Monetary Policy Issues

Some countries in Asia came into the onset of the global financial crisis in the fall of 2009 with substantially tight monetary policies. The United States' (US) subprime crisis had little impact on these economies, whose pressing concerns instead were about the inflationary consequence of overheating and rising commodity prices. In contrast, other countries, notably Japan, were already pursuing easy monetary policies, with extremely low policy interest rates. From about September 2008, however, almost all economies in the region began to ease substantially monetary policies. Those economies with considerable space for easing aggressively reduced their policy interest rates in several steps over the subsequent months. Those with little space did what they could to further ease monetary conditions, including pushing the level of interest rates to virtually zero. As a result, market interest rates in Asia converged to extremely low levels in the early months of 2009, except in a few economies (Figure 2 [ PDF 263.2KB | 1 page ]).

Some economies not only cut interest rates but also expanded the flow of credit to the private sector. For example, the PRC, after reducing interest rates and reserve requirements in the latter part of 2008, removed limits on credit growth, which led to an extraordinary expansion of bank lending in the first quarter of 2009. Exchange rate policy was another tool of monetary easing in some economies. In the second half of 2008, the PRC abruptly halted the policy of allowing the yuan to appreciate gradually against the US dollar. In October 2008, the Monetary Authority of Singapore shifted to a 0% appreciation of the nominal exchange rate in a reversal of a policy of gradual appreciation it had followed since April 2004. Furthermore, in April 2009, Singapore, while keeping its zero appreciation policy, re-centered its policy band to the prevailing level of the nominal exchange rate (which represented an effective depreciation of the currency).

For the most part, monetary policy appears to have worked reasonably well for countries with sufficient policy space. With the level of interest rates sufficiently high at the onset of the crisis, the conventional monetary policy transmission channel was largely intact, allowing a substantial reduction in market interest rates. This may explain the relatively quick economic recovery in such countries as Australia, Korea, and New Zealand. On the other hand, in the countries where the level of interest rates was already low (or virtually zero in some cases) to begin with, the interest rate transmission mechanism was impaired by the zero lower bound (i.e., the constraint that a nominal interest rate cannot fall below zero), requiring the use of “unconventional” monetary policies that involved, instead of interest rate easing, an expansion of central bank liabilities or a change in the composition of their assets. Even in countries where the level of interest rates was sufficiently high, some use was also made of unconventional policies when, in an extraordinary environment of global de-leveraging, rising risk premiums loosened the relationship between policy rates and long-term lending rates. In fact, some type of unconventional policy was used to one extent or another by many central banks in the region, including Australia; India; Japan; Korea; Singapore; and Taipei,China.From the earlier experience of Japan with zero interest rate policy and quantitative easing, as well as the US' recent experience since the onset of the subprime crisis, evidence on the effectiveness of unconventional policies has been mixed (Morgan 2009). More recent experience, however, seems to suggest that central bank purchases of financial assets in certain market segments appear to have some effectiveness. For example, the announcements by the US Federal Reserve Board and the Bank of England to purchase government bonds outright led to a sharp drop in long-term government bond yields and exchange rates; the Federal Reserve's term securities lending facility also reduced the repo financing spreads between Treasury and non- Treasury collateral (Bank for International Settlements 2009). Within the region, Korea's currency swap arrangement with the US Federal Reserve appeared to stabilize the market for shortterm dollar liquidity.

Even though the type of unconventional policies used in Asia was modest compared to those used in the US or the United Kingdom, they nonetheless represent a more active participation of the public sector in the allocation of credit, which during normal times is best left to the market. Sooner or later, therefore, an exit policy must be considered. The need to exit is also important from the point of view of securing sufficient policy space during good times, and to preempt the recurrence of inflationary pressure. The current experience has shown that those economies that came into the crisis with a sufficiently high level of interest rates were able to use monetary policy more effectively. The economies with extremely low interest rates must therefore resist the natural tendency toward the asymmetric use of monetary policy (i.e., interest rate action tends to be more decisive during downturns than during upturns) by raising interest rates decisively when recovery takes hold.

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