Monetary Policy and Stabilisation Trap in Selected Asian Countries Implications for Poverty Reductio

1
Monetary Policy and Stabilisation Trap in
Selected Asian Countries Implications for
Poverty Reduction

• Anis Chowdhury
• Professor of Economics
• University of Western Sydney, Australia

2
Introduction

• deficit financing can lead to a very
  unsustainable economy. Bolivia in the 1980s is an
  extreme example its deficit rose to 28 of GNP
  leading to hyperinflation and serious economic
  crisis. So, each country should aim at roughly
  balancing its budget
• (Human Development Report, 1991, p. 42)
• Generalisation from extreme cases led to the
  policy package of IMF/World Bank in the 1980s
  1990s

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Single digit Inflation and growth stagnation
Sources World Development Reports, 1991, 2002
Sources World Development Reports, 1991, 2002
4
Poverty in the 1990s
Sources World Development Reports, 1991, 2002
Sources World Development Reports, 1991, 2002
5

• Argentina in the 1980s
• hyper-inflation the average annual inflation
  rate around 391 and average annual economic
  growth rate around 1
• 1990s
• orthodox IMF stabilisation package succeeded
  average annual inflation rate 1.5, and the
  economy grew by an average annual rate of 6.7
  during 1991-1997
• However
• the continuation of severe restrictive
  macroeconomic policies forced the economy into a
  deflationary spiral the inflation rate dropped
  to 0.9 and 1.3 in 2000 and 2001 respectively
• economy contracted by 3.4 in 1999 and by 2.1
  in 2000
• unemployment rate rose from 6.5 in 1991 to 17.5
  in 1996
• consequently, the poverty rate (head-count ratio)
  rose from 21.8 in 1993 to 34.3 in 2002, and the
  Gini coefficient from 0.45 to 0.49

6
Asian Experience

• While lower inflationis a positive indicatora
  near-zero inflation rate may be symptomatic of
  demand deficiency leading to capacity
  underutilizationTargeting for a too-low
  inflation ratecan sometimes result in overkill.
  .. Yet another problem with pushing inflation too
  low is that it will make it difficult to bring
  about the large relative price changes that the
  structural adjustment policies aim at.
  (Bangladesh Report, p. 38).
• The point is not that the authority has to fight
  inflation at any price and to only value
  deflationary policy. Rather, it has to face the
  tough question of how far to go with fighting
  inflation, knowing that with ongoing deflation an
  economy might face greater risk of entering into
  the chain of rising unemployment, falling demand,
  and reduction in the level of national
  incomeThis restricted policy should not be seen
  as the only way out, without flexibility. The
  inflation ratehas remained low since 1995 But,
  the targeted inflation of about 4 per centseems
  to be low if the aim is to create employment and
  economic growth. (Cambodia Report, pp. 48,
  60-61).
• In the current context, one of Chinas important
  challenges appears to lie in counteracting
  deflationary pressures and sustaining rapid
  economic growth rather than combating
  inflation...Persistent deflation may have serious
  adverse effects on Chinas economic growth and
  poverty reduction prospects. (China Report, p.
  72).
• Policymakers continue to adhere to tight
  IMF-prescribed fiscal and monetary targets in
  order to achieve single-digit inflation
  ratesMeanwhile, domestic consumption, not
  private investment, is supporting growth. But
  clearly this is not sustainableHigh interest
  rates needed for a low inflation target are an
  impediment to growth in circumstances such as
  Indonesias, where the corporate sector is
  heavily indebted. (Indonesia Report, pp. 15, 19)
  
• Bank Indonesia highlighted Indonesias monetary
  policy dilemma
• if the policy is tightly directed at attaining
  inflation targetit is feared to disturb the
  current economic recovery.
• If Bank Indonesia is still persistent in
  achieving the base money target, extremely high
  increase in interest rate will be required,
  whichcould harm the economic recovery prospects
  
• This sentiment was echoed by the Chairman of the
  Indonesian Chamber of Commerce of Industry Bank
  Indonesia has been keeping interest rates high to
  ease pressure on the rupiah and stall inflation
  however, this discouraged industries from
  making new investments that would otherwise have
  helped create new jobs

7
Realisation at Last!

• Wolfensohn, if we take a closer look, we see
  something else something alarming. In
  developing countries, excluding China, at least
  100 million more people are living in poverty
  today than a decade ago. And the gap between rich
  and poor yawns wider.
• World Bank (2005, p. xiii), there is no unique
  universal set of rules We need to get away
  from formulae and the search for elusive best
  practices.
• Easterly (2001) called the 1980s and 1990s the
  lost decades.

