TCS Daily

Sanity Returns

By Christopher Lingle - August 15, 2006 12:00 AM

Sanity is finally beginning to prevail among central bankers in Asia. After keeping their benchmark interest rates artificially low, they are beginning to anticipate that their domestic monetary policies were adding to a tsunami of excess global liquidity.

At last, central bankers are paying attention to soaring commodity prices and asset bubbles. For too long, they carelessly overlooked the danger signs of excessive global liquidity. With clear signs of rising consumer prices, the message seems to have finally sunk in interest rates were kept too low for too long.

Just this week, the Bank of Korea (BOK) unexpectedly raised its key short-term rate by 25 basis points to 4.5 percent, the fifth time it hiked its key rate since October of last year.

Even the Bank of Japan has decided it is time to end its super-easy monetary policy that kept rates at almost zero since 2001. The European Central Bank raised its short-term rate target, which had been kept unchanged at 2% for over two years.

The US Federal Reserve has been raising its short-term rate target since June 2004 from a 46-year low of 1% in 2004 and is expected to push them higher despite its pause this week. And the Reserve Bank of India raised its key reverse repurchase rate for overnight borrowing by 0.5 percentage point from 5 percent. After currencies market drove the rupiah down to a four-year low against the dollar, the Bank of Indonesia initiated an aggressive increase in its key interest rates, a trend that was reversed. Similarly, the central bank of the Philippines hiked its benchmark rate.

It is ironic that it took so long to identify the disastrous effects of excessive loose monetary policy. For his part, Alan Greenspan recently pointed to the fact that asset prices have been outstripping GDP and declared this to be an unsustainable phenomenon. Unfortunately, he figured it out too late, since his policy decisions were behind the unprecedented era of unusually cheap credit that contributed to artificial "booms" in so many economies.

And now Greenspan's poisoned legacy affects the global economy with high and rising prices for gold, oil and other commodities while domestic economies are saddled with massive debts, both private and public. At the same time, many countries are plagued by "bubbles" affecting financial assets and property with valuations that defied gravity with the same indifference as they did reality.

Unfortunately, the sound of bursting bubbles are more likely to precede a fall back in commodity prices. When asset values become detached from fundamentals, those values cannot hold in the future so that a downward correction is inevitable and an economic "bust" will follow.

Much of the pain that awaits the global economies was set into motion by decisions of central bankers to pump air into economies with artificially-low interest rates. As such, it is NOT the fact that interest rates are currently being pushed up that will cause the problems. The problems were actually set into motion when interest rates were pushed down artificially by central banks!

The blame for impending corrections and recessions must be shouldered by central bankers that often worked in tandem with finance ministries to inflate their money supplies. Irresponsible policy makers seemed to believe that something real and sustainable can be created out of the "nothing" of cheap credit and more pieces of paper money.

It is worthwhile tracing out how the future will play out. Rising interest rates will induce investors to reassess their willingness to accept risk, especially in emerging market economies that have attracted so much of the excess liquidity. One aspect of this might be an outflow of foreign capital from emerging market economies as a reassessment occurs on risk-adjusted rates of return.

This will lead to a large sucking sound as capital flees less developed capital markets and floods back into safer assets. Following these moves, expect the international value of the US dollar to creep inexorably back up, at least in the short and medium term. This will be due to a combination of increased demand and a decrease in the rate of increase in supply as the Fed raises rates earlier and faster than other central banks.

Unfortunately, it may also inspire a misinformed chorus of complaints that global capital markets are unstable as emerging markets are pummeled by the loss of "hot" capital. But the problem does not reflect an inherent instability of markets.

As it is, global capital inflows and outflows are only a symptom indicates the response of investors in terms of their approval or disapproval of policies and conditions in a country. In this sense, capital outflows are not the cause of internal economic turmoil but should be seen as the messenger of good or bad tidings.

It turns out that the observed instability will be the outcome of policy choices relating to monetary and fiscal policy. On the one hand, low capital costs led to more investments being made in businesses with weak business plans that could not survive with higher borrowing costs.

As interest rates rise, these weak businesses will be either be forced to cut their staffs and output or shut down altogether. These closures and cutbacks will lead both to a slowdown in business and financial activity so that unemployment rates will rise throughout the economy.

On the other hand, low rates of return made investments in many economies less attractive. Consequently, a global search for higher risks associated with higher returns bumped up values of stock and real estate in many emerging market to unsustainable heights.

Instead, it should be clear that initial inflows of capital were induced by misguided finance ministries and central banks that made capital so cheap in the first place. The irony (and tragedy) is that the very same logic of the very same groups that initiated policies that created the instability will be asked to use the same dubious wisdom to sort things out.

The dismal economic prospects for the future were set by irresponsible policy choices in the past. Now it only remains to see how it will all play out. Those countries that seemed to benefit most from the liquidity bubble will be most affected by the inevitable corrections as interest rates rise.

It turns out that those economies scoring the highest on the performance charts have the furthest to fall. The bad news is that this the economic slowdowns will hit both India and China. But China is likely to suffer most since it followed Japan's example as a "bubble economy" with exaggerated valuations relating to most economic transactions and asset values.

Christopher Lingle is Senior Fellow at the Centre for Civil Society in New Delhi.

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