Thanks, Asia, for your prudent policies edit

June 25, 2007

Economists tend to say that markets have short memories, in an attempt to explain why, seemingly, markets do not apply large enough discounts to some asset prices even after episodes of turmoil. However, economists typically ignore the fact that they also seem to have short memories and that, often, simplification prevails over careful analysis. A clear example is the ongoing commentary bashing Asian countries for a variety of assorted reasons: adopting mercantilist policies, having learnt the wrong lessons from the 1997 crisis, risking heavy capital losses from their exchange rate reserves, managing their currencies, self-inflicting standard of living costs, etc. While this commentary is largely the result of the fashionable discussion on the global imbalance, and while this is a very convenient way of providing arguments for politicians so that they can tackle, in a partial, biased and inefficient way, the problem of rising income inequality in the Western world, the truth of the matter is that few people seems to remember the conclusions of the post-crisis analysis back in 1997-98 and the policy implications of such conclusions. Ten years later, the Asian crisis feels like a very old event and memories seem to be blurring.

A recent speech by David Burton, head of the IMF’s Asia & Pacific Department , summarizes nicely the causes of the crisis: financial and corporate weaknesses, pegged exchange rates that encouraged excessive foreign exchange borrowing, inadequate reserve levels, and lack of transparency, mostly about the true levels of usable reserves. Thus, Asian countries duly corrected these shortcomings, and proceeded to improve their supervision, regulation and governance frameworks, float their exchange rates, and increase their levels of reserves. It sounds as if Asian countries just did what was expected from them. But implicit in the list of causes of the crisis there is another issue that was hotly debated at the time and that seems to have been forgotten: at the heart of the problems was the wrong sequencing of capital account liberalization. It is useful to remember that, at the time, the international community was discussing whether capital account liberalization should be added to the IMF’s Articles of Agreement, and full liberalization was the doctrine that was being preached from Washington. But many countries opened up the capital account in the wrong order, liberalizing portfolio and short term banking flows but retaining restrictions in FDI, thus fostering short term speculative flows that could easily be reversed. After 1997, the enthusiasm with full liberalization was replaced by the emphasis on proper sequencing as the key to a successful policy framework, and foreign exchange intervention and capital controls in some circumstances has entered the menu of acceptable policies. Why am I focusing on this? Because proper sequencing of any major policy change is the key to success - and the main policy change that Asian countries had to adopt after 1997 was to change their nominal anchor. They could no longer rely on fixed exchange rates, and they had to shift towards inflation targeting regimes. And, given their lack of ex ante credibility, they decided to implement this change with the proper sequencing: let currencies float, but build an insurance mechanism in the form of abundant reserves that prevents destabilizing runs on the currency while the new policy framework gains credibility. Asian countries decided to never again return to the IMF and to never again be at the mercy of financial markets and, with this in mind, they implemented a sequencing of their policy change that was perfectly logical, especially because the international financial architecture, mostly the IMF, did not provide this type of insurance mechanism. It has been therefore a slow, gradual and prudent policy change that is yielding considerable benefits. In fact, this sequencing of policy changes that includes an embedded insurance is not a novelty. Think of a similar policy experiment: a central bank is created ex-novo for a new currency area and, to buttress its credibility, takes at the beginning an extra anti-inflationary insurance by creating a strong and prominent monetary pillar. Yes, this is the case of the ECB, who built an insurance mechanism, the monetary pillar, as a sequencing strategy. In a similar fashion to the current Asian bashing, the ECB was duly critizised by the punditry for adopting its monetary pillar. And, in parallel to the success of the Asian policies, the ECB’s policy framework has been a success, their prudent approach has firmly anchored inflation expectations, and the insurance mechanism is slowly losing prominence . Today, Asian countries are finally graduating from their sequencing experiment. Their inflation targeting regimes have established credibility, their high levels of reserves have protected them from turbulence in foreign exchange markets – in fact, it is remarkable that, despite the many episodes of turmoil in the last few years (GM and Ford downgrades and subprime fears in the US, political turmoil in the Middle East, etc) Asian currencies have remained very stable - and regional integration and policy coordination has advanced rapidly. At this point Asian countries feel confident that their policy frameworks are mature enough to support their floating exchange regimes, thus their creation of Sovereign Wealth Funds to invest some of their excess reserves while their currencies appreciate further as needed. In fact, the assertion that Asian countries have adopted a quasi-fixed exchange rate policy is just refuted by the data: since 2001, a basket of Asian currencies has appreciated close to 25 percent against the US dollar and close to 40 percent against the Japanese Yen – an evolution very similar to that of the euro. Ten years after the Asian crisis the region has built a credible policy framework and can start adopting less defensive policies. Their sequencing has been successful. Asia needed a nominal anchor, and it has built one through a combination of credible inflation targeting, a robust exchange rate system and a strong network of regional arrangements. This is positive for the region and the world, is allowing a gradual rebalancing of global growth, and has only a very marginal impact on the key issue facing the global economy, namely the rapid widening of income disparities. This is related to longer term factors involving mostly taxation changes, inadequate labor market policies and asset market trends, and should be addressed accordingly with national policies. The same applies to the so-called global imbalance, which is the result of a complex mix of factors involving not only Asian reserves but also oil-related savings, corporate sector frugality and house price inflation, and that it is slowly being resolved as long term interest rates increase. There is further work to do in Asia, to be sure but, in the meantime, let’s allow Asian countries to continue, slowly, with their businesses.