Pitfalls of Asian Central Banking
Stephen Roach (New York)
I have been critical of America's Federal Reserve for failing to normalize monetary policy in this post-bubble climate. But the Fed is not alone in deserving blame for nurturing the persistent imbalances that continue to plague a lopsided, US-centric global economy. Other central banks have played an equally important role in condoning this unstable and increasingly risky arrangement. Nowhere is that more evident in Asia, where monetary policy is now moving into the danger zone.
The financial crisis of 1997-98 was Asia's wake-up call. Never again would the region's monetary authorities be caught with inadequate foreign exchange reserves — unable to defend themselves (i.e., their currencies) in tough market conditions. They have succeeded beyond their wildest dreams. On a pan-Asian basis (i.e., including Japan), the region has now amassed a reservoir of about US$2.1 trillion in official currency reserves (as of March 2004); that's more than 80% of the world's total reserves and is almost triple Asia's holdings of $766 billion existing at the end of 1998, at the worst point of the Asian financial crisis. Collectively, Japan (US$827 billion) and China ($440 billion) account for 59% of Asia's total FX reserves; however, adding in Taiwan ($226 billion) and Hong Kong ($124 billion), Greater China's reserves amount to $790 billion, only fractionally below those of Japan. For Japan and China, the accumulation of reserves has been particularly explosive in recent years; since early 2002, the holdings of both countries have basically doubled. (Note: The official data on foreign exchange reserves, maintained by the Bank of International Settlements [BIS], is only available through year-end 2002; our updates through early 2004 are taken from national sources).
The plot thickens when the mix of official reserves is considered. As of 2002, BIS data reveal that dollar-denominated assets made up fully 73% of the world's total official holdings of foreign exchange reserves — more than double America's 30% share of world GDP. There can be little doubt as to who has led the charge. With Asia accounting for the bulk of the world's expansion in foreign exchange reserves, there is every reason to believe that the region has also led the way in driving the play into dollar-denominated assets. Fed Chairman Alan Greenspan has come to the same conclusion. Since the start of 2002, he notes that Asian authorities purchased almost $240 billion in dollar-based assets (see “Current Account,” Greenspan's remarks before the Economic Club of New York, March 2, 2004).
This has serious consequences for the financial underpinnings of an unbalanced global economy. With private sector inflows into dollar-based assets on the wane in recent years, Asia's monetary authorities have picked up the slack. According to Rakesh Mohan, the Deputy Governor of the Reserve Bank of India, “The central banks of Asia are financing roughly 3-3.5% of the current account deficit of the US and most of its fiscal deficit” (see “Challenges to Monetary Policy in a Globalising Context,” published in the January 2004 issue of the Reserve Bank of India Bulletin). Asia's monetary authorities have become the primary financiers of the largest imbalances the world has ever seen.
This is no accident, in my view. It is a conscious by-product of Asia's unflinching reliance on external demand as its primary source of economic growth and development. For years, I have been hearing tales of the emergence of autonomous sources of domestic demand in Asia. The record, however, falls well short of the rhetoric — especially insofar as support from private consumption is concerned. Asia's domestic demand success stories have been few and far between, largely concentrated in the smaller ASEAN economies such as Thailand and Indonesia. For the big Asian economies — namely, Japan, China, and Korea — domestic demand has largely taken the form of unsustainable investment bubbles; the Asian consumer remains all but missing in action.
Lacking in a sustainable foundation of domestic demand, Asian authorities have concluded that they have no choice other than to embrace external-demand-focused growth strategies. This requires vigilance on the currency front in order to maintain export competitiveness. Asia's enormous overweight of dollar-denominated official foreign exchange reserves is central to this strategy. For a consumption-short region, it prevents sharp currency appreciation that might impair export-led growth. Yet by doing that, Asia has little incentive to develop autonomous support from domestic demand. That perpetuates what I believe is one of Asia's most unfortunate vicious circles.