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Monetary Policy and Poverty theories and
evidence

• The channels through which monetary policy can
  affect poverty are
• long-run economic growth
• short-run output stabilisation and
• income distribution.
• Since monetary growth and inflation are
  positively linked, moneys role in poverty
  reduction will be examined by looking at the
• inflation-growth inflation
• short-run trade off between output and price
  stabilisation and
• inflation-inequality relationship.
• We shall also examine the question of central
  bank independence.

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Money in the Long-run Does Inflation Harm
Economic Growth?In theory, the answer is both
Yes and No.

• What is the empirical evidence?
• Extensive empirical research indicates that the
  negative relationship between inflation and
  economic or productivity growth is influenced by
  extreme values or outlying countries having an
  exceptionally high inflation rates (see Figure
  2).
• In the words of Bruno and Easterly (1998), the
  correlation loses significance with the omission
  of single observation Nicaragua, which had
  hyper-inflation and negative growth in the 1980s
  More generally, significance and sign of the
  cross-section correlation depends on the
  inclusion of the countries with high inflation
  crises the above 40 episodes.
• They also observed, the significance of the
  negative growth during 20-40 inflation vanishes
  if a single extreme annual observation is omitted
  Iran in 1980.
• Easterly (2003) reported similar findings and
  regarded inflation rates below 35 as moderate.

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• Figure 3 plots average inflation and growth rates
  over four decades (1960-2000) for 141 countries.
  Two interesting features emerge.
• The inflation-growth relationship was negative in
  the period 1960-1979. But it seems to have
  become non-linear first positive and then
  negative in the later period of 1980-2000. This
  confirms the uncertain nature of the
  inflation-growth relationship.
• The variation in growth rate between the two time
  periods is much larger at both low and high
  inflation. That is, both high and low inflation
  rates can be destabilising, and hence harmful for
  the poor.

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• Thus, one may conclude that while policy makers
  should guard against high inflation, a country
  may need moderate inflation to sustain economic
  growth. This understanding is essential when
  there is excess capacity and persistent high
  unemployment or underemployment.
• The over-fixation with a single digit inflation
  target cannot be justified based on the fear of
  inflation going out of control once it is allowed
  to go beyond, say 10 level.
• Dornbusch and Fischer (1993) found that inflation
  rate in the moderate range of 15-30 does not
  usually accelerate to extreme levels.
• Bruno and Easterly (1998) found that the
  threshold inflation rate of 40 at which the
  probability of inflation rate accelerating rises
  significantly.
• Furthermore, only in a handful of cases inflation
  rate did accelerate and output stagnated or
  declined in the past, and these cases could be
  attributed to unusual circumstances (e.g Iran or
  Nicaragua in the 1980s following dramatic fall of
  the regimes).
• Cross-country scatter diagram (Figure 5) shows,
  the claim of the orthodox school that inflation
  harms the poor breaks down when one considers
  inflation rate in the range of 5-20. Consistent
  with the aggregate inflation-growth relationship,
  the negative relationship between inflation and
  the income of the poor is based on few cases of
  extreme inflation.
• Therefore, contrary to the orthodox view,
  poverty-reduction strategy requires moderately
  expansionary monetary policy, and fear of
  excesses cannot be a basis for sound public
  policy.

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Money in the Short-run Is there any Output
Stabilisation Role?

• Demand Shock Monetary policys role in
  stabilizing output depends on two questions
• To what extent a country is prone to demand
  shocks
• To what extent prices (product prices, exchange
  rate interest rate) and wages flexible
• The components of aggregate demand are less
  stable in developing countries due to
• Narrow export base
• Poverty and the role of current income
• Liquidity constraint for both households small
  firms
• Among key prices
• Exchange rate is quasi fixed
• Wages are sluggish downwards mainly because
  real wage is already too low.

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• Therefore, regardless of whether the adjustment
  happens through output or prices, falling
  aggregate demand will have serious implications
  for the poor.
• If the adjustment happens through cuts in output
  and employment, the first to lose job is
  unskilled and unorganised labour.
• If the adjustment happens through declines in
  wages, again the unorganised and unskilled
  workers would be forced to accept lower wages.

