End of Tightening?

The latest central bank actions in Thailand and China appear to have challenged our view that the monetary policy cycle is likely to turn. On August 24, the Bank of Thailand increased its policy rate by 25 basis points to 3.5 per cent, despite an increasingly uncertain outlook for the global economy and financial markets. Two days later, China decided to include banks’ margin deposits in the reserve requirement ratio (RRR) - a move equivalent to two or three more 50 basis point increases in RRR during the next six months.

These policy actions naturally raise the question of whether Asia’s central banks remain more concerned about local inflation than the downside risk to growth. Indeed, Thailand probably has more reason to be concerned about inflation than other Asian countries because of the spending pledges made in the run-up to the July general elections. The new Prime Minister, Yingluck Shinawatra, has promised, for example, to double the minimum wage and significantly increase the price of rice to boost farmers’ incomes. In fact, however, the Thai economy has slowed noticeably in the past quarter and, with the global growth scare unlikely to dissipate anytime soon, we regard the BOT’s latest rate rise as a last-ditch effort to set inflationary expectations—at least before year-end.

The timing of the People’s Bank of China’s RRR action—just a few hours before the all-important Jackson Hole speech by Fed Chairman Ben Bernanke - was difficult to interpret, but we agree that the coverage of RRR needs to be extended to check the fast-growing off-balance-sheet activities of Chinese banks, such as trust and wealth management products. The move is, indeed, a prudent way of trying to close a loophole in regulatory supervision. Moreover, the fact that the PBOC merely expanded the ratio’s coverage rather than increased the ratio itself suggests to us that this was not simply a tightening action. The new RRR on margin deposits will be implemented gradually over the next six months. This is a smart move: it provides enough of a check on liquidity growth if needed, but it avoids the adverse consequences that would ensue if the RRR were formally increased just as the pressures building toward a renewed global recession intensified.

Safe-Haven Status

While we still think most Asian central banks will take a wait-and-see stance in the next few months, they may find their policy deliberations complicated by upward pressure on their currencies. This could come from two sources—a re-rating of the currencies as safe-haven assets, and speculation about whether or not the Fed will implement QE3.

The possibility of Asian currencies gaining safe-haven status increased this week, when the Swiss central bank forcibly pegged its currency to the euro to prevent its further appreciation. The effect could be more immediate than that of QE3-related speculation. With regard to the latter, it pays to remember the measures Asian countries were obliged to take earlier this year to mitigate the effects of QE2, the previous round of Fed quantitative easing. These included capital controls and other macroprudential measures to prevent the inflow of foreign liquidity from becoming an influx. Capital controls helped reinstate monetary policy independence that central banks needed to continue their rate-tightening cycle amid surging food and global energy prices.

Speculative Inflows Exacerbate Policy Dilemma

The key factor to watch in the coming quarter or so is whether - in the event that renewed capital inflows exacerbate concerns about excess liquidity - Asian countries will still have room to ease monetary policy (we see some risk of constraint, even though we expect inflation to become less of an issue). In China, for example, QE2 led to a renewed surge of hot-money inflows in the final quarter of 2010 and the first quarter of 2011. We estimate that speculative inflows contributed half of China’s staggering $200 billion increase in foreign exchange reserves during the latter period.

The inflows moderated noticeably during the second quarter and we do not yet have sufficient information to gauge what happened in the third. Given the close correlation between hot-money flows and the RMB/USD nondeliverable forward rate, however, the recent rebound of the latter—that is, it is pricing expectations of faster currency appreciation—points to another resurgence of inflows.

Currency Appreciation May Ensue

The outcome of the policy dilemma—the need to ease interest rates once growth overtakes inflation as a policy priority, and the need not to ease prematurely under pressure from hot-money inflows—is difficult to predict. Policymakers may be tempted to reintroduce capital controls to prevent a blowout of domestic liquidity and provide room for policy easing to prop up growth. An additional measure would be to allow currency appreciation to absorb some of the inflows; indeed, this was a key factor behind the strength of Asian currencies during first half 2011.

This positive feedback loop between Asian currencies gaining safe-haven status and the need for currency appreciation as a policy response makes Asian currencies, in our view, a very attractive asset class.