Mar 26, 2024
Intro: Our guest certainly has. Ramkishen S. Rajan is Yong Pung How Professor at the Lee Kuan Yew School of Public Policy. He has been a Visiting Fellow at various regional research institutes, including the Asia Competitiveness Institute, the Institute of Policy Studies as well as the Asian Development Bank Institute.
Professor Rajan specialises in Asian monetary and financial regionalism, exchange rate regimes and effects, monetary policy and financial development in emerging economies and currency crises just to name a few. I asked him to tell us what excites him about this area of study?
Ramkishen S. Rajan: David, thanks for having me. Over the last about two and a half decades, I worked on issues relating to macroeconomic and financial policy management in small and open economies with particular reference to emerging Asia. This is a topic I actually stumbled upon during my graduate time. I was in graduate school during the period of the 1997, 98 financial crisis. And so obviously macroeconomic management was a big issue during that period as countries went through crisis, restructuring and recovery. So broadly, that's what I've been working on over the time.
David: Is crisis a big focus of your work and looking at how economies manage crises?
Ramkishen S. Rajan: So absolutely. When I first started it was really about what causes crisis, crisis models. When you think about people like Paul Krugman, for instance, now everyone knows him for New York Times pro-democratic speeches, but generally a large part of his work before he went into international trade was about currency crisis models.
So my initial dissertation was also on currency crisis models. It then moved on to more crisis management. Post-crisis it was really an issue about countries remaining open to capital flows, how do they manage their economies?
David: And how do they do that?
Ramkishen S. Rajan: So if you think about Asia for instance, there are at least two aspects of economic globalisation: on the trade side and the financial side.
Trade openness and financial globalisation.
In the case of trade openness, most Asian economies have pretty much embraced trade globalisation. Yes, there's India, there's China, a bit slow moving in some areas, but by and large, most people accept the benefits and virtues of trade globalisation. Of course, there's some changes recently, but by and large that's not as controversial as financial globalisation.
And part of the controversy and complexity of financial globalisation is it's not so clear cut. There are at least two dimensions of financial globalisation. One relates to openness of cross-border capital flows, and the other is about internationalisation of the financial sector per se.
David: Looking at small and open economies in our region, what do you find about their central banks, in operation, in actual practice and how does that differ from theory, if any?
Ramkishen S. Rajan: Let's start with the latter, theory first and then why things are much more complicated. Because if things worked in theory there'd be no real research, right? We'd just do textbook stuff, and we are all done.
So let's think about theory. Let's say I'm a small open economy. So, I'm influenced by capital inflows and outflows. Here the issue with small open economies is the following: these economies are faced with policy trade-offs. Do they manage the internal price of money, which is the interest rate or the external price of money, which is the exchange rate?
Let me explain this — and this is what's referred to as monetary trilemma in the literature — but let me explain this. Let's say for instance, the US Fed raises its interest rates. Other things being equal, the shock to the global economy is the US raises its own interest rates because of, say, domestic inflationary concerns.
Having raised interest rates. If I don't do anything as a smaller economy, I'm going to be faced with capital outflows because investors can get higher returns in the US, that is going to be capital outflows. Investors sell my currency in order to buy US dollars to invest in the US, right?
And so now I have a choice. If I want to control my domestic price of money, which is interest rates. So I say, yes, the Fed has raised interest rates. I don't want to raise my own interest rates. Maybe because my domestic economy is in recession, there are leverage issues, et cetera.
So I don't want to raise my own interest rates. I just say, fine, let the exchange rate adjust. People want to sell my currency, let them sell my currency that causes my currency to depreciate. And that's fine. My interest rates stand pat. That's an example of I'm controlling the internal price of money, which is interest rates, but I forsake control over the external price of money, which is the exchange rate.
On the other hand, if I decide, no, the exchange rate is more important to me, and I'll explain why one might be more important than the other. But let's say I decide from a policy perspective, the exchange rate matters much more. Then when the US raises interest rates, what do I do? Assuming I want to maintain an open capital account, which most of these countries have done, now I have two choices.
I either say, okay, I don't want capital outflows, so to disincentivise money from leaving my country, I'm going to raise my interest rates along with the US interest rates. So that would be a case where I forsake control over my domestic price of money interest rates because I want to control the external price of my money, which is exchange rate.
