LATEST UPDATES
Card-image-cap

Economy | Monetary Policy

Monetary Policy Response in Emerging Market Economies: Why Was it Different this Time?

Nov 13, 2020   •   by   •   Source: Proshare   •   eye-icon 1294 views

Friday, November 13, 2020 / 10:52 AM / by BIS Bulletin /Header Image Credit: fromlawyerslife

 

Key takeaways

  • During the Covid-19-induced financial stress inMarch 2020, central banks in emerging market economies (EMEs) departed fromtheir monetary policy playbook by cutting rates even in the face of sharpcurrency depreciations and massive capital outflows.
  • Two factors were at play. First, the cyclicalposition of EMEs gave more room for easing of monetary policy, while structuralchanges improved the anchoring of inflation expectations and kept a lid onexchange rate pass-through. Second, the swift monetary policy easing by theFederal Reserve and other advanced economy central banks calmed globalfinancial conditions. These policies capped the appreciation pressures on theUS dollar, an EME risk factor, and gave EMEs greater room to cut interestrates.
  • Monetary easing and asset purchases helped cushionthe impact of portfolio outflows on local currency sovereign bond markets.Synchronised monetary and fiscal policies supported one another.

 

The playbook of emerging market economy (EME) centralbanks facing a financial crisis calls for them to tighten monetary policysharply in order to stem massive capital outflows and a sharp currencydepreciation. Monetary policy is then procyclical. It is tighter precisely whencapital outflows and currency depreciation dent domestic economic activity.EMEs departed from this playbook in the Covid-19 stress period of March andApril 2020. They were able to cut policy rates and ease monetary policyaggressively, thereby supporting domestic activity. Moreover, some also adoptedasset purchase programmes (Arslan, Drehmann and Hofmann (2020)). Why was itdifferent this time?

 

This Bulletin examines the context and drivers ofinterest rate policy decisions by EME central banks. We compare the interestrate response in three crisis episodes: the Great Financial Crisis (GFC) of2007-09; the stress period of 2015; and the Covid-19 stress period ofMarch-April 2020 (Graph 1). First, in early 2020 most EMEs were at a relativelylow point of the business cycle, with aggregate demand below potential, whilestructural changes that better anchored inflation expectations and reducedexchange rate pass-through ensured that central banks could cut interest rateswithout raising inflation risks. Second, broad and bold actions by advanced economy(AE) central banks curbed the appreciation of the US dollar and calmed theturmoil in global financial markets, allowing rates to be cut aggressively inEMEs in spite of large capital outflows and sharp currency depreciations. Thesetwo factors made a coordinated policy response between fiscal and monetaryauthorities in most EMEs possible - even with limited fiscal space. So far,monetary policy and fiscal policy easing have complemented each other insupporting the flow of credit and aggregate demand.

 

Proshare Nigeria Pvt. Ltd.

 

Cyclical and structuralconditions in EMEs expanded monetary policy space

EMEs' cyclical position at the time of the Covid-19shock opened up more room for easing monetary policy compared with othercrises. In September 2008, most EMEs were in the expansionary phase of theircycle and inflation gaps were positive (Graph 2, left-hand panel). Importantly,central banks still had to rein in inflation expectations (centre panel). Thesecyclical conditions kept central banks from cutting rates immediately and, insome countries, pushed them to raise rates (Brazil, Hungary, Peru and Russia).

 

Proshare Nigeria Pvt. Ltd.

 

Similarly, in the stress period of 2015 economic slackwas scarce and inflationary pressures stemming from currency depreciationsthreatened to de-anchor inflation expectations. Some central banks respondedwith a tighter policy stance (Chile, Colombia, Mexico, Peru and South Africa).By contrast, in early 2020 most EMEs had some slack and inflation rates eitherbelow or only slightly above target. Short-term expected inflation too wasgenerally near inflation targets. The sharp drop in output and inflation thatfollowed the Covid-19 shock compounded the depressed business cycle positionsand opened up space for monetary policy easing.

