The second and more talked about event was the Thai central bank's decision to impose curbs on capital controls on December 18, a move that rocked markets across the region and finally forced the Thai monetary authority to selectively rescind some of the measures.
Some similarities between the two policy steps are obvious and somewhat superficial. For one, both were completely unanticipated and took the markets completely by surprise. They have both been described as regressive, examples of policy heavy-handedness where a lighter touch could have done just as well.
The RBI, for instance, could have mopped up surplus liquidity through market instruments such as Monetary Stabilisation Scheme bonds. The Bank of Thailand could have pared interest rates and squeezed the arbitrage gap that attracts capital.
In my reading, there is a deeper link between the two events. The challenges and imperatives before Asian central banks are slowly undergoing significant structural shift. Central banks across the region are grappling with these and finding newer ways to respond more effectively to these emerging challenges. The policy moves in both India and Thailand could just be an augury of things to come.
What is the key problem? Asian central bankers are reconciling to the fact that their markets will continue to attract large volumes of capital, given that their growth prospects look robust compared to other economies. Thus, short-term downturns notwithstanding, the fundamental tendency for their currencies would be to appreciate.
The pressure to appreciate could actually intensify as China continues to loosen its controls on the renminbi and the yen gains ground on the back of a strong Japanese economy and potential interest hikes. As these two regional "anchor" currencies float up against majors, particularly the dollar, they would tend to pull up the entire Asian pack, including the rupee.
Currency appreciation could compromise export competitiveness and monetary authorities across the region find it imperative to stymie this. The conventional tack would be to intervene in the foreign exchange market and build reserves. This is not as simple as it appears.
The flip side of a growing pile of foreign exchange reserves is an increase in domestic liquidity, i.e. more money sloshing around. This could breed inflationary pressures or drive imbalances in financial markets.
A Bureau of International Settlements paper (Mohanty and Turner, BIS, September 2006), focusing on a cross-section of markets, found a significant positive relationship between equity and housing price-inflation, and reserve growth.
Thus, a prudent central banker has to make sure that the liquidity impact of reserves is offset through sterilisation, that is by issuing bonds (like the monetary stabilisation bonds). But this comes with costs. In markets like India, Indonesia and Thailand, there is a positive "carrying cost"-the interest on these bonds is higher than the return on the portfolio of foreign reserves. Currently, given low domestic rates, the carrying cost is low in a number of markets.
However, if this is measured using historical interest rates (the decadal average for 1995-2005), the cost is close to 1 per cent of GDP for India, going by Mohanty and Turner's estimates. There is every possibility that as interest rates climb back up, the carrying cost will increase. (It is interesting to note that China's situation is fundamentally different from India's. Its yields are lower than the US', and since the dollar remains the principal reserve currency, China has a negative carrying cost.)
It follows that the higher the quantum of reserves, the larger the total carrying cost. This could have two implications. It could limit the degree of intervention in the forex market or it could induce the central bank to look for low-cost options to suck out liquidity. I see the CRR increase as an example of the latter.
Let me try and explain this. The driving factor behind the CRR hike was, in my opinion, the sudden surge in capital inflow in November and early December, which put strong upward pressure on the rupee. The RBI intervened in the market and added significantly to its stock of reserves, adding to rupee liquidity in the process.
It then faced a choice of conventional sterilisation (perhaps through a fresh issue of MSS bonds) that would add to carrying cost or the option of hiking the CRR. The latter would have a similar effect of curbing liquidity but since it does not pay interest on CRR balances, it would not add to the carrying cost.
The rationale, if you look at it carefully, was rather simple. As foreign exchange reserves balloon further, "low-cost" measures like this could become the norm rather than the exception.
The other problem that stems from large foreign exchange reserves is that of "valuation" losses. This, if the local currency appreciates against the major currencies. If the rupee, for instance, moves up against the reserve currencies, the forex reserve portfolio is worth less in rupee terms. This does not have a direct monetary impact but dents the central bank's balance sheet. If the dent is big enough, it could lead to questions about the central bank's credibility as the monetary policy authority.
If these losses were to be offset by government transfers (recapitalisation), there could be concerns about the central bank's independence. With the Thai baht appreciating by as much as 8 per cent this year against the dollar, concerns about consequent valuation losses must have been a factor in putting in place a somewhat desperate measure like capital controls instead of risking another round of "costly" sterilised intervention.
The principles of central banking in Asia are likely to change. Be prepared for surprises!
The author is chief economist, AMN Amro. The views here are personal.
