Download Current Policy Challenges Faced by Emerging Market Economies and Korea 1. introduction

343
Current Policy Challenges Faced by
Emerging Market Economies and Korea
Woon Gyu Choi
1. Introduction
I would like to begin with a discussion of the policy responses of emerging market economies (EMEs) to monetary policies of advanced economies. I will suggest the likely response of EMEs to tapering of quantitative easing (QE). One of
the recent interesting developments in this regard is that they did not respond
uniformly to Chairman Bernanke’s announcement of possible QE tapering in
May and June 2013, which sheds light on the present heterogeneity within the
EME group. EME policymakers should consider various factors ranging from
economic fundamentals to the long-term challenges that their economies are
facing. As a specific example, I will describe current challenges faced by the
Korean economy.
2. Monetary Policy Normalization and EME Policy Options
Prospects for Monetary Easing and Portfolio Rebalancing
First I will discuss advanced economies’ monetary policy normalizations and
policy options for EMEs. Central banks’ active provision of liquidity, dubbed
unconventional monetary policy, is now widely accepted as a weapon belonging to the central bank arsenal. With the U.S. economy recovering, policymakers are steering the economy toward a new normal—a process accompanied by
normalizing the central bank balance sheet and thus reducing liquidity supply.
QE tapering in the United States is expected to start in the near future, but the
European Union and Japan have not yet witnessed any clear signs of recovery
or inflation to presage a change in course. The U.S. Federal Reserve’s reduction
in liquidity provision will initiate global portfolio rebalancing, forcing EMEs to
deleverage or unwind the liquidity that flowed into them during the time of QE.
The driving force behind global portfolio rebalancing would be the U.S.
recovery and the concomitant normalization of U.S. interest rates. As expectations of the Fed’s QE tapering build, investors in advanced countries become
concerned about a projected depreciation of EME currencies. If the Fed decides
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PROSPECTS FOR ASIA AND THE GLOBAL ECONOMY
to initiate tapering, the markets will turn bearish in the short run, but the decision may also reassure the markets that the economy is on the right track for
recovery. Recovery in advanced countries is good news for exporters in EMEs.
Global Liquidity and EME Responses
Along with portfolio rebalancing on a global scale, changes in policy-driven
liquidity from advanced economies have a direct impact on EMEs. My understanding on this matter is largely based on the recent study I conducted with
my colleagues at the Bank of Korea.1
This study derives three global liquidity catalysts from financial data of
advanced economies and then analyzes their impacts on EMEs using a panel
vector autoregression. The three global liquidity catalysts are exogenous
liquidity, endogenous market liquidity, and risk aversion (negative risk appetite). The exogenous liquidity momentum is identified as a policy-driven factor:
It increases with the monetary base and decreases upon a policy rate hike.
In the context of this study, QE tapering is regarded as a negative exogenous global liquidity shock to EMEs, having impacts on their financial sectors,
which induces policy reactions. The shock and reactions together determine
QE’s overall impacts on growth, inflation, and the current account in each
country.
As summarized in Figure 1, a negative exogenous liquidity shock brings
about capital outflows from EMEs, causing the exchange value of the national
currency and stock prices to tumble. In response to nominal effective exchange
rate depreciation, the authorities increase the policy rate and release foreign
reserves to support the currency in a bid to fend off a crisis. Output then suffers
from a lack of funds because of the outflow of foreign funds and the scarcity of
domestic funds owing to monetary policy tightening. If foreign funds had been
directed mainly toward the demand side of the economy, the shock that unwinds
foreign funds will exert deflationary pressure. This deflationary pressure is offset by an inflationary pass-through effect from currency depreciation, leaving
the ultimate impact on the price level unclear. A silver lining to this economy
characterized by sluggish demand and depreciation is a current account surplus, which may moderate concerns over the crisis to some degree.
Tighter policy and release of foreign reserves to avoid leakages of foreign funds are rationalized in terms of the aim of retaining the foreign funds
domestically and limiting exchange rate volatility. However, a policy rate hike
is controversial since it may further worsen already sluggish growth, leading
eventually to enlarged outflows.
