Manuel Sánchez: Monetary expansion - is the sky the limit?
Remarks by Mr Manuel Sánchez, Deputy Governor of the Bank of Mexico, at the 5th annual
National Asset-Liability Management Americas symposium, organized by Central Banking
Publications, Mexico City, 13 May 2016.
* * *
It is an honor to participate in this conference on asset and liability management organized by
Central Banking Publications. I would like to thank this organization for the invitation to be
here with you, and also for their many contributions to the field through significant analysis
and information on urgent issues faced by central banks around the world.
I will focus on some implications of unconventional monetary policies in advanced countries
for the global economy and financial markets. To this end, I will first attempt to analyze the
possible benefits and costs of the unusual monetary accommodation that characterizes
today's international environment. Then, I would like to describe some of the effects of these
stances on emerging-market economies. Finally, I will make some comments on the outlook
for monetary policy and the challenges faced by reserve and fund managers.
As usual, my remarks are entirely my own and do not necessarily reflect the views of the Bank
of Mexico or its Governing Board.
Are the benefits worth the risks?
Since 2007, central banks in advanced countries have undertaken unprecedented monetary
loosening. Three key measures have been, to start with, the reduction of policy interest rates
at a rapid pace to levels close to zero, later combined with forward guidance. Next, special
lending facilities were offered to meet increased liquidity demands amid the crisis.
Unconventional policy has continued through the third measure, successive quantitative
easing (QE) programs, aimed at supporting growth and averting low inflation.
As a result, central bank balance sheets have been growing substantially, reaching high levels
relative to GDP. At the same time, the liability side of the ledger typically has contained
growing amounts of commercial bank reserves, well above levels the banks are required to
maintain.
In this context, unprecedented liquidity prevails in the financial system. Central banks have
played an unusually dominant role in the financial markets, with QE programs focusing on
domestic securities. They have engaged in large-scale purchases of long-term government
bonds, but also private-sector securities, such as mortgage-backed securities in the United
States.1
Typically, central banks have executed these purchases in the secondary markets, without
sterilizing them. There have also been programs designed to recompose central banks'
portfolios, as with the Fed's operation twist during 2011-2012.
With all this happening, central banks have ended up entering the credit business,
undertaking quasi-fiscal operations, and running the risk of drying the markets out by
absorbing too many securities. The dominant role of central banks in the financial markets is
clear from the large percentages of government bonds purchased each year relative to totals
issued, as well as stocks already accumulated. In this sense, central banks have become
"buyers of first resort" for federal governments and in some private-sector markets.
See Graph 1.
Furthermore, five central banks to date have set policy interest rates below zero, as a
complement to already significant expansionary monetary programs. The lowest is the rate of
the Swiss National Bank, which is at a negative 0.75 percent.
Monetary accommodation has led to historically low short-term interest rates. For example,
the distribution of short-term government rates across advanced countries has shifted
significantly to the left, with a mode close to zero, and almost no intersection with the
distribution prevailing before the crisis. See graph 2.
The combination of negative policy interest rates and balance sheet expansions has brought
about ever-increasing proportions of government debt carrying a negative yield. A sharply
increasing trend in the amount of government debt issued at negative rates began at the end
of 2015. Roughly one-third of total outstanding government debt among advanced countries is
now estimated to carry a negative interest rate. See graph 3.
No doubt central banks were effective at providing more liquidity during the crisis, playing their
role well as lenders of last resort. However, despite some evidence that expansionary policies
have supported economic activity, returns in this regard seem to be decreasing.2
At the same time, the effectiveness of lax policies remains unclear where inflation, core
inflation, and inflation expectations are concerned. Nevertheless, fears of deflation appear
somewhat magnified in light of historical evidence pointing to the absence of a clear negative
relationship between deflation and growth.3
Independently of benefits pursued, extraordinary monetary accommodation may be
generating significant costs, which could become more evident in the future. I would like to
highlight three of them.
One is the potential build-up of financial imbalances in the form of excessive risk-taking and
growing indebtedness since the crisis. Certainly, there is no evidence the world as a whole
has been in a process of de-leveraging, particularly with increasing ratios of government debt
to GDP taken into account.4
Another manifestation of costs is the possible overvaluation of assets. In some stock markets,
PE ratios are higher than long-term averages, in spite of the fact earnings prospects are
restrained by relatively low growth outlooks. Also, the gaps between housing and consumer
price indices in some advanced countries, such as Switzerland, Australia, and Norway, have
been rising rapidly in the last few years.
