This paper examines the post-crisis monetary responses taken by emerging market economies (EMEs) in response to huge capital inflows. It explores how six selected advanced and secondary EMEs dealt with the classic policy trilemma and also investigates the effect of sterilized interventions. Despite the use of only a small sample, this paper has relevance today given the recent large capital inflows to EMEs. The empirical section offers the new trilemma ‘holy trinity’ to replace ‘impossible trinity’. The paper focuses on the most obvious route for sovereign debt sustainability, that is, price stability via the monetization of government debt or open market operations (OMOs). It explores the implications of sterilized interventions on domestic interest rate, on capital flow and on exchange rate stability.
Field of Research: Finance and economics
JEL Codes: E52, E58, E63, F31, F36, F41
Capital inflow surges have become common for emerging market economies (EMEs) following the East Asian financial crisis in 1997/98, raising great concerns among policymakers. This paper examines the post-crisis monetary responses of selected EMEs faced with huge capital inflows. The responses of central banks varied between EMEs in different regions, depending on policy constraints, the policymakers’ economic and institutional background, and other factors. We can learn from the past experiences of volatile capital flows. This paper adopts Keynes’ theory of money supply and simple interest rate determination. The negative effects of large capital inflows such as exchange rate overshoot, financial instability, inflation, and economic downturn concern all banks
in the affected regions (Chantapacdepong 2012).
Sterilized interventions by the central banks are one way to circumvent these negative
effects (BNM 2010a). Policymakers, however, must consider the classic trilemma
—the problem of simultaneously managing interest rates, the flow of capital, and the exchange rate. The trilemma suggests that only two out of three goals can be achieved at a time
(Sivalingam 2009). Different combinations of policy recently tried in various regions appear
in Table 1 below.
_______________________________________________________________________
*Zetty Zahureen Mohd Yusoff, School of Commerce, University of South Australia, Australia
Email: mohzb004@mymail.unisa.edu.au
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Table 1: Policy trilemma adopted by developed and developing countries,
2010
– 2012
Interest rate Capital flows Exchange rate
US
Euro area
China
Malaysia
Independent MP
Independent MP
Free
Non-independent MP Free
Controlled
Non-independent MP Free
Freely floating
Managed floating
Managed floating
Managed floating
Philippines Independent MP Free Freely floating
Singapore Independent MP Free Freely floating
Source
: Adapted from Mankiw (2010) and Hsing (2012)
Note : MP = Monetary policy
This paper shows how six selected EMEs of advanced and secondary EMEs consisting of;
Asian countries with managed exchange rate (i.e., Malaysia, China and India) and some with floating currency regime (i.e., Thailand and Indonesia), leading region in EMEs with freely floating ER (i.e., Turkey) that cover those with Islamic and non-Islamic based financial system had dealt with the policy trilemma. It also shows the extent of sterilization operations that coped with large and volatile capital inflows after the crisis. Sterilization, full or partial, had mixed consequences. Understanding the relationship between first, how capital flow affects interest rate, second, how reserve affects interest rate, and third, how exchange rate (ER) affects money supply (MS), and all of these connect to sterilization operations might neutralize the negative effects. The trilemma suggests that lower interest rates (via freely set rates or independent MP), and free international capital mobility, and exchange rate stability (maintaining currency value via a managed float) cannot coexist
(Sivalingam 2009).
Though it is impossible to control foreign capital inflows that a begin of reserves accumulation but the regional monetary authorities should persist with
aggressive sterilizations on a huge scale to deal with reserves accumulation (Ouyang,
Rajan & Willett 2008) to maintain lower rates of interest and stable rates of currency.
Turkey, Malaysia and Thailand are selected samples of advanced EMEs. Turkey’s impressive economic performance in the 1980s that benefited from the Iran-Iraq War
1980-
88) won high marks from Wall Street’s credit-rating agencies (Wikipedia 2012a).
