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FRBSF

WEEKLY LETTER

Number 94-38, November 4, 1994

Explaining Asia's Low Inflation
One feature of the Asia-Pacific Basin that distinguishes it from most developing regions of the
world is its relatively low inflation. In the 1980s,
inflation in the region averaged 7 perc~nt, close
to the average for industrialized countries, but
well below the average of nearly 30 percent for
developing countries as a group, or the average
of 55 percent for Latin America. Asia's success in
curbing inflation is of particular interest, because
of the light it might shed on alternative explanations for low inflation, including central bank
independence and domestic conditions that affect the incentives for price stability.

The evidence that central bank independence
can lead to lower inflation is mixed. On the one
hand, Germany's central bank has the greatest
degree of legal independence and has experienced consistently low inflation. It can be argued
that the U.s. disinflation of the early 1980s might
have been much more difficult if the Fed had not
had the independence to pursue such a disinflationary policy, although this argument does little
to explain the high inflation of the 1970s. Moreover, Japan's central bank has little formal independence and one of the lowest rates of inflation
among industrialized countries.

This Weekly Letter examines the relationship between central bank independence and inflation
for seven emerging economies in Asia and finds
that the relationship is quite weak. Instead, it is
argued that low inflation largely reflects domestic
conditions conducive to price stability.

To analvze the relationship between central
bank in'dependence and fnflation more systematically, Cukierman, Webb, and Neyapti
(CWN, 1992) construct an index of central bank
legal independence. The index labels a central
bank as more independent if: (i) its CEO has a
relatively long term of office and is not easy to
remove; (ii)it has authority to set monetary policy even if its views conflict with the executive
branch; (iii) price stability is its major or only
objective; (iv) its lending to the public sector is
restricted. CWN's results indicate that legal independence is associated with low inflation for
industrialized countries, but not for developing
countries.

Legal central bank independence and inflation
A central bank is "independent" if it can make
monetary policy decisions that are free from political pressure and that can be overruled only
with great difficulty (for example, through legislation). Such independence may be achieved
either by giving the central bank an unambiguous mandate for low inflation, or by giving the
central bank autonomy along various dimensions, such as budgeting, policymaking, and the
tenure of the central bank chief executive officer
(CEO). The argument that central bank independence may contribute to lower inflation rests on
the premise that monetary policies to guarantee
lower inflation may be politically unpopular. Politicians seeking reelection may prefer monetary
policies that stimulate the economy in the short
run regardless of the impact on inflation. A central bank that is not independent may be unable to resist pressures for inflationary stimulus,
whereas a central bank that is independent might
be able to do so.

PACIFIC BASin nOTES

The implications of CWN's results for developing
(or rapidly growing) Asian economies are unclear. (We will refer to these economies as
emerging Asian economies.) On the one hand,
the results for all developing countries suggest
that no relationship between legal independence
and inflation will be found in the emerging Asian
economies. On the other hand, average inflation
in emerging Asian economies is much lower
than in developing countries as a group, and
close to that of industrialized countries. As in the
industrial countries, legal independence may be
associated with low inflation in Asia as well.

Pacific Basin Notes appears on an occasional
basis. It is prepared under the auspices of the Center for Pacific Basin Monetary and Economic Studies
within the FRBSF's Economic Research Department.

FRBSF

Figure 1
Central Bank Legal Independence
and Annual Inflation

To assess the relationship between central bank
independence and inflation in emerging Asian
economies, Figure 1 presents CWN's legal independence index values and average inflation for
1980-1989 for several emerging Asian economies: Indonesia, Korea, Malaysia, the Philippines, Singapore, Taiwan, and Thailand; Hong
Kong is excluded because it had no central bank
in the 1980s, and China is excluded because it
had significant price controls over the period. An
index value of ten signifies full independence.
For comparison, the corresponding values for the
U.S., Germany, Japan, and the average for all developing economies also are presented.

