Policy Analysis

Table 8 [ PDF 15.8KB | 1 page ] summarizes where Asia stands with regard to exchange rate regime choice and capital account openness. Two aspects are particularly important to our analysis: the distinction between de jure and de facto capital account restrictions, and the extent to which monetary policy autonomy is ceded.

4.1 Asia and the impossible trinity

The ‘impossible trinity' asserts that a country can only have two of three things: exchange rate flexibility, capital account openness, and monetary policy autonomy. In the extreme, a country with a completely open capital account and a completely fixed exchange rate must give up monetary policy autonomy.⁴ In the typical Asian setting, increasing de facto openness has come about through de jure liberalization coupled with domestic financial sector development, and the evasion of capital controls that become possible with a large current account. Under these conditions, exchange rate inflexibility can lead to distortions in monetary policy. Even though a country might try to regain monetary policy autonomy through financial repression, imposition of capital controls, or sterilization, the logic of the impossible trinity suggests that exchange rate pegging comes at the cost of autonomy in monetary policy.

In an emerging market setting, the procyclicality of capital flows is particularly important. When times are good and business cycle conditions are buoyant, capital tends to move into the country. To prevent exchange rate appreciation, the central bank will buy dollars, a move which while ultimately lower domestic interest rates. Conversely, when the economy is in a downturn, capital tends to leave the country. The central bank combats this by selling dollars, which in turn raises domestic interest rates. Procyclical capital flows therefore interact with exchange rate pegging to induce procyclical monetary policy. This is the sense in which monetary policy is distorted in an emerging market setting.

Asia-11's response to the impossible trinity has been diverse; economies such as Singapore and Hong Kong, China have opted for high capital account openness and low or no exchange rate flexibility, while economies like India and PRC has opted for low capital account openness and inflexible exchange rates. Between 2000–2008, Asia-11 economies have moved towards greater de facto capital account openness, with the exception of Malaysia, the Philippines, and Indonesia. Meanwhile, exchange rate flexibility remained unchanged in most economies, except in Indonesia where it decreased, and Malaysia, India, and PRC, where it increased.

In the impossible trinity framework, a country could have a fixed exchange rate and give up independent monetary policy. An open capital account with a fixed exchange rate leads to the loss of monetary policy autonomy, as has been experienced in Hong Kong, China. The currency board of Hong Kong, China is a consistent monetary policy framework, with domestic interest rates fluctuating as a result of the exchange rate peg.

A floating exchange rate with an open capital account is also consistent with the impossible trinity framework. Economies with floating exchange rates turn out to have an R² in the exchange rate regression of 0.4 to 0.5. These economies are able to achieve open capital accounts and monetary policy autonomy. The Asian country which is closest to this configuration is Korea; India, meanwhile, has made the biggest strides towards adopting the same configuration.

The interesting questions involve those economies with low capital account openness and inflexible exchange rates. If a country had an inflexible exchange rate and a de facto closed capital account—with gross flows on the BOP of well below 40% of GDP—then it could obtain monetary policy autonomy. For instance, in the late 1980s, India was able to have monetary policy autonomy since exchange rate inflexibility was combined with gross flows to GDP of roughly 25%. None of the Asia-11 economies occupied that region of the graph in 2000 and 2008.

The country that was closest to this configuration in 2008 was PRC, which has been striving for very little exchange rate flexibility coupled with considerable capital account openness. This prompts us to ask: Has PRC been able to preserve monetary policy autonomy?

Many authors have examined Chinese monetary policy with a focus on issues such as the mechanisms for sterilization, the measurement of sterilization coefficients, and the interplay between sterilization and the banking system. However, these issues are not directly essential to analyzing the procyclicality of monetary policy. In our analysis, therefore, we treat these issues as intermediate factors that influence the outcome of monetary policy: the domestic short-term interest rate. We re-expressed the short-term interest rate in PRC in real terms, and juxtaposed it against business cycle conditions. This allowed us to assess the extent to which interest rates were high in a business cycle expansion and vice versa, and examine whether monetary policy was counter-cyclical.

Figure 8 [ PDF 16.6KB | 1 page ] examines the extent to which monetary policy in PRC became procyclical in the recent business cycle expansion. The graph—which uses quarterly GDP growth to measure business cycle conditions—reflects an enormous boom from 2002–2007. Juxtaposing this against the 90-day treasury bill rate (expressed in real terms), we see that from 2002 until early 2008, the real interest rate dropped by an enormous 800 basis points. This suggests that monetary policy was expansionary during periods of growth. This is consistent with the idea that exchange rate pegging converts procyclical capital flows into procyclical monetary policy. The use of loose monetary policy during an unprecedented business cycle expansion helped induce an acceleration in inflation and an asset price boom.

The 800-basis point decline in the real interest rate during an unprecedented business cycle expansion suggests that PRC was unable to avoid the impossible trinity, through sterilized intervention or other techniques based on either capital controls or financial repression. While a wide variety of these measures were attempted, they failed to prevent the outcome: the only way to obtain the pegged exchange rate was to have a very low interest rate in real terms.

A similar analysis was conducted for India, with similar results. Even though India had more exchange rate flexibility than PRC, monetary policy was ultimately forced to yield negative real rates in the expansion and switch around to positive real rates in the downturn.⁵ In Asia, PRC and India are in the best position to preserve monetary policy autonomy despite having exchange rate inflexibility, given relatively modest values of de facto openness and an underdeveloped domestic financial system. However, the evidence suggests that even in these two economies, exchange rate pegging resulted in procyclical monetary policy.

The constraints of the impossible trinity are likely to be even more acute in Malaysia, Taipei,China, and Thailand, which have more de facto openness and better developed financial systems than PRC and India, but also less exchange rate flexibility than India.

Among the Asia-11 economies, Korea has made the most progress towards the mainstream configuration of industrial economies. Korea has high capital account openness, and the most flexible exchange rate in Asia. It has also made considerable progress in establishing the institutional capability of its central bank. However, the Korean exchange rate regime, with an R² of 0.65, lags the flexibility seen with floating rates, where the R² attains values of 0.4 to 0.5.

Financial sector development and de facto openness in the Philippines and Indonesia are low. In principle, these economies could have chosen exchange rate pegging with monetary policy autonomy. Among the Asia-11 economies, these are the two economies where the monetary policy distortions associated with exchange rate inflexibility would be the lowest. Despite this, these economies have chosen to have considerable exchange rate flexibility.

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