Taiwan - Fai-nan Perng (Published: 30 August, 2010) - 理財

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Fai-nan Perng

Published: 30 August, 2010

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Fai-nan Perng, Governor of the Central Bank of the Republic of China (Taiwan)

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Capital mobility brings many benefits to a country's economy but can also
create instability and worsen crises. Measures can and should be put in place
to curb the more risky forms of capital flow and foreign-exchange speculation.


For my generation of central bankers, the rapid growth of cross-border
financial transactions and international capital flows is one of the most
important economic developments we have experienced over the past 30 years.
There is no question that capital mobility can bring multiple benefits, yet
in a number of countries international capital flows have been closely linked
to financial crises. It is little wonder that the subject of capital account
liberalisation remains highly contentious. Perspectives differ because what
is beneficial to some countries may make others more vulnerable. After the
recent financial crisis, however, there is greater consensus on the costs and
benefits associated with international capital flows and how such flows can
be better managed.


Not all capital flows are created equal. International capital movements in
the form of foreign direct investment create a win-win situation for the
recipient country and the investing country. Short-term capital, however, is
highly volatile. Large and sudden inflows of foreign capital lead to exchange
rate overshooting, loss of trade competitiveness, domestic credit booms and
asset price bubbles, all of which can elevate systemic risks and create
financial fragility. Once the economic and financial conditions start to
deteriorate, the direction of capital flows will reverse abruptly, with
devastating consequences. The pro-cyclical nature of international capital
flows also gives rise to concerns that foreign investors suffer from
excessive optimism and are prone to herd behaviour, both of which amplify
asset booms and busts.


From a theoretical perspective, an economy cannot simultaneously pursue
monetary independence, exchange-rate stability and capital mobility. Each
country, therefore, must strike a balance that will ultimately promote
financial stability and foster long-term economic development. International
capital flows present a set of macroeconomic and prudential policy
challenges. There is no shortage of tools for meeting these challenges.
Fiscal policy, monetary policy, exchange-rate policy, prudential regulation
and capital flows management come immediately to mind. Yet the abundance of
policy tools belies the difficulty of finding the appropriate policy mix.


Faced with a surge in capital inflows, prudential regulations that target
specific segments of the economy can play a useful role in dampening the
demand for speculative capital. Hong Kong, Singapore, South Korea and Taiwan,
for example, have all recently introduced targeted prudential measures to
curb real estate speculation as international capital inflows continue to put
upward pressure on asset prices in these countries.


Allowing the exchange rate to adjust passively to capital flows is another
possibility. But for small economies with deregulated capital accounts, this
policy will lead to wild exchange-rate fluctuations that can create havoc for
the tradable sector. For these countries, a better option would be to keep
the nominal exchange rate flexible, while allowing the real exchange rate to
reflect economic fundamentals. This will make it less attractive for currency
speculators to take advantage of a rigid exchange rate regime and will soften
the impact of volatile capital flows. Accumulating official reserves can also
act as a buffer.


Capital management needed


For many countries, choosing the right exchange-rate regime and maintaining
an appropriate level of foreign exchange reserves may not suffice. In the
face of substantial inflows, macro and prudential policies should be
complemented by some form of capital management. This sentiment is shared by
a number of governments around the world. For example, Brazil announced in
October 2009 that a 2% tax would be levied on foreign investment in local
bonds and stocks. On June 13, 2010, South Korea unveiled measures to mitigate
the volatility of capital flows and exchange rates, including setting
ceilings on the foreign exchange derivatives positions of domestic banks and
foreign bank branches at 50% and 250% of their capital, respectively. On June
16, Indonesia announced a series of measures to stabilise its financial
markets, including abolishing the rule limiting banks' on-balance-sheet net
open positions to a maximum of 20% of their capital, while maintaining
overall net open positions at 20% of capital; widening the overnight
inter-bank rate corridor and imposing a minimum one-month holding period for
Bank Indonesia Certificates.


As a small and highly open economy, Taiwan recognises that unfettered
financial liberalisation and unbridled international capital flows can put
financial stability at risk. While many countries are busy debating which of
the many government agencies should be responsible for monitoring systemic
risks and financial stability, there is no ambiguity in Taiwan. Promoting
financial stability and maintaining exchange rate stability are two of the
four operational objectives set out for the central bank in Taiwan's Central
Bank Act. Articles 19 to 31 and 33 to 35 of the act go as far as listing a
variety of policy instruments that can be used to achieve those objectives,
including targeted prudential regulations.


