks have multiple tools

One important point which perhaps has not received sufficient attention is that Asian

monetary policy frameworks have become increasingly sophisticated, and make use of

a number of different policy tools, including both macroeconomic and macroprudential

ones. Management of capital flows provides another instrument for such control. Unlike

central banks in advanced economies, Asian central banks have shown themselves

willing and able to use such tools regularly and aggressively. This means that the

standard characterizations of monetary policy frameworks focusing on the use or non-

use of explicit inflation targeting are probably too simplistic. In some cases, they have

also developed more explicit cooperation frameworks with financial regulators and

finance ministers to monitor and manage systemic financial risk. This multiplicity of

instruments should make it easier for central banks and financial regulators to achieve

both price and financial stability, even when the requirements of these objectives may

appear to differ in the short run.

5.3 Monetary policy and the trilemma

The well-known “Impossible Trinity,” or trilemma hypothesis, states that an economy

cannot enjoy monetary policy independence, free capital flows, and a fixed exchange

rate simultaneously. Although some economists concluded from this that policy

frameworks under this constraint would tend to gravitate to “corner solutions”—either

fixed exchange rates or fully floating exchange rates—this generally has not happened

in East Asia. Instead, most economies in the region have moved to an “interior

solution” characterized by independent monetary policy, some restrictions on capital

movements, and some degree of currency flexibility coupled with active intervention.

The main exceptions to this are Hong Kong, China, whose exchange rate is pegged to

the US dollar, and Japan, which, with rare exceptions, maintains a free-floating

exchange rate.

There have been various attempts to categorize exchange rate regimes. These have

Brunei Darussalam’s currency is linked to the Singapore dollar.

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been complicated by the fact that a country’s officially announced regime is not

necessarily an accurate reflection of that currency’s behavior. One recent empirical

attempt to quantify currency flexibility in East Asia is Patnaik and Shah (2012), who

apply the methodology of Frankel and Wei (1994) to identify the extent of correlation of

11 Asian currencies with major reserve currencies. Figure 7 shows the mean and

median trend of flexibility of these currencies since 1991. The vertical axis shows the

amount of currency movement explained by movements of key currencies, i.e., the R2

from the Frankel-Wei equation. Although currency flexibility in recent years is higher

than that it was before the Asian financial crisis, correlations with key currencies are

still high, suggesting that these currencies are far from freely floating.

Figure 7: Evolution of Exchange Rate Flexibility in Asia

Source: Patnaik and Shah (2012).

There have also been various attempts to quantify the three aspects of the trilemma—

monetary policy independence, freedom of capital flows and exchange rate flexibility.

Ito and Kawai (2011) developed estimates of these values to place East Asian

economies on the trilemma triangle. These results clearly show a wide range of values,

but skewed in the direction of monetary independence, with only partial financial

openness and exchange rate flexibility. The key point is that these combinations

appear to provide fairly complete monetary independence to these economies. There is

no obvious evidence that the trilemma-related factors have meaningfully constrained

monetary policy in these economies.

Another important factor contributing to policy flexibility in the region is the

accumulation of large foreign exchange reserves, which help to buffer capital outflows

when they occur. These reserves contributed substantially to the ability of Asian

economies to weather the shocks of the GFC, although the process of reserve

accumulation certainly raised questions about its contribution to the development of

earlier global current account imbalances.

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5.4 Recent experience of advanced economies shows

problems remain

The above experience suggests that Asian monetary policy frameworks have

performed well, that some restrictions on capital account openness and currency

flexibility are useful, and that no major changes are needed. Perhaps the main

suggestions would be to make financial stability an explicit objective of monetary policy

and two strengthen institutions for regional policy cooperation, including the CMIM.

However, it is too early to claim that the major problems of monetary policy have been

solved. Notably, the Bank of Japan so far has failed to deliver a convincing and

sustainable escape from deflation despite having a floating exchange rate and having

made many innovations in both monetary policy and the communication of that policy.

This exception should raise warning flags, since Japan is the most advanced economy

in the region, and therefore arguably represents the future toward which other Asian

economies are evolving. The recent experience of central banks in other advanced

economies, especially the US, the United Kingdom, and the eurozone, should give

pause for thought as well, in view of their recent struggles to achieve their policy

objectives. Most worrisomely, the ballooning of government debt and increasing calls

on central banks to act as “lenders of last resort” to governments in those countries

suggest that that the demon of fiscal dominance may not be securely chained.

It is beyond the scope of this paper to analyze the reasons for these shortfalls in

monetary policy performance, as they touch on the fundamental limits of monetary

policy. As noted in Morgan (2012) the experience of using unconventional monetary

policy measures when the policy rate falls to zero suggests that they are effective in

relieving specific bottlenecks in financial markets and raising asset prices, but is less

effective in stimulating aggregate demand.

