Tarisa Watanagase: Issues important to small and open emerging market
economies
Speech by Dr Tarisa Watanagase, Governor of the Bank of Thailand, at the Panel Discussion on
Financial Globalisation, Capital Flows, and Challenges for Central Banks, at the 77th Annual General
Meeting of the Bank for International Settlements, Basel, 24 June 2007.
* * *
My discussion will focus on the issues important to small and open emerging market economies. The
first is regards to whether the present situation of sustained inflows into emerging markets is really
sustainable. What do these seemingly sustained inflows tell us, particularly in terms of investors'
assessment of riskiness of the region? Or from another angle, have risks in the region declined? I will
discuss this in the context of financial innovations in risk management, and conclude with a few
remarks on how these developments affect central banks across the globe.
My first question, therefore, arises from the observable reduction of risk premia for financial assets in
the region. On the surface, this low risk premia implies lower risks. But does, it, really?
We all realize that the international financial system is currently in an environment with low risk premia
across a broad set of asset classes, combined with low volatility in the prices of these assets.
Furthermore, this low risk premia has been sustained despite the various episodes of risk aversion in
the recent past. This raises concerns about whether prices - and consequently the risk premia
themselves - accurately reflect actual risks.
Of course, it is arguable that the search for yield in riskier assets is due in part, no doubt, to the
historically low interest rates and abundant global liquidity, partly a result of recent expansionary
monetary policy around the world. This has encouraged greater risk-taking, resulting in a substantial
reduction in risk and liquidity premia over the entire maturity spectrum.
On the other hand, however, low risk premia could also reflect changing risk appetite. More
importantly, it is unclear whether this change in risk appetite has arisen from permanent or transitory
factors. I make this distinction because permanent factors would imply that this reduction in risk
premia is here to stay. Transitory factors, on the other hand, imply that the risk premia would rise once
these factors reversed.
Let me try to identify some of the permanent factors that have resulted in the shift in risk appetite and
preferences. These include, firstly, changing demographics. The aging population has led to a larger
volume of pension funds, which need to seek higher returns in emerging market assets. Secondly,
technological advances, such as the IT revolution and decline in costs of telecommunications and
transportation, have substantially lowered costs for cross-border financial transactions. Thirdly,
changes in exchange rate regimes and capital account liberalization over the years have lifted many of
the previous obstacles to crossborder financial transactions. Fourthly, financial innovation has made
credit risk transfer mechanisms more widely available, increasing the appeal of riskier assets. Fifth,
the high level of liquidity may be a result of structural factors, or in some cases, policy factors, making
savings in emerging markets persistently higher than in developed markets, given the lack of social
welfare, healthcare, etc. This has resulted in a higher marginal propensity to save for consumers in
emerging markets and contributes to a persistent global savings glut. Sixth, greater diversification in
international reserves management, as well as sovereign wealth funds, may have led to increased
investment by authorities in more diverse assets as well.
On the other hand, numerous transitory factors may also have been responsible for this change in risk
appetite and risk premia. A reversal in any of these factors could result in risk aversion away from
emerging markets and destabilizing capital flows, and a rise in risk premia. Let me name a few factors.
Firstly, the situation of global imbalances and slide of the USD has led to preference for investment in
emerging markets, particularly given ongoing - but by no means sustainable - expectations of
appreciating currencies in emerging market economies. Secondly, low interest rates worldwide and
the high level of global liquidity have led to search for yield in riskier investments. This may be a
temporary phenomenon if we believe that the extended period of accommodative monetary policy
worldwide is unsustainable, and eventually monetary would need to tighten to compensate for this era
of profligacy. Thirdly, similar investment strategies employed by hedge funds and other funds could
lead to momentum trading and herd movements, both in terms of inflows and outflows. Any shocks
that trigger a change in these strategies could result in large movements of capital.
In any case, whether owing to the changes in risk appetite or not, we must remind ourselves that the
current pricing of risk is based on the expectation that strong growth and contained inflation will
continue to prevail. Any unexpected deterioration of the macroeconomic environment, however, could
trigger a rapid turnaround in sentiment.
This leads me to my next point, which I had raised earlier, of whether the increase in capital flows to
emerging markets was likely to result in an increase in risks? This seems the likely case. For example,
local investors do not usually provide counter-trade to hedge funds but rather take similar positions,
hence increasing the overall risks.
In addition, investment of hedge funds in a particular country is usually only a small fraction of their
whole portfolios, and inflows reversals may take place easily. Individual risk management can also
collectively induce systemic risks, and central banks may be required to resolve such problems to
avoid adverse impacts from sudden reversal of capital flows.