To prevent Taiwan's foreign exchange market from being disrupted by
international capital flows and to ensure that exchange rates are determined
by economic fundamentals rather than short-term capital movements, the
Central Bank of the Republic of China (Taiwan), or CBC, has introduced a
number of measures to manage foreign capital inflows. By way of background,
foreign ownership accounts for 30% of Taiwan's stock market capitalisation.
Although Taiwan has more than 10,000 registered foreign institutional
investors (FINIs), roughly 20 are responsible for more than 40% of all FINI
foreign-exchange transactions. The volume of FINI foreign-exchange trading
tends to fluctuate wildly, frequently disrupting Taiwan's foreign-exchange
market.


Under the current system, foreign capital invested in the local securities
markets can move in and out of the country freely. However, some foreign
portfolio investors have built up sizable Taiwanese dollar positions in
low-yielding or non-interest-bearing investments. One suspects that these
FINIs are more interested in currency speculation than securities investment.
To prevent currency speculators from increasing exchange-rate volatility, the
CBC constantly has to remind foreign investors to use Taiwanese dollar funds
in a manner consistent with the declared purpose of securities investment. A
reporting system is also in place to track large foreign-exchange
transactions. These efforts have been largely effective, partly because the
CBC has the power to carry out target examinations related to the
implementation of foreign exchange and monetary policy.


Regional co-operation has a useful role to play in managing international
capital flows. Because foreign investors are prone to herd behaviour,
financial crises are often triggered by capital flows linked to the contagion
effect. In these instances, events and shocks experienced by one country are
quickly transmitted to another economy, an entire region, or the rest of the
world. For example, the 1997-98 Asian financial crisis that originated in
Thailand quickly spread to other Asian economies. More recently, the same
phenomenon was also observed during the global financial turmoil and the
European sovereign debt crisis.


Working together


As the world becomes increasingly interconnected, it is important for
countries with similar macroeconomic characteristics to work together to
mitigate the risks associated with international capital flows. As I pointed
out during the 2010 Asian Development Bank annual meeting in Tashkent,
Uzbekistan, there are several ways in which regional co-operation can promote
financial stability, including mechanisms to monitor capital flows, financial
support facilities and regional exchange-rate arrangements.


A number of east Asian countries have been co-operating under the framework
of regional economic surveillance to monitor short-term capital flows.
However, this co-operation has seldom moved beyond information sharing. If
these countries can take concrete and concerted actions, it will help promote
regional financial stability.


In terms of financial support facility, the Chiang Mai Initiatives
Multilateralisation (CMIM) [a multilateral currency swap arrangement between
13 Asian countries] came into effect on March 24 this year with a reserve
pool of $120bn. However, the CMIM should evolve into a comprehensive
multilateral swap mechanism across Asia with a credible regional institution
at the centre to serve as the primary intermediary.


Regional exchange-rate stability is conducive to promoting economic and
financial stability. When exchange rates are stable, lower transaction costs
and reduced uncertainty will boost growth in intra-regional trade and
investment. Asian countries should set up a formal regional exchange-rate
coordination mechanism through which stable currency relationships can be
established.


Over the past few years, the world economy has faced unprecedented
challenges. Governments from all over the world have adopted aggressive
expansionary monetary and fiscal policies to deal with the worst economic
recession since the 1930s. These decisive actions have produced positive
results. Although Asian economies have fared well in the early recovery
phase, we should be mindful that the global financial crisis has also exposed
a number of vulnerabilities.


It is encouraging to see that on June 27, 2010, the G-20 economies pledged to
strengthen the global financial system and build a more stable and resilient
international monetary framework. The need for regional and multilateral
efforts to deal with capital volatility and prevent crisis contagion,
however, has been largely overlooked. The international community should work
together to put the necessary measures in place to manage international
capital flows more effectively so that each country can pursue appropriate
policy and reforms to maintain financial stability and promote sustainable
economic growth.


Fai-nan Perng is governor of the Central Bank of the Republic of China (Taiwan)

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