The other option I have is to say I'm not going to suddenly raise interest rates because it might affect the domestic economy. So people are selling my currency. What I will do is I'll go into the foreign exchange market and buy my currency supply and demand. If people are selling, I buy to keep the price constant, the price being exchange rate.
As I buy my currency, what's happening effectively, the central bank is draining liquidity or taking its own money out of the system. When it takes its own money out of the system. What does that mean? A contractionary monetary policy. So as it's reducing money supply, effectively what it's doing still is raising interest rates.
So really fundamentally, if I choose to maintain the exchange rate at a certain level, whether I raise interest rates immediately or I raise it gradually via foreign exchange intervention, the end effect is the same. The only difference is with foreign exchange intervention, I'm losing international reserves.
I'm basically buying time. But there's a cost of buying time, which is the loss of foreign exchange reserves. So that's the way you think about it from a textbook perspective.
So the question is, why should I decide one is more important than the other? It really boils down to what is a more important price instrument? An economy consists of domestic demand and external demand. External demand is exports. Domestic demand is your consumption and investment.
So now if consumption and investment make up a large share of my overall economy, then it's the domestic price of money, which is interest rates that matter. The cost of capital matters to firms. The cost of capital matters to you and me if you're going to buy furniture or durable items. Domestic cost of capital matters. If consumption and investment, which is domestic demand matters much more, it's the internal price of money, which is dearer to me. So I give up the external price of money.
If, on the other hand, exports make up a large share of my overall economy, then the price of money that's important is the external price of money, which is the exchange rate.
Not surprisingly, this is where the textbook works from a technocratic perspective.
If you look around the region, relatively small economies, Hong Kong, Brunei, Singapore, Timor-Leste all have versions of fixed exchange rates. Timor-Leste is an extreme case. After gaining independence, they just adopted the US dollar wholesale as legal tender. That's an extreme form of fixed exchange rate. Brunei has a fixed exchange rate to the Singapore dollar. Hong Kong has a fixed exchange rate to the US dollar. Singapore has a slightly more adjustable rate, but by and large, it's heavily managed and is heavily managed against a basket of currencies.
That is how things ought to work from a textbook perspective. So it's not that the textbook principles don't work, but there are more complications for other economies.
David: What is the current thinking about the dominance of the US dollar? And maybe put it in perspective just because you did mention at the beginning that you started your career when the Asian financial crisis was happening. And it seems a lot of the Asian economies learned from that and improved their situation since then. But if you were doing a health check on the Asian economies, how do you feel about that and what is that relationship to the US dollar dominance that you mentioned?
Ramkishen S. Rajan: So let me narrow down that a bit more. On the one hand, if you do a health check, generally the financial sector is far more robust than it used to be. Yes, there are issues here and there, but by and large, the part of the problem with the Asian financial crisis was, I think of this as a mental model of policy makers.
Thailand was the extreme case. So think about Thailand. I digress a bit, but just to put this in context. Thailand from the late seventies, early eighties started liberalising its trade and investment regime. When they liberalised initially nothing much happened, but then they got lucky.
They got lucky from the perspective of policy is like life, right? A combination of good luck and doing the right thing as it were. But you need luck. So in the case of Thailand, yes, they opened up on the trade and foreign direct investment side, but they had a stroke of luck because that was a time when we had the Plaza Accord.
The Plaza Accord was an agreement that the Americans made with Japanese, Germans, et cetera. But let me focus on Japan here in this part of the world where Japan, having become an export powerhouse from the sixties onwards after the Second World War and certainly after, after the Korean War, during the entire period their currency was more or less pegged to the US dollar.
So it was fixed. So the exports were doing really well, but they didn't change the value of the currency. And the US, which was de-industrialising at that time, came to an agreement with Japan, pretty much forced Japan to allow the currency to become more flexible.
Flexibility in this case means currency appreciation. So the yen starts appreciating quite significantly. It moved from, I forget, some 220 yen to the US dollar, to almost overnight a 100 yen to the US dollar.
So now, if I'm a Japanese manufacturer, Honda, Toyota, et cetera, it's taken me a long time to penetrate into the US market. Now suddenly having penetrated the US market, my cost in US dollar terms have skyrocketed because my costs in yen terms have remained unchanged. But because the yen has become so much more expensive, the price of the car is going to be much more expensive in the US.