After five years into the crisis, Malaysia now is moving forward to hold and sustain a recovery by way of restructuring its banking and financial system targeting medium to long
term benefits (BNM 2012b). Thailand had widened up the degree of capital liberalization
since the early 1990s and showed an impressive growth path for over a decade until it was
hit by the Asian financial crisis in 1997 (Sangsubhan 2008). These three regions are
categorized as advanced EMEs either because they are upper or lower middle income growth national income (GNI) countries with advanced market structures or high income
GNI countries with lesser developed market infrastructures (Wikipedia 2012c). China,
Indonesia and India are selected samples of secondary EMEs. China launched its
Economic Stimulus Plan in dealing with global financial crisis of 2008/09 (Wikipedia
2012b). The post global crisis has speculated that world will see rebalancing of economic
powers towards Asian economies, principally China as well as India and Indonesia due to their faster recovery from the global effect. These three regions fall under secondary
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EMEs either because they come from low income, lower middle, upper middle and high income GNI countries with reasonable market infrastructures and significant size or come from upper middle income GNI countries with lesser developed market infrastructures
(Wikipedia 2012c).
The subsequent loss of confidence in emerging and developing Asia economies resulted in a massive turnaround in capital flows in 2008. Huge and volatile capital flows to emerging and developing Asia economies in the last fifteen years repay study (Figure 1 and 2). Table 2 and 3 summarize balance of payments (BOP) data from the IMF revealed how these economies experienced a sharp reversal in net private capital flows nearly 200 percent between 2007 and 2008. Some emerging economies allow their currency to float freely and some allow their currency to float but with government interventions (a
“managed float”). Other simply let their foreign reserves accumulate. In the end, these
capital inflows will normally be sterilized to avoid domestic inflation (BNM 2010c). There
are two types of interventions, sterilized and unsterilized. However, this paper only discusses the ‘sterilized intervention’ that requires of buying and selling of government bonds to offset intervention and ignore the ‘unsterilized intervention’ that requires no
changes to the monetary base to offset intervention (Lien 2010).
Table 2: Net capital flows to emerging and developing economies,
1997
– 2012 (
USD billions )
Average
(1997 –
2001)
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012(e)
Private capital flows, net 80.3 61.6 181.1 242.4 320.7 299.4 700.1 259.5 285.2 527.0 521.0 394.7
Direct investment, net
Private portfolio flows, net
Other private capital flows, net
158.0
-13.7
-64.0
149.0 148.8 187.5 293.2 303.6 440.2 479.6 313.9 332.0 418.3
-48.8 -1.0
-38.6 33.3
16.9 41.1 -39.5 105.9 -72.9 86.0 232.9 101.1
38.1 -13.7 35.3 154.1 -147.1 -114.7 -37.9 1.6
403.8
79.3
-88.4
Official flows, net 10.0 16.4 -45.0 -68.4 -95.0 -163.9 -92.6 -97.8 135.0 74.7 -109.8 -109.7
Change in reserves -58.4 -154.0 -320.0 -414.6 -590.6 -755.4 -1210 -724.9 -520.3
-
873.8 -831.6 -733.3
Source : IMF, WEO April 2012 database, http://www.imf.org/external/pubs/ft/weo/2012/01/weodata/index.aspx
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Figure 1: Capital flows movements in emerging &developing economies,
1997 – 2012 ( USD billions )
Billions (US$)
Table 3: Net capital flows to Developing Asia,
1997 – 2012 ( USD billions )
Private capital flows, net
Direct investment, net
Private portfolio flows, net
Other private capital flows, net
Official flows, net
Change in reserves
Average
(1997 –
2001)
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012(e)
6.4
53.5
-6.8
-40.2
10.8
-32.6
53.4
60.1
-12.0
5.2
-10.7
78.6
58.5
22.1
-2.1
-16.0
162.4
68.3
39.6
54.4
-19.9
126.8
131.9
15.5
-20.7
-3.2
97.6
131.6
-46.3
12.4
2.7
206.5
175.4
64.0
-32.9
1.3
83.0
169.6
9.1
-95.7
-6.6
188.7
104.1
56.8
27.8
20.2
-114.5 -187.7 -245.5 -281.0 -361.5 -612.2 -491.5 -467.3
331.8 303.2
160.1 168.1
101.3 64.7
70.3
21.4
70.4
9.7
264.9
163.2
69.8
31.9
15.0
-
584.5 -468.5 -441.0
Source : IMF, WEO April 2012 database, http://www.imf.org/external/pubs/ft/weo/2012/01/weodata/index.aspx
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Billions (US$)
Figure 2: Capital flows movements in Developing Asia,
1997
– 2012 (
USD billions )
This paper is organized in four sections, of which this is the first. Section 2 discusses classic policy trilemma in the literature and the economic background of the six selected
EMEs. Section 3 introduces a new approach to the trilemma, called ‘holy trinity’. We analyze sterilization and policy. Section 4 discusses the various policy implications due to sterilized interventions on the policy trilemma.
