S&P warns of policy dilemma for central banks

Standard & Poor's Ratings Services (S&P) said Asian central banks may face a dilemma brought about by the surge in capital to emerging markets.

S&P said investment flows are converging on developing Asia again. Along with these inflows come currency appreciation and other challenges, offering Asian central banks some "unpalatable options," the rating firm said.

It said some Asian policymakers' response, such as recent capital control measures, have a limited impact on sovereign creditworthiness.

"In most cases, these policies aimed to prevent instability arising from excess liquidity, asset price bubbles, or a potential disorderly future withdrawal of invested funds," Kim Eng Tan, S&P's credit analyst, said.

"The measures taken recently have usually been targeted, rather than all encompassing, and were introduced in a reasonably transparent manner," he added.

Aside from the region's brightening economic prospects, the developed economies' accommodative monetary conditions and rising fiscal concerns have also strengthened capital flows into Asia, the rating firm said.

The Bangko Sentral ng Pilipinas (BSP) is the only central bank in the region that has yet to raise its key interest rates since the recent global financial crisis, rendering the Philippines "behind the curve" in terms of monetary policy normalization.

Surging investment flows strengthen currencies, hurting exporters in capital-receiving countries. The inflows also weaken financial stability by contributing to asset price inflation. "Central banks in Asia now have a policy dilemma," Tan said, adding that financial disruption could be greater if the capital flows reverse abruptly in the future.

On the other hand, efforts to stem the inflows can slow financial system development and delay necessary structural reforms, he said.

"Since a large amount of foreign funds are invested in liquid assets such as government bonds, a capital flow reversal can happen easily," Tan said.

In the past, capital control had elicited an overreaction in the markets, leading to economic volatility. Policymakers can minimize market disruptions if the controls are implemented in an investor-friendly manner, the S&P official said.

"For instance, investors are likely to object less to changes that are announced in advance and that do not affect their prior investments," he said.

"Conversely, changes that governments implement without providing sufficient reaction time are likely to upset investors and could create market volatility. It's a tricky balance of keeping the costs from outweighing the benefits," Tan added.