How Long Can Asian Central Banks Postpone Currency Adjustment

1
How Long Can Asian Central Banks Postpone
Currency Adjustment?

• John Greenwood
• Chief Economist, AMVESCAP
• February 26th, 2005

2
Outline

• Exchange Rate Arrangements and their Implications
  for Monetary Policy
• The Case of China, and initial results of recent
  tightening actions
• Possible problems ahead
• Historical case studies
• Conclusions Will there be a repeat of the Asian
  Financial Crisis of 1997-98?

3
Global Exchange Rate ArrangementsAs of December
31st 2002

• Framework Countries
• 1. No Separate Legal Tender 40
• 2. Currency Board Arrangements 8
• 3. Other Conventional Fixed Peg Arrangements (inc
  managed rates) 40
• 4 Pegged Exchange Rates With Horizontal Bands 5
• 5. Crawling Pegs 4
• 6. Exchange Rates Within Crawling Bands 6
• 7. Managed Floating With No Pre-Announced Path
  for Fx Rate 42
• 8. Independently Floating 41

Source IMF, International Financial Statistics,
January 2003
4
Exchange Rate Arrangements
Types of Exchange Rate Mechanism
Fixed Exchange Rate Permanent or Temporary Fix
Managed Exchange Rate Formula or Discretionary Peg
Floating Exchange Rate Clean or Dirty Float
Currency Boards Permanently Fixed Rates
Central Banks Fixed but Adjustable
5
Two Alternative Approaches to Monetary Stability
(2) Control the Price of Money
(1) Control the Quantity of Money
Fixing the Price Requires 1) Willingness of
Authority to supply or withdraw base money on
demand 2) Guaranteed convertibility of base money
at fixed price.

• Fixing the Quantity Requires
• 1) Central Bank with ability to manage
  high-powered money.
• 2) Reliable forecast of required money supply for
  given price level and level of real GDP.

6
Typical Central/Commercial Bank Balance Sheets
Central Bank Assets Liabilities Domestic
Currency Securities Bank Notes Coin
Issued Foreign Exchange Reserves Reserve Deposits
of Banks Other Assets Net Worth
Commercial Banks Assets Liabilities Vault
CashReserve Deposits Deposits at
Central Bank Loans and Investments Foreign
Assets Foreign Liabilities Net Worth
7
Chinas Foreign Exchange Reserves Soaring
CHINA'S VISIBLE TRADE BALANCE FX RESERVES (US
BN)
9/2/05
50
600
FOREIGN EXCHANGE RESERVES US BN
VISIBLE TRADE BALANCE, 12 MMT
40
500
30
400
20
300
10
200
0
100
-10
-20
0
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
VISIBLE TRADE BAL,12MMT
FOREIGN EXCHANGE RESERVE(R.H.SCALE)
Source DATASTREAM
HIGH 46.57 15/7/98, LOW -16.28 14/1/94, LAST
38.40 14/1/05
HIGH 574 30/11/04, LOW 18 31/1/90, LAST
574 30/11/04
8
Rising Foreign Reserves Caused an Acceleration in
Money Credit Growth in 2002-03
CHINESE MONEY AND BANK LOAN GROWTH YOY
9/2/05
25
25
20
20
M2 GROWTH
15
15
BANK LENDING GROWTH
10
10
5
5
0
0
1999
2000
2001
2002
2003
2004
M2 GROWTH YOY
BANK LENDING GROWTH YOY
Source DATASTREAM
HIGH 21.55 29/8/03, LOW 9.32 31/5/01, LAST 14.60
31/12/04
HIGH 23.92 29/8/03, LOW 2.79 29/9/00, LAST 11.55
31/12/04
9
To Prevent Inflation, the Central Bank Started to
Sterilize Inflows from Sept 2002
PEOPLES BANK OF CHINA Assets Liabilities Domest
ic Currency Securities Bank Notes Coin
Issued Foreign Exchange Reserves Reserve Deposits
of Banks STERILIZN BONDS ISSUED Other
Assets Net Worth
Commercial Bank Balance Sheets Assets Liabilities
Vault CashReserve Deposits Deposits
at Central Bank Loans and Investments
S-Bonds Foreign Liabilities Foreign Assets
Net Worth
10
The Pace of Sterilization has been Accelerating
11
Chinas Inflation Accelerated, but is now
Subsiding
CHINESE INFLATION - CPI PPI YOY
9/2/05
30
30
25
25
CPI
20
20
15
15
PPI
10
10
5
5
0
0
-5
-5
-10
-10
87
88
89
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
CPI
PPI
HIGH 28.40 1/2/89, LOW -2.68 1/6/99, LAST 2.40
1/12/04
HIGH 8.40 15/10/04, LOW -5.68 13/11/98, LAST
7.10 15/12/04
Source DATASTREAM
12
Pacific USD Bloc Is It Sustainable?
US dollar Overvaluation
Asian Currency Undervaluation
Intervention in Asian Fx Markets
Asian Trade Surpluses
Asian Fx Reserves Grow
US Trade Deficits
US Job Losses via Outsourcing
Asian Economies Overheat
Asian Currency Revaluations
Source INVESCO PERPETUAL
13
Pressure Points from Sterilization
Sterilization bonds issued Initial success
banks lend less to domestic economy
1. Negative Spread Yield on sterilization bonds
exceeds return on US Treasuries CENTRAL BANK
LOSSES
2. Delayed Bubble or Inflation Export sector
expands, wages and profits spill over to domestic
economy. OVERHEATING
3. Other Central Banks sell US Under-valuation
exacerbated. FURTHER EXPORT BOOM
Source INVESCO PERPETUAL
14
Historical Case Studies of Pressure Points from
Sterilization