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F i g u r e 1
Effects of QE Tapering and EME Policy Responses
QE Tapering
Capital Flows
Stock Price
Financial Sector
Exchange Rate
Policy Rate
Foreign Reserves
Policy Response
GDP
CPI
?
Current Account
Real Sector
QE Tapering and EME Responses
What I have just described is the average response of EMEs as drawn from
data analysis. The recent reaction of global investors to the Fed’s announcements regarding the possible QE tapering sheds light on the pattern of differentiation within the EME group (see Figure 2). Between May and October
2013, most Asian EMEs saw their currencies depreciate, and some EMEs suffered a loss of more than 5 percent in their stock market capitalization. The two
main exceptions were China and Korea, whose currencies strengthened and
whose stock markets turned bullish. Countries with external vulnerabilities—
such as the so-called fragile five (India, Indonesia, Brazil, South Africa, and
Turkey)—faced sudden capital outflows.
Capital outflows in turn are attributable to persistent deficits on the current account (see Figure 3). The fact that the fragile five also run persistent and
large budget deficits suggests that their current account deficits may be engendered by weak fundamentals associated with fiscal deficits and that mounting
concerns over external and fiscal sustainability may call for capital outflows.
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F i g u r e 2
EME Market Responses to Bernanke’s Remarks
C Equity Funds Flow
USD billions
20
10
ASEAN
% Change
15
Fragile 5
10
5
0
–5
Turkey
Brazil
South Africa
India
Indonesia
Vietnam
Thailand
Singapore
Malaysia
Philippines
China
–10
–15
D Bond Funds Flow
USD billions
50
USA (right axis)
East Asian 3
ASEAN
Fragile 5
15
East Asian 3
Japan
Turkey
South Africa
Brazil
India
Indonesia
Vietnam
Fragile 5
Thailand
Singapore
Philippines
ASEAN
Malaysia
China
Japan
Korea
East Asian 3
B Stock Prices
% Change
4
2
0
–2
–4
–6
–8
–10
–12
–14
Korea
A Exchange Rates
5
0
–5
–10
USD billions
6
40
4
30
2
20
0
10
–2
0
–4
–10
–6
–20
–8
USD billions
40
20
0
–20
USA (right axis)
East Asian 3
ASEAN
Fragile 5
–60
–80
Dec-12
Dec-12 Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13
–40
Feb-13
Apr-13
Jun-13
Aug-13
F i g u r e 3
EME Fundamentals
East Asian 3
B Fiscal Balance
ASEAN
% of GDP
30
Fragile 5
East Asian 3
ASEAN
Fragile 5
25
20
15
10
5
0
–5
Note: Percent of GDP is calculated as three-year average.
Brazil
South Africa
Indonesia
India
Vietnam
Thailand
Singapore
Malaysia
Philippines
Japan
China
Korea
Turkey
South Africa
Brazil
Indonesia
India
Vietnam
Thailand
Singapore
Philippines
Malaysia
Japan
China
Korea
–10
% of GDP
10
8
6
4
2
0
–2
–4
–6
–8
–10
–12
Turkey
A Current Account
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EME Policy Choices
In retrospect, the signaling of possible QE tapering served as a test run. The
differing outcomes within the EME group left individual countries with two
policy options: a defensive policy to fend off a crisis, or a domestic-oriented policy to neutralize or cushion the impact of fund outflows.
A defensive policy would be the conventional choice, as in the panel VAR
model I mentioned. Such a policy incorporates a hike in the policy rate and the
release of foreign reserves. However, the higher interest rate entails the weakening of the domestic economy, rendering its equity markets less attractive to
foreign investors, thereby accelerating fund outflows and currency depreciation. Releasing foreign reserves may also backfire if the level of remaining foreign reserves is perceived as inadequate or if the pace of reserve drawdowns is
too fast.
The alternative choice would be a domestic-oriented policy. Countries with
solid fundamentals can determine the policy rate to achieve a policy objective
in terms of inflation or employment. They may opt to maintain the policy rate
while other EMEs increase theirs. If there is little concern about a financial crisis, policymakers may craft their policy for domestic goals even under an external shock that temporarily destabilizes the foreign exchange market. They
could also deploy foreign reserves to smooth out excessive volatility in the foreign exchange market. The downside of this policy is that the relatively low
interest rates speed up the draining of foreign funds from the bond market, further weakening the domestic currency and raising concerns about financial stability. Where the domestic financial system is still far from being mature, the
additional liquidity resulting from the low policy rate may not penetrate those
sectors in need of liquidity but be hoarded by financial institutions.
