One thing is clear: stronger cooperation between central banks will make these challenges easier to manage.
The central banks in Asia’s advanced and emerging economies face opposing problems. Central banks in advanced economies are being asked to do too much, while the central banks in emerging economies are unable to do enough.
In advanced economies, central banks have stabilised financial markets, stimulated economies and stopped financial creaks from becoming financial crises. They are pushing down the cost of government, corporate and bank borrowing through unlimited purchases of government debt, corporate bonds and commercial paper the like of which has not been seen before. Their actions have helped ensure the effective functioning of markets in turbulent and uncertain times.
These actions have their consequences. They create moral hazard for investors, encouraging risky investments on the assumption that central banks will come to the rescue. They create moral hazard for governments, encouraging the delay of structural reforms and fiscal supports or reckless foreign policies on the assumption that central banks will pick up the mess. They distort the ability of financial markets to price and allocate risk, making it hard for investors to judge what is risky and what is not. They create asset price bubbles through substantial increases in liquidity and create cross-country spill-overs through sharp shifts in exchange rates and capital flows.
Asia’s emerging economies face the opposite problem. Low inflation and stronger and deeper financial systems give central banks more room to manoeuvre than in previous crises, but they remain far more constrained than their advanced economy peers. Large-scale government spending often means large-scale international borrowing. This presents a brutal trade-off between supporting the economy and increasing financial risks. Large-scale asset purchases by central banks involves a similarly brutal trade-off between supporting the economy and risking runaway inflation and capital outflows from spooked investors.
These common and differentiated challenges create opportunities for cooperation in managing the side effects of these policies. First, fiscal cooperation between governments means fiscal stimulus has a bigger bang-for-your-buck, helping to take the pressure off monetary policy. Greater coordination on fiscal stimulus between governments will increase the economic impact of those fiscal measures and give vital political cover to help governments do more.
Second, central bank cooperation can stop the wave of financial crises sweeping across emerging economies. Central bank currency swap lines stop crises in their tracks by providing vital foreign exchange to repay foreign debts and reassuring markets. Most Asian economies, particularly those which desperately need these swap lines, have been left out of the US Federal Reserve’s swap arrangements. It falls to Asia to fill the gaps. Enhanced central bank cooperation with global and regional crisis-fighting institutions, including the IMF through better coordination of swap lines and a new issuance of Special Drawing Rights, will be vital.
Third, central bank cooperation can help stabilise exchange rates and volatile asset prices. Increasing the availability of currency swap lines and creating facilities that allow central banks to swap sovereign debt assets for currencies help prevent the fire sale of assets to obtain more cash. This helps stabilise both currency values and asset prices, providing breathing space for policymakers and confidence for investors.
Fourth, cooperation helps central banks to learn from each other and share experiences. Some might think this is insignificant. It is not. Even the governors of the world’s largest central banks recognise the value in learning from each other and better understanding how their policies create spill-overs onto other economies, and spill-backs onto their own economy. Former US Federal Reserve chairs, including Bernanke and Yellen, have noted how learning from other countries has changed their domestic policy settings.
In the first of this week’s lead essays, Andrew Sheng explores the challenges posed by the unprecedented actions being undertaken by central banks. ‘Central bankers can no longer pretend that they are apolitical independent institutions’, warns Sheng. ‘They wield a tool that can make or destroy the social fabric. It is time to have a serious conversation about the post-pandemic social contract that must include the role of central banks’.
Sheng details the sheer scale of the actions being taken by central banks across Asia. He notes that the Bank of Japan already holds half of all Japanese government bonds and owns 9 per cent of all Nikkei-indexed exchange traded funds, while the US Federal Reserve now owns nearly 60 per cent of outstanding US mortgage-backed securities. By April 2020, the balance sheets of the central banks from the United States, Europe, Japan and China had more than tripled since 2007, rising to over US$21 trillion.
Sheng explores some of the consequences of these actions. One is moral hazard. ‘There is increasingly significant moral hazard built into investor expectations’, warns Sheng. ‘Every time financial markets wobble, central banks exercise the “Greenspan put” by cutting interest rates or injecting liquidity’.
Sheng cautions that the sheer scale of central bank asset purchases has significant implications, yet to be properly considered, for the functioning of financial markets. ‘When central banks are that large, their asset purchases significantly affect total resource allocation and market distribution of risks’.
There is the question of what happens next. ‘Who will pay for the pandemic losses when central banks end up holding a large chunk of financial assets on their balance sheet?’ asks Sheng. ‘Won’t this mean the socialisation of losses and privatisation of gains? If these losses are inflated away, won’t the poor and savers bear the losses of credit defaults?’.
These are difficult questions. As Sheng says, ‘the pandemic has opened a Pandora’s box of unanswered questions to which central bankers have no clear answers’.
If the crisis raises difficult challenges for advanced economies, they are even worse for emerging economies. ‘The bottom line’, as Harvard’s David Dapice notes in our other lead essay this week, ‘is that there is limited fiscal space, or ability to spend much more, to respond to emergencies like this virus. Developing countries do not have the same deep and liquid bond markets that rich countries do, so they often have to issue bonds in foreign currencies, especially if bond issuance exceeds the ability of local bond buyers to absorb the new debt’.
‘This creates a dilemma’, says Dapice, ‘where the ability to use their own right to print money runs into the fear that this will cause their exchange rate to weaken and make it more difficult to repay debt’. ‘In trade-dependent countries, this can also considerably boost inflation’.
Dapice details the perfect storm of challenges facing emerging economies, including their large informal sectors and the threat of a flood of liquidity into these economies from low global interest rates.
External assistance will be needed to support emerging economies, but Dapice warns that such assistance is typically too small and too slow. ‘There will be emergency loans from the IMF, World Bank and other groups but they will not be nearly enough to allow a response similar to the rich countries’.
Thomas Sowell once warned that, in economics, ‘there are no solutions, there are only trade-offs’. COVID-19 is more proof that he was right.
The EAF Editorial Board is located in the Crawford School of Public Policy, College of Asia and the Pacific, The Australian National University.
This article is part of an EAF special feature series on the novel coronavirus crisis and its impact.