Inflation
(percent)

Two broad conclusions emerge. First, central banks

5

in emerging Asian economies are not usually independent. In particular, the independence index
value among emerging Asian economies is about
3 on average, slightly lower than the 3.3 average
for all developing countries, and well below Germany's 6.9 or the U.s:s 4.8. However, average
inflation in emerging Asian economies was much
lower than the 29 percent rate for all developing
countries. The contrast is even more striking
comparing the emerging Asian economies to
Latin America (not shown), where the index averaged 3.6 and inflation averaged 55 percent.

Second, among the emerging Asian economies,
a higher central bank independence index value
is not associated with lower inflation. For example, the Philippines has the largest legal independence index in the region and the highest
rate of inflation. Taiwan's independence index is
among the lowest in the region, but so is its inflation rate.
These results suggest that central bank independence does not explain low inflation in emerging
Asian economies. This may be partly because the
legal independence index is an imperfect measure of actual independence, and also because
legal independence may not be necessary to
guarantee low inflation if there are incentives
to maintain price stability, or if there is less pressure on central banks to inflate.

Incentives for price stability
The policies of Asian central banks might have
led to low inflation if there were a strong incentive at all levels of government to maintain price
stability as a result of the openness of their economies. In particular, it can be argued that emerging Asian economies have depended very heavily
on international trade as the basis for their economic success, and they have maintained their

30

25

• All Developing

1

20

15

• Philippines
10

Indonesia.
• Korea
Taiwan. • Thailand
• U.S.
Japan.
• • Malaysia
Singapore

• Germany

O+------r----r----~----,

o

2

4

6

8

Legal Independence
international competitiveness by avoiding excessive inflation. As noted by Edwards (1989, Chapter
6) in many developing economies, high inflation
has been associated with real exchange rate appreciation and a corresponding loss of competitiveness. Romer (1993) also argues that open
economies have less incentive to stimulate the
economy, partly because any given increase in
output will be associated with more inflation
in open economies than in closed economies.
To assess the plausibility of the argument that
openness will be associated with less inflation,
Figure 2 illustrates the relationship between the
size of the trade sector in 1985 and average inflation in 1980-1989 in Asian economies. It is
apparent not only that emerging Asian economies are highly open-the ratio of exports plus
imports to GNP ranges from a low of about 30
percent for the Philippines and Indonesia to a
high of 260 percent for Singapore-but also that
in these economies openness is associated with
low inflation-the Philippines and Indonesia
have the highest rates of inflation and Singapore
the lowest. (In fact, Asian economies are on average more open and have far less inflation than
Latin American economies.) Figure 2 thus supports the view that the greater openness of these
economies gives them a greater incentive to curb
inflation. Using more formal statistical analysis,
Romer (1993) shows that openness (as measured
by the ratio of imports to output) appears to lead
to lower inflation in a large sample of countries
for the period since 1973.

Figure 2
Openness and Annual Inflation

budget formulation is primarily the responsibility
of civil servants rather than politicians, and parliamentary rules restrict the legislature's ability
to alter the budget. The more successful Asian
economies also have been able to avoid central
bank subsidies to banks or large state enterprises. This type of financing often is not reflected in the budget estimates, but it can be
highly inflationary.

Inflation
(percent)
14

- Philippines
12

10

1
I

8
6
4
2

-Indonesia
-Korea

-Thailand
- U.S.
-Taiwan
-Malaysia
•
_ Germany
Japan

-Singapore

o -+---r----r---r--r---~-...,
o 0.5
1.5
2
2.5
3
Openness

in Asia, the inflationary impact of budget deficits
has been limited even in those cases where the
deficits are large. For example, Malaysia's very
rapid growth and high rates of private saving allowed it to sustain large deficits (averaging 11 percent of GNP) without triggering inflation. Rapid
growth and private saving increased the demand
for money and domestic financial assets, thus
raising the proportion of the deficit that could be
financed by printing money without inflation, as
well as the overall level of government borrowing
that was willingly financed by domestic and foreign residents. (See World Bank 1993 for more
details on the points raised in this section.)

