Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]

Module: 3 Monetary Policy In An Open Economy

Globalisation and Monetary Policy

Impact of External Borrowings on Capital Flows

Empirical evidence suggests that reserve requirements may be effective in the short-run in reducing the volume of total capital inflows and may also help to lengthen the maturity composition of capital flows. The effectiveness may, however, get offset if higher reserve requirements induce more external borrowing as banks pass on the burden to their clients in the form of higher loan rates.

In order to moderate capital inflows, countries have also resorted to imposing or tightening prudential limits on banks' offshore borrowings and foreign exchange transactions (e.g. India, Indonesia, Malaysia and the Philippines). The Bank of Slovenia used reserve requirements specific to foreigners' deposits, introducing in 1994 a 40 per cent non-interest bearing reserve requirement on some foreign loans with a maturity of less than five years. In 1996, this was extended to cover maturities of up to seven years. In 1992, Mexico limited foreign currency liabilities of commercial banks to 10 per cent of their total loan portfolio. In January 1994, Malaysia imposed limits on non-trade related swap transactions on commercial banks. Taiwan put a ceiling on foreign holdings of domestic shares in 1994 and Malaysia limited foreigners' holdings of domestic bank deposits unless they were related to trade or physical investment. Malaysia also prohibited residents from selling short-term money market instruments to foreigners Annex IV.1.

In the current episode of surge in capital inflows, Thailand announced measures to restrict short-term external capital inflows. Effective September 2003, financial institutions were allowed to borrow Baht from non-residents or engage in similar transactions without underlying trade or investment for amounts not exceeding 50 million Baht per entity only for contracts over 3 months. Recently, China allowed foreign institutional investors with at least $10 billion in assets to buy yuan-denominated stocks and bonds with a lock-in period of three years.

As regards the efficacy of capital controls and other prudential measures, empirical evidence suggests that these are unable to reduce the volume of capital flows. The expected effect vanishes over time as market participants find ways to evade the controls. Alternatively, the effectiveness would require progressive widening of the scope of the controls with long-run costs which may outweigh the short-run benefits. Prudential measures are, however, able to alter the composition of capital inflows towards more durable components such as foreign direct investment. Capital controls, therefore, restrict volatile components of capital flows and lengthen the maturity of capital inflows. To that extent, by tilting the composition, controls could be useful as a step to reduce future vulnerability. But, since these do not reduce the overall volume of capital inflows, controls do not provide a higher degree of monetary independence.

Shifting of public sector and government deposits from the commercial banks to the central bank and foreign exchange swaps also provide avenues for absorption of liquidity. Foreign exchange swaps - sale of foreign exchange by the central bank against domestic currency and a simultaneous agreement to buy the same amount at a certain date in the future at the forward exchange rate - however, involve QFCs since such swaps might have to be done at a margin favourable to commercial banks. A few central banks have used standing deposit facilities (overnight/term) to absorb liquidity from the financial system.

If capital flows persist, the monetary policy instruments would need to be supplemented by other durable macroeconomic policies such as fiscal adjustment, liberalisation of trade policies and capital outflows, and finally, a greater degree of flexibility in the exchange rate. As regards liberalisation of capital outflows, Chile allowed pension funds to invest some of their assets abroad and liberalised investment outflows for selected private companies. Countries such as Taiwan and China have utilised forex assets for foreign direct investment abroad. Taiwan has allowed insurance companies to invest in foreign securities and domestic securities investment and trust companies to raise funds from the domestic market and invest in foreign securities under an aggregate ceiling. China has allowed domestic firms to retain forex earnings rather than surrender to the central bank. Several international financial institutions (IFIs) were allowed to issue local currency bonds in Taiwan and to use swap derivatives for remitting the funds abroad. During 2003, Thailand (i) permitted institutional investors to invest in overseas securities; (ii) encouraged mutual funds to invest on behalf of local residents in the Asian bonds issued by sovereign and quasi-sovereign entities; and (iii) increased the holding period of foreign currency deposits from 3 to 6 months. Efficacy of these measures, however, may be limited as such measures make the host country a more attractive place to invest and therefore, may induce greater inflows.