Yes, I can try and reduce my margins to some extent, but that's not going to be sustainable when you have an effective doubling of the price of the yen.
So what did they do? They said, let's try to reduce the cost of production by looking around the rest of the world. Then they looked at Thailand. Thailand was opening up, culturally, et cetera, they were comfortable with Thailand, it's not just about economics. And so Thailand almost overnight becomes the Detroit of the East.
So the reason I mentioned this is because of the mental model and Asian financial crisis. So Thailand's policy makers are looking at this and saying we have liberalised in a few years now we have done so well. At that time, Thailand was considered the darling of the global economy. So, then their mental model was more liberalisation, the better. So, we have liberalised the trade side and investment side, let's start liberalising the financial side.
Problems.
You liberalise the financial side, what does that imply? They didn't bother about thinking about different aspects of financial globalisation. They liberalised capital flows and they liberalised the financial sector simultaneously.
And that led to a significant boom in the economy, not just foreign direct investment, but short-term capital starts coming into the economy and when there's an external shock or any kind of shock, suddenly investors reconsider risk and there's a massive capital outflow.
And if you haven't regulated your financial sector properly, when there's capital outflow these banks and financial institutions get caught with this outflow of capital. So the Asian financial crisis was really predominantly a financial crisis.
They grew on the trade side, but they didn't pay enough attention to the financial sector side, right? And so that's the mental model dimension of it. So on the one hand, going back to your question, yes, they have dealt with the regulatory side much better. There's much more robustness in the financial sector.
But predominantly the basic issue for this part of the world has been the US dollar's dominance, in terms of capital flows trade, et cetera. And why does this matter? It matters for the following reason.
Let's go back to the same argument, right? Let's say the Fed raises interest rates. Now I've chosen to have more flexibility of my currency because I want to manage my interest rates. That's the starting point.
So there's capital outflow from my country. I'm not raising interest rates, so my currency depreciates. For Australia, UK, et cetera, this is okay, my currency depreciates that makes my exports more competitive. Foreigners find my assets cheaper, and so there's capital inflow, more exports. I'm good. That's the textbook version.
For Asian economies post-crisis, things haven't worked out as well because once the currency depreciates, there are few problems. The currency has depreciated, but the basis of gaining export competitiveness is my goods are priced in my own currency terms. So when I convert it to US dollars, it's cheaper.
But a large chunk of the goods in this part of the world are priced in US dollars. Partly because the US is still the predominant export market because of global value chains, et cetera, right? So you have the situation on the trade side. On the one hand, I'm importing a lot of goods in US dollar terms, but my exports are also in US dollars.
So when my currency depreciates, the cost of imports rises, but I don't gain cost competitiveness on the export side. So all that the currency depreciation has done is to increase inflation domestically. Similarly, a large chunk of corporate debt in this part of the world is still done in US dollars.
So now you have a situation when my currency depreciates, my borrowing, which is in US dollars, and therefore my liabilities that I pay, which is in US dollars, have risen in domestic currency terms, unless I have a large chunk of my assets in US dollars, which many of them don't. So my liabilities have skyrocketed in domestic currency terms.
My domestic assets are still in domestic currency, so therefore there's a sharp crunch on my balance sheets. This happened in the Asian financial crisis and still is a problem for a lot of corporates today.
The last issue is where the change has happened is a lot of countries here have developed local currency bond markets. So the corporate side is still predominantly US dollars, but the government bonds are increasingly in local currency terms. So we thought, oh, that's good. You won't have this balance sheet mismatch. But we realised something else. And that's after the global financial crisis. And that something else was, all you have done basically is instead of me as the government having the foreign exchange exposure, I passed it to you, say you are the investor. You have bought Indonesia rupiah bonds. Now, when the US dollar rises, the Indonesia government is fine because they don't have foreign exchange risks, but you have foreign exchange risks.
And now if my foreign exchange markets are fairly shallow, not very developed, I as an investor haven't hedged those risks properly. So if I don't hedge those risks properly, now I'm faced with a problem. I have this foreign exchange exposure. So when the US dollar appreciates a lot of these investors want to limit their losses or book whatever profits they have, so they start selling off the government bonds. And so yes, there's not a foreign exchange risk, but there's still a massive capital outflow tightening of credit and that creates all sorts of problems.