The choice between the two policy options will depend largely on the macroeconomic fundamentals of the particular economy and the nature of the driving
shock—a push or pull factor. Having said that, those countries with weak fundamentals—such as twin deficits and high inflation pressure—do not have sufficient room for policy maneuvering. If global factors dominate the nature of the
external shock, the efficacy of monetary policy may be limited.
3. Korea’s Challenges in Policy Implementation
Now I turn to the case of Korea. Korea has experienced currency appreciation and stock price increases since May 2013. To my mind, these strong developments are attributable to the country’s improved fundamentals since the
2008 financial crisis (see Figure 4). In particular, Korea’s policy efforts have
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F i g u r e 4
Indicators of Macro-Financial Soundness in Korea
Percent
70
2007
2012
60
50
40
30
20
10
0
Fiscal balance to
nominal GDP
Current account to
nominal GDP
Short-term
external debt to
foreign reserves
Banks’ capital
adequacy ratio
Central govt. debt
to nominal GDP
brought about banks’ improvement in capital adequacy and a sharp drop in the
ratio of short-term external debt to foreign reserves. The current account has
improved—owing to the strong performance of globally competitive Korean
firms and weak domestic demand. In the meantime, the budget surplus has
shrunk upon the implementation of stimulative fiscal programs.
Although short-term fundamentals do not pose an immediate concern,
Korea has its own share of challenges. The first challenge is imbalance between
domestic demand and export-driven demand. Exports account for more than
50 percent of Korea’s GDP (Figure 5A). This imbalance may be partly attributable to the slow pace of the development and integration of regional financial
markets, especially the bond markets (Figures 5B and 6).
The second challenge is the combination of disparity in sectoral savings
and subdued corporate investment. While the total saving rate has been slowly
decreasing, the increase in the corporate saving rate has largely compensated
for the decrease in the household saving rate since 2000 (Figure 7). This implies
that retained earnings are neither being reinvested nor paid out as dividends to
boost household income. While the saving-investment gap in Asia has narrowed
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F i g u r e 5
Imbalance between Domestic Demand and Export-Driven Demand
A Export of Goods and Services (2012)
B Asia: Share in the World Economy (2012)
75
57
52
31
31
30
24
27
32
UK
Italy
France
Japan
Germany
Indonesia
China
Philippines
Korea
Thailand
Malaysia
15
Rest of
World
27.7
11.2
EU
21.5
32.5
Asia
28.3
Japan
8.3
[GDP]
Source: World Bank, WDI, 2013.
19.9
29.0
USA
22.5
USA
87
% of GDP
100
90
80
70
60
50
40
30
20
14
10
0
27.2
32.1
4.4
[Trade]
12.2
35.5
18.5
29.7
29.4
22.6
6.9
Stock Market
Capitalization
14.7
Percent
100
90
80
70
60
50
40
30
20
10
0
Debt Securities
Total
Source: IMF, GFSR, 2013, World Bank, WDI, 2013.
F i g u r e 6
Intraregional Trade and Stock/Bond Investment (2012)
A Intraregional Trade
B Stock/Bond Investment
Percent
70
Percent
70
Export
Import
Equity
Debt
60
60
50
50
40
40
30
30
20
20
10
10
0
Asia
EU
0
NAFTA
Asia
EU
NAFTA
Source: IMF, DOTS and CPIS database.
F i g u r e 7
Saving Rates in Korea
A Saving-Investment Gap
B Private Saving Rate
Percent
10
Percent
45
Percent
25
40
5
0
15
25
20
–5
10
15
Total saving rates (right)
Public gap (left)
Private gap (left)
–10
–15
1970
20
Household Share
35
30
10
Nonfinancial Corporate Share
5
5
0
0
1980
1990
Source: Bank of Korea, ECOS.
