An address by Lesetja Kganyago,
Governor of the South African Reserve Bank,
at the National Asset and Liability Management Conference
London
2 March 2018
Challenges for emerging-market central banks
Good morning, ladies and gentlemen, and thank you for the opportunity to address
you on some of the challenges facing emerging-market central banks.
Since the most recent global financial crisis, central banks have faced mounting
challenges. Not only were they at the forefront of saving the global economy from
'the only game in town'
collapse; they were also seen as in restoring economic growth.
Central banks also began to play a more pivotal role in ensuring financial stability in
general. With these additional responsibilities and expectations, the independence of
central banks became increasingly questioned, as financial regulation is considered
by some to be primarily political in nature rather than technical.
The economic dimension to independence is also of importance, particularly in
emerging-market economies.
My remarks today will focus on these two dimensions of independence and will
consider the extent to which emerging markets have increased their resilience in
recent years.
Political independence
The case for central-bank independence is based on the time inconsistency argument
that politicians promise low inflation but are tempted to go for higher growth through
expansionary monetary policies. An independent central bank, with a clear mandate
to maintain price stability and without the concerns of the electoral cycle, is better-
placed to focus on and achieve price stability.
The problem of ceding enormous power to unelected officials in democratic societies
is solved by distinguishing between goal independence and operational
independence. In many countries, central banks have been granted the latter form of
independence. This distinction accords neatly with an inflation-targeting framework,
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where the goal of monetary policy the inflation target is set by law or by the elected
government, and the central bank has to implement monetary policy and achieve the
inflation target without political interference.
Pressures on central banks to use monetary policy to stimulate growth are not new. It
is generally accepted among central bankers that while monetary policy can affect
cyclical growth, its ability to determine longer-term potential output is limited. Since the
global financial crisis, we have seen the potential output estimates in many countries
being revised downwards. And while the need for structural reforms has been very
clear in many countries too, the focus has been on monetary policy to sustain a growth
recovery.
Concerted central-bank actions were probably successful in preventing a full-blown
global depression, but their ability to bring about a growth recovery was less certain.
There were, at times, excessively high expectations as to what monetary policy could
achieve with respect to growth, and failure in this respect had the potential to
undermine the credibility and legitimacy of monetary policy in general. In the event,
and it is only now that we are seeing a return to 'normal'
recovery has taken some time,
growth rates on a sustainable basis. We have yet to see if the massive expansion of
balance sheets and the high levels of liquidity generated by low interest rates and
quantitative easing will ultimately lead to the high inflation that some have feared.
While this is unlikely, it remains a risk.
The global crisis originated in the financial sector and subsequently required a
rethinking of the role of central banks with respect to financial stability. Prior to the
crisis, this responsibility was often not explicitly part of central-bank mandates. Since
then, much has changed. And while there are differing approaches among countries,
the tendency has increasingly been to locate this responsibility within central banks.
A financial-stability mandate becomes more complex when dealing with the issue of
independence, as it does not fit neatly into the 'goal versus operational independence'
dichotomy. What constitutes financial-stability goals is less clear-cut than in the case
of monetary policy. In addition, the policies that are available to achieve or maintain
financial stability often require cooperation and coordination between various
regulatory authorities, including, at times, the fiscal authorities. A challenge for central
banks is ensuring that monetary-policy independence is not undermined in the
process. This is particularly the case in the event of conflicts between competing
objectives.
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Furthermore, macroprudential policies for example caps on loan-to-value and loan-
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to-income ratios and criteria for loan eligibility often have a more visible distributional
dimension, and financial-sector lobbies and interest groups are usually strong. As a
consequence, central banks have unwittingly been thrust more squarely into the
political realm. As their responsibility for financial stability increases, central banks
could become increasingly politicized, more so than in the case of monetary policy.
Macroprudential policies are often likened to taking the punchbowl away just as the
party is starting. Such actions are never popular.
If independence is to be maintained, central banks need to foster the political
consensus that underpins independence. This requires even greater transparency and
accountability than in the case of monetary policy. Central banks also need to have
the courage and political backing to make tough calls. There is always the danger that
unhappiness with central-bank actions in the financial-stability field could undermine
the credibility and legitimacy with respect to their core mandate of price stability.
The issue of independence can also be related to central-bank balance sheets, which
were brought under greater scrutiny in the wake of the global financial crisis. The
balance sheets in the advanced economies expanded dramatically following the
extraordinary monetary-policy measures undertaken in those economies. As I will
elaborate on a little later, these actions also had implications for the balance sheets of
central banks in the emerging markets.