So yes, a bit complicated, but the basic point is that the countries in this part of the world that have moved to a greater exchange rate flexibility, things haven't been nearly as sanguine as one would've liked because of the dominance of the US dollar.
David: You talked about how some countries might have a shallow FX market where if they have a deeper one, that kind of cushions the changes a bit more. How do countries develop a deeper FX market? How do they encourage that?
Ramkishen S. Rajan: That's actually a really good question and that's something that economists have been struggling with. The Bank of International Settlements is looking into this, et cetera.
So part of this has to do with the size of the country, right?
You think about China. China has been an interesting case and there are all sorts of other issues, contemporary issues with China that we know about. But for a long while China maintained its currency fixity. Yes, they moved to a degree of flexibility, but they're back effectively to fixity now.
But China's argument was the following: yes, we'll move to flexibility, but we are not going to do a big bang. We have seen what's happened in other countries with a big bang sort of move to flexibility because financial markets do not develop overnight. They have to be nurtured. So policy becomes really important here.
So you're doing two things here. On the one hand, you're trying to incentivise your corporates and financial sector participants that, look, you have to expect there’s going to be greater flexibility of the currency, so you’d better hedge against these risks. Incentivise. On the other hand, hedge against these risks, how do I do it?
And it goes back to your question. The financial sector has to develop. And they don't develop overnight. You need the government to be nurturing this. Greater depth basically implies that the government has to help corporates and financial sector participants deal with corporate sector risk management better, et cetera.
But there's still a fundamentally issue, many people don't have the answer to this, which is fundamentally, is it the case that as long as you have a relatively small economy and China's economy is big on the trade side, but still small on the financial sector side, is it sort of a chicken and egg issue?
As long as you have a small economy, your financial sector is always going to lack depth. And if that's the case, from a policy perspective, that in turn means that if you lack depth and it's a relatively smaller economy, you can never expect to benefit significantly from having a completely flexible exchange rate regime.
So maybe you have to do other things. And what do I mean by other things? And this is part of a large chunk of what I've been working on.
Many of these countries in this part of the world say, okay, we've moved to greater exchange rate flexibility, but we can't be like the UK, Australia, et cetera, that has moved to complete flexibility. And so what we do is try to manage the economy using a hodgepodge of multiple counter countercyclical instruments. So these countercyclical instruments could be foreign exchange intervention, reserve management, macro prudential policies.
This is again, a conundrum because the more I do this, the more I come in from a policy perspective and limit the extent of exchange flexibility, that remains a disincentive for complete development of these foreign exchange markets.
So you see this chicken and egg problem here, right?
David: The policy choices, it just seems so difficult. The chicken and egg problem and the more you try to control things, the less control you have.
Ramkishen S. Rajan: Absolutely, sorry to interrupt David, if you think about this, one of the big things that IMF has done from a policy perspective in recent times, conceptual things when Gita Gopinath took over as Chief Economist and Deputy Managing Director, is they came up with this big thing about the integrated policy framework, the IPF.
That's a big issue for the fund. The IMF used to say: flexible exchange rates, no capital controls. That was their neoliberalism suggestion in the 80s and 90s until the Asian financial crisis occurred.
Then over time they said, okay, exchange rate flexibility, but maybe capital controls in some periods of time. Then they said, okay, maybe it's better to have more exchange rate flexibility, but we understand if you are not going to have complete exchange rate flexibility.
So a lot of the IMF policy has evolved, they become more open-minded, but still recognising that it was behind the curve in a sense, recognising the complexities faced by emerging economies in Asia and elsewhere.
But then the IPF is an important sort of addition, it's not perfect by any means, but it's important because what the IPF has basically done is the following: emerging policy makers in this part of the world have said, don't tell us what not to do, we know that things are not perfect. So in the textbook perspective, don't tell us about textbook way of doing things. We understand that we have to use these various policy instruments and we are not going to stop using them because that's what's worked, But then help us understand best practice.
When there's a shock, how much of the shock do I deal with in terms of foreign exchange intervention? How much do I use partial capital controls, if at all? How much do I use in terms of financial sector policies, et cetera?
There is no best practice.
So it was really about trial and error in this part of the world. So the IPF's big contribution has been to develop typologies to help policy makers think about what combination of tools and when to use them in response to various shocks.