The trilemma issues and economic background of advanced and secondary EMEs
‘Impossible trinity’ refers to the apparent impossibility of controlling the interest rate,
exchange rate, and capital flows all at once. Hsing (2012) finds evidence for a trade-off
among these three policy goals for Malaysia, the Philippines and Singapore but less evidence for Indonesia and Thailand. Malaysia faced this trilemma during the East
Asian financial crisis in 1997/98. The Malaysian government imposed capital controls and pegged its exchange rate in September 1998. In 2009, the Malaysian economy experienced similar external shocks when it could not sell manufactured exports following the financial crisis in the US. This time around, Malaysia weathered the storm
because of large internal reserves (Sivalingam 2009).
Some emerging economies such as China and India face fewer output fluctuations because the policy trilemma are converged as they pursue managed exchange rates backed up by large international reserves, some degree of monetary autonomy and
restrained financial integration (Aizenman, Joshua & Ito 2012). Large international
reserves help to stabilize exchange rates for EMEs fearful of floating their currency
(Taguchi, Nataraj & Sahoo 2011). Although Indonesia has had a high degree of
financial openness since 1980s, with major reform of its banking sector achieved in
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October 1988, but that openness decreased in 1995. The Asian financial crisis 1997/98 forced to a structural change of the Indonesian economy. After the crisis, Indonesia shifted from managed ER to a floating ER regime and achieved an independent monetary policy
(Hadiwibowo & Komatsu 2011). Thailand and Korea are another two Asian countries that
shifted to floating exchange rates, decreased their interest rates, and thereby retained
monetary autonomy (Taguchi, Nataraj & Sahoo 2011).
Aizenman, J., Chinn and Ito (2008) claimed there was a trade-off among three trilemma
variables that happened between developing and industrialized countries. Prior to the
1990s, maintaining exchange rate stability (ERS) was a top priority in all countries. But, starting in 2000, developing countries focussed on managing their ER and retaining an independent MP. Conversely, industrialized economies reduced their MP autonomy and
increase their reliance on ERS (Hsing 2012). China achieved considerable ERS, retained
MP autonomy and capital controls (Mankiw 2010), but failed to allow financial integration
to play any significant role (Aizenman, J. & Sengupta 2011). Turkey took a different
approach. In 2010, its central bank cut the policy interest rate to 6.5 per cent from 7 per cent to stimulate lending activity. However, the rate cut did not work since the central bank and local banks did not set the policies to discourage consumption and did not encourage productive investment. Easy borrowing adversely affected the country by raising its reserve requirements. Consequently, Turkey needed to apply some capital controls to discourage illegitimate transfers as well as to counter a trade deficit due to bad cash
management (Financial Times 2010). Following the collapse of the stabilization policy based on a crawling ER peg in 2001, Turkey let the lira float (Karahan & Colak 2012).