The Asian-style growth recipe also provides great support to the income-short, saving-deficient, and overly indebted American consumer. By funding the bulk of America's record twin deficits, the Asian bid for dollars prevents what would otherwise have been a sharp back-up in US interest rates. For what it's worth, my guess is that intermediate to longer-term yields in the US would be at least 100 bp higher today were it not for the Asian bid for dollar-denominated assets. The Asian subsidy to US interest rates not only keeps the magic alive in America's asset markets — bonds and property, alike — but it also provides the means by which purchasing power can be extracted from such holdings through the ever-efficient financial technology of asset-based refinancing vehicles.
Is this any way to run the world? My answer is “absolutely not.” Central banks — both in the United States and Asia — have created a monster that they may no longer be able to control. Income-short American consumers have turned to tax cuts, asset-driven income extraction, and debt as the means to sustain current consumption. The Federal Reserve has encouraged this recklessness by offering the steroids of essentially free money at the short end of the yield curve (a 1% nominal federal funds rate in a climate of 1.7% headline CPI inflation).
Asian central banks are playing the mirror image of the same game — buying dollars to keep their currencies from rising and thereby subsidizing Asia's ability to sell exports to overly indulgent American consumers. Yet by running ever-widening current account surpluses and having to purchase massive amounts of dollar assets in order to maintain currency targets, Asian central banks are flirting with the growing risk of abdicating control over their domestic financial systems. Japan's massive and unprecedented currency intervention in 2003 and early 2004 is the most glaring and extreme example of the Asian gambit; while it may make sense for an economy in deflation, it is not sustainable for a post-deflationary Japanese economy. At the same time, China's aggressive purchases of dollar-based assets are already complicating the efforts of its central bank to rein in the liquidity-driven excesses of an overheated economy.
Like all periods of financial market excess, this one is likely to end in tears. But, in my opinion, there is nothing fundamentally sound about this increasingly precarious arrangement. In recent years, it has become fashionable in policy and investor circles to argue that imbalances in the classic sense — current account and budget deficits, saving shortfalls, and rising private sector indebtedness — have lost their meaning in this increasingly interdependent era of globalization. It's all about “capital flows,” goes the logic of the latest New Paradigm. And America's IT-enabled productivity-led prowess of the past eight years is widely considered to make the US deserving of the special breaks it is getting in world financial markets. The dollar's role as the world's major reserve currency is the icing on the cake of this logic.
In my view, the capital-flow thesis is nothing more than another “greater fool” theory — precisely the type of logic that was in favor as Nasdaq was cresting toward 5,000 about four years ago. I couldn't agree more with India's Deputy Governor Mohan, who also notes in the above-cited paper, “Global capital flows impact the contact of monetary policy on a daily basis. The problem, however, is that capital flows typically follow a boom-bust pattern.” As soon as you hear the word “flows” to describe the new way the world works, the endgame is no longer in doubt. It's just a question of when — and under what conditions. I fear we are now entering the most seductive phase of this liquidity boom.
Central banks did a masterful job in fighting the ravages of high inflation. But in my opinion, they are doing a terrible job in coping with the challenges of an inflationless world. It is the height of absurdity for America's Federal Reserve to hold its policy rate at 1% when growth in the US economy is now running at a 5-6% clip. It is equally reckless for Asian central banks to operate under the delusion that massive reserve accumulation and open-ended buying of dollar-denominated assets are a recipe for prosperity. These are dangerous and unsustainable policy strategies that can only exacerbate the ever-mounting imbalances of a lopsided global economy.
Such profound disequilibria should be a wake-up call for misguided central banks and complacent world financial markets. Instead, the authorities are asleep at the switch and investors have been lulled into a false sense of complacency. America's Federal Reserve has led the charge in pushing monetary policy into the danger zone. But the US authorities couldn't have done it alone. The complicity of Asian central banks is an equally worrisome development for the global economy |