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• Thus, the poor unorganised workers are forced to
  choose between jobs and lower real wages. In
  either case, the average income of the poor is
  likely to drop when nominal GDP growth drops from
  its trend. Cross- country (Figure 7) evidence
  shows that average income of the poor is
  negatively related to aggregate demand
  variability.
• This negative relationship does not breakdown
  even when the outliers are omitted.
• Therefore, from the point of view of protecting
  the poor, monetary policy needs to stabilise
  output in the face of adverse demand shocks.

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• Supply Shock It is generally accepted that the
  developing countries are more prone to supply
  shocks than demand shocks.
• This is due to their heavy dependence on
  agriculture and imported raw materials, and
  energy (oil).
• While alternating floods and drought are almost
  regular phenomena affecting agriculture,
  declining terms of trade due to rising prices of
  imported raw materials and energy adversely
  affects the industrial sector.
• The choice between output and price stabilisation
  becomes starker in the case of a supply shock.
  This can be shown diagrammatically

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Figure 8 Adjustment to Supply Shocks
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• In panel A, the response to an adverse supply
  shock is an expansionary monetary policy to
  stabilise output at Q0.
• In panel B, the response is a contractionary
  monetary policy to stabilise the price level at
  P0.
• When the response is an expansionary policy, the
  price level rises further to P2, causing higher
  inflation.
• When the objective is price stabilisation with a
  contractionary monetary policy, output declines
  further to Q2.

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Inflation and Income Distribution

• Inflation can disproportionately hurt the poor
  through two channels
• Wage rise lags behind price rises
• Poor mostly save in money and inflation reduces
  the value of their savings.
• Counter arguments
• If real wage declines due to inflation then
  employment should rise. Therefore, the employment
  effect of inflation can outweigh the real wage
  effect on poverty.
• The gain from expansionary monetary policy will
  not be temporary if the inflation rate remains
  moderate. This is evident from the positive
  relationship between moderate inflation and
  economic growth as demonstrated earlier.
• The poor are largely net financial debtors. Thus,
  inflation can benefit the poor by reducing the
  real value of their net debt. On the other hand,
  lower inflation not only increases the real value
  of financial debt, the high interest rate policy
  aimed at bringing inflation down increases the
  debt servicing cost of indebted poor. This makes
  them, doubly disadvantaged.

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• Evidence
• Studies have found that income distribution
  narrows during the expansionary phase and widens
  during the contractionary phase of a business
  cycle.
• Figure 9 presents the scatter plots of average
  inflation and inequality (measured by Gini
  coefficient). Once again, we find that the claim
  of adverse distributional effect of inflation is
  based on extreme inflationary cases.
• There seems to be no relation between inequality
  and inflation when the inflation rate ranges
  between 5 and 15. On the other hand, inequality
  rises with the variability of nominal GDP growth
  (Figure 10).
• The evidence presented in Figures 9 10
  vindicates the need for output stabilising
  monetary policy that allows for moderate
  inflation.

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Central Bank Independence and Inflation-targeting

• The empirical evidence on the performance of
  independent central banks is still mixed.
• The conditions required for the success of an
  inflation-targeting approach include
• the lack of fiscal dominance and
• the absence of any other objectives.
• None of these conditions appears to hold in most
  developing countries.
• The revenue base of these countries is very low
  and their capital market is underdeveloped. This
  forces most developing countries to borrow from
  the central bank.
• These countries also have some sort of
  quasi-fixed exchange rate systems needed to
  prevent imported inflation and to attract
  short-term portfolio foreign capital.
• Thus money supply responds to developments in
  government finance and the balance of payments.

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• Leaving aside the technical argument, there is a
  broader issue of democratic governance and
  technocratic insulation of institutions.
• It is pertinent at this juncture to quote Milton
  Friedman who is on record for voicing the concern
  ' money is too important to be left to the
  central bankers'. His concerns are elaborated in
  the following quote
• The political objections are perhaps more
  obvious than the economic ones. Is it really
  tolerable in a democracy to have so much power
  concentrated in a body free from any direct
  political control? One economic defect of an
  independent central bank is that it almost
  invariably involves dispersal of responsibility
  Another defect is the extent to which policy is
  made highly dependent on personalities A third
  technical defect is that an independent central
  bank will almost invariably give undue emphasis
  to the point of view of bankers The defects I
  have outlined constitute a strong technical
  argument against an independent central bank.

