REMARKS BY JAVIER GUZMÁN CALAFELL, DEPUTY GOVERNOR AT THE
BANCO DE MÉXICO, AT THE "POLICY DIALOGUE: GLOBAL FINANCE
EXPLORATION". INTERNATIONAL FINANCE FORUM 2018 ANNUAL
CONFERENCE "NEW GLOBALISATION: A PATH TO THE FUTURE". Guangzhou,
China, November 24, 2018.1
Let me start by expressing my appreciation to the organizers for the
opportunity to participate in this 2018 edition of the IFF Annual Conference.
Following a period of strong inflows in 2017 and early 2018, nonresident
portfolio capital flows to emerging market economies (EMEs) started to
reverse in late-April this year, with bond and equity fund withdrawals
accumulating to date about US$28 billion. This has responded to a spike in risk
aversion, reflected in a series of waves of uncertainty over the year in response
to a combination of developments. The latter include upward-trending
interest rates in the US, a surge in trade-related tensions, geopolitical
developments, a deceleration of the Chinese economy, the decline in key stock
markets, heightened political and policy uncertainty in a number of EMEs, as
well as sharp declines in oil prices to levels not seen in about a year, among
others. As a result, financial conditions in these economies have shown a
significant tightening which, according to some estimates, is comparable to
that experienced during the taper tantrum episode of 2013.2
In the face of mounting pressures, the immediate policy response in EMEs has
relied mainly on a couple of tools. First, monetary policy has in general turned
more restrictive, with reference rates increasing sharply in specific instances
where conditions deteriorated more severely owing to persistent external
vulnerabilities and perceived idiosyncratic risks. Secondly, the exchange rates
of many EMEs have adjusted in response to these shocks, with some of these
currencies receiving support from foreign exchange intervention, either in the
spot market of via derivatives.
Among the factors explaining the reversal of capital flows and consequent
tightening in broader EME financial conditions, monetary policy normalization
in the United States is particularly noteworthy. Naturally, higher interest rates
in the US can be expected to represent a drag on capital flows towards EMEs.
Notwithstanding some recent easing, market repricing of upside risks for the
future trajectory of the federal funds rate in previous months led to outward
pressures stronger than formerly anticipated. In fact, more than 40 percent of
the estimated outflows from EMEs in the year through the third quarter of
2018 that can be attributed to external factors was explained by increased
market expectations about the Federal Reserve policy rate.3
It is worth to highlight that global financial conditions remain accommodative
in relation to historical standards, albeit tighter than a year ago. There are
many factors at play behind such an outcome and their interrelationships are
complex. However, two stand out in this respect. First, the tightening bias at
the global level that may derive from interest rate increases by the US Federal
Reserve is, at least partially, countered by the persistent degree of
accommodation pursued by the central banks of other major AEs, in what has
turned out to be a divergent monetary normalization cycle in these countries.
Secondly, in the United States, domestic financial conditions actually loosened
even as the monetary policy rate started to increase in December 2015 and
the Federal Reserve began unwinding its balance sheet in October 2017. In
fact, financial conditions in that country started to tighten only around the
beginning of 2018.
Needless to say, such an outcome runs counter to intuition. However, it is
important to bear in mind that an economy's financial conditions, broadly
defined, are the result of the interplay of a large number of variables whose
impact may work in opposing directions. In the particular case of the United
States, the strengthening of the short-term growth outlook, resulting partly
from the fiscal stimulus underway, may have raised expected corporate profits
and thus supported asset prices through most of the run-up to the sharp
market corrections of recent. This effect was likely reinforced by the cross-
border impact of large-scale asset purchases by central banks in Europe and
Japan, hence stimulating demand for higher-yielding US securities.
Furthermore, the tightening effects of monetary policy actions in the US may
have been hindered by a gradual and in general predictable pace of increase
in interest rates in that country.
In view of the difficulties inherent to trying to predict market movements, even
more so in the context of unprecedented circumstances such as the ones
prevailing at present, it is not at all clear how rapidly global financial conditions
will tighten as the Federal Reserve and other major central banks continue (or
embark in) their respective policy normalization cycles. To some observers, the
recent adjustments in international financial markets (rising interest rates,
declining stock indices, and depreciating currencies vis-à-vis the US dollar) are
a welcome development as they are consistent with a strong economic
outlook, reduced risks of deflation in some AEs and, in general, a thus-far-
successful exit from the massive monetary accommodation of the decade
following the outburst of the crisis.4 However, the risk of a sudden, sharp
tightening in financial conditions cannot be discarded.
At the current economic and political global juncture, a number of factors
increase significantly the risk of a potentially disruptive scenario. Among these,
it is worth highlighting, first and foremost, the possibility of surprises in AE
monetary policy normalization. This is particularly worrisome in the case of the
US, where notwithstanding downward adjustments in market expectations
about the future path of interest rates following the recent market rout,
inflation could surprise to the upside as a result of ongoing fiscal stimulus
measures implemented in the context of an economy operating at, or near,
full capacity, in addition to price pressures that may derive from increased
import tariffs. Secondly, market sentiment might be adversely affected by
increased political and policy uncertainty in a wide range of economies, both
advanced and emerging. At the top of these concerns is the further escalation
(or, at least, the persistence) of global trade tensions, especially between
China and the US, whose broader implications can well go beyond the specific
sectors that to date have been targeted. Thirdly, confidence on the resilience
and credibility of policy frameworks in EMEs may erode, as external shocks
combine with existing vulnerabilities in many of them and growing concerns
about central bank independence in some particular instances.
