Manuel Sánchez: The impact of monetary policies of advanced countries
on emerging markets
Remarks by Mr Manuel Sánchez, Deputy Governor of the Bank of Mexico, at the 55th annual
meeting of the National Association of Business Economics, San Francisco, 9 September 2013.
* * *
I am honored to participate in the annual meeting of the National Association of Business
Economics. Thank you for inviting me to speak on the implications of monetary policies of
advanced countries for emerging markets. As you know, this topic is at the heart of policy
making in most central banks today.
The monetary expansion undertaken in developed countries in recent years has no parallel
in history, and its repercussions, already significant, are still to unfold in full. Moreover, recent
indications by the U.S. Federal Reserve that it might soon start unwinding its unconventional
policies have raised a host of questions regarding the characteristics of this and the following
stages of its overall exit strategy.
As a consequence, the financial boom emerging markets enjoyed during previous years
stemming from lax monetary stances in industrialized countries has begun to be displaced by
tighter financial conditions and increased uncertainty. From the beginning, not all emerging
economies were affected equally, and this will likely continue to be the case in the future. But
for the sake of simplicity, I will try to comment and conjecture on general trends in these
countries, without neglecting international differences.
Specifically, I will organize my remarks as follows. First, I will examine the effects of
expansionary monetary policies of the main advanced economies on emerging-market
countries; second, I will discuss the implications of the recent change in market sentiment;
and third, I will identify some policy challenges faced by emerging economies in dealing with
this rapidly changing international environment.
Previous financial boom
From the outset of the big financial crisis, the central banks of major industrialized countries
have implemented a variety of unconventional policies, first, to restore confidence in financial
markets and, later, to boost economic growth. The leader in these efforts has been the U.S.
Federal Reserve, which widened its liquidity facilities significantly and, by the end of 2008,
reduced its policy interest rate to near zero.
Afterwards, the Fed began purchasing financial assets from the market, notably Treasury
bonds and mortgage-backed securities, in successive programs referred to as quantitative
easing (QE). Also, it has provided forward guidance expressing its intention to maintain the
Fed funds rate near zero for an extended period of time, conditioned on certain parameters
related to unemployment and inflation expectations. These policies seek, among other
objectives, to influence market expectations and thereby reduce long-term real interest rates.
Other advanced economies have followed suit, employing similar features of monetary
accommodation.
QE is widely seen to support private spending and employment, while stable inflation
expectations are maintained. The domestic transmission channels may encompass first, a
rise in perceived consumer wealth through increases in asset prices; second, the rebalancing
of investor portfolios toward assets that are imperfect substitutes of those purchased by the
Fed, typically with higher risk-adjusted returns, thereby making funds cheaper across many
productive areas; and third, signaling that policy interest rates will remain low for an extended
period of time, contributing further to the flattening of the yield curve.
So far, the expansionary monetary policies in the United States and other advanced
countries have been effective at normalizing the functioning of financial markets and, to a
certain extent, still open to debate, firming the pace of the ongoing economic recovery.1
While these benefits were important, there have been some costs and risks associated with
the unusually lax monetary policies of advanced countries, among which the following stand
out. First, negative real interest rates punish savings and reward investment, thereby
implying a transfer of resources from the former activity to the latter. To counter this effect,
savings institutions such as mutual and pension funds may seek higher returns in risky
assets with price implications that may not be fully understood.
Second, extraordinarily benign financial conditions may have created an environment of
over-leveraging and excess lending, potentially endangering the stability of the financial
system. Third, the size and composition of the asset purchases may have distorted resource
allocation, postponing balance sheet adjustments and crowding out other financial-market
players. Fourth, the independence of monetary policy from fiscal policy may have been
damaged. Finally, central banks are navigating in uncharted waters and, hence, risks of
higher inflation may emerge if eventual monetary unwinding is inadequate.2
To different degrees, these costs and risks have impacted emerging economies. In
particular, ample global liquidity and the search for yield translated into a financial boom for a
variety of asset classes, including local government bonds, currencies, private-sector
borrowing, stocks, and real estate.
