CENTRAL BANKERS PERSPECTIVES
In the early 1980s Swiss economist Karl Brunner spoke about the “peculiar mystique” surrounding central banks. He said the mystique thrived on a pervasive impression that central banking was an esoteric art that was revealed by an inherent impossibility to articulate its insights in “explicit and intelligible words and sentences.” Twenty years ago most central banks would probably have agreed with Brunner’s sentiments. After all, at that time the monetary policy decision-making process was not as transparent as it is today.
Over the past few months, turmoil in the global credit markets has highlighted the need for central banks to respond openly and unambiguously in order to avoid widespread confusion and uncertainty in the marketplace. “The actions of central banks in major economies helped calm the market,” says Amando Tetangco Jr., governor of the Philippine central bank, Bangko Sentral ng Pilipinas (BSP), referring to the recent actions by central banks. It is a role central banks are used to performing.
Twenty years ago the markets were having to deal with a crisis of a different kind. Following a bull run on the stock markets, which commenced in the early 1980s with hostile takeover bids and leveraged buyouts, “Black Monday” descended in 1987. Five hundred billion dollars was wiped off the Dow Jones index in one day, precipitating a knock-on effect globally. Having tightened monetary policy earlier to control inflationary pressures, the US Federal Reserve lowered short-term interest rates to prevent the onset of a recession. Confidence was restored, and the stock market rebounded. Events in the past 20 years have highlighted the calming and strengthening influence central banks can have on financial markets, and this influence has become increasingly important in view of the increasing levels of integration in global financial markets.
A Mixed Blessing
Asian central banks know only too well the impact that sudden reversals in global capital flows can have on domestic financial markets. As more and more capital poured into Asia’s Tiger economies in the 1990s, it resulted in speculative bubbles, which increased volatility in domestic FX and capital markets. This was the trigger for the 1997-1998 Asian economic crisis, which in the intervening years has shaped monetary policy in the region.
“Central banks have learned quite a few lessons from our experiences in 1997 and 1998,” says Zeti. The actions of the central bankers of Taiwan and the Philippines bear that out. Following the crisis, in an effort to limit contagion, the Central Bank of the Republic of China (CBC) defended its currency by cutting off channels for speculators to build up foreign currency positions. It also implemented monetary policy measures to successfully stabilize domestic financial markets. Meanwhile, Tetangco says the gradual de-regulation of capital flows since the 1997 crisis has also helped reduce the wider pressures on respective currencies in the short term, as well as allowing for more efficient capital flows in the long run.
“These liberalization efforts helped expand the scale and scope of the foreign exchange market and also enhanced market efficiency,” says Perng. In order to boost market depth and liquidity, central banks also opened up local capital markets to foreign investment. In Taiwan, the CBC lifted restrictions on foreign investment in domestic securities, and it also facilitated the development of the FX derivatives market. “Against the background of increased exchange rate volatility, foreign exchange derivatives began to be used for hedging and enhancing market liquidity,” says Perng.
In Malaysia, the central bank focused on developing the local bond market, which is now one of the largest in Southeast Asia. “This helped diversify the financial system and enabled it to absorb inflows and outflows. There was no concentration in the impact on any particular segment of the financial system,” explains Zeti.
Banks Working Together
The years following 1997 also saw increasing levels of cooperation between central banks, particularly in Asia. Through the Chiang Mai initiative in 2000, central banks in the ASEAN+3 cooperated on monitoring capital flows and regional surveillance and established a network of bilateral swap agreements between ASEAN countries and China, Japan and Korea. There was also the Asian bond market initiative, which sought to develop more liquid regional debt markets, and even today there is talk of the need for a “regional exchange rate stability mechanism” to protect Asian currencies from worsening global imbalances.
Central banks also spearheaded far-reaching reforms to enhance risk management, transparency and corporate governance in the financial services sector, a trend that continues to this day. “We increased the capacity of the financial system to absorb sudden shifts in capital flows by strengthening financial intermediaries, enhancing governance and risk management practices and improving liquidity in the financial markets,” says Zeti. Bank Negara Malaysia announced an aggressive roadmap for the development of the financial services sector, which sought to achieve a more diversified financial system. Through increased competition and participation by international players it has enhanced the banks’ asset quality.
In an effort to speed up the writing off of bad debts, the CBC in Taiwan lowered required reserve ratios and raised the remunerative rate on banks’ reserve accounts. This combined, with other measures, saw NPL ratios in the country’s banking sector decline from a peak of 11.8% in 2002 to 2.24% five years later.
