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Asian soft-pegs like Sri Lanka face ‘impossible trinity’ as US tightens

ECONOMYNEXT – Asian countries which are soft-pegged to the dollar are facing impossible balancing act to maintain economic stability and growth as monetary conditions in the United States tighten, the Asian Development Bank said.

Sri Lanka also has a soft-peg to the US dollar.

Though the Fed had not yet raised policy rates, it has ended quantity easing and excess liquidity in the US banking system has been shrinking steadily since the last quarter of 2014, tightening the dollar monetary system, strengthening the currency and lowering commodity prices.

Pegged countries that try to push growth through low interest rates then face currency pressure, capital outflows, excessively high interest rates when corrective measures are put in place to arrest currency crises, which leads to sharper than necessary downturns and banking crises as well.

Unlike countries with hard pegs (fixed exchange rates) like Hong Kong where money is not printed to keep rates down and promote ‘growth’ other Asian nations have the ability to print money to maintain a political growth objective while they try to maintain a peg to the US dollar.

Such policies lead to high credit growth and imports, generating currency instability and eventually a loss of confidence among foreign bond holders who then try to flee the country, analysts say.

"In this regard, monetary authorities in the region may need to respond to the increase in the US interest rate in kind, by symmetrically tightening domestic liquidity," ADB said.

"Unfortunately, unlike in the US, growth is currently weakening in most of developing Asia.

"This difference in the momentum of economic growth points to a need for developing Asian economies to pursue monetary policies diametrically opposed to the expected policy of the US by loosening their domestic liquidity positions.

"Though required to catalyze economic growth, easy money policy is not what developing Asia needs now to safeguard domestic financial stability, in the current context of managing capital outflows to ease exchange rate pressures toward depreciation."

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Soft-pegs face the so-called impossible trinity of monetary policy objectives of targeting exchange rates and interest rates simultaneously and allowing free capital mobility.

The impossible trilemma put forward by Robert Mundell and Marcus Fleming shows that Keynesian style stimulus in impossible to practice in the real world because countries are not self-sufficient autarkies.

The ADB report however wrongly labelled the soft-peg as a fixed exchange rate.

A ‘fixed exchange rate’ is a currency board or hard peg and is only found in a few countries in Asia including Hong Kong, Macau and Brunei.

These countries are not associated with currency crises and high economic instability stay out of the media, the public eye and in most cases researchers engaged in empirical studies.

ADB divided countries in to four categories: those with pegs and capital controls, a peg without capital controls, a flexible exchange rate with capital controls and a flexible exchange rate without capital controls.

The ADB said monetary policy was found to be fairly independent of the US in countries with capital controls, regardless of which exchange rate regime they adopt.

"More specifically, the study found that, in economies with fixed exchange rates but no capital controls, a US interest rate increase by 100 basis points is followed on average by an increase in a peripheral economy’s interest rate by 65 basis points.

"In economies with flexible exchange rates and no capital controls, the same change in the US interest rate induces an increase in peripheral interest rate of only 45 basis points."

The countries in the study were: Argentina; Australia; Belarus; Bolivia; Brazil; Canada; Chile; the People’s Republic of China; Colombia; Costa Rica; Ecuador; Germany; Hong Kong, China; India; Indonesia; Israel; Japan; the Republic of Korea; Mexico; New Zealand; Pakistan; Peru; the Philippines; Singapore; South Africa; Thailand; Turkey; and the United Kingdom.

Among the countries Hong Kong is a true currency board, Ecuador is dollarized (which for all intents and purposes is similar to a currency board) and Singapore is a modified currency board in that it does not pursue a policy rate.

Panama another dollarized country in the region was not included. Like currency boards, dollarized countries also tend to stay out of the public eye due to the boring stability.

Australia, Canada, New Zealand, UK, Germany and Japan are independently floating countries. (Colombo/Sept24/2015)

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