Navigating the Great Transition: An Emerging Market Perspective
Speech by Dr. Veerathai Santiprabhob
Governor of the Bank of Thailand
School of International and Public Affairs, Columbia University
October 5, 2016
Ladies and Gentlemen,
It is a pleasure for me to be here in New York and to have a chance
to participate in the policy discussion at SIPA. Given the increasingly
complex policy challenges facing the global community, the contribution
that SIPA makes in educating future leaders to serve the global
public interest is critical. I would like to thank Professor Ito for
inviting me. He was one of my early mentors at graduate school and
I have benefitted from his many insights ever since.
This coming weekend I will be attending the Annual Meetings of
the IMF and the World Bank. As you know, this is one of the biggest
global forums for addressing issues related to the global economy
and world financial market. The discussions will be especially
pertinent this year given the complex and highly unpredictable state
of the world that we face. Former premier Wen Jiabao once
described China's growth performance as "unstable, unbalanced,
uncoordinated, and unsustainable". This seems like an apt description
of the global economy at this juncture.
Unstable because the proliferation of popular discontent fueled by
rising income inequality amidst ongoing international conflicts have
greatly elevated geopolitical uncertainty. Unbalanced because with
anemic recovery of advanced economies, much of the growth in
the global economy continues to be driven by emerging markets.
In many cases, most prominently in China, this growth has been
fueled by increasing leverage. Uncoordinated because in a highly
integrated world, monetary policy and financial regulatory policy
generate substantial cross-border spillovers yet they are being
conducted with almost exclusive focus on domestic mandates.
And finally, unsustainable because a world in which up to a third of
all government bonds in some advanced economies are held by their
own central bank and over a third of all developed-country
government bonds trade at negative nominal yields cannot be
a viable long run equilibrium.
This precarious state of affairs is, to a large extent, a reflection of
key fundamental forces that have been at play for some time,
with their impact now becoming increasingly self-evident. What I
want to do today is to set out these underlying forces, draw out their
implications for monetary policy, and offer some tentative
suggestions of how central banks may respond. In doing so, I will
focus from the perspective of emerging markets.
As the old saying goes, the only constant is change. But the speed
of that change is not constant. The pace of change tends to pick up
around major transitions before settling down again when some sort
of equilibrium is reached. The Great Moderation was a period of
relatively steady change during which world output grew steadily
and inflation was low and stable. The global financial crisis created
a major upheaval that led to the Great Recession. The subsequent
recovery has been remarkably drawn out and almost 10 years on,
you could say that we have been living through a Great Transition.
I would like to highlight three pivotal transitional forces that have
shaped our economic and political landscape.
First, after decades of rapid expansion, world trade has slowed
down considerably. During 2012 to 2015, world trade volumes grew
at around 3 percent per annum, much less than the pre-crisis
average of 7 percent for 1987-2007. Cyclical factors have certainly
been at work, but the slower pace of growth relative to world GDP
points to deeper structural forces at work. Chief among these is
the waning impact from the integration of China and central and
eastern European countries into the world economy, as well as
the diminished room for further international fragmentation of
production through global-value-chain trades. More speculatively,
rising protectionism may have also dampened trade in recent years.
Nevertheless, the level of trade integration across the world is
as high as it has ever been.
Second, economies the world over have seen a rising contribution
of the service sector to growth. A key driver of this transformation
has been technological innovation, especially in digital communication.
For the world as a whole, the share of services as a proportion of
GDP is now as high as 70 percent. This shift has not been confined
to advanced economies but can also be seen in emerging markets.
In China, for example, the service sector has grown to more than half
of GDP in 2015, much of it driven by a surge in e-commerce and the
expansion in logistical services required to support it. Moreover, as
the cost of digital technology declines, a wider range of services are
becoming more tradable including design, marketing, business
processes, and education. Thus not only has the service sector
become more important within a country, the share of international
trade in services has also increased markedly.
The third, and perhaps most unsettling transitional force, is the
ultra-accommodative monetary policy stance adopted by major
advanced economies. What started out as extraordinary responses
to a precipitous crisis, unconventional monetary policy measures
have not only been maintained, but in many cases have been applied
more intensively with ever greater degree of experimentation and
radicalism. It is striking that after all this time, the crisis mentality
among policy circles has yet to fully abate.
