Capital flows, exchange rates and policy frameworks in emerging Asia
The BIS set up a Working Group on “Capital flows, exchange rates and policy frameworks in emerging Asia” under the direction of its Asian Consultative Council (ACC) to focus on the joint use of monetary, macroprudential, exchange rate and capital flow management policies to deal with capital flows and exchange rate volatility. This report is based on responses to two surveys of ACC members. The Working Group members view ample global liquidity as the most important driver of capital flows, followed by the higher growth prospects of the recipient countries and, for some economies, capital account liberalisation. In general, exchange rates are considered important because of what they imply for monetary and financial stability, rather than because they are a target in their own right.
The members agree that the effects of the exchange rate can be summarised into three channels: trade competitiveness, pass-through to inflation, and financial channels. The trade channel and the inflation pass-through channel have become less important over time, while the financial channel has increased in importance. Moreover, the importance of the different channels is state-dependent: during normal times, no single channel is dominant across members, while the financial channel is dominant during volatile times. The overall effect is that currency depreciation is expansionary during normal times, but it is contractionary during volatile times for most members. In approximate order of importance, the largest sources of spillovers to domestic financial conditions are the monetary policy decisions of major economies, global investors’ risk appetite and the strength of the US dollar.
The member central banks’ modelling efforts, as they relate to capital flows and exchange rates, divide into two broad camps: large-scale, theory-based models used to model the macroeconomy and produce forecasts of main macro variables; and smaller-scale models with less theory behind them (eg vector autoregressions, composite indices and stress-testing exercises) used to assess financial stability risks. One reason behind this distinction is that theory-based models do not generally account for the possibility of the relationships between macroeconomic variables changing when there are threats to financial stability. Relatedly, theory-based models generally exclude the effects of policy tools other than interest rates.
Determining the appropriate policy response to exchange rates and capital flows generally relies on the careful monitoring of FX liquidity, including the speed of exchange rate change, and the effects of capital flows on asset prices, with a view to ensuring orderly market functioning. Many Working Group members report that they allow exchange rates to be flexible and market-determined during normal times, but all stand ready to intervene in FX markets in response to excessive FX volatility to maintain external stability. In addition, some are prepared to utilise capital flow management measures when intervention is insufficient. Meanwhile, reliance on macroprudential measures to target specific domestic financial stability objectives has generally increased over time.
A majority of Working Group member central banks come close to the Tinbergen principle of one instrument for one objective. At the same time, in practice, some tools can affect multiple objectives. Moreover, employing a combination of tools in a complementary manner can strengthen the effectiveness of policies, and also help to mitigate some of the unwanted side effects of policies.
The Covid-19 pandemic has served as a stress test of current policy frameworks. Central banks from the region used the full range of conventional policy tools in response to the crisis, and also expanded their toolbox, to ensure sufficient liquidity, both in their own currency and in US dollars, as well as bought assets, provided lending to key sectors and relaxed regulatory requirements, all in an attempt to prevent negative feedback loops between the real and financial sectors. Cooperation with the government has been a key element of the policy response. The member central banks generally view their responses as having delivered a positive impact on external and financial stability in the near term, but such unprecedented measures are also seen as set to have a significant impact on their economies for some time to come.
Financial channels are weaker overall for the three Working Group observers than for the members. Therefore, the implications of exchange rates and capital flows for financial stability are less of a concern.