Javier Guzmán Calafell: Global divergences - implications for Latin
America
Remarks by Mr Javier Guzmán Calafell, Deputy Governor of the Bank of Mexico, at the 2016
Institute of International Finance (IIF) Latin America Economic Forum, organized by the IIF
with the sponsorship of Mercantil Servicios Financieros, during the session on "Global
divergences - implications for Latin America", Nassau, Bahamas, 9 April 2016.
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The views expressed in this document are strictly personal.
Let me start by thanking the organizers for the kind invitation to participate in this interesting
discussion.
While different paths for the main macroeconomic and financial variables across countries
and regions are a normal characteristic of the world economy, divergence has become one
of the major subjects of concern more recently. The most important feature in this regard is
the observed and expected decoupling of monetary conditions and policy cycles in the main
advanced economies, with the United States having recently initiated a rate hiking phase, on
the one hand, and Japan and the Euro Area still implementing ultra-accommodative
monetary policies with the perspective of further easing, on the other.
Monetary policy divergence in the advanced economies is the ordinary result of different
economic cycles and the efforts of the corresponding central banks to comply with their
mandates. In fact, as would be natural to expect, divergence has been a frequent trait of
previous policy cycles in advanced economies. To the extent that these policies are
implemented efficiently and as required by current and expected conditions, they should be
beneficial for the world economy. Furthermore, unsynchronized economic and monetary
policy cycles in advanced economies would in principle tend to make life easier for emerging
market economies, since some of the negative spillovers could be at least partially offset.
With this in mind, why is divergence such a source of anxiety this time? In my view, the
answer lies in a combination of factors.
First, monetary policies in advanced economies have major spillover effects. In particular,
asynchronous monetary policies have important implications for the behavior of exchange
and interest rates in these countries and, given their systemic role at the global scale, in the
rest of the world. The accompanying volatility in asset prices and capital flows is accentuated
by the presence of financial market imperfections. The situation looks even more
complicated when the insufficient understanding of global monetary policy spillovers is taken
into consideration.
Second, with globalization and in particular the push for less restricted capital movements in
many economies, cross-border financial linkages and therefore international spillovers of
monetary policy in the advanced economies have increased. For instance, in a recent study
the BIS concludes that the sensitivity of emerging market local currency yields to bond yields
in the US has accentuated over time, with potential of spillovers from US long-term Treasury
bonds larger at the end of 2015 than during the "taper tantrum".1
Third, in a situation of global uncertainty resulting from concerns about the strength of the
world economy, subdued world trade, low commodity prices, tightening international financial
conditions, and problems of a geopolitical nature, among others, the volatility of capital flows
and unease about the implications for exchange and interest rates resulting from monetary
policy divergence further accentuate the perception of risk.
Fourth, the causes of policy divergence themselves have been a source of apprehension.
This includes discomfort about the potential impact of the normalization of monetary policy in
the United States on emerging market economies, as well as doubts about the underlying
strength of the US economy and therefore the justification to increase interest rates in this
country. The situation is worsened by the growing perception that monetary policy is
reaching its limits, and results from monetary policy actions that sometimes run counter to
expectations, as shown by the recent appreciation of the yen and the euro following a
relaxation of the monetary stances by the corresponding central banks.
Fifth, the extent to which divergence may provide some breathing space for emerging market
economies may not be wide, given the dominance of the US dollar in international financial
markets. It may be useful to note in this respect that according to IMF estimates, the share of
total variation in domestic bond yields in the five largest Latin American economies
attributable to US shocks is twice the share corresponding to euro area shocks.2
Sixth, vulnerabilities in emerging market economies have become increasingly evident. This
has been partly the result of external factors, commodity price declines and tighter financial
conditions particularly important among them, which have put pressure on both external and
fiscal accounts. However, problems of a domestic origin have also played a prominent role in
some economies. In this context, economic activity in this group of countries has decelerated
for five consecutive years and prospects are bleak.
Is monetary policy divergence likely to persist?
The possible evolution of policy divergence among advanced economies is subject to some
question marks. To start with, while improvement in labor market conditions has allowed a
reduction of the unemployment rate in the US to levels around long-run estimates, progress
in the inflation front is more modest and some measures of inflation expectations have
shown a downward adjustment. One must add to this the possible implications for the US
economy of global economic and financial developments. As a result, the anticipated pace of
monetary policy normalization has moderated and the possibility of an additional relaxation,
even though remote, has not been totally discarded. Furthermore, some have argued that
the US economy may be crossing through a period of secular stagnation, i.e. a chronic
excess of saving over investment that acts as a drag on demand, reducing growth and
inflation, and pulling down real interest rates. Under these conditions, the functioning of
monetary policy is impaired, with fiscal policy becoming a more efficient tool.3 Others have
also pointed to the potential limits on policy divergence resulting from common external
shocks or trends that cause economic conditions to be synchronized across economies, or
from the transmission of foreign shocks across borders through exchange rate and other
financial channels.4
Notwithstanding the above, with the US economy showing a strong labor market, an increase
in some measures of inflation, resilience to external shocks, and the perspective of both a
gradual strengthening of economic activity and an upturn of inflation, the predominant view,
shared in general although with some differences by analysts, markets, and Fed officials, is
that interest rates in this country will continue to follow an upward trend in coming years.