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• Stern and Stiglitz (1996) have made the point
  more succinctly
• The degree of independence of the central
  bank is an issue of the balance of power in a
  democratic society. The variables controlled by
  the central bank are of great importance and thus
  require democratic accountability. At the same
  time the central bank can act as a check on
  government irresponsibility. The most successful
  economies have developed institutional
  arrangements that afford the central bank
  considerable autonomy but in which there is a
  check provided by public oversight, an oversight
  that ensures the broader national interest is
  taken into account in the final decisions.

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• In this respect, it is worth highlighting the
  distinction between "goal independence" and
  "instrument independence".
• The former refers to central bank's ability to
  set the inflation target independently of the
  government.
• The later is its independence in the choice of
  instruments and hence relates to central bank's
  day to operations.
• No central bank can be entirely independent of a
  democratic government while it can be entirely
  free in choosing its instruments.
• Most developing countries are new democracies. In
  such a situation, a central bank with both goal
  and instrument independence may choose a very low
  inflation target which can undermine a nascent
  democracy by delaying economic recovery.
• Furthermore, the very argument that an elected
  government cannot be trusted with the
  responsibility of managing the economy goes
  against the very principle of representative
  democracy.

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• The above issues have become more prominent in
  Indonesia as the new central bank law (enacted in
  1999) grants the Bank Indonesia (BI) both goal
  and instrument independence.
• This has been responsible for open disputes
  between the BI and parliament in a number of
  occasions on the appropriateness of monetary
  policy stance.
• The national planning agency (BAPPENAS) has also
  expressed concerns about the mismatch between the
  monetary policy stance of the BI and fiscal
  policy.
• The Indonesia country report (p. 19) observes
• It is difficult to ease monetary policy and
  achieve some consistency between fiscal and
  monetary policies when the Bank of Indonesia (BI)
  remains relatively autonomous and wedded to
  tight monetary policies. While BI should have
  autonomy in determining its policy instruments,
  its objectives should be subject to public
  discussion and oversight. By setting low
  inflation as its overriding objective, BI can
  compromise the achievement of other objectives,
  such as growth of income and employment
  generation, which most people value highly, in
  addition to price stability.

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• It is rather strange that under the provision of
  the current legislation of BI independence,
  neither the president nor the parliament can
  remove the governor of BI before the expiry of
  his/her tenure.
• This led to the much publicised stand-off when
  President Wahid wanted to remove the Governor
  after he was indicted in a corruption case.
• The Governor refused to resign even when he was
  convicted following a guilty verdict.

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• In sum, inflation targeting and central bank
  independence are not merely technical matters, as
  the orthodoxy tends to believe.
• It is pertinent at this juncture to point to the
  observation made by a central bank insider, Guy
  Debelle (1996 1).
• An increase in the inflation aversion of the
  central bank, while always reducing inflation
  rate, may reduce welfare because of its adverse
  effects on output and government spending. The
  net welfare effect is shown to depend on the
  weights in the welfare functions of the fiscal
  authority and society. Thus, increasing the
  central bank's inflation aversion is not
  necessarily a free lunch.

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• Thus, the essence of inflation targeting is
  embedded in the so-called social welfare function
  that includes both inflation and economic growth.
  
• High unemployment that is required to bring
  inflation rate to a single digit level or to keep
  inflation rate in the range of 3-5 has
  significant and systematically regressive effects
  on the distribution of income.
• The poor fare worse when unemployment rises and
  persists, especially when there is no adequate
  safety-net or social security system. At the same
  time the real value of their net debt rises with
  falling inflation.
• Hence the poor have reasons to be more averse to
  unemployment and less averse to inflation than
  the elite in society.
• As the poor lack voice and representation, the
  choice of weights for inflation and unemployment
  in the social welfare function raises an
  important issue of conflicts and political
  economy of public policy.

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Policy Recommendations

• Recognise both price and output stabilisation
  roles. That is, avoid both too conservative and
  too expansionary monetary policy. Inflation in
  the range of 10-20 can be regarded as safe both
  from the point of view of avoiding a
  stabilisation trap and harmful affects of
  expansionary monetary policy.
• Achieve consistency with the fiscal policy
  stance. Safe expansionary monetary policy within
  the above guideline will allow governments to
  borrow from the central bank to finance
  employment-intensive public investment programs
  in infrastructure. This can create and stabilise
  employment without pressure on interest rate.
  Thus private investment is unlikely to be crowded
  out rather both domestic and foreign investment
  will be encouraged by demand growth and
  externality benefits from improved physical
  infrastructure.