Conclusions
less pressure to inflate
Apart from having an economic incentive to
maintain price stability, the pressures to inflate
on central banks in emerging Asian economies
also have been smaller than in other regions.
One reason is that these economies have grown
very fast as a result of increases in their productive capacity; this minimizes the pressure to
boost economic growth through inflation.
Another reason is that budget deficits in emerging Asian economies are by and large sustainable, or easily financed, so that the pressure on
Asian central banks to inflate in order to finance
deficits is small. In some cases, the size of budget deficits is limited by law. For example, in
Thailand, deficits are limited to a small percentage of the year's total expenditure, and there is a
cap on the percentage of the budget that can be
spent servicing the foreign public debt. Budget
authorities also consult the central bank to assess
the inflationary impact of budget deficits. In Indonesia, expenditures have been limited to the
amount financed by domestic revenues and foreign aid since 1967.
Budget deficits also have been curbed by insulating the budget process from political pressure.
For example, in Thailand and Indonesia, detailed

The example of Asian economies highiights some
of the conditions under which countries may
achieve low inflation in the absence of central
bank independence. These countries achieved
low inflation in part because the need to keep
the large trade sector competitive created strong
incentives for maintaining price stability. In addition, rapid growth and sustainable budget deficits
reduced the pressures on central banks to inflate.

Ramon Moreno
Senior Economist

References
Cukierman, Alex, Steven B. Webb and, Bilin Neyapti.
1992. "Measuring the Independence of Central
Banks and Its Effects on Policy Outcomes:' The
World Bank Economic Review 6(3), pp. 353-398.

Real Exchange Rates,
Devaluation and Adjustments. Cambridge, Mass.,

Edwards, Sebastian. 1989.
The MIT Press.

Romer, David. 1993. "Openness and Inflation:' Quarterly Journal of Economics 108(4), pp. 869-904.
World Bank. 1993. The East
Oxford University Press.

Asian Miracle. New York:

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve'Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor or to the author..•. Free copies of Federal Reserve publications can be
obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120.
Phone (415) 974-2246, Fax (415) 974-3341.

Research Department·

Federal Reserve
Bank of
San Francisco
P.O. Box 7702
San Francisco, CA 94120

Printed on recycled paper IC>& ~.
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Index to Recent Issues of FRBSF Weekly Letter

DATE NUMBER TITLE

AUTHOR

4/15
4/21
4/29
5/6

Furlong
Furlong/Soller
Cromwell
Huh
Moreno
Booth
Neuberger/Schmidt
Schmidt
Sherwood-Call/Schmidt
Trehan
Cogley/Schaan
Levonian
Walsh
Walsh
Throop
Sherwood-Call
Glick
Huh/Kim
Huh/Kim
Trehan
Laderman
Kasa
Zimmerman

94-15
94-16
94-17
94-18
5/13 94-19
5120 94-20
5/27 94-21
6/10 94-22
6/24 94-23
7/1
94-24
7/15 94-25
7/22 94-26
8/5
94-27
8/19 94-28
9/2
94-29
94-30
9/9
9/16 94-31
9/23 94-32
9/30 94-33
10/7 94-34
10114 94-35
10121 94-36
10/28 94-37

Interstate Banking in the West
California Banks Playing Catch-up
California Recession and Recovery
Just-In-Time Inventory Management: Has It Made a Difference?
GATS and Banking in the Pacific Basin
The Persistence of the Prime Rate
A Market-Based Approach to CRA
Manufacturing Bias in Regional Policy
An "Intermountain Miracle"?
Trade and Growth: Some Recent Evidence
Should the Central Bank Be Responsible for Regional Stabilization?
Interstate Banking and Risk
A Primer on Monetary Policy Part I: Goals and Instruments
A Primer on Monetary Policy Part II: Targets and Indicators
Linkages of National Interest Rates
Regional Income Divergence in the 1980s
Exchange Rate Arrangements in the Pacific Basin
How Bad is the "Bad Loan Problem" in Japan?
Measuring the Cost of "Financial Repression"
The Recent Behavior of Interest Rates
Risk-Based Capital Requirements and Loan Growth
Growth and Government Policy: Lessons from Hong Kong and Singapore
Bank Business Lending Bounces Back

The FRBSF Weekly Letter appears on an abbreviated schedule in June, July, August, and December.