In 2001, India changed from tight control to a more liberal regime according to Shah
(2008) and Mohan and Kapur (2009) as cited in (Hutchison, Sengupta & Singh 2012). This
structural change has impacted the financial environment and external constraints and influenced policy trade-offs between the trilemma choices. The classic trilemma still faces
India when she tries to control MP and capital flows, while intervening in FOREX markets
(managed ER). High levels of international reserves are neutralized by intervention in the
FOREX market through sterilized operations (Subbarao 2012).
Capital flows and sterilized interventions in selected EMEs
Capital inflows to Asia increased substantially five years after the global financial crisis in
2007/08. This is believed to have its roots in the aftermath of the 1997/98 Asian financial
crisis (BNM 2010c). Theoretically, large and volatile capital inflows occur from industrial to
emerging economies due to factors like large-scale global liquidity, low industrial country
interest rates and lower risk aversion (Cavoli & Rajan 2009). It seemed that the net private
capital flows into emerging markets would rise to USD825 billion by the end of 2010, an
increase of about 42% compared to 2009 (BNM 2010c). Additionally, the Federal
Reserve’s decision to buy another USD600 billion of US Treasury bonds under "QE2" has increased capital flows to the region. After growth throughout 2012, Emerging Asia most recently has started to experience slow-down. Governor of BNM, Dr Zeti Akhtar Aziz further estimated that massive and more volatile capital flows would flood again into emerging markets in the next few years due to
‘global policy spillovers and the
deleveraging activities in US and Europe’ (BNM 2012a).
On the positive side, surges in capital inflows into the regions can be used to finance investments, diversify risk and expand the economic activity. On the negative side, if the flow is not properly managed then it can quickly reverse, causing instability and inflation.
EMEs should cooperate to manage this risk. In Malaysia, the Bank Negara Malaysia
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(BNM) took various actions during the peak of the crisis (end of 2008) such as increasing its financial markets capacity through growth in the size of the Sukuk market (107% of
GDP), strengthening regulatory and supervisory frameworks, passing new legislation – the
Central Banking Act
– to promote financial stability (BNM 2010b).
Table 4 shows the extent of the sterilization been utilized (partially or fully) by selected five
Asian countries in neutralizing the large and volatile of foreign capital inflows after the East
Asian financial crisis (except for Turkey – nil sterilization). Obviously, Malaysia had sterilized the full reserve effect on any capital inflow. Conversely, other Asian countries had sterilized the partial reserve effect on their capital inflows (Indonesia, Thailand, China and India). Therefore, concerning the risks related to liquidity inflows is vital for monetary policy transmission and should be an alternative to exchange rate policy in managing volatile capital inflows in the future.
Table 4: Sterilization of full/partial reserve effect of capital inflows in Asia, 1990
–
2007
Sterilization Degree of after the crisis sterilization
Remark
(pre-vs.-post Asian financial crisis)
Korea
Malaysia*
Indonesia
Singapore
Thailand*
Less
More
More
Philippines* Less
More
Less
Full
Full
Partial
Partial
Partial
Partial
Korea maintain high levels of sterilization after the Asian financial crisis in 1997/98
Malaysia maintain high levels and did oversterilize it for the post-crisis
Indonesia has tended to sterilize more after the Asian crisis
Philippines less sterilization post-crisis
Singapore had sterilized more compared to before the Asian financial crisis
Thailand sterilized less following the
Asian crisis
China* Less Partial China only sterilized a little after the crisis
India* More Partial Like Indonesia and Singapore, India had sterilized more after the Asian crisis
Source
: Adopted from Cavoli and Rajan (2009)
Note : * Current NIEs
Based on the above tables, we could see recent trends towards greater control of capital inflows in emerging markets. Earlier literature on the effect of reserve inflows on the domestic interest rates concluded that sterilization affects only domestic interest rates
(Cavoli 2007). This can be measured using the interest rate model by Edwards and Khan
(1985) as cited in Cavoli (2007)
. David Hume’s theory of the effect of exchange rate
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fluctuations on the money supply (MS) says a country will have an undervalued ER when it experiences a surplus account that will increase the money supply and subsequently
cause inflation (Williamson 2009). This study postulated that China, Thailand and some
other Asian countries such as Korea and Philippines sterilized less while Malaysia,
Indonesia and India had sterilized more of their reserves after the financial crisis (Cavoli &
Rajan 2009). Previous research on managing huge and volatile capital inflows has
concentrated on relationships between reserves and interest rates, as well as the relationship between the exchange rate and money supply.