A final manifestation of costs is the possibility that negative rates hurt banks, as well as money
market funds and other non-bank financial institutions such as insurance companies, with no
clear payoff in terms of economic growth. For example, in a recent survey conducted by the
ECB, banks estimated that the most important effects from negative rates include lower net
interest income and lending rates, as well as squeezed loan margins. The estimated impact
on lending volume is minimal.5
These imbalances and pressures could set the stage for significant disruptions to the
functioning of markets down the road. Given the fact policy makers are still reaching deep into
their bags of tools to tune markets years after the crisis, another period of severe turmoil
would likely be even more problematic.
Emerging economies between a rock and a hard place
Let's now look at the implications of extraordinary monetary accommodation in advanced
countries for emerging markets. This policy at first led to more favorable financial conditions.
Starting in 2010, emerging economies drew greater portfolio capital flows and enjoyed both
rising commodity prices and bouts of financial asset appreciation. Starting in 2014, however,
with markets anticipating U.S. monetary normalization and fears mounting on the health of the
Chinese economy, the tables turned.6
A positive result of the financing bonanza was that the share of nonresident holdings of
localcurrency government securities in the total outstanding reached record levels before the taper
tantrum. Since 2014, the trend has clearly declined, although in a moderate fashion, with
relatively high levels still the case. See graph 4.
Despite fears of persistent currency appreciation expressed by policy-makers in emerging
markets due to QE in advanced countries, the fact is that on average, appreciation for these
currencies has proved short lived. Indeed, emerging-nation currency trends have generally
been towards weakening. See graph 5.
Many emerging economies responded to advanced-country monetary expansion mainly in two
ways. One was to loosen their own monetary stances. This can be seen by looking at the
declining levels of policy interest rates below what different Taylor rules dictate since 2003.7
Another response to extraordinary monetary easing in advanced countries has been
acceleration of FX reserve accumulation, something which has been significant in emerging
economies. This trend has only softened slightly recently, as a result of some countries
seeking to avoid excessive currency weakening. See graph 6.
One manifestation of probable imbalances in emerging economies stemming from lax
advanced-nation monetary policy has been much higher leverage used by corporations.
Higher corporate debt has been a natural result of better financial conditions. While the use of
higher debt at lower rates can be justified on the part of both firms and governments as a way
to take advantage of an opportunity, the danger is of a significant deterioration of external
conditions, for example, because of a sudden change in market sentiment. This could
generate difficulties for debt service and could cause financial disruptions.8
These risks are more complicated for emerging economies in the present general context of
declining output growth and rising inflation. Policy trade-offs would be particularly tough in the
case of reversed capital flows. See graph 7.
Outlook and challenges
Let's now turn to the possible implications for the future. Monetary policy in advanced
countries is at a crossroads. To begin with, less than fully satisfactory results in terms of
output and inflation from monetary accommodation will likely lead to more gradual
normalization and even further easing in some countries.
In addition, divergence of monetary policy across countries will likely prevail. An important
corollary is that the dominant role of monetary policy in advanced countries could result in
further postponement of needed adjustments to contain financial risks and structural reforms
to enhance productivity growth.
Furthermore, balance sheets will not diminish in the near term and may even expand in some
places. Also, negative policy rates could become more prevalent, and rates could even fall
further.
Tools such as long-term interest rate targeting and fiscal deficit monetary financing may gain
traction. All these measures will make eventual unwinding of lax polices more complex and
riskier in terms of price and financial stability.9
Low effectiveness of monetary policy could lead to disillusionment and loss of credibility. The
latter effect is natural, given the overburdening of monetary policy with several goals. After all,
monetary policy can only do so much. Some things it can do, and others it cannot.
In this context, emerging economies must prepare for possibly less benign times. Any
imbalances built up from monetary accommodation in advanced countries, or from domestic
policies, will have to be managed carefully. Economic fundamentals should be strengthened,
including appropriate monetary policy, sound fiscal stances, and well-implemented structural
reforms.
Finally, reserve and fund managers will continue to face a difficult environment. While risks
and uncertainty are greater, very low returns on assets can be expected, even at longer
maturities. Less market liquidity and more volatile environments are also part of the outlook.
The duty of optimizing safety, liquidity, and returns, obviously, will be ever harder.
Final remarks
In conclusion, central banks in advanced economies are navigating unchartered waters, and
thus, the overall results of their stances and their eventual unwinding are difficult to assess.