This leads us to the question of whether we are underestimating the inherent risks of these capital
flows? Let me explain why this may be the case.
First of all, net capital flows are small. Gross capital flows, however, are much larger: this may suggest
that the economy's degree of vulnerability is actually larger than currently accounted for. Should we
therefore be concerned with large two way (gross) flows, as opposed to net flows, and the size of the
much larger global balance sheet if counted in this way?
Arguably, large gross capital flows and the flow of surplus capital from emerging markets to more
developed markets may be a structural phenomenon, as mentioned earlier. The characteristics of
developed financial markets, in terms of lesser financial frictions, better information and fewer
borrowing constraints leading to better liquidity and lending, as well developed social welfare systems,
are reflected in the persistent gap in savings compared to developing markets. In addition, financial
integration has facilitated cross border arbitrage transactions, resulting in easier liquidity conditions
globally.
The implications and associated risks of this high level of global liquidity are different depending on
whether the current state of affairs is a new equilibrium consistent with the conditions under
globalization (e.g. case above), meaning that monetary policy should not try to counteract this
phenomenon.
However, if the current phenomenon is due to temporarily excessively accommodative monetary
policy that would eventually translate into higher inflation, this would require eventual tightening and
lead to the risk of capital reversals.
But there are also compelling reasons to argue that risks have been better distributed, given financial
innovation and various credit risk transfer mechanisms. Let me therefore pose another question: has
the use of these credit risk transfer mechanism helped to distribute risks, making the financial
environment a safer place?
On the plus side, credit transfer mechanisms can "redistribute" risks, as default losses would be
absorbed by a larger number of investors than otherwise. Some of the losses may be borne by
sophisticated players (such as hedge funds or some institutional investors) who are well diversified
and can better bear the losses. Credit transfer mechanisms also allow banks (via credit derivatives) to
improve their own risk management and enable them to diversify their risk profiles.
However, the use or risk transfer mechanisms can contribute to opacity in the distribution of risks,
especially once risks are transferred to unregulated entities (i.e. non-banks). This could lead to
bunching of risks in particular areas. Additionally, the use and constant innovation of credit risk
transfer mechanisms has allowed risk to take on more complex forms, making risk less traceable.
My final point will be on the resulting challenges to central banks of small open economies.
Central banks need to understand how globalization affects three main objectives: (1) the domestic
inflation process, (2) the transmission mechanism of monetary policy, and (3) financial stability. Let me
point out at the outset that empirically, there is still some disagreement to the extent of each effect.
First of all, it has been argued that the domestic inflation process has been largely changed by trade
globalization. In particular, increased trade openness and stronger international competition from low
cost suppliers in emerging economies has resulted in lower prices of imported goods and limiting
pricing power of domestic firms. In addition, higher international wage competition in labour markets,
as well as upward pressure on productivity growth (albeit this is difficult to distinguish from effects of
technological developments), have provided downside risks to inflation.
On the other hand, higher commodity prices due to stronger demand for energy related commodities
and industrial raw materials pose an upside risk for inflation.
Secondly, the monetary policy transmission mechanism has been changed by financial globalization.
Policy interest rates influence short-term interest rates. But recently, the response of long-term rates to
changes in the policy instruments has become less apparent. This raises concerns of whether central
banks' monetary policy is becoming less effective, particularly given that savings and investment
decisions are more influenced by long-term rates.
Additionally, the conduct of monetary policy has become harder in light of financial globalization. A
policy rate increase to tame inflationary pressures may induce further capital flows, thus bringing more
liquidity into the domestic market.
Thirdly, domestic financial stability is to a greater extent affected by global liquidity conditions. For
instance, growth in cross-border financial flows increasingly influences domestic asset prices.
However, this effect can be broken down into two main scenarios. The first is through changes
consistent with fundamentals. An example of such a change is the wave of worldwide mergers and
acquisitions, resulting from globalization, and improvements in efficiency through economies of scale
and integration. While this has exerted upward pressure on equity prices, this may not be a great
concern for stability.
On the other hand, some changes drive prices away from fundamentals. This includes asset price
moves caused by excessive investment in developed financial markets, or short term capital inflows
into emerging markets in search of yield, or through carry trades, etc., which may result in asset price
misalignments.
In this regard, the question arises whether the central bank's price stability objective is enough for
financial stability, given destabilizing asset price movements, coupled with movements in the
exchange rate, which may not be in line with fundamentals.