What are policy makers to do amidst continued decline in FX reserves?

Trailing inflation risks, according to Morgan Stanley, are constraining the willingness of policy makers to act in a pre-emptive fashion.

Morgan Stanley said:

Should the net FX outflow situation continue to deteriorate, we expect policy makers to announce more policy measures to prevent any unintended tightening in domestic liquidity conditions. However, trailing inflation risks are constraining the willingness of policy makers to act in a pre-emptive fashion.

We believe that policy makers would announce further policy measures only after further net FX outflows instead of being pre-emptive and injecting liquidity ahead of time. In this context, policy makers could choose from a tool kit of unwinding sterilized liquidity balances, conducting OMOs (buying government bonds, injecting liquidity) and cutting cash/required reserve ratios.

Specifically, for China, we expect policy makers to favour quantitative adjustment through RRR cuts, OMOs and window guidance, while keeping the policy rate unchanged for now.

In India, we believe that the RBI would have to continue with ad hoc purchase of government securities to address the tightness in inter-bank liquidity. In the context of a moderation in inflation trajectory, we believe that the RBI would indicate a change in policy stance with a CRR cut – either at the January 24 policy meeting or in mid-February (after the January WPI release).

In Korea, according to press reports (Korea Herald), the Vice Finance Minister has indicated that the government is looking to impose additional measures to curb excessive capital flows.

In Indonesia, we expect BI to continue to unwind OMO balances.

Most countries have also signed currency swap agreements with China and Japan. We believe that China and Japan could play a more active role in the region if the DM deleveraging trend gets more disruptive.

While so far the impact of the deleveraging in DM and global funding risks has been manageable, it has adversely affected the cost of risk capital, particularly external debt, in the region.