When Thailand’s introduction of capital controls sent its stockmarket plunging a few days before Christmas, you could have been forgiven for thinking, “Here we go again”. It is almost ten years since the start of the Asian financial crisis, when capital flight on a huge scale caused financial markets and economies in the region to collapse. The problem that Thailand and other Asian countries face today, however, is the exact opposite: how to stop capital flowing in.
Worldwide, an abundance of liquidity has lured investors into riskier assets in search of higher returns. Though there is no agreement on how to measure liquidity, using the global supply of dollars as a proxy, The Economist estimates that in the past four years it has risen by an annual average of 18%, probably the fastest pace ever (see chart below).
Last year it washed through emerging economies in record amounts, pushing up their currencies. Between the start of 2006 and mid-December the Thai baht rose by 16% against the dollar—more than most other currencies tracked by The Economist. When capital inflows accelerated in December, the Bank of Thailand panicked and slapped a tax on inward portfolio investment (similar to that used in Chile). After share prices fell by 15% in a day, the controls were hastily removed from equities. They remain on debt investments.
This clumsy flip-flop has severely undermined the credibility of Thailand’s economic policymakers. Yet the drastic measures highlight the seriousness of a dilemma faced elsewhere in Asia: how to curb domestic liquidity when foreign capital is flooding in. Thailand could have allowed the baht to rise further, but it had already gained against all other Asian currencies last year, raising concerns about exporters’ competitiveness.
Some economists argue that Thailand should simply have cut interest rates to stem capital inflows, making bonds less attractive to foreign investors. But this is to misunderstand the nature of the problem. David Carbon, an economist at DBS, a Singapore bank, argues that the baht’s strength is not the real issue, because Thailand’s exports have continued to grow strongly. Instead, the Bank of Thailand is more worried about excessive domestic liquidity. Lower interest rates would simply add to the problem, generating higher credit growth, inflation and asset prices. Similarly, central-bank intervention to hold the baht down by buying dollars would also boost the money supply.
Moreover, as Brad Setser of Roubini Global Economics points out, Asian central banks are having to buy dollars not just because of their current-account surpluses, but also because foreign investors are moving money into the region. If the dollar subsequently falls, the central bank may make a loss on its reserves, but the country’s exporters gain. However, though Asian countries may be happy to subsidise their exporters they are not so keen to offer the same subsidy to foreign banks, pension funds or hedge funds.
Capital controls are a way around what economists call the “impossible trinity”: an economy cannot simultaneously control domestic liquidity, manage its exchange rate and have an open capital account. Only two of the three are possible. Controls on short-term capital inflows, if (a big if) they are implemented in a well-thought-out and transparent way, can offer a viable compromise, curbing capital inflows and excessive money growth, while taking pressure off the currency.
Other Asian countries are also looking for ways to discourage foreign capital inflows. In December South Korea raised reserve requirements on foreign-currency debt to make it harder for banks to borrow from abroad. China has kept its restrictions on portfolio capital inflows, helping it to hold down its exchange rate. This, however, is squeezing the competitiveness of other Asian economies. Many economists reckon that a rise in the yuan would do little to reduce America’s trade deficit, but it would certainly help to take pressure off other Asian exporters—and assist in curbing the gush of global liquidity.
The deluge of spare cash has two main sources. First, average real interest rates in the developed world are still below their long-term average. Second, America’s huge current-account deficit and the consequent build-up of foreign-exchange reserves by countries with external surpluses has also pumped vast quantities of dollars into the financial system. A large chunk of Asia’s reserves and oil exporters’ petrodollars have been used to buy American Treasury securities, thereby reducing bond yields. In turn, low bond-market returns have encouraged bigger inflows into higher yielding emerging-market bonds, equities and property, especially in Asia. Liquidity has been further boosted by the use of derivatives, and by carry trades (borrowing in currencies with low interest rates, such as yen, to buy higher-yielding currencies).
The spread on emerging-market bond yields over American Treasury bonds fell to another record low last week. Share prices in emerging economies have risen by 243% on average from their trough in 2003. That still leaves the average price/earnings ratio below its historical average and less than that in developed countries, so for most markets it is premature to talk about bubbles. But if asset prices continue to climb at their recent pace, central bankers will become increasingly nervous.