Although considerable research has been devoted to provide intermediate solutions
(sterilized interventions) to the influx of capital inflows in the regions via classic policy trilemma ‘impossible trinity’ (Figure 3), limited attention has been paid to new policy trilemma ‘holy trinity’ (Figure 4). The ‘holy trinity’ is the simultaneous pursuit of price stability, financial stability, and sovereign debt sustainability. Until now, none of the theories indicates that these three policy objectives are consistent to one another.
However, the ‘holy trinity’ also faces trade-off especially in the short-term in a country with
high inflation, a fragile financial system, and a ballooning public debt (Subbarao 2012).
Figure 3:
Classic policy trilemma ‘impossible trinity’
Exchange Rate Stability (ERS)
Independent Free International
Monetary Policy Capital Mobility
Source
: Adapted from Subbarao (2012)
Figure 4: New policy trilemma ‘holy trinity’
Price Stability (PS)
Financial Sovereign Debt
Stability (FS) Sustainability (SDS)
Source
: Adopted from Subbarao (2012)
Recent trend of surge and volatile capital inflows has been extensively discussed among the economists and policymakers because they force a currency to appreciate, promote inflation risks due to massive reserves accumulation, and trigger BOP crises. However, this monetary effect can be neutralized by buying foreign reserves and engaging in sterilization
– buying domestic currency assets in the open market (Cavoli & Rajan 2009).
Therefore, the research questions of interest are:
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When capital flowed into emerging markets after the Asian crisis, how did each of the markets respond to this? This question requires an observation of action taken by central banks in the selected EMEs.
How did sterilization operate through classic policy trilemma —interest rate, capital mobility and exchange rate —and to what extent? This question compels an assessment of utilization on a degree of sterilization for each EMEs region, and what is an implication of newly introduced ‘holy trinity’ compared to ‘impossible trinity’ given the same sterilized interventions in the selected regions of EMEs? This question demands an assessment on a degree of changes (increase or decrease) on domestic interest rate, perfect or imperfect capital mobility and stability of exchange rate.
This paper focuses on the most obvious route for ‘sovereign debt sustainability’ as
mentioned by Subbarao (2012)
that particularly concerns on ‘price stability’ through monetization of government debt
—resort to open market operations (OMOs). These markets are open in the sense that dealers compete with one another on the basis of price
alone (Kocherlakota 2010). The main purpose is to gain liquidity position, which is needed
to allow domestic money markets to facilitate the transmission of monetary policy. This should add to the literature when examining the sterilization impact of OMO on ‘price stability’. It is hoped that such disequilibrium in the FOREX market in highly open economies can be restored through sterilization operations in maintaining liquidity in the
market (BNM 2010a).
3.1 Model 1: Reserve vs. Interest Rate
The interest rate determination model based on Edwards and Khan (1985) as cited in
Cavoli (2007) was used to investigate whether sterilization is an appropriate policy
response during recent trend of large and volatile foreign capital inflows for advanced and secondary EMEs. The presence of sterilization of the reserve effects of capital inflows would place an upward pressure on interest rates or at least maintain the interest rate at the existing level prior to capital inflows surge. The policy implication is ‘sterilization may
keep interest rates high and thus prolong the capital inflow’ (Cavoli 2007).