So I think the IPF has been a good contribution, but a more general point here, yes, it's complicated. But it's a really ongoing contemporary issue. And so I think the IPF is a good contribution, not perfect by any means, but it's really helped us now start to think about some of these issues a bit more analytically.
Until now, it's really been an issue about if I'm a Thai policy maker, I look at what's best for my country and I work things out based on experience, et cetera, in Singapore, et cetera, same thing. But they had nothing really to fall back on. At least now the IPF is there as a starting point.
David: Is there anything that worries you right now? Anything that keeps you up at night as you look at the different economies in our region?
Ramkishen S. Rajan: As you get older, you try not to worry so much about things. So from that perspective, not as much. But taking your point more specifically.
The big issue is the following and let me tie this into the second aspect of financial globalisation, which we haven't talked about. So let's mention that a bit briefly, which the last few years I've also been working on that, which is the internationalisation of the financial sector.
So let me explain how these things are related. Macro economy is like the human body, right? Everything is related to something else in some manner.
So this part of the world has said the following. Okay, we'll allow for degree of flexibility of the currency, but we'll use things like foreign exchange intervention, macro prudential policies, et cetera in various manners to help stabilise the economy. The problem is the following, as countries in this part of the world in particular, but globally also utilise financial sector policies like macro prudential policies to enhance the resilience of the financial system, there's a lack of coordination of such policies across countries.
So I like to differentiate between Asia or at least East Asia and Europe.
What did Europe do? Europe said in the first step — pre-formation of the Euro — they said, let's move towards a currency union, but we are not willing to give up central bank sovereignty as it were.
So the Germans, French, et cetera, maintain their own central banks. The idea was, I as Germans, Italians, et cetera, we limit the extent of exchange rate flexibility vis-a-vis each other.
And eventually we'll go from plus minus 10 per cent, plus minus five per cent, eventually zero. If it's zero, we might as well adopt a common currency. That was how they started thinking about moving to common currency. But they did not give up monetary policy independence. So ‘92, ’93, crisis happened. Crisis was really about lack of monetary independence.
The Germans raised interest rates, the Italians, French, et cetera, didn't raise interest rates. And so there was all this inconsistency in policy. So then they learned over time, if I really want to commit to having a fixed exchange rate, a common currency, I have to forsake complete monetary policy independence.
So the creation of the ECB. After the Eurozone crisis, they said if I want to make a monetary union really robust, it's not just enough to think about giving up monetary sovereignty, I have to think of giving up financial sector sovereignty because the Eurozone crisis is really about a banking sector crisis.
So, on the one hand, the Eurozone is talking about having a common banking union in terms of having common financial regulatory policies, having common deposit insurance policy, et cetera. Things are moving, not completely there yet, but that's the direction they're moving. On the other hand, in the case of East Asia, they have said to manage our economy, we have to have these independent tools that we are going to use, and we are not going to coordinate these tools.
So yes, on the one hand, ASEAN and East Asia may talk about trade integration and they'll talk about openness in terms of foreign direct investment. But essentially, if Singapore decides to use their macro prudential policies, they do it based on what's happening to the domestic economy. They don't worry about what Malaysia is doing. They don't worry about repercussions and rightly so because nothing is coordinated. Same thing for other countries as well.
So this has been going on for some time. The problem I have is with the advent of big tech in finance and the growing role of what you'd call regionally, systemically important financial institutions, which means they have a market in these different economies, anything that happens to their balance sheets, could that have feedback effects to other economies.
So my sense is, if these economies, by failing to better coordinate financial policies over time, that might compromise regional financial stability.
Just a plug here, this is part of how I got interested in this in more detail was a few years ago I participated in this Asian Development Bank project and the book, et cetera, has come out, it's called Redefining Strategic Routes to Financial Resilience in ASEAN+3.
So the basic point, again, related to all of this, we have paid a lot of attention to capital flows. We have managed capital flows by doing our own thing. But as we haven't integrated on the financial regulatory side, but the financial sector on a de facto side may be becoming more integrated because of the systemically important financial institutions, et cetera.
And that might be a point of weakness. And so that needs to be looked at in a bit more detail.
David: Thank you so much. You've given us so much deep and complex information on these topics. It's been very eye-opening to look at all the ifs and buts that you were referring to that go into these decisions.
Ramkishen S. Rajan: Sure. David