Since 1997, central banks have also sought greater flexibility in money market and interest rate frameworks so they can more readily respond to massive capital inflows. This coincided with a general shift from fixed to floating exchange rates. “A more flexible exchange rate regime allows us to respond to structural changes in the regional and international environment. At the same time, it also allows us to deal with potential periods of disequilibrium in the market and create an orderly and efficient FX market,” Zeti explains.
On balance, for a country with an open capital account, a floating exchange rate system is the best possible choice, says Stanley Fischer, governor of the Bank of Israel. But the best possible choice still has its problems. “With a flexible exchange rate system you may get contagion effects on the exchange rate, but you also get a more robust financial system, with the exchange rate serving as an extra shock absorber,” he explains.
Markets are also in a better position to ride out a crisis thanks to the stockpiling of FX reserves by central banks. In Asia alone, it is estimated that foreign reserves excluding gold have risen from approximately $680 billion at the end of 1997 to almost $3.4 trillion in 2007. “The FX reserves built up over the years have put Taiwan in a better position to weather potential currency crises,” says Perng. However, prolonged reserve accumulation can result in possible asset price inflation and higher interest rates, says Tetangco.
By issuing central bank bills, Bank Negara Malaysia conducts “sterilization operations” in the market to counteract any negative impact on domestic markets from so much liquidity swilling around in the system. “Open market operations withdraw liquidity from the financial system so that we can maintain stable interest rates,” says Zeti.
Maintaining the Balance
Central banks need to maintain a delicate balance between the provision of adequate liquidity and—the raison d’être of most central banks’ monetary policy in the 21st century—keeping inflation flow and interest rates at levels that encourage economic growth and price stability. In order to achieve this, some central banks have moved from monetary policy tied to an exchange rate anchor to an inflation-targeting regime, which aims to keep core or headline inflation within a target range.
With inflation reaching 9.3% in 1998, BSP introduced inflation targeting in 2002. The actual inflation rate for January to October 2007 is below the lower end of its 4% to 5% target range. “Inflation targeting has provided the central bank with a more transparent, information-intensive and forward-looking approach in which monetary policy decisions are based on the assessment of the future evolution of inflation and inflation expectations,” Tetangco explains.
But not all central banks are proponents of inflation targeting. CBC in Taiwan uses monetary targeting with M2 (money supply) as the intermediate target, which it says has helped keep inflation in check. Bank Negara Malaysia believes that inflationary expectations can be anchored based on its track record of low inflation and broader transparency concerning the monetary policy decision-making process. By being more open and transparent with regard to the future direction of monetary policy, central banks believe they can better manage market and household expectations, thereby reducing uncertainty, particularly in times of market unrest.
In the past decade central banks have also sought to establish their independence from political pressure to support deficits. It was only 10 years ago that the Bank of England was granted independence, which meant interest rate decisions were no longer made by Treasury but by an independent monetary policy committee. The Bank of Israel is looking to institute similar measures, and Fischer believes the Bank of England’s independence was “well justified” by the quality of the bank’s monetary policy and the performance of the UK economy.
The Benefits of Independence
Recent events in the global credit markets have also highlighted the importance of an independent central bank in its capacity as “lender of last resort.” Although the Bank of England came under political pressure for not intervening soon enough in the Northern Rock affair, Fischer believes central banks acquitted themselves fairly well, although he says Northern Rock illustrated the costs of not having an appropriate legal framework in place for dealing with a bank in difficulties, as well as the need for greater levels of communication between financial regulators and central banks.
Although the trend is to move the financial supervisory function outside the central bank, based on her experiences during the 1997 Asian financial crisis Zeti believes the function should reside within the same institution. “The central bank is involved in the money and FX markets as part of its responsibility to manage reserves,” she says. “Therefore it understands market developments. This is integral in making an overall assessment of financial stability and performing its role as lender of last resort. Having this information at your disposal means central banks can make decisions in a prompt and decisive manner.”
While recent actions taken by central banks helped maintain “orderly financial markets,” Tetangco of BSP says it also contributed to rapid liquidity growth. “Central banks did the right thing in injecting liquidity into the market,” he explains, “but there was already a high level of liquidity in the global financial system.” He says this presents its own set of challenges for central banks. “It can generate inflationary pressures, and this excess liquidity needs to be mopped up by central banks or used in the economy for productive activities such as infrastructure improvement and financing of micro, small and medium enterprises.”
In the coming months, Tetangco says, central banks may need to tighten monetary policy, but the magnitude of the tightening will need to be managed carefully in order to avoid a recession. Perhaps, more than ever before, the world’s central banks will be the key to restoring calm and order to the financial system.