Speeches

"MONETARY POLICY - THE CHALLENGES AHEAD"

Introduction

1. Distinguished guests, ladies and gentlemen, good morning. It is my pleasure to join you today for the 25th annual conference of the Federation of ASEAN Economic Associations. May I extend a warm welcome to all delegates from our ASEAN neighbours.

2. Since its inception in 1976, the FAEA has served as a useful forum for the exchange of views on economic issues. This year's theme on monetary and financial management in the twenty-first century is well chosen. In the aftermath of the Asian financial crisis, countries in the region are undertaking reforms and developing their financial markets to address the weaknesses exposed by the financial crisis. At the same time, governments are thinking hard about how to deal with the challenges posed by globalisation and the advent of the new economy. Specifically, what macroeconomic institutions and strategies do we need to put in place?

Post-Crisis Recovery

3. Three years after the crisis, the regional economic recovery is broadening and generating its own momentum. From its initial reliance on fiscal support and a global electronics boom, the upturn is now increasingly led by domestic demand.

4. Governments are also making substantial progress in structural reform. Banks in the region have been consolidating through re-capitalisation and merger & acquisition. Governments are improving supervisory and regulatory frameworks. They are strengthening the authority and independence of supervisory authorities and bringing accounting and disclosure standards closer to international best practices.

5. Nevertheless, in each of these areas, much more needs to be done. We need to press on and prepare our financial systems for the challenges of the future. The role of financial intermediaries will be greatly amplified. In the new economy, new ideas are continually being hatched. Some are good ideas, others may be less feasible. Banks and other financial institutions will decide which ideas have the best chances of success and provide them with funding. In this way, they facilitate technological innovation in society.

6. At the same time, governments are also acutely aware of the need to re-examine their macroeconomic policy framework. In particular, experiences from the crisis have focused attention on the framework of monetary and exchange rate policy.

Monetary Policy Principles

7. Many countries in Asia are strengthening the institutional framework for conducting monetary policy. Korea, Indonesia, Thailand and the Philippines are putting in place an inflation-targeting framework. Japan, after dismissing the idea earlier, is now reviewing it. Monetary authorities in Asia have also been managing their exchange rates more flexibly. For example, they have been assigning a greater weight to the Yen in their currency baskets at the expense of the US dollar. This better reflects underlying trade patterns.

8. The market looks positively at such efforts. Arrangements like inflation-targeting systems and central bank independence help establish credibility in monetary policy management by providing a clear conceptual and institutional framework for the conduct of monetary policy.

9. However,these efforts alone are not enough. Monetary policy in the future will operate in a much more complex world. Financial markets will continue to grow in sophistication. Advances in information technology will facilitate even more rapid movements in cross-border capital flows. In this environment, central banks can no longer think of monetary policy as merely the adjustment of monetary policy instruments or intermediate targets. Other elements in the policy transmission channel will become increasingly important. Monetary policy needs to operate within a framework of consistent macroeconomic policies, and be supported by strong economic institutions.

10. The events of the Asian crisis have shown us that in many instances, the development of our institutions has not kept pace with our rapid economic growth or with changes in the global financial markets. This has complicated the task of monetary policy management.

11. Let me give you an example. Economists categorise the recent events in the region as a dual balance-of-payments and financial crisis. The simultaneous occurrence of the two crises placed governments in a dilemma over the best policy response. While the balance of payments problem called for a devaluation of the exchange rate and a tightening of fiscal and monetary policy (to reduce excess demand), the problems in the financial and banking sector called for an easing of liquidity condition. In fact, policies directed at the balance of payments problems were at the cost of weakening the financial system. Optimal policy at that time was thus severely constrained by the weak banking and corporate sectors.

12. It is in this context that I wish to emphasise the increasingly multi-dimensional nature of monetary policy. Allow me to highlight four sets of factors, which I think will become increasingly important in supporting the conduct of monetary policy in the future.

13. First, as with any national objective, the central bank needs the support of the general population for its mandate to maintain price stability. Undoubtedly, businesses and consumers are clear about the benefits of price stability. Stable prices allow firms and households to think and act long-term in their production, savings and investment activities. On the other hand, rapid increases in the general price level confuse market signals. This leads to misallocated resources and energies, which can ultimately throttle an economic expansion. Moreover, innovative activities like research and development will flourish only in an environment of stability and certainty.

14. However, even while they may agree on the benefits of price stability, the population at large may have difficulty understanding why the central bank has to pre-emptively tighten policy during a boom. The public may question why the central bank should "take away the punch bowl just when the party gets going", a phrase made famous by former US Federal Reserve Chairman, William Martin.

15. That is why it is important to educate the public on macro-economic issues and key economic concepts. There may be a short-term sacrifice involved in maintaining price stability but this is much better than paying the long-term consequences of an inflationary spiral. It would help our cause if we can make the rationale and process of formulating monetary policy more transparent and readilyavailable to the public.

16. Second, the need for supportive fiscal policy to complement monetary policy will be more important than before. Monetary policy cannot bear the burden of macro stability alone. A central bank can only freely pursue its price stability objective if it is supported by prudent fiscal policy. This frees the central bank from the constraint of having to extend credit to the government or having to squeeze the private sector to maintain overall financial balance. Investors worldwide are getting more sophisticated. They continually assess the latest news on policy actions and economic statistics. And if they judge that a country has chosen the wrong policies, that fiscal and monetary policy are at odds with each other, their judgement will be swiftly reflected in the markets. Capital will flow out of the country. The currency will weaken.