Perhaps the most widespread and prolonged effect in emerging economies was the
continuous down-shift in yield curves, in tandem with that of the United States, often more
significant, pushing domestic interest rates for different maturities to all-time lows. There is
evidence that the effect on other asset prices, on average, has also been considerable.3
An important vehicle for the financial boom in emerging-market economies was a surge in
capital inflows by nonresidents, observed since 2010. Although annual flows were not
unprecedented, this time their persistence, and more importantly, their composition,
characterized by a higher proportion of portfolio funds, were distinctive features.
Although there is no agreement on the relative importance of the determinants of the capital
flows, it is generally accepted that they include the prolonged monetary easing of advanced
countries, a reduction of global risk aversion, which may not be independent from the
previous factor, and the idiosyncratic characteristics of recipient countries, such as prospects
for economic growth and financial stability, as well as the depth and flexibility of their financial
markets.4
The available information suggests that, as a general rule, capital inflows did not result in
widespread financial imbalances in emerging economies. For example, most of them
maintained relatively stable ratios to GDP in their current accounts, public-sector debt, total
external debt, and domestic credit to the private sector. Nevertheless, there seem to be
1
For a review of the effectiveness of QE, see Martin, C. and C. Milas (2013), "Quantitative easing: a sceptical
Oxford Review of Economic
survey", Policy, 28(4).
2
For an exposition of these and other risks and costs, see, for example, Carney, M. (2010), "Living with Low for
Long", speech to the Economic Club of Canada, Toronto, Ontario, December; and Caruana, J. (2012),
"International monetary policy interactions: challenges and prospects", speech given at the conference
"CEMLA-SEACEN, Punta del Este", Uruguay, November.
3
For an estimation of the international impacts of QE, see Chen, et al. (2012), "International spillovers of central
bank balance sheet policies", BIS Paper No. 66, October.
4
Two empirical analyses of the factors that explain capital flows are Ghosh, A.R., et al. (2012), "Surges", IMF
Working Paper, WP/12/22, January; and Fratzscher, M. (2011), "Capital flows, push versus pull factors and
the global financial crisis", ECB Working Paper Series, No. 1364, July.
vulnerabilities in some countries, such as significant FX exposure, as well as indications of
overheating and excess credit, and additional information, especially as monetary tapering
proceeds, may uncover further financial imbalances in these or other nations.5
The beginning of unwinding
Since last May, there has been a negative change in investor sentiment towards emerging
markets, expressed in sharp asset-price drops and heightened volatility. Notably, currencies
have trended weaker, and domestic long-term interest rates have risen to levels not seen in
more than a year. Also, portfolio capital inflows from nonresidents have slowed and even
reversed, while the duration of foreign holdings of local-currency government bonds in some
countries appears to have fallen.
The trigger of this shift in sentiment has been the market perception that the Federal Reserve
will soon start reducing its asset purchases and conclude the program by the first half of the
following year. Additionally, the estimated time before the first hike in the Fed funds rate has
been shortened. The revisions in expectations were fueled by the Fed's forward guidance
referenced to inflation and unemployment, official statements suggesting the proximity of
tapering, and incoming data revealing improved economic conditions and prospects in the
United States.
As a result, the U.S. yield curve has steepened, reflecting a higher term premium and thus
probably the expectation of a greater supply of long-term bonds, as well as, to a lesser
extent, anticipation of increases in the Fed funds rate. Other industrial nations have also
seen similar effects.6
As was the case during the recent boom, the interest-rate reaction in many emerging
markets has been more pronounced than in the United States, revealing additional risk
premiums which may be related to credit and liquidity. Also, increased global risk aversion
and deteriorated prospects for economic growth in emerging economies could be additional
negative factors.
The possibility that the Fed may soon start reducing its asset purchases is a welcome
development. The exceptionally loose monetary policy in the United States and other
advanced countries cannot be indefinitely sustained, as the costs and risks involved may be
rising and surpass the intended benefits. Additionally, the decision to taper will ultimately
hinge on an improved U.S. economic outlook, which should benefit the rest of the world,
including emerging markets. Finally, tapering may facilitate the adjustment required in certain
economies afflicted by financial disequilibria which, at least in part, may have resulted from
the abundance of foreign funds.
