In the wake of the recent global financial crisis, central banks in Western countries reduced global interest rates dramatically. Small open economies, particularly those in Asia that were perceived as having desirable growth prospects, experienced surges of foreign capital inflows.
Many commentators argue that these capital inflows associated with easy monetary policies in Western economies posed potential threats of rising inflation or sudden reversals in flows for the recipient countries. However, Western central bankers maintained that the policies were appropriate for stimulating their domestic economies, and that ensuring the recovery of the advanced economies was also in the interest of the emerging economies.
These surges in capital flows also led to reconsideration of the merits of capital account restrictions. Some studies argue that, by using a combination of capital account restrictions and sterilisation of capital inflows, a central bank can mitigate the effects of excess foreign capital flows caused by external shocks.
Nevertheless, capital controls and sterilisation policies are not without costs, particularly in an environment with low prevailing global interest rates. Research shows that the large increases in the spread between domestic and foreign interest rates following the crisis raise substantially the cost of sterilisation and therefore present a tradeoff between sterilisation costs and inflation stability.
The optimal monetary policy response in China to an unexpected decline in foreign interest rates includes slowing the pace of sterilisation and allowing for increased inflation. Moreover, it was demonstrated that had China liberalised both its capital account and exchange rate policies, the optimal monetary policy response would have been able to substantively mitigate Chinese macroeconomic volatility subsequent to the global financial crisis. While China’s situation is unique, primarily because of its largely closed capital account, many similarities exist for the central banks of Asia’s small open economies.
These economies also are subject to capital account pressures associated with lower foreign interest rates; in their case, these pressures manifest themselves in surges in capital inflows. In small open economies with open capital accounts, monetary policy is likely to be less effective in mitigating surges in capital inflows as raising interest rates can be counterproductive by raising the attractiveness of a nation as a destination for foreign investment. Still, if assets are imperfect substitutes, sterilisation can be effectively used as a policy response.
As our environment is one of imperfect risk sharing, there is a role for monetary policy to improve welfare in the face of external shocks. Moreover, as our analysis is conducted in a consistent model with comparable steady states, we can coherently compare welfare outcomes across alternative monetary regimes. To our knowledge, our paper is the first that examines these issues for small open economies in a full monetary model that allows for consideration of the implications of central bank sterilisation decisions. Sterilisation policies can play an important role in smoothing external shocks in our model, and indeed, they appear to be an important policy component empirically as well.
Simple capital control policies leave substantive scope for welfare improvement through monetary policy.
Under simple capital controls, welfare outcomes are substantively improved by moving from a central banker with standard weights to an inflation-stabilising central banker who puts greater weight on controlling inflation volatility.