 

Structural improvements in EMEs' inflation process arealso likely to have supported central banks' countercyclical response. In thepast two decades, EME central banks have gained more credibility andindependence. Together with a shift towards fiscal consolidation, centralbanks' institutional progress reduced the sensitivity of inflation expectationsto global and domestic inflation shocks and contributed to long-term inflationexpectations converging closer to central bank targets (Yetman (2020) and Graph2, right-hand panel). These changes lowered exchange rate pass-through, whichfurther anchored inflation expectations (Ha et al (2019). As a result,inflation dynamics became more stable and less persistent (Kamber et al(2020)). In turn, central banks were able to ease monetary conditions to bufferthe fall in output without a significant risk of de-anchoring inflationexpectations.

 

AE central bankresponses quelled turmoil in global and EME financial markets

Financial turbulence and sharp currency depreciationtend to go hand in hand with higher inflation risks. Despite the differentnature of the three crisis episodes considered, in all of them financialmarkets experienced severe stress. Significant reversals in capital flows andincreased risk aversion raised the costs of external financing and tightenedfinancial conditions across EMEs (Graph 3, left-hand panel). While the economiceffect of financial turbulence on future average inflation could be negligible,tighter financial conditions and sharp currency depreciation increase tailrisks (Banerjee et al (2020). These risks seemed lower for most countries inthe Covid-19 stress period of March 2020. The key difference this time aroundwas the trajectory of the US dollar, which eased financial conditions and maderoom to orient monetary policy towards domestic objectives.

 

Proshare Nigeria Pvt. Ltd.

 

The US dollar is a significant risk factor for EMEs.An appreciation affects EMEs' growth through financial channels linked todollar debt and foreign ownership in local currency bond markets (Hofmann andPark (2020). AE central banks' policy actions curbed US dollar appreciationand calmed the turmoil in global financial markets (Graph 3, centre panel). Inthe space of a few weeks, AE central banks deployed the facilities that took monthsto activate during the GFC (Cavallino and De Fiore (2020). These actions,especially those implemented by the Federal Reserve, were bolder and broadercompared with other crises and expanded central banks' role to that ofmarket-maker of last resort. In addition, Federal Reserve swap lines and theFIMA Repo Facility addressed the severe stress in US dollar funding markets andgave EMEs access to US dollar liquidity. The effects of these policies onfinancial markets were immediate. The US long-term interest rate hit itsminimum level in March and then recovered. At the same time, the US dollarbroad index halted its sharp appreciation and slowly depreciated. Finally, ascommercial banks were well capitalised, they continued to provide cross-border credit,which also contributed to a better external financing environment. As financialmarkets stabilised, EME central banks were able to cut rates aggressively inspite of capital outflows and exchange rate depreciation.

 

Financial conditions in EMEs started to ease one monthafter the start of the shock as central banks deployed an expanded toolkit tosupport financial markets and the flow of credit (Graph 3, right-hand panel,and online appendix). In addition to cutting rates, EME central banks implementeddomestic lending operations and funding facilities to reduce illiquidity risks.They established direct lending to the private sector to ease financingconditions and intervened in FX markets to reduce currency volatility. Togetherwith supervisory authorities, they eased prudential regulations to increasebanks' capacity to lend. And in an unprecedented move for some central banks,they implemented asset purchase programmes of long-term government securities inthe secondary market. These interventions provided liquidity and prevented firesale spirals in those markets (Arslan, Drehmann and Hofmann (2020)). Finally, afew EMEs also drew on the IMF's Flexible Credit Line for macroeconomicstabilisation purposes. The simultaneous deployment of multiple instrumentscompounded the calming effects of AE central bank policies on domestic markets.

 

A synchronised monetaryand fiscal response

Fiscal policy was also on the front line of theeconomic policy response. In EMEs, the response was smaller than in AEs butlarge by historical standards (Graph 4, left-hand panel). The differencecompared with AEs reflects in part the markets' willingness to finance reliefmeasures (Alberola, Arslan, Cheng and Moessner (2020). Even before the crisis,gross government debt had risen in EMEs, limiting fiscal space (Graph 4, centrepanel). However, EMEs' improved public debt profile allowed governments toissue additional debt and expand spending (right-hand panel). Deeper localcurrency government debt markets allowed governments to increase the averagematurity of their debt, thereby reducing rollover risks. In addition, theglobal low interest rate environment helped to compress long-term rates in mostEMEs and to lower the cost of issuing additional debt. This reduced the risksof switching to a perverse equilibrium where high rates and rollover risks feedinto one another.