• 1. Central Bank spread-losses
• e.g. Bank Negara Malaysia in 1990s.
• 2. Delayed Asset Bubble or Overheating
• e.g. East Asian economies prior to Asian
  Financial Crisis of 1997-98.
• 3. Third party sales of US
• e.g. central banks of Russia (Nov 20th 2004) and
  Korea (Feb 18th 2005) have recently announced
  reserve diversification policy.

15
1. How Bank Negara Malaysias Sterilization
Failed in the 1990s
MALAYSIA MYR/USD INTEREST RATE DIFFERENTIAL
CURRENCY
2.00
5
22/2/05
T/BILL DIFFERENTIAL
4
2.50
3
3.00
2
3.50
1
0
4.00
MYR/USD
-1
4.50
-2
5.00
-3
-4
5.50
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
06
MYR/USD T/BILL DIFFERENTIAL
MALAYSIA TO 1 US - MARKET RATE
(EP)(R.H.SCALE)
Source DATASTREAM
16
2 (a) Asian Stock Market Bubble, 1993-97
MSCI ASIA ALL COUNTRY EX-JAPAN INDEX (US)
22/2/05
450
450
400
400
350
350
300
300
250
250
200
200
150
150
100
100
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
MSCI AC ASIA EX JP U - PRICE INDEX
Source DATASTREAM
17
2 (b) Widening Asian Trade Deficits Symptom of
Overheating (until 1997)
COMBINED TRADE BALANCES OF N.ASIAN TIGERS
ASEAN, US BN
22/2/05
80
80
CHINAHKKOREATAIWAN
60
60
40
40
20
20
0
0
ASEAN
-20
-20
-40
-40
87
88
89
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
06
Source DATASTREAM
18
Current Problem US adjustment mainly against
the euro, pound, yen and commodity currencies
US/EURO RATE AND RELATIVE PRICES
1.80
1.80
1.60
1.60
US TO EURO (SYNTHETIC PRE-1999)
1.40
1.40
1.20
1.20
1.00
1.00
USPPI/GERMAN PPI
0.80
0.80
0.60
0.60
78
80
82
84
86
88
90
92
94
96
98
00
02
04
Source DATASTREAM
19
US Dollar Could Fall Further
FED'S TRADE-WEIGHTED US DOLLAR INDEX, MAIN
TRADING PARTNERS
150
150
MAR 1973100
140
140
130
130
120
120
110
110
100
100
90
90
80
80
70
70
73
75
77
79
81
83
85
87
89
91
93
95
97
99
01
03
05
Source DATASTREAM
20
Summary

• FIXED or FLOATING?
• Economies must be allowed to adjust to external
  conditions
• CONSEQUENCES OF STERILIZATION
• At best a short term solution, at worst can
  exacerbate the problems
• Governments may have learned the micro lessons of
  1997-98, but from a macro or monetary policy
  viewpoint, the same mistakes are being repeated

21
Conclusions

• Although some Asian central banks are pursuing
  more flexible exchange rate policies,
• most are experiencing overall balance of
  payments surpluses (which implies currency
  undervaluation)
• whose monetary effects are being counteracted
  with large-scale sterilization.
• How long can this continue? Only so long as (1)
  central banks do not make losses from
  sterilization operations, or (2) Asian economies
  do not become overheated (inflation rising or
  current account deficits unsustainable).