The G-20: Asia's Central Banks Face a Policy DilemmaBy
It's called the impossible trinity, and it's an economist's way of saying "you can't have your cake and eat it too." Conceived by Nobel Prize winner Robert A. Mundell and International Monetary Fund economist Marcus Fleming in the 1960s, the hypothesis states that no country can have an open capital account (in which portfolio and direct investment moves in and out of a country freely), a fixed or closely limited exchange rate, and an independent monetary policy. It's certainly possible to pursue two of the three policies successfully. If a country's government tries all three, however, something has to give.
The impossible trinity is a fascinating concept for academics: Now it's turning into a painful reality for the central bankers and finance ministers of Asia. As interest rates and growth have sagged in the U.S., investors have poured their money into the still immature markets of Asia, placing unbearable upward pressure on currencies, driving asset prices and stocks sky-high, and stoking the fires of inflation.
With officials headed to Seoul for the meeting of the Group of 20 economies, the representatives of China, Korea, Indonesia, and other countries were expected to voice their anxiety over the challenges they face. They have already vented freely at the Federal Reserve for its plan to spend another $600 billion on asset purchases to lower U.S. rates even further.
Until recently, many Asian governments allowed free flows of capital and kept their exchange rates fixed. To keep their currencies from rising, they often printed money and bought dollars with it. In effect, they adopted the easy-money policy of the Federal Reserve. Asian policymakers now are starting to realize that they can't have it all. "One of the worst jobs in the world next year is being an Asian central banker," said Robert Subbaraman, Nomura Holdings' (NMR) chief economist for Asia excluding Japan. "This 'impossible trinity' dilemma is starting to bite. They are facing capital inflows that potentially can be very destabilizing."
Asia has attracted $2.3 billion of capital daily since April 2009, according to DBS Group Holdings. Stock markets in India, Indonesia, Malaysia, and the Philippines have reached record levels. The MSCI Emerging Market Asia Index of stocks has advanced more than 17 percent this year, compared with 9 percent for the Standard & Poor's 500-stock index. All of the region's major currencies, except the greenback-pegged Hong Kong dollar, have strengthened, even as policymakers across the region seek to stem the gains to keep exports flowing.
In India, where the central bank has raised interest rates six times this year, officials acknowledge the dilemma: If they jack up rates to smother inflation, they also lure foreign money in search of double-digit returns. The outside money in turn inflates prices in real estate and stocks—which forces the central bank to push up rates even more. "At the national level, we have to manage the impossible trinity," Reserve Bank of India Governor Duvvuri Subbarao said on Oct. 27 in Mumbai. "Managing exchange rates in the face of volatile inflows entails a cost no matter what you do."
Interest Rate Pause
To avoid another flood of foreign capital, the central banks of Malaysia, Thailand, and Korea have paused in raising interest rates. The central banks of Indonesia and the Philippines haven't lifted rates. Yet central banks may fall "behind the curve" should they keep borrowing costs low, even as inflationary pressures increase, says Chetan Ahya, an economist at Morgan Stanley (MS) in Singapore. China held steady on rates until October. Now the government may miss its goal of keeping inflation to 3 percent this year, Zhang Ping, head of the National Development and Reform Commission, said in early November.
Capital controls may be the only answer for some governments. To make outside investors pause, Thailand last month removed a 15 percent tax exemption for foreigners on income from domestic bonds. On Oct. 29, Thai central bank Governor Prasarn Trairatvorakul said he wouldn't rule out controls if the baht's appreciation accelerates.
In South Korea, where a bank tax and a levy on financial transactions are under consideration, central bank Governor Kim Choong Soo has said capital controls may be "useful." The Indonesia central bank said it may extend a holding period for foreign purchases of central bank notes to three months from one. "We are going to see more capital controls," says Robert Prior-Wandesforde, head of India and Southeast Asia economics at Credit Suisse (CS) in Singapore. "QE2 [Bernanke's policy of bond purchases] will just accentuate it." Above all, Asia does not want its economy affected by decisions made in Washington, says Nomura's Subbaraman. "We need to set economic policy based on our own cycle."
The bottom line: Asian central banks realize they cannot have free capital flows, controlled currencies, and low rates at the same time.