While secular stagnation cannot be discarded, the counterarguments to this possibility are
well known.5 It is also worth noting that even if the above mentioned limits on divergence as a
result of external factors became operative, the continuation and even increase in this trend
would not be necessarily precluded. With far more serious economic difficulties in the euro
area and Japan than in the US, it is difficult to imagine a closer synchronicity of their
monetary policies in the foreseeable future. In view of the above, I concur that policy
divergence among advanced economies is likely to remain a central feature of the world
economy still for a significant period. In any case, from an emerging market country
perspective, it is far better to assume this will be the case and prepare accordingly.
What should be the proper response to this scenario?
I think this has at least two dimensions.
The first one is of course the reaction at the country level. Policy divergence in the advanced
economies will continue to give rise to challenges for both macroeconomic and financial
stability in emerging market economies. Taking into account the integration of financial
markets worldwide, and the characteristics of the world economy mentioned above, this may
affect even those countries with sound economic fundamentals. The key then, is how to
ensure that any adverse impact from divergence is not long-lasting or, in other words, how to
differentiate from weak economies.
While the proper framework must consider the particular characteristics of each country, the
general recommendations are well known. Emerging market economies should implement
cautious fiscal and monetary policies, focused on the assuagement of any macroeconomic
vulnerabilities. Exchange rate flexibility should play a major role in the absorption of external
shocks, although interventions in the foreign exchange market may be needed to face
problems of a temporary nature and to ensure an orderly market functioning. Proper macro
and microprudential policies will be key for financial stability. In particular, given the systemic
importance of some key players for domestic financial systems, a careful and thorough
monitoring of specific banks, firms, and market sectors is called for. The above should be
supplemented by measures of structural reform, aimed at increasing productivity and the
potential for growth.
Reality, however, is more complicated than theory. While policy recommendations seem
straightforward, their implementation is far more troublesome. Recent experience in a
number of emerging (and in fact also advanced) economies clearly show that proper
macroeconomic diagnoses cannot be taken for granted. Furthermore, policymakers
frequently face political restrictions to set in motion the required measures. The need to
ensure a proper coordination of different policy tools will often result in additional
implementation challenges. One should also consider that the adequate timing of policy
action is not always clear-cut. For instance, in the face of macroeconomic risks, monetary
policy may need to respond even under the presence of a low inflation rate and stable
inflation expectations. Determining the specific moment for action is not easy in
circumstances like these.
The causes of divergence and the magnitude of the challenges it originates, suggest that a
response based solely on domestic policy efforts may be both insufficient and unfair. This
leads me to the second dimension of the strategy, namely, the need for efforts at the
international level. The crucial element here is what can be done regarding the most relevant
form of divergence, i.e. monetary policies in advanced economies. As the experience during
the initial stages of the global financial crisis shows, coordination may play a key role in some
circumstances. However, it is also true that this may face significant obstacles. Different
economic cycles, at the heart of the current policy divergence in advanced economies, is a
case in point, and there are also hurdles of a political and institutional nature.
However, it is also clear that the scope for more and better cooperation in this field is wide.
Indeed, it is imperative that advanced economies take proper consideration of the
international repercussions of their monetary policy actions. Moreover, there is widespread
agreement that our understanding of monetary policy spillovers is modest, but it is far from
clear that sufficient efforts are underway to change the status quo. I am also of the view that
some proposals that have been put forward recently to agree on mutually acceptable rules
for responsible monetary policy behavior deserve to be analyzed and discussed more
thoroughly. Finally, recent experience with the "taper tantrum", on the negative side, and with
the first increase in the federal funds rate in the US after seven years virtually at zero, on the
positive one, underlines the crucial role of proper communication efforts to avoid surprises
and unpleasant market reactions.
Allow me to make a final reflection. Paradoxically, a major source of divergence for emerging
market economies in general and for Latin America in particular, derives from some
convergence in the rates of growth of the two main economies in the world. While as I noted
above the US economy is expected in general to proceed with a gradual recovery in coming
years, the deceleration of the Chinese economy is projected to continue, due to its ongoing
rebalancing from investment to consumption, and from industry to services. Naturally, this
has different implications for emerging economies, with those with closer economic links to
China and with exports more concentrated on primary commodities facing the most acute
challenges. On the other hand, it is also true that a successful transition in China to lower but
more sustainable rates of economic expansion should at the end be a net positive for the
world economy.