In other words, most Asian economies may simply have been lucky in that they still

have relatively high trend growth rates and low government debt ratios, and were able

to pick “low-hanging fruit” by improving their monetary policy frameworks. Also, the lack

of exposure to sophisticated financial instruments in the run-up to the GFC meant that

central banks in the region mainly faced garden-variety drops in aggregate demand

rather than more challenging financial sector disruptions. Their risks in this regard are

likely to increase in line with rising financial development. In that sense, monetary

policy frameworks in the region have not yet been adequately tested.

6. CONCLUSIONS

Monetary policy frameworks in East Asia have evolved substantially in the past two

decades, mainly in response to the shocks of the Asian financial crisis and the GFC.

The Asian financial crisis showed the importance of exchange rate flexibility and

credible policy frameworks, leading to increased central bank independence, greater

focus on inflation policy and more flexible exchange rates. A number of Asian central

banks adopted explicit inflation-targeting frameworks, and even those that did not have

evidently placed greater emphasis on controlling inflation than previously.

The GFC highlighted the problem that surveillance and regulation of system-wide

financial stability was inadequate in many countries in the pre-crisis period, and that

ADBI Working Paper 435 Morgan

central banks may not have focused sufficiently on financial stability risks. The

dimensions of systemic risk in both procyclicality of the financial system and

interconnectedness of various financial institutions and markets were not adequately

appreciated, nor was the need for a macroprudential perspective on such risks.

Moreover, when responsibility for financial supervision was divided among central

banks and financial supervisors, most countries lacked an adequate architecture to

ensure coordinated surveillance, analysis, information sharing, and policy actions.

Defining financial stability is not an easy task because it has multiple dimensions and is

related to complex financial systems. But this should not lessen the need to do so.

Central banks’ overview of the macroeconomic developments and financial system

conditions, together with their oversight of payment and settlement systems, gives

them a unique perspective on system-wide financial stability. The case is strong for

central banks to have an explicit mandate for financial stability. Although there may be

short-term conflicts between the traditional central bank objective of price stability and

that of financial stability, in the medium and long term, these objectives should be

largely consistent with each other because development of a financial crisis during

periods of price stability will eventually lead to deflation and economic downturn.

Central banks have various tools to support financial stability, including standard and

“unconventional” monetary policy tools, currency market intervention tools, and, in

some cases, supervisory authority, macroprudential tools and capital flow management

tools. These can be used to help prevent crises by dampening the credit cycle and

strengthening banks and other financial firms to ensure that they are adequately

capitalized and reserved to be able to ride out systemic shocks. Asian central banks

have in fact frequently resorted to such tools to safeguard financial stability and reduce

the volatility of capital flows. There is no guarantee that macroprudential and capital

flow management tools will always be effective, but a multiplicity of tools makes it

easier to achieve both price stability and financial stability. This also implies that central

bank policy frameworks are more complex than simply being characterized by the

presence or absence of explicit inflation targeting.

Monetary policy frameworks in the region have evolved to deal with greater financial

and openness and depth. The ratio of gross capital inflows to GDP is still showing an

upward trend, although that of net capital inflows appears to be stabilizing or declining.

Domestic financial markets have also deepened substantially, which should contribute

to strengthening the monetary transmission mechanism. Aside from Japan, there is no

evidence of major failures of the policy transmission mechanism in the region.

Overall, monetary policy frameworks in the region appear to have worked well in

achieving low and stable inflation coupled with economic growth. This mainly reflects

three factors: central banks have focused on price stability as the main objective of

monetary policy; institutional arrangements have facilitated the successful pursuit of

this objective; and other economic policies, mainly fiscal policy, have supported this

pursuit by reducing concerns about fiscal dominance. We may add to this the

availability of a large number of policy tools, including unconventional policies,

macroprudential measures and capital flow measures that help to deliver financial and

economic stability. East Asian central banks also appear to have coped well with the

constraints of the trilemma hypothesis, and for the most part have gravitated toward an

“interior solution” with independent monetary policy, partial financial openness and

partly managed currencies. On the whole, this positive experience does not suggest

the need for any major changes in policy frameworks. Perhaps the most important

suggestion at this stage is to give greater weight to financial stability as a policy

ADBI Working Paper 435 Morgan

objective and to strengthen institutions for regional policy coordination, including the

CMIM.

However, the failure of the Bank of Japan to escape from deflation, and the more

recent failures of advanced economy central banks in the US and Europe to achieve

full recoveries, points to problems that may confront other Asian economies in the

future as they achieve higher levels of economic and financial development. Therefore,

their recent positive experience to some extent reflects luck as well as improved policy

frameworks. In that sense, monetary policy frameworks in the region have not yet been

adequately tested.

ADBI Working Paper 435 Morgan

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