 

The synchronised fiscal and monetary policy responsewas more aggressive than in other crises (Graph 5, left-hand panel), with thetwo interventions complementing one another. On the one hand, in most EMEs,governments' full or partial indemnities and loan guarantees to borrowerspartially insulated central banks from credit risk and supported theiroperational independence. This allowed central banks to ease credit conditionsand promote financial stability. On the other hand, central bank assetpurchases and liquidity support helped to cushion the impact of portfoliooutflows from the local currency sovereign bond market. Indeed, EME sovereignyields declined despite moderate portfolio inflows for dollar denominated bondsand virtually zero inflows for local currency bonds (right-hand panel).Avoiding disruptions in the long-term part of the yield curve further supportedfiscal expansion. Finally, an unintended benefit of the monetary easing andasset purchase programmes was to soften the fiscal burden. That said, this wasnot the intervention's main intention.

 

Proshare Nigeria Pvt. Ltd.

 

Up to now, EMEs appear to have overcome their fear offloating and of sudden capital outflows. They have allowed currencydepreciations in spite of massive outflows in local currency government bondmarkets, which have not returned completely. But the looming second wave ofCovid-19 and the dampening of the recession will stress fiscal and monetarypositions even further. Erosion of confidence in the monetary system andgeneralised higher uncertainty could lead to a quick uptick in inflation. Inturn, a vicious spiral between inflation and exchange rate depreciations couldtake off. In addition, a worsening outlook and increasing government debt couldlead to higher sovereign yields, reducing policy space.


Proshare Nigeria Pvt. Ltd.

 

Conclusions

The Covid-19 shock has been singular in all respects.Its sheer magnitude was reflected in the unprecedented capital outflows duringMarch and April. As it hit all economies alike, EMEs could cut ratesaggressively to buffer the economic shock without concerns about interest ratedifferentials with their peers. However, that the interest rate response wascountercyclical does not necessarily imply that EMEs are immune from the riskof sudden stops. First, the shock has so far been mostly deflationary, whichmay have lowered the likelihood of an inflationary depreciation spiral, atypical weakness of EMEs. Second, AEs' monetary accommodation curbed the dollarappreciation and led to extremely benign global financial conditions, whichmade EMEs' returns more attractive.

 

The crisis is ongoing, and the second stage - including dealing with the insolvency of many corporates in the hardest-hitsectors - is just starting (BIS (2020)). In this stage, the risk of shifting toan adverse loop between fiscal and monetary policy is higher. On the one hand,raising interest rates when inflationary pressures take hold will be harder aspublic debt continues to increase. Central banks will be even less inclined toraise rates if global financial conditions tighten again and the costs ofexternal financing increase. On the other hand, the need to continue providingfiscal stimulus will threaten fiscal sustainability. These vulnerabilitiescould increase risk premia, erode investors' confidence and depreciate thecurrency, raising inflation risks and de-anchoring inflation expectations.Finally, there are the challenges of the reallocation of real resources in theeconomy and the difficulty of relying on fiscal and monetary stimulus. Theabiding need for structural reforms is more alive than ever (Carstens (2020).


Proshare Nigeria Pvt. Ltd.

 

Related News

  1. Endorsement of the CBN's Development Finance
  2. Slowdown in the Expansion of PSCE
  3. Personal Statements By The MPC Members At The 132 MPC Meeting of Sep 21-22, 2020
  4. MPC Surprise Rate Cut: Limited Impact on Credit Growth
  5. LDR Policy: Plausible But Insufficient to Stimulate Growth
  6. Banks Lend, the CBN Pushes Forbearance
  7. Low Liquidity Expected to Dampen Impact of Lower Rates
  8. Possible Implications of MPC's 100bps Policy Rate Cut
  9. CBN Communique No. 132 of the MPC Meeting - Sep 21-22, 2020
  10. CBN MPC Reduces MPR to 11.50%, Retains Other Parameters After Sept 2020 Meeting

 

 Proshare Nigeria Pvt. Ltd.

 Proshare Nigeria Pvt. Ltd.

Get the App

apple-store  play-store

Connect with us


Proshare is a professional practice focused on delivering research and information services to bridge the gap between investors and markets; by delivery on credible, reliable, and timely engagements through the following areas — Impact Research, Market Intelligence, Strategic Advisory, Stakeholder Relations & Digital Media.