Fiscal policy can also be employed to reduce interest-sensitive capital inflows. A tightening of fiscal policy would reduce aggregate demand. This would, therefore, enable a reduction in domestic interest rates and thus help to reduce interest-sensitive component of capital inflows (Begg, 2001). Fiscal restraint as a policy response, however, is constrained by inflexibility of fiscal policy and is, therefore, relatively infrequently used. Within emerging economies, fiscal tightening as a deliberate attempt to manage capital flows during the 1990s was more evident in the East Asian economies vis-à-vis Latin America. More recently, Thailand has exhibited substantial fiscal correction.

As regards exchange rate response, cross-country experience shows that almost all countries allowed greater variability of the nominal exchange rate in the face of sustained capital inflows. In contrast to fiscal policy response, nominal exchange rate appreciation has been more common and larger in Latin America than in East Asia. Use of exchange rate as an instrument of sterilisation also has pitfalls. If nominal appreciation continues for a while, the resultant real appreciation could pose risk to external competitiveness.

The broad conclusions drawn from the foregoing analysis can be summed up thus. Countries faced with large capital inflows have attempted initially to sterilise while allowing some impact on monetary growth. Sterilisation is market based, but it is costly. It is useful if flows are short-term in nature. The danger is, however, that sterilisation may increase interest rates and this may continue to attract more capital. On the other hand, capital controls work against the market, but may be effective in smoothing volatility of inflows. If inflows persist, additional measures may have to be attempted, including a liberalisation of outflow controls, an adjustment or progressive increase in the flexibility of the exchange rate and a further strengthening of the prudential framework for the financial system.

In sum, increased global integration implies that a national monetary policy that diverges from the consensus of policies pursued elsewhere elicits rapid capital flows and sharp exchange rate movements. Increasingly, it is recognised that monetary policy cannot alter the movement of capital flows; it can only hope to fashion a credible response to its effects. In this, 'central banks must inoculate themselves against whimsy and keep their eyes on the fundamentals'. Openness and, in particular, capital flows erode the control of the monetary authority over its monopoly - the monetary base - and reduces the credibility of money supply as an intermediate guideline for policy.

Thus, even though monetary policy is conducted exclusively for domestic goals, the international linkages have to be taken into account for policy formulation. More than ever before, the choice of monetary arrangements depends on the choices that other countries make. The structural changes associated with globalisation have led to a higher degree of uncertainty in the environment facing the monetary policy. Such changes have, for instance, loosened the association between output growth and inflation, thereby raising question marks on the existing well-tested economic relationships. The uncertainty in regard to the current state of the economy (availability and interpretation of macroeconomic data/indicators) as well as the structure (the monetary transmission mechanism) is heightened vis-a-vis a closed economy framework. In an environment of such a heightened uncertainty, it is suggested that monetary policy response should be based on bounded discretion with no activism, smoothness, judgement, flexibility, pre-commitment, time consistency, transparency, and accountability.

The experience with capital flows has important lessons for the choice of the exchange rate regime. The advocacy for corner solutions - a fixed peg a la the currency board without monetary policy independence or a freely floating exchange rate retaining discretionary conduct of monetary policy - is distinctly on the decline. The weight of experience seems to be tilting in favour of intermediate regimes with country-specific features, without targets for the level of the exchange rate, the conduct of exchange market interventions to ensure orderly rate movements, and a combination of interest rates and exchange rate interventions to fight extreme market turbulence. In general, emerging market economies have accumulated massive foreign exchange reserves as a circuit-breaker for situations where unidirectional expectations become self-fulfilling. It is a combination of these strategies which will guide monetary authorities through the impossible trinity of a fixed exchange rate, open capital account and an independent monetary policy.