It is generally agreed that central banks should not be too concerned about incurring
losses or making profits on their balance sheets. These should be regarded as part of
the broader government budget constraint. Furthermore, central banks do not have a
profit motive but act in the broader interest of the economy. However, central banks
that incur continuous losses may ultimately require recapitalization by government and
may consequently bring themselves under greater political scrutiny. These issues
could divert attention from their core mandate.
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The South African experience is perhaps instructive although not unlike the problems
faced by other emerging markets. The South African Reserve Bank recorded losses
for five consecutive years from 2010, mainly attributable to reserve-accumulation
activities. As capital flows to the emerging markets expanded as the search for yield
intensified, many central banks attempted to ameliorate the impact on their currencies
by buying reserves.
South Africa's -
In case, we stepped up reserve accumulation not to influence the
currency, but rather to add to what we considered to be a suboptimal level of reserves.
Whatever the motive, the impact on profitability is the same. With interest rates at the
lower bound in the advanced economies and typically significantly higher in the
emerging markets, sterilization activities were conducted at a loss. Countries differ as
to how they treat these losses, and the preferred approach often depends on legal
frameworks and institutional structures. It can, however, in some instances raise
often seen as 'losing taxpayers'
questions about central-bank activities, as they are
money'
and putting independence at risk.
Monetary-policy independence
While the political dimension of independence remains an ongoing challenge, the
issue of monetary-policy independence in the emerging markets has come to the fore
again recently. This is against a backdrop of what appears to be a turning point for
global financial markets, following an extended period of low volatility and low interest
rates in the advanced economies and an absence of inflation pressures. For some
time now, the world has been anticipating interest-rate normalization in the United
States (US) in particular. To date, this has been happening at a very slow and
measured pace, and has been well communicated.
Over the past few weeks, global financial markets have reacted to the prospect of
tighter-than-expected monetary-policy settings in the US. There was a widespread
market reaction to the sharp drop in US equity prices and a large spike in the VIX.
After the initial bout of volatility, the markets appear to have stabilised somewhat, but
they remain vulnerable to further changes in sentiment and perceptions of risk. It does
seem, however, that the prolonged period of easy money and highly liquid markets
may be coming to an end, raising concerns about spillovers to the emerging markets
who, as usual, are the innocent bystanders.
The current turbulence in global financial markets coupled with the return of volatility
is in some ways reminiscent of the so-called 'taper tantrum' of 2013. After a number
of years of interest rates at the zero bound and quantitative easing, the world suddenly
faced the prospect of a withdrawal of stimulus. The mere suggestion that the Federal
Reserve System (Fed) was considering a reduction in quantitative easing hit the
financial markets hard. Long bond yields ratcheted up in the US, raising fears that the
nascent growth recovery would be reversed. In the event, the Fed had to allay fears
of an excessively tight policy cycle and, in reality, what tightening has occurred since
then has been very moderate and well communicated.
But while there are similarities to the taper tantrum, there are important differences as
well. At that stage, it was only the US that was looking to tighten policy. Today, the
cycle is more synchronised. There are expectations for a more aggressive tightening
cycle in the US than had previously been priced in, and further interest-rate increases
are expected in the United Kingdom. In addition, the European Central Bank is
beginning a gradual withdrawal of stimulus. Monetary policy in Japan is, however,
expected to remain highly accommodative.
A further important difference between then and now is that, after a number of false
starts, the growth recovery in the advanced economies appears to be more
entrenched and broad-based. This will be positive for the emerging markets.
There are also tentative signs that inflation may be on the rise as well, and the likely
fiscal expansion in the US is also expected to provide some impetus. Wage growth in
the US, which has been surprisingly subdued despite the tighter labour-market
conditions, recently showed signs of increasing and contributed to much of the recent
bout of volatility in the markets.
This time does seem to be different, and monetary-policy tightening appears to be
more clearly countercyclical.
The market overreaction at the time of the taper tantrum in 2013 had a marked effect
on a number of emerging markets, who had been the main beneficiaries of the capital
flows generated by the highly liquid conditions. Long bond yields in the emerging
markets increased and currencies depreciated as capital flows began to reverse.
Monetary policies were generally tightened, although there were differences in timing
and degree.
According to Eichengreen and Gupta1, the countries hit the hardest were those with
wide fiscal and current-account deficits and open capital markets. South Africa fell into
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this category, along with Brazil, India, Indonesia, and Turkey together given the
dubious title of 'the fragile five'. Since then, however, most emerging markets have
adjusted significantly and are more resilient. But this resilience is currently being put
to the test.