Potential unseen costs from extraordinary accommodation include financial imbalances from
excessive risk-taking and high debt. Market disruptions fueled by these imbalances could be
hard to manage.
Emerging markets must be prepared to face greater risks and volatility due to potential
spillover effects from this scenario. Reserve and fund managers, for their part, will have to use
all their knowledge and talent to achieve the best risk and reward relationship possible in such
a constantly evolving context.
Advanced economies: Central banks' holdings of government bonds
% of outstanding market size, March 20161
30
20
10
0
Italy
Spain
Japan
States
France
Finland Ireland Austria
Belgium
Portugal
Kingdom
Germany
Netherlands
United
United
1
Except for Japan, which shows data as of the end of 2015.
Source: Own calculations based on the ECB, Bank of Japan, Bank of England, Federal Reserve,
SIFMA, Japanese Ministry of Finance, U.K. Debt Management Office, and Bloomberg.
Graph 2
Advanced economies: Two-year government bond
interest rate distributions1
Proportion of total
1.2
May 10, 2016
December 28, 2007
0.9
0.6
0.3
0.0
-2 -1 0 1 2 3 4 5 6 7 8
1
Includes Australia, Austria, Belgium, Canada, France, Germany, Japan, the Netherlands,
Singapore, Sweden, Switzerland, the United Kingdom and the United States.
Source: Own calculations based on Bloomberg.
Advanced economies: Government debt with negative interest rates1
Trillions of dollars
8
Others
Japan
Germany
6
France
4
2
0
Jul-14 Jul-15
Jan-15 Jan-16
Oct-14 Apr-15 Jun-15 Oct-15 Apr-16
Aug-14 Sep-14 Dec-14 Feb-15 Aug-15 Sep-15 Dec-15 Feb-16
Nov-14 Mar-15 Nov-15 Mar-16
May-15
1
Includes Sweden, Denmark, Austria, Belgium, Czech Republic, Finland, Ireland, Italy, Netherlands
and Spain.
Source: Own calculations based on the market value of the JPMorgan GBI Broad Index.
Graph 4
Emerging economies: NR holdings of local-currency
government securities
% of total outstanding1
28
25
22
19
16
13
10
Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16
Sep-10 Sep-11 Sep-12 Sep-13 Sep-14 Sep-15
May-10 May-11 May-12 May-13 May-14 May-15
1
Unweighted average of ratios for Brazil, Colombia, Hungary, Indonesia, Israel, Malaysia, Peru,
Poland, Russia, South Africa, South Korea, Thailand and Turkey. Total outstanding includes Bonos
M, Cetes, Bondes D, Udibonos and BPA.
Source: Own calculations based on finance ministries, central banks and other national authorities.
Emerging economies: Local currency value in U.S. dollar terms1
January 2007 = 100
110
100
90
80
70
Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16
Sep-10 Sep-11 Sep-12 Sep-13 Sep-14 Sep-15
May-10 May-11 May-12 May-13 May-14 May-15 May-16
1
GDP weighted average for the Chinese yuan, Russian ruble, Turkish lira, Korean won, South
African rand, Brazilian real, Indian rupee, Polish zloty, Hungarian florin, Malaysian ringgit, Mexican
peso, Thai baht, Chilean peso, Indonesian rupee, Philippine peso, Colombian peso, and Peruvian
sol. Data to May 11, 2016. Source: Own calculations based on Bloomberg and IMF.
Graph 6
Advanced and emerging economies: International reserves
Trillions of dollars
15
Advanced economies
China
12
Russia
Brazil
Mexico
9
Rest of the world
6
3
0
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Source: IMF, IFS database.
Emerging economies: CPI and GDP1
Annual % change
6
CPI
GDP
5
4
3
2
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
2010 2011 2012 2013 2014 2015
1
Unweighted averages. For inflation, countries are Brazil, Bulgaria, Chile, China, Colombia, the
Czech Republic, Ecuador, Egypt, Hungary, India, Indonesia, Mexico, South Korea, Lebanon,
Malaysia, Morocco, Nigeria, Peru, the Philippines, Poland, Romania, Russia, Saudi Arabia, South
Africa, Thailand, Turkey, Ukraine and the United Arab Emirates; For GDP, countries are the same,
plus Argentina, minus Lebanon and United Arab Emirates.
Source: Own calculations based on IMF and Haver Analytics.