S-E Asia still has room in monetary policy arsenal

Inflation monetary policy

AS countries around the world scramble to enact various forms of expansionary fiscal and monetary policies to alleviate the shock from Covid-19, a key concern arises among economists: can countries afford to pay for these policies?

Among the South-East Asian countries, Singapore is the only one whose fiscal stimulus drew on reserves and not on additional borrowing. Other countries weren’t so fortunate to operate with such a large fiscal policy arsenal, which affects their ability to stimulate the economy.

For example, the initial aid package in Indonesia was only 4.4% of GDP according to Statista, whereas other countries had stimulus packages of around 10% of GDP.

A close look at the historical context reveals that Indonesia’s constraints stem from the budgetary constraints imposed in the aftermath of the Asian Financial Crisis, which restricted the amount of borrowing that the government could do.

To further borrow to stimulate the economy, the government had to pass laws alleviating that budgetary constraint.

On the monetary side, central banks in South-East Asia provided liquidity to constrained companies.

Thailand, Malaysia, the Philippines, and Indonesia also cut interest rates by 0.25 to 0.75 percentage points between April to June 2020.

Other countries like Singapore relying more on exchange rate management have less discretion in using monetary policy to stimulate the economy, but still have unconventional tools at their disposal.

Public announcements and communications that manage expected inflation can still induce lower real interest rates.

Looking at the data, despite Singapore increasing the interest rate relative to last year, the expected real interest rate is still lower than the real interest rate realized last year. But what does this mean?

Real interest rates and consumption

In economics, the adjective “real” means measured in goods as opposed to “nominal”, which means measured in currency.

The real interest rate is the nominal interest rate subtracted by the inflation rate.

Measuring this movement of goods and services through time is useful because, presumably, people save not because they intrinsically care about dollars in the future, but because the dollars in the future can be used to consume more goods and services. When applied to the past, the realised real interest rate tells you whether the savings you made in the last year can be used to buy more or less things today.

When applied to the future, the expected real interest rate tells you whether your savings today can be expected to buy more or less things in the future.

In bad economic times, central banks adopt monetary policy to decrease the real interest rate so people shift consumption from the future to today.

Without such stimulus, the concern is that in bad times, people save more and decrease consumption even more. So, all else equal, lowering real rates can increase consumption today. In South-East Asia, where household debt is not high, this mechanism may still have some hopes of stimulating the economy.

For example, Trading Economics shows that household debt to GDP – a measure of how much households borrow relative to the total income generated in the country – in Singapore is around 52% as of the fourth quarter of 2019 and around 68% in Malaysia. In contrast, in the United States was 75% over the same period.

Real interest rates and investments

Just as the real interest rate affects households’ consumption versus savings decisions, it also affects the demand of funds for real investments. Such investments may be firms borrowing in order to build new factories and purchase more equipment.

The costs of such projects depend on the risk premium as well as the real interest rate. Therefore, if the real rate decreases, all else equal, the cost of capital decreases overall as well.

The case for South-East Asia

Considering recent monetary policy, with the exception of Vietnam, South-East Asian countries witnessed both a decrease in central bank rates as well as an increase in expected inflation.

Since changes in the expected real interest rate are equal to the change in central bank rates minus the change in expected inflation, a lower central bank rate and higher expected inflation means the expected real interest rate has decreased.

This simultaneous decrease in central bank rates and increase in expected inflation provide hope that the monetary policy stimulus would be more likely to work as intended in stimulating consumption and investments.

Considering all the South-East Asian countries above (except Vietnam) expect a higher inflation rate this year than last year, despite lower GDP forecasts, is consistent with countries expecting a negative aggregate supply shock.

In this scenario, quantities of goods and services in the economy shrink and simultaneously, the prices of such goods and services go up.

Unlike in previous downturns where aggregate demand decreases and expected inflation decreases, in a negative supply-driven shock to the economy, monetary policy tools aimed at reducing real interest rates are effective.

In contrast to South-East Asia, other countries like New Zealand, Australia, China, and India saw declines in expected inflation, which dampens the expansionary effect of monetary policies aiming to lower the real interest rate.

The views are the writer’s own.

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