1
Eichengreen, B and Gupta, P. 2013. 'Tapering talk: the impact of expectations of reduced Federal
Reserve security purchases on emerging markets'. World Bank Working Paper No 6754
One of the clear lessons of the 2013 episode was that the emerging markets are not
immune to monetary-policy developments in the advanced economies. This raises the
question as to whether small open economies (and that is what most emerging
markets are) can conduct monetary policy independently of developments in
advanced-economy financial markets. The traditional Mundell-Fleming model has
taught us that monetary policy cannot be conducted independently where exchange
rates are fixed. However, flexible exchange rates were expected to provide insulation
against cross-border spillovers. Furthermore, perfect exchange-rate flexibility would
obviate the need for reserves. This view of the world has changed since then, and for
good reasons. Very few countries allow their exchange rates to float freely nowadays.
In the past few years, the issue of monetary-policy independence and the insulation
properties of flexible exchange rates have been reconsidered. There is little doubt that
very few countries are immune to spillovers from developments in the major advanced
economies. The question is: to what extent, if at all, can emerging markets insulate
themselves from external shocks?
The well-known 'trilemma' tells us that, with free capital mobility, independent
monetary policies are possible only if exchange rates are floating. However, the sheer
scale of financial globalisation in recent years has led to a rethinking of the trilemma.
Hélène Rey2, for example, has posited the existence of a global financial cycle that is
strongly related to monetary conditions in the US and to changes in uncertainty and
risk aversion. It is argued that, because credit cycles and capital flows respond to
global factors, they may be inappropriate for the prevailing cyclical conditions of many
economies. This implies that, for some countries, the global cycle can lead to
excessive credit growth when the economy is booming and excessive contraction
during a downturn. In other words, it is conditions in the advanced economies that
determine domestic financial conditions in the smaller economies, and not domestic
policy rates.
2
Rey, H. 2015. 'Dilemma, not trilemma: the global financial cycle and monetary policy
independence'. National Bureau of Economic Research Working Paper No. 21162.
As Obstfeld, Ostry, and Qureshi3 have pointed out, there are a number of reasons why
we would expect monetary policy to be constrained where financial integration
pertains. For example, the substitutability between domestic and external financing
could limit the effectiveness of domestic policy interest-rate changes on credit
extension and asset prices. They also note that, even if we observe divergences
between short-term rates as an indicator of insulation, there is likely to be greater co-
movement of longer-term rates. Much will then depend on the extent to which long-
term rates influence real variables.
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For Rey, therefore, the trilemma does not exist. Rather, it is a dilemma or what she
calls 'an irreconcilable duo'. That is: independent monetary policies are possible if,
and only if, the capital account is managed, directly or indirectly, via macroprudential
policies. These could include capital controls if macroprudential policies are
insufficient. In other words: flexible exchange rates do not ensure independent
monetary policies when capital is highly mobile. This is a rather significant conclusion
for emerging markets as it means that, under conditions of free capital mobility,
monetary-policy independence is not possible, irrespective of the prevailing exchange-
rate regime.
But this view is not without its critics. For example, Obstfeld et al. and Gita Gopinath4
agree that the dilemma view may be overstated. However, their evidence suggests
that although the trilemma lives on, it does not appear to exist in its strong form. They
show that countries with exchange-rate flexibility are less sensitive to changes in
global risk and less prone to economic boom-bust cycles. And although independence
is not absolute, there is less loss of independence than in the case of countries with
fixed exchange rates. In other words: the choice of exchange-rate regime does matter,
but we should not expect complete independence with flexibility. The trilemma may be
weakened, but it still applies.
Furthermore, the extent to which countries can conduct independent monetary policies
also depends on their underlying resilience to global spillovers. It is generally accepted
3
Obstfeld, M, Ostry, J D and Qureshi, M S. 2017. 'A tie that binds: revisiting the trilemma in emerging
market economies'. International Monetary Fund Working Paper WP/17/130.
4
A
Gopinath, G. 2017. 'Rethinking macroeconomic policy: international economy issues'. paper
at the
presented to the conference on 'Rethinking macroeconomic policy IV' Peterson Institute for
International Economics.
that most emerging markets have also become more resilient since the taper tantrum:
the macroeconomic fundamentals have generally improved and the domestic financial
markets have developed further. In particular, real policy rates are generally higher,
inflation is within the target range in most of the inflation-targeting emerging markets,
and both fiscal and current-account deficits have generally narrowed. For example: for
a selected sample of non-oil-exporting emerging markets5, current-account deficits as
a percentage of gross domestic product (GDP) have narrowed significantly since
2012, averaging 0.7% in 2016 compared with 2.2% in 2013.