The agglomeration of these transitional forces has had profound
impacts on economies the world over. Together, the slowdown in
world trade and the shift to services have underpinned important
changes in inflation and growth dynamics.
In terms of inflation, globalization has for many years increased the
importance of foreign factors in price dynamics. Persistently low
and more synchronized inflation is partly attributable to the effects
of rising competitive pressures in world markets as well as common
forces such as falling energy prices. As global trade adjusts,
the influence of external factors has regained prominence.
At the same time, the rising importance of services has impinged on
the inflation process. Services prices tend to be more rigid than
goods prices because they embody a larger share of labor input, and
wages tend to be sticky. This may have contributed to inflation
having become more persistent. At the same time, the digital
revolution has driven the prices of many modern services, such as
telephone calls, news, and entertainment to essentially zero.
The upshot is that the link between inflation and domestic measure
of economic slack, as traditionally captured in the Phillips curve,
has weakened and disappeared altogether in some cases.
In terms of growth, slowing global trade and the rise of services
implies slower and less capital intensive economic growth.
For highly open economies, slowing world trade has undermined
export as a growth engine. At the same time, the transition to services
has also contributed to the growth headwinds given that modern services
is less labor and capital intensive than manufacturing. Think of
Google's 40,000 workforce compared to General Motors' 800,000.
Or the fact that Uber is the world's largest provider of auto transport
without owning any cars. Or that AirBNB is one of the world's biggest
provider of accommodation without owning a single hotel. Given that
investment is a relatively interest rate sensitive activity, to the extent
that the transition to services has dampened investment, it may have
also made the economy less responsive to monetary policy.
Finally, the ultra-accommodative monetary policy stances of
advanced economies have contributed towards greater global
asset price co-movements and increased cross-border financial
spillovers. In the context of a highly globalized financial system,
extreme monetary easing has 'pushed' capital to other parts of
the world, particularly emerging market economies where yields are
higher, and boosted asset prices globally. The exceptionally long
period of zero interest rates has also led to a buildup of financial
positions that are attractive or justified only if yields remain low.
As a result, global bond yields and exchange rates have become
acutely sensitive to shifting expectations about monetary policy
changes in advanced economies. Such excessive sensitivity has put
global markets on a knife edge with frequent bouts of volatility.
These developments have critical implications for the transmission
mechanism of monetary policy and its conduct. On the one hand,
the greater influence of global factors and structural growth
headwinds may have made inflation and output less responsive to
monetary policy. On the other hand, financial markets and asset prices
globally have become more sensitive to monetary policy actions and
communication.
This raises a dilemma. With inflation and output below targets,
monetary policy is eased. Against the tide of global factors and
growth headwinds, inflation and output fail to respond, and
the temptation is to do more and more. In the meantime, financial
markets respond vigorously to low interest rates and the search for
yield accumulates in the form of greater financial fragility over time.
Something will eventually have to give. The relevant monetary
policy trade-off at this juncture, then, is not the traditional one
between inflation and growth but between inflation and growth
on the one hand, and financial stability on the other.
How, then, should central banks respond to this new trade-off?
I see three main avenues.
First, central banks need to expand their set of policy tools.
Measures to limit excessive risk-taking in the boom and limit losses
in the bust, such as counter-cyclical capital requirements, leverage
limits, and stable funding ratios are the most obvious additions.
These fall under the heading of macroprudental tools. For emerging
markets where the brunt of the impact from excess global liquidity
has been felt in exchange rates, capital flow management measures
would help to alleviate these pressures. Moreover, central bank
operational frameworks - such as collateral rules that dictate which
types of securities can be pledged for central bank liquidity,
the types of assets central banks choose to hold, or the structure of
liabilities that they choose to issue - offer ways to influence certain
segments of financial markets directly. The challenge going forward
is to operationalize these micro and more targeted policy tools in
a systematic way.
Here it is important to stress that any one set of instruments
working alone is unlikely to be sufficient. Interest rate policy,
macroprudential levers, and capital flow management measures all
interact and their application should be viewed as a whole rather
than in isolation. More broadly, the underlying institutional and legal
frameworks that govern financial markets must be taken into
account. These include financial product regulations, deposit
guarantee systems, as well as the resolution framework for troubled
financial institutions. A national financial stability framework that
brings together and assesses the whole spectrum of financial
regulation serves this important function.
