New round of easing set to increase liquidity

Emerging Markets ADB editions, May 3 2013 (with Antony Rowley and Elliot Wilson)

A new round of easing in the US and EU is set to increase the already heavy volumes of liquidity heading for Asian assets, fuelling concerns about the dangers of inflows into emerging markets.

On Wednesday The European Central Bank cut its headline interest rate by 25 basis points to 0.5%, while European Central Bank president Mario Draghi said the bank had an “open mind” over introducing negative interest rates on Eurozone deposits and was “technically ready” for them – a move that would prompt bank funding to enter the market to seek returns rather than resting in deposits. Earlier in the day, the US Federal Reserve said it was willing to up the pace of its third quantitative easing programme and could increase the $85 billion it already spends per month on asset purchases.

These measures follow the aggressive monetary policy easing undertaken by Japan – a move whose impact on Asia was defended yesterday by Japan’s finance minister, Taro Aso, to Emerging Markets.

“Many people do not understand the reality of deflation,” he said. “This is the vital difficulty which we have faced for the last 15 to 20 years and the shrinking of the Japanese economy is not good for other parts of the world.

“We have to expand our economy and [achieving] a certain one per cent or two per cent inflation rate is [essential] not only for Japan but also for our neighbours and the rest of the world.”

However, IMF deputy managing director Naoyuki Shinohara told Emerging Markets yesterday that emerging economies would face challenges from rising capital inflows if they became volatile.

“Monetary easing in advanced economies including Japan tends to encourage the movement of capital to emerging and developing countries,” he said.

“Capital inflow into this [Asia] region itself is a good thing. It is good for growth in the region and it is good for investment. But volatility is the problem.”

Countries receiving capital flows “need to be careful in managing macro-economic policy as well as in taking necessary macro-prudential measures in order to cope with the situation,” said Shinohara, who advised flexible exchange rates to help ameliorate the impact of flows.

Capital flows, and how to address them, have become a central theme of this meeting.  Bank of Japan governor Haruhiko Kuroda, who until March was president of the Asian Development Bank, told journalists in Delhi yesterday: “So far I have not much observed that big asset bubbles are occurring due to capital inflows” because of Japanese easing.

But the ADB’s own Asian Bonds Monitor sounded a warning in its most recent edition, saying that inflows “might put upward pressure on exchange rates, making exports less competitive. There are also concerns that higher levels of liquidity could lead to excessive credit growth, thus fuelling asset price bubbles in the region.”

Data from Haver Analytics suggests that quarterly net flows into Asian equity and bond funds had been higher in the last two quarters than during the peak of inflows in 2006-7, with well over US$20 billion of net flows into equity mutual funds alone in both of those quarters.

Frances Cheung, senior strategist for ex-Japan Asia at Credit Agricole CIB, told Emerging Markets: “Policymakers in the region are concerned about capital flows, especially amidst this low interest rate environment.

“At a time when growth is so timid, policy makers are keen to maintain export competitiveness. But I don’t think they will come up with any drastic measures, as capital controls are not fashionable and will not be welcomed by the market.” He suggested central banks will discourage inflows into short-end instruments by reducing the return on them, or curbing inflows into them directly. “More drastic measures risk backfiring and policymakers should learn from past experience.”

A crucial distinction for Asian states is the intention of the money that comes in: buy-and-hold, or flighty speculative capital. “The challenge is to ensure that they inflows arrive in the form of long-term FDI rather than in the form of hot money inflows,” said Anoop Singh, director of the Asia Pacific department of the IMF.