17. I believe that many central banks have recognised the importance of consistent economic policies. Some have undertaken a public exchange of letters to cement working relations with the Ministry of Finance. In Australia, for example, the Treasury and the central bank jointly issued a statement in 19 96 on the conduct of monetary policy, to clarify their respective roles and responsibilities.

18. Third, a sound banking system and deep and sophisticated capital markets will be even more crucial in the future. As pointed out earlier, banks lie at the heart of the entire intermediation system. They play a central role in the smooth functioning of the financial intermediation process. They do so either directly through their own deposit taking and lending operations, or as intermediaries to other financial institutions. If there are structural problems in the banking sector, banks will not be able to effectively transmit monetary policy signals throughout the economy. Furthermore, if there are unsound banks in the financial system, the central bank may need to act as a lender of last resort. This may conflict with the central bank's objective of maintaining price stability.

19. In this regard, regulators and governments should not neglect the establishment of a strong credit culture - the "software" of good governance. Banks must base its lending on commercial viability, rather than "relationships". It is encouraging to note that there has been growing interest in the Financial Supervision Assessment Programme launched by the IMF and the World Bank last May. This programme aims to provide a comprehensive assessment of the soundness of the entire financial system. Increasingly, central banks around the world have started to recognise the importance of identifying the risks and vulnerabilities in the financial sector at an early stage, and implementing corrective actions.

20. Deep and sophisticated capital markets will further enhance the monetary policy transmission mechanism. Financial markets play an important role in the pricing of assets across the maturity spectrum. These prices can serve as a valuable source of information for both the central bank and other economic agents. Central banks usually effect monetary policy through changes in some short-term rate. In well-developed markets, changes in the short-term rates will be quickly transmitted to the longer-term rates that influence aggregate demand. At the same time, central banks can also use the term structure as an indicator of the stance of monetary policy and how much of a policychange is still in the pipeline. This is especially important given the long and variable lags in monetary policy.

21. Fourth, more resources will need to be devoted to the monitoring of the economy. This partly reflects that fact that we need to have an informed view about the economy for us to implement pre-emptive monetary policy effectively. This requires access to the most effective and up-to-date analytical tools, including forecasting models and other early warning indicators. Central banks in Asia are investing to build up their research capabilities. The Bank of Thailand, for example, has recently unveiled a new macroeconomic model to aid the Monetary Policy Board in setting monetary policy. Moreover, with the advent of the new economy, we can expect changes in underlying structural relationships. It is crucial that we anticipate such changes and fine-tune our monetary policy formulation and strategy accordingly.

Monetary Policy Management

22. There are also some aspects of monetary policy management that central bankers should take note of in the new economy. I will highlight two points.

23. First, central bankers may need to communicate with the markets more than before. I am not advocating that the central banker indulge in talking the market up or down. I am simply saying that keeping the communication channels open will ensure that the market understands the central bank's actions and may in fact move in anticipation of its decisions. In this way, the financial markets are more likely to respond in the intended manner and not negate the central bank's announcements.

24. Second, I would like to point out that central banks which adopt an inflation targeting strategy must also pay close attention to exchange rate movements. Optimal monetary policy strategy dictates that central banks smooth out excessive movements in the domestic currency. Wide swings in the exchange rate can threaten price stability, as well as cause disruption to the export sectors in the economy. This is particularly important for small open economies.

25. Let me say a few words on how Singapore has responded to this challenge. Our monetary policy regime is based on the management of the exchange rate, given the high degree of openness of our economy. The design of our framework is very similar to that of the inflation-targeting framework. We set a path for the trade-weighted exchange rate based on our expectations of the medium-term outlook. We set a band around the central policy line. The width of the band is determined by our assessment of underlying volatility in the currency market. It also gives us the flexibility to intervene when market conditions are right, thereby allowing us to move the rate towards the central rate without unduly affecting the real economy and unsettling the currency market.

26. This managed float system has proved to be effective in achieving our monetary policy objective of price stability. Indeed, over the last two decades, the inflation rate for Singapore has been about two-and-a-half percent per annum, compared with the OECD average of seven percent. The trade-weighted Singapore dollar has also been fairly stable along an appreciating path. This is achieved not just by the central bank alone. These years of price stability are also a testament of the conservative and prudent fiscal policy pursued by the government, the soundness of the financial system,and the population's traditional habit of thrift, as well as their willingness to make short-term sacrifices for the long-term good of the nation when the need arises.

Conclusion

27. At the start of the twenty-first century, central banks in Asia are confronted with two challenges. First, we need to adapt our monetary policy framework to rapidly changing circumstances and conditions in the external environment, in particular by working more closely with fiscal policy planning and financial sector supervision. Second, we must also make our economic system more resilient and up-to-date to deal with globalisation and the technological revolution brought about by the Internet. We do this by looking beyond the traditional elements of the monetary transmission mechanism to the design of institutions and structures. These must be strong enough to withstand the volatility of the global marketplace and facilitate the growth of innovation and creativity. In this way, we can reap the benefits of globalisation and realise the full potential of the new economy.

28. On this note, I wish you a fruitful conference. Thank you.