Pretend you’re Darmin Nasution, Indonesia’s central bank governor, and inflation is running at about 6 percent. Do you raise interest rates or cut them?
This isn’t a trick question, but one facing Asia’s monetary authorities as they brace for a possible third round of U.S. quantitative easing, an effort by the central bank to get more money into the economy. No matter what Federal Reserve officials say, waning U.S. growth has many here convinced that QE3 is on the way. Asian currencies are rising in anticipation.
Here’s where things get tricky for Nasution and his peers. Normally, they would raise borrowing costs to cool prices and contain asset bubbles. Yet that may only attract more hot money as investors rush to higher returns. Lowering rates might ease the speculative capital flows but also fan inflation.
These times are anything but normal as the Fed, Bank of Japan and European Central Bank have rates at or near all-time lows. Asia is on the front line of the struggle with cheap money and unprecedented liquidity.
Things are about to get even more unsettling.
Even if Fed Chairman Ben S. Bernanke opts against tripling down on quantitative easing, it’s now clear that rates everywhere will stay unusually low for longer than many investors expected. And with the most developed economies barely growing, Asia will be getting an even bigger share of the loose cash careening around the world financial system.
There’s no doubt that Asia is a different place than it was in 1997, the last time it wrestled with too much hot money. It has since strengthened financial systems, built more liquid bond markets and amassed trillions of dollars of currency reserves. This bulwark will be seriously tested in the next six to 12 months.
Before the weak economic news of the past month or so, markets buzzed about exit strategies ― withdrawing the monetary easing that followed the 2008 financial crisis. Fears of a double-dip U.S. recession have returned, though, and so has talk of closing the monetary floodgate. Europe is reeling, too, with no end in sight to Greece’s debt crisis or the risk of contagion emanating from the euro zone. Japan is in bad shape as the fallout from the March 11 earthquake, tsunami and nuclear crisis hamper spending and investment. China is stepping up efforts to slow growth and contain inflation.
These days, when the Fed says it will keep rates “exceptionally low” for an “extended period,” it sounds suspiciously like “indefinitely.” That’s dangerous for Asia, which has resorted to controls to tame the capital influx. But those tools are far from effective.
One reason many in Asia are convinced that Bernanke will do more is because America’s funk is so persistent, almost reminiscent of Japan. The first round of quantitative easing stabilized the U.S. financial system and calmed nerves around the globe. The second one disappointed, as evidenced by the slowest pace of growth in U.S. payrolls in eight months during May.
Congress is gridlocked, making new fiscal stimulus measures unlikely. That leaves the onus on Bernanke to pump liquidity into the economy. He will face huge resistance from those worried that he’s debasing the dollar, yet Bernanke may have no choice. In that way, the Fed’s experience is becoming a bit like that of the BOJ, which engaged in roughly two decades of quantitative easing.
In Asia, traders have been anticipating QE3, sending the Singapore dollar, Malaysian ringgit, Indonesian rupiah and Thai baht higher.
Even Japan’s yen is gaining in spite of post-tsunami radiation leaks, a leadership void and a deepening recession. Yen bulls even ignored a May 31 move by Moody’s Investors Service to put Japan’s debt rating on review for a downgrade, citing concerns about public debt levels.
“It says a lot about where we are that so many look at the yen and decide it seems the most stable,” Donald Amstad, director at Aberdeen Asset Management Asia Ltd., told me in Tokyo last week.
Nasution’s plight in Indonesia tells another part of the story. Gross domestic product in Indonesia may rise more than 6.5 percent from a year earlier this quarter because of an increase in foreign direct investment. Yet inflation is uncomfortably high. Consumer prices rose 5.98 percent in May from a year earlier after having increased 6.16 percent in April.
Indonesia has refrained from boosting interest rates since February amid hopes inflation would cool. The risk is that officials underestimate the effects of increased monetary stimulus by the U.S. central bank or others in the developed world. If higher inflation takes hold, containing it won’t be easy.
Asian policy makers must be mindful of the bubble fix. Massive capital inflows have a way of boosting growth and offering a false sense that recovery is afoot. In reality, they just create new bubbles.
Asia has done an impressive job of weathering the global financial crisis. Yet its performance of the past 2 1/2 years is no guarantee it can continue to do so.
By William Pesek
William Pesek is a Bloomberg View columnist. The opinions expressed are his own. ― Ed.