In addition, challenges of a structural nature may complicate matters further.
First, as noted above, the context in which monetary policy normalization in
the US and other AEs is taking place is unprecedented, making in turn its
potential ramifications difficult to assess and foresee. For one, interest rates
had never been so low for this long, while the unwinding of the stimulus
provided by unconventional monetary policy measures adopted at such a large
scale remains untested. In light of these and other uncertainties, including the
ones related to the characterization and definition of "normalcy" itself, it is
evident that the potential for policy mistakes is sizable.5 On the one hand,
adjusting policy too fast may, among other risks, prompt disruptive responses
in international financial markets with adverse implications for the real
economy, both at the domestic and international levels. On the other hand,
moving too slow may encourage the continued accumulation of debt as well
as the buildup of risks and vulnerabilities in the financial sector.
Secondly, on account of the greater financial integration across markets and
economies that has been brought about by globalization, the control of
domestic financial conditions by policy makers may prove to be quite
challenging. As per some estimates,6 about 20 to 40 percent of the observed
variation in domestic financial conditions can be explained by a single,
common factor, namely global financial conditions, an effect that tends to be
larger (over 60 percent in some instances) in EMEs. The situation is further
complicated by the fact that local financial conditions tend to react faster and
more strongly to external shocks than to adjustments to the domestic
monetary policy stance. Furthermore, it is not rare to see external financial
conditions being driven to a larger extent by factors other than
macroeconomic conditions, such as abrupt swings in investor sentiment,
financial contagion, or regulatory changes, where the tools available to
counter them may be more limited or ineffective.
Thirdly, the global financial structure has undergone profound changes in the
post-crisis years, that remain to be fully tested in situations of widespread
stress. One of them relates to evidence suggesting an increased segmentation
of market liquidity, and the consequent risk that lower levels of liquidity
enhance the potential for wide fluctuations in asset prices and financial
instability. In this respect, it is important to bear in mind that the abundant
liquidity resulting from overly expansionary monetary policies in AEs is
anticipated to decline significantly in coming years. Another change is the
increased presence of foreign investors in local EME bond markets. It is true
that the level of risk is a function of the type of investor, with large institutional
investors showing in general a higher degree of stability. It is also the case that
at the end, both foreign and domestic investors will have a similar reaction to
episodes of acute turmoil. However, it can also be argued that nonresident
holders of domestic assets may be more sensitive to the impact of shocks,
especially in those cases where we see a significant share of investors
operating through mutual funds and exchange traded funds.
In light of the above, it is clear that EMEs should stand ready to face the
materialization of these and other risks. While isolation from changes in global
financial conditions is unfeasible, the evidence clearly shows that domestic
policies do make a crucial difference. As in previous episodes of turmoil, during
the current one global investors have differentiated among EMEs on the basis
of their economic fundamentals and other idiosyncratic factors.7 For instance,
the deterioration of indicators of creditworthiness and currency depreciations
have been sharper in countries facing more important economic and political
challenges. Similarly, although estimations of correlation of the idiosyncratic
component of market exchange rates, or more generally of contagion among
different EMEs, have increased recently, they remain at low levels.
It would be both naïve and unfair, however, to assume that EMEs will be able
to overcome these challenges by themselves. Global financial stability is a very
complex task, and therefore its attainment and preservation is a shared
responsibility that requires coordinated efforts from all the parties involved.
The role of AEs in this task is paramount to its fulfillment. Indeed, a careful
communication of monetary policy decisions, a proper evaluation of spillover
effects, strong support for the creation of an adequate global financial safety
net, and even coordinated policy action whenever needed, among other
actions, should be key ingredients of this cooperative approach.
AEs have a clear responsibility for the current state of the world economy and
therefore they should assume an equally important role in overcoming the
consequent challenges. But beyond this, it is evident that they have a lot to
gain from a solid performance of EMEs and stable financial markets at the
global level.
It should suffice to recall that, by virtue of their growing importance and
integration into the global economy and financial system, the scope for
spillovers from EME shocks into AEs has risen over the past decades to
significant levels. According to IMF estimates, more than a third of the
variation in AEs stock market returns and in their exchange rates in recent
years can be traced to spillovers from EMEs. Moreover, given the extent of
financial market integration and the particular features of international
financial markets at present, financial volatility in EMEs may be widely
transmitted even in the absence of crisis or near-crisis episodes.
In other words, policy makers in AEs need to carefully consider not only the
consequences of their policy decisions on EMEs, but also the risk of spillbacks
from EMEs as a result of policy actions in AEs.
The implications for international policy cooperation are evident.