2000
2010
1980
1990
2000
2010
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since the global financial crisis (Figure 8), reduced savings are coupled with
lower investment. In Korea, the recent sluggishness of investment—substantially attributable to heightened policy uncertainty—could weigh on the economy in the long run by constraining its growth potential.
The third challenge is household debt. The ratio of household debt to disposable income in Korea now stands at 160 percent, having steadily increased
even after the global financial crisis, in contrast to the situation in the major
economies (Figure 9). At this point, household debt does not seem to drag down
demand, and the associated risks are under control. Household debt will be
manageable unless very large shocks strike. However, prudent caution should
be exercised, especially for vulnerable groups (say, multiple-loan borrowers,
F i g u r e 8
Savings and Investment in Asia
A 2007
B 2012
Percent
60
50
Average
Thailand
Korea
0
Singapore
10
0
Philippines
20
10
Malaysia
30
20
Japan
30
Indonesia
40
Hong Kong
40
China Mainland
Average
Thailand
Korea
Singapore
Philippines
Percent
60
Savings/GDP
Investment/GDP
50
Malaysia
Japan
Indonesia
Hong Kong
China Mainland
Savings/GDP
Investment/GDP
Source: IMF, WEO.
F i g u r e 9
Household Debt
A Household Debt/GDP
B Household Debt/Disposable Income
Percent
120
UK
110
UK
USA
Percent
200
100
180
90
Korea
140
USA
Japan
80
Japan
160
Korea
120
70
Germany
2005
2006
2007
2008
2009
Source: BOK staff calculation.
2010
2011
2012
100
Germany
60
80
50
60
40
40
2005
2006
2007
2008
2009
2010
2011
2012
CHOI | POLICYMAKER PANEL | Current Policy Challenges Faced by Emerging Market Economies and Korea 351
low-income or old-age groups, and self-employed households) to ward off potential spillovers.
4. Closing Remarks
To sum up, the prospective QE tapering will call for global portfolio rebalancing whose impacts on individual countries in the EME group will be diverse.
Individual countries may opt for a defensive policy to ward off a crisis, even at
the cost of domestic goals. Alternatively, they may choose a domestic-oriented
policy which has its own set of benefits and risks. The challenge is then where
to place a fulcrum between global and internal factors in forming the policy
positions. While Korea currently benefits from strong and seemingly resilient
fundamentals, it faces eventual structural challenges such as the shortfall of
domestic demand, weak linkages between savings and investment, and household debt overhang—not to mention the presage of demographic changes.
I close my remarks with some suggestions for policy coordination. Governor Powell suggested the gradual restoration of advanced economies’ monetary
policy, taking into account international linkages. In this regard, I would like
to note as follows. Advanced economies and EMEs are more than ever intertwined, and global policy coordination is critical for the sustainable growth of
the global economy. Advanced economies are asked to provide transparent and
consistent policy signals to reduce policy uncertainty. EMEs, for their part,
have to improve the macroprudential soundness of their financial systems and
implement structural reforms to strengthen their fundamentals. Furthermore,
once global investors suspect a crisis in one or two vulnerable countries within
a peer group, this could provoke panic reactions across comparable EMEs.
Against this backdrop, efforts to strengthen the global/regional financial safety
net should be a matter of high priority. Korea has recently agreed on bilateral
currency swap lines with Indonesia, the United Arab Emirates, and Malaysia.
Our moves are likely to help the entire cohort of EMEs better withstand negative external shocks.
Finally, in the event of a global liquidity crunch, central banks would need
to carry out appropriate policies of credit easing to ensure the seamless supply of funds to those vulnerable sectors hit by an abrupt credit crunch. EMEs
are prone to financial market failures owing to information asymmetries and
financial infrastructure shortages. The Korean economy is faced with sectoral
liquidity shortage amid ample aggregate liquidity. Funneling aggregate liquidity by the central bank into market liquidity and loans for investment could be
called a “modern reincarnation” of credit policy. In light of this, a contemporary
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reincarnation of credit policy could help restore growth potential and rebalance
liquidity flows.
NOTE
1 The results of the research project, entitled “Global Liquidity Momenta and EMEs’ Policy Responses,” were presented at the 2013 Bank of Korea annual international conference.