"Central Banking and the Challenges Ahead"
Opening Address by Mr Koh Yong Guan MD, MAS, at the Joint 5th NTU Asia-Pacific Central Banking Conference and 11th Annual PACAP/FMA Finance Conference, 8 -10 Jul 99
CENTRAL BANKING AND THE CHALLENGES AHEAD
Good morning. I am pleased to be here today.
1 Central banking is a highly hazardous profession, especially in this part of the world. The Asian financial crisis has taken a heavy toll on the region's central bankers. Of the ten central bank governors who attended the Southeast Asian Conference of Central Banks in Bali in February 1998, only three returned to the meeting in Seoul in May this year. Although I have been in MAS for only one and a half years, I already feel like a veteran observing a battle ground strewn with bodies.
2 The Asian financial crisis has raised the profile of Asian central banks. I see many of my counterparts featured regularly in the leading newspapers and financial magazines. The impact of monetary policy on financial markets and the economy is more powerful and immediate in fragile times. Likewise, supervision and regulation of the financial sector comes under greater scrutiny by global investors during periods of financial market turmoil.
3 This conference provides an excellent opportunity to discuss some of the challenges that central banks in the region face. Instead of providing an extensive analysis of some of these issues, I will pose four broad questions which I hope will stimulate some interest during the next few days of the conference.
4 The first question is: should central banks be concerned with asset prices? The standard objective of monetary policy is to promote sustained non-inflationary growth. Price stability is the primary goal of a central bank because it provides the basis for sustained output and employment growth. But how is price stability measured? Consumer price inflation, the traditional target, has been the least worry for central bankers during the crisis.
5 Rather, within a short window of time, central banks have had to grapple with a host of other concerns: excessive swings in stock market values, over-investment in real estate and emergence of property market bubbles, and massive inflows and outflows of capital.
6 Excessive rise or falls in the stock market can create conditions that distort the real economy, just as instability in consumer prices does. Indeed, more so than consumer prices, dramatic swings in asset values can affect confidence and wealth, which in turn affect consumption and business investment. Such swings are exacerbated by herd behaviour and speculative activity, with adverse consequences.
7 But is it the business of central banks to deal directly with changes in asset prices? If it is, should they do it by using traditional tools of monetary policy, like interest rates? Or should they resort to other measures like curbing foreign capital flows or intervening in the stock markets to prevent a price collapse or an asset bubble from forming? These remain controversial and unresolved questions.
8 The second question is: how should central banks deal with volatile capital flows? In the years preceding the crisis, there were large capital inflows to the region. These inflows provided benefits by raising levels of investment and encouraging economic growth. But it also appreciated the real exchange rate, widened the current account deficit, increased external borrowings, particularly short-term debt, and caused asset inflation. When crisis struck, a sharp reversal of capital flows followed. The net swing from inflows to outflows between 1996 and 1997 amounted to more than US$100 billion for crisis-Asia.
9 No other issue has triggered more debate than the issue of capital flows. Should central banks impose controls to prevent capital outflows? Or is it inflows that should be controlled in the first instance? Will such measures work? And should not the whole question of opening up the capital account hinge on how strong the regulatory and supervisory framework is?
10 Many central banks today would be quite unwilling to impose capital controls. The preference has been to rely on traditional monetary policy operations to deal with excessive capital flows. For instance, many central banks have undertaken sterilised intervention to varying degrees to temper the upward pressure on monetary aggregates and the exchange rate arising from strong capital inflows. But some would argue that such sterilisation actually encourages more capital inflows and heightens the risk of a crisis. With foreign capital rushing back into the region, Asian central banks are intervening and sterilising to prevent their exchange rates from appreciating and the monetary aggregates from rising too quickly - but again, is this deja vu?
11 My third question for you is: what should be the balance between regulation and market discipline in promoting financial sector stability? The crisis has highlighted the importance of sound regulation and supervision of the financial sector. In crisis-countries, recapitalisation and the carving out of bad loans have strengthened weak banks and restored their viability. But what must we do to ensure that these bad loan practices of the past will not be repeated? Can regulation alone do the job, especially in an environment of increasing sophistication of financial products and technological innovations? More broadly, how "tightly" should central banks regulate financial institutions? Too much regulation and protection may stifle the development and growth of the financial sector.
12 In Singapore, we are moving towards a regime that places greater emphasis on supervision than regulation. Instead of a "one-size-fits-all" approach, we want to give greater latitude for strong and well-managed institutions while maintaining stricter standards for weaker institutions. Hence the need for more frequent and risk-focused examinations of institutions. But how quickly can we move to a risk-based supervisory approach? It calls for the development of good risk-control systems and more importantly a change in the mindset of regulators as well as financial institutions. Second, how much reliance can central banks place on greater transparency and disclosure to impose market discipline on financial players to act prudently? Related to this is the question of how to deal with highly-leveraged institutions like hedge funds? Does the answer lie in direct regulation of these institutions, or indirect regulation through supervising their bank counter-parties, or imposing greater disclosure requirements on them so that market discipline will restrain them?
13 My fourth question is: is monetary policy sufficient for macroeconomic stability? This may come as a surprise if it comes from a professional central banker. However, I am not a professional central banker, but a civil servant seconded to a central bank. Nevertheless, it is a question worth thinking about. We have seen since the early 1980s a growing international consensus on the very important role that central banks play in macroeconomic stability. There is widespread agreement that the appropriate objective of central banks is price stability, that they should be free to pursue this objective with independence, and achieving this objective is the best contribution they can make to sustained economic growth. And this is indeed the basis on which the MAS has operated.
14 But I wonder if the pendulum has swung too far the other way to the extent that monetary policy is seen as the primary determinant of macroeconomic stability. Are not fiscal discipline and sound microeconomic policies equally important in ensuring economic stability and market confidence? Prudent monetary policies can achieve low inflation but if fiscal policies are too expansionary and labour markets are inflexible then price stability comes with high interest rates and high unemployment. In Singapore's case, MAS has been able to pursue a credible and effective exchange rate policy in large part because our fiscal position has been strong and we have paid particular attention to ensure that our macroeconomic policies are sound.
15 Besides these four questions, the crisis has raised many other thorny issues about the role of central banks. With signs of economic recovery and financial stability, we are all breathing easier today. But can we central bankers now declare victory and claim credit for this remarkable economic recovery? Or has it been more sheer luck? One other thing: have we learnt anything from the crisis in the last 18 months? All through 1997 and 1998 I was hopeful that we were receptive to learning and looking for lessons to be learnt. But now, in 1999 I am no longer sure the financial industry have learnt or want to learn anything from the crisis of 1997. Indeed, we have short memories or even no memory. This is one more question I will leave you to ponder over.
1 Global Economic Prospects and the Developing Countries, World Bank, 1998/99. Crisis-Asia refers to Indonesia, Korea, Thailand, Philippines and Malaysia. The figure of US$100bn is equivalent to about 11% of these countries' GDP before the crisis.