The second response to the more complex monetary trade-off is
greater policy coordination. The underlying rationale for coordination
is that in certain situations, the collective outcome of central banks
acting individually according to their mandates may be inferior
because cross-country spillovers are not internalized. The current
aggressive monetary easing of advanced economies are a case in
point. Whether intended or simply a by-product, the outcome has
the semblance of competitive devaluations.
As a starting point, it is important that advanced economies acknowledge
the potential spillovers of their policy. The Federal Reserve, in particular,
wields outsized influence given the dominance of the US dollar in global
trade and finance. Emerging market countries need to coordinate in
voicing their concerns and engage in dialogue. At a minimum,
consultation minimizes surprises and the exchange of views helps
to narrow differences in perceptions. But there is a more implicit form of
coordination that I believe holds much potential. That is the coordination
of monetary policy frameworks.
This brings me to the third and perhaps most profound avenue for
dealing with the new monetary policy trade-off. And that is
the adoption of a monetary policy framework that systematically
takes financial stability into account. Successive boom-bust
financial cycles have made it clear that unsustainable buildups of
credit and leverage lies at the heart of financial fragility. It is hard
to deny the critical role that monetary policy plays in this.
Monetary policy sets the price of leverage and hence has first order
implications for the pricing of all financial assets and the evolution
of the financial cycle.
A framework in which monetary policy reacts systematically to
the financial cycle, in addition to traditional inflation and output
developments, will help to keep the economy on an even keel.
This differs from an approach in which policy leans against the wind
only when financial stability risks become evident. Given the long
and drawn-out nature of financial cycles, such an approach would
inevitably lead to doing too little too late, as the cumulative impact
of policy over the whole financial cycle is ignored.
Just as the proliferation of inflation targeting frameworks starting in
the 1990s helped to bring down the level and volatility of inflation
rates worldwide, a general trend towards a more systematic leaning
against the financial cycle approach to monetary policy, especially
among advanced economies, could yield significant benefits.
I believe that if central banks coordinate on such a framework, and
thereby adopt a longer through-the-cycle perspective in policymaking,
the problems from cross-border spillovers and perceptions of
competitive devaluations will be significantly diminished.
The key challenge will be one of communication. As is well known,
the long lags of policy creates a need for central banks to
"take the punch bowl away when the party gets going". Given the
longer duration of financial cycles, the need to act well before the
risks become obvious may mean that central banks will have to
"take the punch bowl away even before the party gets started".
But that is a political economy challenge that needs to be resolved
and managed through careful redesign of central bank mandates.
Heed must be paid also to institutional arrangements, especially for
central banks where the financial supervision authority lies with
another body as coordination will be harder.
This will take time. But the risks to financial stability is immediate.
In the interim, central banks may need to interpret their mandates
more flexibly and avoid overly narrow and zealous interpretations
of price stability. Inflation targets need to be implemented flexibly
and over longer horizons. All the while explaining clearly and
consistently the logic of policy. In doing so, it should be stressed that
fundamentally, macroeconomic and financial stability are two sides
of the same coin. Macroeconomic trajectories cannot be sustainable
if the financial sphere is out of equilibrium. And the avoidance of
financial boom-bust cycles leads to better economic outcomes over
the long run. The perceived trade-off between growth, inflation, and
financial stability, therefore, is to a large extent an artifact of
the short horizon focus of policy.
Ladies and Gentlemen,
The history of economic thought in the twentieth century has seen
macroeconomics evolve through a series of intellectual transformations
from the Keynesian Revolution to Monetarism, and finally to
the New Classical or Rational Expectations paradigm. Likewise,
monetary policy has shifted through successive frameworks.
From the system of fixed exchange rates under Bretton Woods,
to monetary targeting during the Great Inflation in the 1970s,
to inflation targeting in the context of the Great Moderation, and
finally to an assortment of unconventional monetary policies in
the wake of the Great Recession. Today, as we navigate our way through
the Great Transition, the search for a new framework is ongoing.
The limitations of prevailing approaches focused on short-term
stabilization of output and inflation gaps has become clear.
The onus on our generation is to ensure that the transition leads
us to a new and better place, rather than to more of the same.
My contribution to that end today has been to hopefully steer you
towards the relevant and pressing questions. At an institution of
learning as esteemed as this, it is your role to undertake meticulous
scholarship that moves us towards the right answers.
Thank you very much.