In an effort to contain financial disaster, central banks of the world’s major economies have taken a concerted emergency action to provide cheaper dollar funding to these troubled banks at the end of November 2011. Further, the President of the European Central Bank (ECB) recently pledged readiness to act more aggressively in averting a deeper financial crisis.
This serious threat of financial crisis is not new to the global economy. Triggered by different factors, the world has observed two similar crises within the last decade; the burst of the dotcom bubble in the early 2000s and the beginning phase of the global financial crisis through 2007 and 2008, which culminated in the bankruptcy of Lehman Brothers and the freezing up of global finance. In both cases, aggressive policy easing took place in the leading industrial economies, sending real interest rates to a very low level.
The current situation inEurope may still lead to a global economic slowdown if the debt problems are not resolved, propelling the global financial system into another deep crisis comparable to that of 2008. The policy reaction this time should not be much different from 2008. At the very least, the ECB and central banks should relieve pressure on banks and the financial sector by cutting interest rates further to ensure that affordable liquidity is available for the financial sector. As observed in both the burst of the dotcom bubble and the global financial crisis, such action would result in a low international interest rate environment.
Given the integrated global financial system, any such shock would have implications for small, open economies elsewhere. For emerging ASEAN economies (Indonesia, Malaysia, the Philippines and Thailand), the two episodes of internationally originated financial shocks in the past decade seem to have insignificant effects unless coupled with a global recession that pushed their domestic output down at the same time. To better understand the effects of adverse international financial shocks, however, it is useful to isolate these shocks and analyse their impact on the macroeconomic performance of these economies. This type of structural analysis typically suggests the shock’s effects on inflation and output tend to be largely similar and relatively small. An isolated negative shock in international interest rates would tip the ASEAN economies toward an environment with lower inflation and higher output volatility, albeit generally small in magnitude.
Although small, the impacts of purely international financial shocks on ASEAN economies tend to be long lasting, with implications for the management of future macroeconomic stability. It seems the larger the size of the international financial shock, the greater the consequences of maintaining future economic stability for ASEAN countries.
How should emerging ASEAN economies react to an isolated adverse international financial shock? Typically, to counter a drop in the international interest rates, a country may reduce its domestic interest rate. This discretionary policy action may counter the short-run inflation effects from the international financial shock, but would aggravate the short-run impact on the country’s output gap at the same time. Consequently, the country would end up facing greater volatility in its domestic output. In this way, the cure may worsen the illness. Discretionary monetary policy action may only be sensible when the global financial shock is accompanied by a global recession that also reduces domestic output at the same time. In this case, the cure will have the desired short-run impact of limiting the global shock’s effect on both domestic inflation and output.
Yet, confronted with the external shock’s long-lasting effects, the short-lived domestic interest rate shock will only work for containing short-run volatility implications and will leave domestic policy makers with a hanging problem of managing volatility in the medium to longer term. In this regard, efforts to manage the domestic economic implications of a single, large shock in the international financial system would entail not just a simple short-run policy response in emerging ASEAN countries, but more complicated adjustments to their overall economic structure.
To deal with the effect of an adverse international financial shock, individual authorities in emerging ASEAN economies should opt for policies which provide longer-term structural adjustment to their economy. To this end, emerging ASEAN authorities should support the current efforts to restructure the global financial system in order to reduce future risks of more volatility. In addition, the similar pattern of effects on emerging ASEAN countries highlights the need for enhanced policy coordination and cooperation among these countries to better deal with such disturbances.
Arief Ramayandi is an Economist at the Asian Development Bank. The views are solely of the author’s and do not necessarily reflect the views or policies of the Asian Development Bank.