However, a complete exit from the extraordinary monetary accommodation in the United
States could be complex indeed. There is no precedent from which to derive lessons. It will
likely take several years. Implementation of the strategy should be neither premature nor
delayed relative to the pace of economic recovery. Since future changes in the course of
monetary policy or forward guidance cannot be ruled out, maintaining credibility could be
challenging. To these difficulties, add the peculiarities of the eventual exit strategies of other
advanced countries.
Therefore, the future external scenario for emerging markets will necessarily involve
considerable uncertainty. Successive stages of monetary unwinding in the United States
could imply further downward, not necessarily smooth adjustments in asset prices. At the
same time, capital flows from abroad may become much scarcer and even exhibit a sudden
stop.
Nevertheless, portfolio adjustments may affect emerging economies differently according to
their fundamentals. In general, it is reasonable to expect that countries with better
macroeconomic foundations and growth outlooks may suffer less than those characterized
by financial imbalances, stringent external funding needs, overheated economies or asset
price bubbles.
Policy challenges
What can policymakers in emerging markets do in order to deal with the challenges of
tapering and the eventual exit from expansionary U.S. monetary policy? Given globalization,
developments in and measures adopted by large industrial countries have always affected
the performance and policy options of emerging economies.
The present situation is no exception. If the era of unusually cheap foreign funding is indeed
over, economic policy in emerging economies must accept that reality, not be oriented
towards trying to cancel it, any attempt at which would inevitably fail and likely result in
financial instability.
A more reasonable policy objective for emerging economies may be to seek to prevent and
manage possible problems derived from more restrictive conditions. As each country may be
affected differently, the importance of specific alternatives will vary internationally.
During the boom, discussions on the role of economic policy were centered on how to deal
with abundant capital inflows from abroad. Consistently, emerging-market policy actions
focused on either discouraging capital inflows or attempting to mitigate possible adverse
effects from those funds.
Measures within the first category included reducing policy interest rates to levels probably
inconsistent with price stability and, most notably, enforcing a variety of capital controls.
Examples within the second group involved accumulating international reserves,
strengthening the fiscal stance, and improving the supervision and prudential regulation of
the financial system.7
Each measure implied possible benefits and limitations, and many countries adopted actions
from both approaches to varying degrees. However, in general, even when international
differences are taken into account, the economies that showed more resilience to negative
effects from the external bonanza seem to have been those that relied more heavily on the
second approach, thus preserving their economic fundamentals.
For the tightening period, countries can now contemplate and some are already applying
analogous policy alternatives, either by directly seeking to discourage capital outflows or
preventing the surge of possible systemic problems. As in the boom years, well-known
tradeoffs can resurface. For example, a floating exchange rate regime can serve as a buffer to
upward pressures on domestic interest rates, and an exchange-rate peg may result in
sharper steepening of the yield curve.
As is usually the case, there is no unique recipe for successful economic policy for all
countries. However, adequate regulation and continuous surveillance of the financial system
and markets are essential defenses for turbulent times. Also, the pursuit of price stability and
sound fiscal balances and, in extreme cases the provision of liquidity under appropriate
conditions by central banks, complete the foundation for stability. Finally, structural reforms
to enhance productivity growth and investment opportunities are an essential complement for
attracting stable capital flows.8
Concluding remarks
To conclude, the unconventional policies implemented by major industrialized countries'
central banks during the last five years fueled abundant capital inflows and low funding costs
in emerging markets. As a result, asset prices rose considerably, and although widespread
financial imbalances have not been evident, some countries did experience overheating and
price bubbles. Newly available information may uncover further financial imbalances in these
or other nations.
The market perception that the Federal Reserve will soon start tapering asset purchases has
resulted in significant reductions and heightened volatility for asset prices in emerging
markets. Given the complexity of what could be the overall exit strategies of the United
States and other advanced nations, emerging economies necessarily face a highly uncertain
external scenario. Despite foreseeable adverse financial conditions, it is reasonable to
expect that global portfolio adjustments may affect countries less severely if they enjoy
stronger economic fundamentals.
Finally, emerging economies have different policy options at their disposal in the unwinding
phase, especially to try to prevent and manage the surfacing of possible problems. The
strengthening of the foundations of domestic financial stability and the implementation of
structural reforms to enhance productivity growth and investment, have never been more
important.