Several Asian economies have been raising policy interest rates, though real interest rates still remain rather low. There has also been a fair amount of exchange rate appreciation. Since mid-2009, most regional currencies have appreciated by about 5 to 6 per cent in real effective terms. Monetary policy in Asia is likely to remain tight in the months ahead. This should help to get the price of capital right, tame asset price inflation, and reduce the risk of misallocated resources. 15. Indeed, as emerging Asia continues to grow, allowing the exchange rate to steadily appreciate over the medium term is vital to ensuring that capital inflows are moderated and capital is allocated to productive investments. 16. But interest rates and exchange rates cannot take the burden of adjustment entirely, especially over the short term, given the scale and pace of capital inflows. Therefore,  2  BIS central bankers’ speeches  macroeconomic policy adjustments have been complemented in some Asian countries by macroprudential measures, like reductions in banks’ loan-to-value ratios and debt-to-income ratios. In exceptional cases, resort to capital flow management measures may be necessary to bring the situation under control. Strengthen infrastructure for allocating capital 17. Next, emerging Asia must strengthen its infrastructure for allocating capital. Banks are still the principal channel for allocating capital in Asia, and post-Asian financial crisis, many Asian authorities have taken steps to strengthen their banks. Banking systems were cleaned up of their non-performing loans, recapitalised, and strengthened.

But when interest rates soared from 1980 onwards, the payments to service this debt began to cripple the economy. At the same time, the projects these investments went into failed to deliver the expected returns. It all ended in a severe debt crisis that set back Latin America by at least a decade. Essentially, a mispricing of capital resulted in cheap funding and overinvestment. 11. Developed economies are equally prone to the risks of mispriced capital. The subprime mortgage crisis, which precipitated the global financial crisis less than three years ago, is another example of mispriced capital leading to excessive risk taking and leverage. Low interest rates in the US fuelled both a housing and a credit bubble that eventually burst, dragging down investors and intermediaries alike. 12. In emerging Asia, today, high levels of domestic savings coupled with large capital inflows pose the risk of unproductive investments and asset bubbles. When capital inflows slow down, as they inevitably must, the consequent unwinding will be rapid and possibly unpleasant. Asian policymakers have been responding to the situation in various ways 13. First, they have allowed the price of capital to rise – either through exchange rates or interest rates or both. Second, they have regulated the demand for capital through fiscal tools, such as transaction taxes and stamp duties. Third, they have regulated the supply of capital through administrative tools, ranging from restrictions on bank lending to selective capital controls. 14. The most effective way is to price capital correctly.