IMF issues warning to Asian central banks on risk of overheating

The International Monetary Fund (IMF) has warned central banks in Asia that they may have to respond quickly to new financial stability risks, as interest rates have been held lower than historical levels in many countries.

The IMF's Regional Economic Outlook for the Asia Pacific region, published today, said the region was leading the global "three-speed recovery", and predicted growth would average around 5.75% in 2013.

However, Anoop Singh, director of the IMF's Asia Pacific Department, expressed concern that some central banks could be complacent about emerging risks. "We are seeing in many countries continuing accommodative financial policies," he said. "We are concerned that this is leading to higher asset prices and concerns over credit ratios in many economies."

The IMF's report said central banks needed to guard against "potential overheating pressures", which could emerge quickly, but faced a difficult trade-off against the risks posed by the fragile global recovery. Central banks in many countries had maintained "slightly lower policy rates than their past behaviour would suggest", which the IMF said was fine while a low inflation environment persisted, but could cause problems now risk appetite is beginning to return.

Nevertheless, Singh said most Asian firms were in a strong position to deal with future turmoil. "Corporate and financial sector balance sheets in the region are generally very sound," he said.

The Japanese case

While urging caution from many, the report did say additional monetary easing in Japan was beneficial, adding that this was "appropriately focused" on domestic issues. After complaints that the policy constituted competitive devaluation, the G-20 countries stressed their determination to avoid "persistent exchange rate misalignments" at meetings in February and April.

While the report supported the Bank of Japan's policy choices overall, the analysis did recognise that the effects of the policy were complex and heterogeneous across countries. The IMF identified two main channels through which effects would be felt: financial and trade.

The financial channel operated mainly through capital movements out of Japan, of which much would flow to the rest of Asia. However, the destabilising effect of these flows was offset, the report said, by a lower chance of a sharp rise in Japanese government bond yields. Given the size of Japan's government debt-to-GDP ratio, which currently stands at well over 200%, this could "adversely affect growth around the world", the IMF warned.

The effect through the trade channel was also "far from uniform", the IMF said, depending on the country's position in the supply chain. Many countries import intermediate goods from Japan, and the weaker yen resulting from monetary easing would reduce costs, but would also make Japanese exports more competitive. Japanese firms would face higher prices for some inputs however, particularly energy, making the effects of a weaker yen unclear.

Whether the policy would be enough to restore Japan to growth and inflation, however, depended on the rest of the economic stimulus package – the fiscal and structural reforms that together with monetary easing constitute so-called 'Abenomics'.

Details of the new strategy are due over the summer. "The more ambitious structural reforms are, the more likely inflation expectations will rise; the more credible fiscal reforms are, the lower the risks of a sudden rise in bond yields," the report said.