Asia faces challenges in managing capital flows in the aftermath of the global financial crisis, and policymakers would be wise to strengthen their toolkits to deal with unpredictable and often excessive flows, Deputy Prime Minister Tharman Shanmugaratnam said yesterday.
He said that the world was in an "unprecedented situation" in the face of the extremely low interest rates set in advanced economies, along with highly accommodative monetary policies such as America's third round of quantitative easing.
As global investors seek better returns, there are significant implications for emerging market economies, he said.
"With large amounts of liquidity now moving between markets, short-term shifts in investor sentiment leads to volatility in capital flows."
Mr Tharman, who is also Finance Minister, was at the opening of the 8th World Islamic Economic Forum (WIEF) in Johor Baru, where he delivered a special address at the invitation of Malaysian Prime Minister Najib Razak.
As an example of volatility in capital flows, he pointed to how a shock in the European periphery can send money invested in emerging markets right back to the US or other safe havens.
There is a lot that is good about capital flows, even short-term ones, he said, because they add liquidity to the market.
"However, we know too that capital inflows can be too much of a good thing. They can lead to asset prices or exchange rates becoming disconnected from fundamentals. And the sudden withdrawal of capital from emerging economies when investors switch from 'risk on' to 'risk off' can be destabilising."
The minister listed three sets of responses that Asian policymakers should adopt.
The first is to curtail volatility in the exchange rate in the short term, as the costs of volatile and uncertain exchange rates are high in small and open economies - which is what most Asean economies are.