Timely insights for central banking, by central bankers

This is a timely book that should be essential reading for all those with a serious interest in financial markets and economic policymaking in the Asian region. This is all the more so because books that pull together rigorously researched ideas on central bank policymaking and apply those insights to the Asian context are few and far between.

The book is important because central bank policies have played a major role in the series of crises and shocks that have ravaged Asia in the past quarter of a century. The Asian financial crisis that started in 1997 was partly caused by poorly conceived exchange rate regimes, weak supervision of financial institutions, and an inadequate understanding of how both of these were affected by capital flows made volatile by fluctuating expectations of how developed countries would calibrate their monetary policies. The global financial crisis was also the product of misjudged central bank policies in the US and developed economies which allowed excessive credit growth, while the supervision of financial institutions and monitoring of potential crisis points such as housing bubbles was weak.

In the global crisis and the current pandemic, radical new approaches to monetary policy such as quantitative easing have helped to prevent a terrible worldwide depression — but we have yet to fully understand its implications for the future. Just the fear of tapering of quantitative easing in 2013 sparked off massive capital outflows and currency depreciations in emerging markets. Some fear that something similar could happen again when currently ultra-loose monetary policies begin to normalise. Others fear that much worse could be in store for the world economy as a result of the near-zero interest rates and ultra-loose monetary conditions that now prevail.

The book helps us to better understand these risks and likely trajectories going forward by bringing together some of the most authoritative minds on these topics, including Oliver Blanchard, Barry Eichengreen, Jacob Frankel and Maurice Obstfeld. Each of the eight chapters in the book was the result of meticulous research and provides helpful insights into how monetary and exchange rate policies should be configured in this part of the world. Much of it is centred around exchange rate regimes, but there is also good thinking on financial stability and capital flows.

Lessons in policy formulation

There are some specific big contributions that the book makes which are worth highlighting. First, it provides central bankers in the region with important lessons in policy formulation in the context of a highly challenging global economy. These challenges go beyond the terrible crises that have rocked the global economy. The financial sector today is highly globalised and inter-connected — banks, capital markets, insurance companies, currency markets and commodity prices are all linked together as complex adaptive systems. By their nature, the behaviour of such systems is difficult to predict. Because financial markets are constantly innovating, adapting and evolving, policymakers and market participants are often taken by surprise by developments and realise only too late that their existing policy tool kit was wanting. Moreover, shocks are more quickly and more substantially transmitted from one part of the system to another. This makes the job of a central banker an unenviable one.

In this context, Obstfeld’s 2014 paper (which appears as Chapter 2 in the book) is on how emerging economies can use monetary policy to mitigate external stresses created by volatile capital flows. His study looks at the downsides of financial globalisation for monetary policy. In addition to the well-known monetary trilemma (navigating between exchange rates, interest rates and capital account opening), he introduces the notion of the financial policy trilemma — the incompatibility of trying to achieve national sovereignty in making financial policy versus maintaining international financial integration versus ensuring financial stability.

In addition, Eichengreen’s chapter warns that capital account liberalisation comes with considerable risks. By undertaking a detailed study of the experience of China, he argues that policymakers should focus less on headline measures of financial development such as market capitalisation and instead look more at the basics — the efficiency of the financial system in meeting the needs of households and firms. This back-to-the-basics approach is exactly what we need to see more of in policymaking.

Primer on policy responses

A second big contribution is as a primer on challenges and appropriate policy responses, made so much more applicable because it adopts a pragmatic approach and is related to specific concerns in Asia. Monetary Authority of Singapore managing director Ravi Menon in his chapter makes the important point that relying solely on monetary policy to secure financial stability as conventional wisdom used to ordain is not enough: central bankers have to re-think this approach. He observes that there is a range of possible policy options for central bankers. They could stick with the traditional focus on price stability only. Or they could switch to using policy interest rates to target both price as well as financial stability. Or they could use a range of tools including rates and macro-prudential ones to target both. Menon makes a persuasive case for the judicious use of macro-prudential policy tools and shares Singapore’s experience in this regard.

In Chapter 5, Frankel looks at the merits of fixed versus various kinds of floating exchange rate regimes. He concludes that the choice of an exchange-rate regime makes a big difference. His detailed work provides insights into the implications of capital flows for particular exchange rate regimes. Chapter 6 is similarly useful — it is written by specialists in the Bank for International Settlements (BIS, often referred to as the central banks’ central bank) and shows how the BIS’ set of metrics for financial vulnerability can be used by financial supervisors to monitor the build-up of vulnerabilities. They study the consequences of the shift in the pattern of credit intermediation from banks to bond markets and warn about the pro-cyclicality and the slow-moving nature of balance sheet aggregates.

The discussion in Chapter 8 attempts to place the evolving thinking about the roles and interactions of monetary policy, macroprudential policies, foreign exchange interventions and capital controls together in one framework. It concludes with a proposal for a global safe asset which could help produce a “more self-stabilising global financial architecture”.

Tackling controversial issues

A third significant contribution is that the book is not afraid to tackle difficult or controversial issues. For example, in his chapter, Blanchard argues that capital controls — once considered taboo by orthodox economists — are natural and useful tools. Blanchard concludes that emerging economies have to live with the fact that developed economies will create spillover effects on them because he does not see much scope for coordination of policies by the powerful developed countries. In Chapter 7, Pierre-Olivier Gourinchas studies the prospects for the US dollar’s hegemonic status. He identifies future dangers as the dollar diminishes and makes the interesting observation that a transition to a more renminbi-centred exchange rate regime could occur faster than many expect.

Conclusion

The book is not perfect. A concluding chapter that brought together the valuable insights from the ground-breaking work in the eight chapters and applied them to the future challenges would have been useful.

But that is a small issue and overall, the editors should be applauded for distilling the immense amount of deep research conducted over the years into a single readable book. Overall, the book does a great service to all those interested in central bank policymaking in the region and how it will evolve over time — not just the central bankers who bear the responsibility as practitioners but also financial market participants whose trading and investment strategies will be very much buffeted by monetary policies as well as the economists who have to understand these changes and explain them to the market.

This review would not be complete without a word about the Asian Monetary Policy Forum which gave rise to the papers that are published in this book. This Forum was set up in 2014 and, despite its relative youth, has emerged as a highly credible platform for rigorous thinking about global financial issues and how they apply to Asia. The hope is that in time, it will build on the growing body of high-quality research it has nurtured to offer innovative prescriptions on policy that are pertinent to the countries in this region.

At this moment, what is most pertinent for the region is the exit from the pandemic. Sadly, the Covid-19 virus has persisted for longer than expected and is taking a much greater toll on people and economies than we had hoped for. As we celebrate National Day in a somewhat more subdued tone this year, this book can help guide policymakers as they navigate through what will hopefully be the final phase of this crisis.

Manu Bhaskaran is CEO at Centennial Asia Advisors

Cover photo: Bloomberg