Mon, Jun 25, 2007 - Page 8 News List

Editorial: The central bank shows its hand

The central bank's many recent efforts to stem capital outflows appeared to have achieved modest success last week, as the benchmark TAIEX index surged to a fresh seven-year high and the NT dollar advanced to a five-month peak.

Since late last month, the central bank has used every available opportunity to induce investors to keep their money in the nation's financial institutions, as capital had been flowing out of the country at an appalling rate.

The monetary policymaker warned of possible losses when investing in overseas mutual funds, it urged securities investment trust firms to provide mutual funds targeting local stocks and it even allegedly acted to strengthen the review process for foreign funds seeking to raise money here.

To weaken the attraction of "carry trades" - using the undervalued NT dollar to buy higher-yielding assets abroad - the central bank decided to narrow the spread between interest rates in Taiwan and other countries, and in particular the US, by announcing a bigger-than-expected interest rate hike on Thursday.

The bank raised the discount rate on 10-day loans by 0.25 percentage points to 3.125 percent. This was the 12th interest rate hike since October 2004, but was twice as large as the 0.125 percentage point hikes of the past.

But what is particularly noteworthy is that the central bank also sharply increased the required reserve ratio on foreign currency deposits from 0.125 percent to 5 percent, which is the first such adjustment by the monetary authority in five years.

This unexpected 40-percent hike in the reserve requirement ratio indicated the authority's desire to raise the cost of accepting foreign currency deposits for banks. As expected, several banks responded immediately by cutting their interest rates on foreign currency deposits. Naturally, this will work to discourage people from holding such deposits and to move to NT dollar accounts instead.

Make no mistake: The central bank's latest measures were not aimed solely at curbing inflationary pressure, as it claimed. Instead, the bank actually acted to slow capital outflows and support the weak local currency. The latest rate hikes could represent an end to the bank's "low interest rate, low currency exchange rate" policy, which has been in place for nearly three years to support the domestic economy and boost exports.

Even so, it is too early to say whether the bank's latest actions will succeed in breaking the trend of capital outflows, given that the level of Taiwan's benchmark interest rate is still far behind the US federal fund rate of 5.25 percent.

People may show less interest in holding foreign currency deposits in the short term, but they can still invest in banks with offshore banking units as these accounts offer higher interest rates than those available domestically.

It also remains to be seen how long the central bank will be able to shore-up the NT dollar without hurting export performance. The feasibility of deriving a higher exchange rate in this manner needs further examination.

Moreover, the bank needs to pay attention to large capital flows. Its blatant stance on supporting the sagging currency risks attracting hot money that may eventually push up the prices of real estate, stocks and other assets.

Compared with Hong Kong and China, where the prices of property and stocks are ballooning alarmingly, Taiwan’s situation poses no immediate concerns. But no one can predict when the hot money will be shifted to a country with a more favorable interest rate, with significant impact on the domestic market.

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