Sunday, January 31, 2010

Central Bankers in Asia Face New Challenges in the Fight against Inflation

Sources: Asian Central Banks Signal a Tightening Trend; India Increases Reserves Burden on Banks; India's Central Bank Moves to Reverse Some Stimulus Measures

Asian central banks used to wait for the U.S. Federal Reserve to act before loosening or tightening their monetary policy (in an effort to limit the fluctuation of their currencies against the dollar). This time, however, is different. As the economic recovery gains momentum and inflationary pressures are getting stronger in the region, several central banks have begun to take steps to address inflation worries even when the Fed is not expected to tighten its monetary policy until later this year.

For example, India's central bank made its first significant move last Friday to exit the loose monetary policy taken as stimulus measures during the global financial crisis. The Reserve Bank of India increased the cash reserve ratio (the proportion of deposits that banks must keep with the central bank) by 75 basis points. The Philippine central bank also signaled a tightening trend by raising its rediscounting rate. In 2010, Asian central banks need to increase rates by 2.5 percentage points according to Frederic Neumann of HSBC in Hong Kong.

However, Asian central banks by acting alone may increase the risk of exacerbating the inflation as well. Since the Fed keeps interest rates close to zero, rising rates in Asia would induce more capital from investors who seek higher yields. As these inflows of capital make local currencies appreciate, exporters become less competitive. Also, currency appreciation may create asset bubbles.

China, however, is in a different situation. Since it pegged its currency to the U.S. dollar, it is less risky for China to tighten its monetary policy unlike other neighboring countries. While China has started to tighten credit, its neighbors hesitate because of the risk of currency appreciation that will make their goods more expensive compared with goods produced in China. However, if China allows its currency to appreciate, other Asian countries will feel more comfortable raising rates.

1. After the global financial crisis, emerging markets seem to gain greater influence. What kinds of challenges and chances do emerging markets face?
2. According to the Institute of International Finance, net private sector capital flows to emerging economies will increase to $722bn in 2010 from $435bn in 2009, and warned that "such a rapid move" may create another global financial bubble in emerging economies, especially Brazil, China and India. How should these emerging economies manage these inflows of capital without creating another global financial bubble?

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