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• Develop directed credit programs to
  employment-intensive small and medium
  enterprises, agriculture and rural industries.
  This is essential because they are more dependent
  on bank credits than larger enterprises that have
  better access to capital markets. Therefore, even
  when over-all credit growth needs to be
  restrained, directed credit to SMEs and
  rural-agricultural sectors must be maintained to
  avoid asymmetric adverse impact on employment.
  This will protect the income of the poor and
  offset likely adverse impacts of cyclical
  downturn on inequality.
• Central banks should be given autonomy to choose
  and implement the instruments of monetary policy
  within the over-all economic objectives dictated
  by the poverty reduction strategy of the
  government. This means a participatory policy
  making process so that the trade-off parameter
  between inflation and unemployment reflects the
  concerns of the poor, and not of the elite or
  multilateral agencies.

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• Given that there is no evidence of a trade-off
  between employment creation and moderate
  inflation, the conflict between goals and
  instruments is not as stark.
• Yet for two targets the monetary authorities can
  have two instruments
• Traditional instrument of interest rate (or such
  instruments as reserve requirements) assigned to
  keep inflation at a moderate level.
• Specialised credit regulation directed to
  employment creation.

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The central banks can consider a number of
options in designing specialised credit programs

• Follow the Indian example, where all banks
  (public and private) are required to lend at
  least 40 per cent of their net credit to the
  priority sector. If banks fail to meet this
  requirement, they are required to lend money to
  specific government agencies at a very low
  interest as a penalty.
• Alternatively, use some carrot and stick measures
  by combining the penalty system with incentive
  based measures such as asset based reserve
  requirements, support for pooling and
  underwriting small loans, utilising the discount
  window in support of employment generating
  investments

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• Asset based reserve requirements are an effective
  tool for creating incentives for banks to invest
  in socially productive assets. For example
• Based on well-research findings of employment
  elasticities, the central banks would list a set
  of employment generating investment, and a lower
  reserve requirement would apply for the deposits
  invested in these activities than the deposits
  invested in speculation or Treasury Bills.
• The central banks can also take steps to create
  liquidity and risk sharing institutions for loans
  to small businesses which have promise to
  generate employment, but do not have adequate
  access to the credit market. For example, the
  central banks can provide financial and
  administrative support for asset backed
  securities which would take loans to small
  businesses and other employment intensive
  activities, bundle these investments and sell
  them as securities on the open market.
• Finally, the central banks can open a special
  discount window facility to offer credit,
  guarantee or discount facilities to institutions
  that are on-lending to firms and co-operatives
  engaged in employment intensive activities.

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• To achieve the RER target, the central banks
  should intervene in the exchange market.
• That is the nominal exchange rate should move to
  hold RER at a stable and competitive level for an
  extended period of time.
• There are basically three options
• 1.      interest rate manipulation
• 2.      sterilised intervention
• 3.      capital controls.

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• To support the developmental role of exchange
  rate, monetary policy must maintain stable and
  low real interest rates. By boosting exports this
  will complement the employment target of monetary
  policy.
• Will low interest rates set off inflationary
  nominal depreciation (under speculative exchange
  rate dynamics)?
•  
• Targeting RER can help central banks avoid this
  problem.

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• Finally central banks need to have some controls
  on capital flows. This will give central banks
  controls over monetary aggregates and hence
  monetary policy independence to keep real
  interest rates low, stabilise employment and keep
  inflation at a moderate level, while the exchange
  rate policy aims to maintain international
  competitiveness.

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• There are, of course, many critics of capital
  controls. However, they must accept that the
  Mundell-Fleming model conceived of capital flows
  as largely money-market flows or at most money
  and bond markets flows.
• An important development in the world economy in
  the late 1990s was the shift of international
  capital flows from the fixed income market both
  money and bond flows to the equity market
  both portfolio equity flows and FDI.

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• A decline in policy interest rates can raise
  expected corporate earnings. This can lead equity
  prices to rise and attract foreign investors with
  extrapolative expectations to buy more equities.
  Therefore, equity effect of lower interest rates
  can be larger than the money-bond market effects
  to overturn standard Mundell-Flemming results.
• Thus, capital account openness should not be
  viewed as an all-or-nothing proposition. The
  increased importance of equity flows has
  increased the effective scope of a capital
  account policy of semi-openness. A capital
  account can be open to equity flows both
  portfolio and FDI, but closed to money and bond
  flows.