This model determines the relationship between capital mobility and sterilization. The more mobile capital is, the more the domestic interest rate is influenced by external factors
(i.e., foreign interest rates and fluctuations of current and expected future ER). The presence of high capital mobility renders sterilization ineffective. On the other hand, the less mobile capital the more domestic interest rate is driven by internal factors or domestic variables (sterilization). We conclude that sterilization policy may only impact domestic interest rates during ‘imperfect capital mobility’.
3.2 Model 2: Exchange Rate vs. Money Supply
The exchange rate model based on Qayyum and Khan (2003) as cited in Hashmi et al.
(2011)
was used to examine the monetary policy implications of sterilized interventions in
EMEs. This model is used to investigate whether sterilizing the money supply is an effective policy response to overcome high inflation during foreign capital inflow surges into the regions. The purpose of sterilization in the case of currency devaluation is to reduce the composition of money supply. This policy works well in a managed floating
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regime in which sterilization may keep the money supply at equilibrium and keep pushing the value of the currency to appreciate. According to the Mundell-Fleming framework
(Fleming 1962; Mundell 1963)
, monetary policy (MP) will be ineffective under a ‘fixed ER’ if international capital is perfectly mobile. Put simply, the central bank cannot control the supply of money, not even in the short-run. Conversely, fiscal policy (FP) will be ineffective
under a ‘flexible ER’ (Hadiwibowo & Komatsu 2011).
According to David Hume’s Theory (1711-16) as cited in Schabas (2008), an undervalued
exchange rate (ER) means that the country runs a payment surplus. This scenario might put pressure on the supply of money and might cause inflation to occur until equilibrium is reached. In equilibrium, a fixed ER implies a particular value of the money supply (one cannot choose both). One way to reverse the negative effect of high inflation is to tolerate a real appreciation through sterilized intervention or to let central banks allow for currency
appreciation (Williamson 2009).
3.3 Summary of policy trilemma effect and utilization of sterilization in EMEs
Table 6: Classic policy trilemma and sterilization adopted by EMEs, 1997 – 2012
Interest rate Capital flow ER regime Reserve Sterilization
Malaysia Non-independent MP Free
Thailand
Turkey
Indonesia Independent MP
China
Independent MP
Independent MP
Independent MP
Managed float 4 th
Large Full
Freely float 3 rd
Large Partial Free
Controlled Freely float 5 th
Large Nil
Free Freely float 6 th
Large Partial
Controlled Managed float 1 st
Large Less
India Independent MP Controlled Managed float 2 nd
Large Less
Source
: Adapted from (Sivalingam 2009), (Mankiw 2010), (Hadiwibowo & Komatsu 2011), (Taguchi, Nataraj & Sahoo
2011), (Hsing 2012), (Karahan & Colak 2012), (Subbarao 2012) and (Financial Times 2010)
Malaysia, Thailand, Turkey and Indonesia should learn from major economies in EMEs such as China and India based on previous action taken during large and volatile capital inflows. In dealing with classic policy trilemma, both countries run monetary policy autonomy to freely set interest rates to respond to domestic situation and also to maintain stability of their exchange rates via managed ER regime, but they have decided to impose restrictions on capital flows. By doing that, both countries need to sterilize less of their reserves, and lead them to be the top two among the selected EMEs in the regions by holding high foreign reserves (USD3,285,090 millions for China and USD295,290 millions
for India) (Wikipedia 2012d). Countries in advanced EMEs should feel ashamed of
themselves because China and India are only secondary EMEs (among the lower and middle income GNI with reasonable or lesser developed market infrastructures) but able to face volatile capital inflows more efficiently by managing and locating their reserves effectively.
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Furthermore, fully exploiting the classic policy trilemma with the help of sterilization and slowly adapting the new policy trilemma have positive implications when facing surges and volatile capital flows in the future. Most importantly, the liquidity risks in relation to OMOs in money market are of paramount for monetary policy transmission and this can be a another preference as opposed to exchange rate policy in managing large inflows. The liquidity effect on OMO is seen applicable in solving the matter of overconcentration on the banking system.
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