In South Africa's case, our deficit has narrowed from
its widest level of almost 6% of
GDP in 2013 to its current level of 2.3% of GDP.
The deficits of the other so-called 'fragile' countries have also shown sizeable
contractions. As a group, therefore, they have greater ability to withstand the impact
of exogenous shocks, including sudden stops and higher interest rates in the
advanced economies.
An indicator of increased resilience is the fact that, since the crisis, a number of
emerging markets have made considerable progress in developing deeper and more
accessible domestic-currency-denominated bond markets. They no longer suffer from
to as 'original sin'. South Africa is
what is often referred again a good example of this.
Prior to the crisis, although South Africa had a well-developed domestic bond market
by emerging-market standards, non-residents held about 9% of total rand-
denominated government debt. Today, this stands at around 40%.
This development is seen as reducing emerging-market dependence on foreign-
currency debt. It is also seen as a means to reduce exposure to external shocks and
increase resilience. However, this does not insulate emerging markets completely. A
sudden stop or a reversal of flows would impact on bond yields and the exchange rate.
The ability to absorb exchange-rate changes would differ from country to country.
Countries with lower levels of foreign-currency indebtedness would be less sensitive
5
Argentina, Brazil, Egypt, India, Indonesia, Malaysia, Mexico, Pakistan, the Philippines, Poland,
South Africa, Thailand, Turkey
to the balance-sheet effects of large exchange-rate changes. Furthermore, it also
implies that bond yields become more sensitive to global factors.
Nevertheless, there is evidence that local-currency credit spreads are much less
correlated across countries than foreign-currency credit spreads, and global factors
explain significantly less variation in local-currency spreads than in foreign-currency
spreads.6 In a similar vein, work by Shakill Hassan7 at the South African Reserve Bank
shows a low correlation between South African short-term rates and global rates, but
the correlation increases for longer maturities. Yields at the short end of the South
African terms structure are highly responsive to domestic factors which affect the
domestic monetary-policy stance. By contrast, long-term yields are highly responsive
to changes in global bond-market developments.
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A further indicator of increased resilience is the level of foreign-exchange reserves
something that would be close to the heart of the attendees of this conference. As I've
mentioned earlier: despite increased exchange-rate flexibility, the need for reserves
has not disappeared. We have seen that, over time, foreign-exchange reserve
holdings have increased quite markedly in the emerging markets. This is true even if
we exclude China, which has the largest holdings of reserves. Since 2005, the reserve
holdings in a sample of emerging markets referred to earlier (excluding China)
increased by 178% by the year 2017.
It is generally agreed that the primary motive for reserve accumulation is
precautionary, as insurance against speculative attacks in times of crisis. According
to research conducted by the International Monetary Fund8, there is strong empirical
evidence that reserves reduce the likelihood of balance-of-payments pressures in the
emerging markets. Reserves could provide the means to respond to exogenous
shocks, and could calm or even prevent disorderly markets. Central banks have,
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however, tended to accumulate rather than to use reserves a phenomenon
'the
sometimes referred to as fear of losing reserves'.
6
Du, W and Schregger, J. 2016. 'Local currency sovereign risk'. Journal of Finance 71(3).
7
Hassan, S. 2015. 'Speculative flows, exchange rate volatility and monetary policy: the South African
experience'. South African Reserve Bank Working Paper Series WP/15/02.
8
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International Monetary Fund. 2014. Assessing reserve adequacy specific proposals.
While higher levels of reserves may create the perception of resilience, simply having
reserves on their own is not an effective buffer against speculative attacks or crises.
Reserves do not eliminate vulnerabilities. They are not a substitute for sound policies
and strong, well-regulated financial sectors.
Conclusion
In conclusion, it would appear that, at long last, the recovery from the global financial
crisis is on track. It has been a difficult path, with a number of false starts and
disappointments. No doubt, the road going forward will not be without its difficulties.
The recovery itself is expected to bring about new challenges, for the emerging
markets in particular. It is inevitable that monetary-policy normalization in the
advanced economies will happen, and that the era of high global liquidity will come to
an end. The impact on capital flows and global financial markets will create particular
challenges for central banks at a time when political independence is being
questioned. While vulnerabilities differ from country to country, the emerging markets
in general appear to be more resilient in the face of the recent market volatility. Their
macroeconomic fundamentals and policies have improved, making them better-placed
to weather the storm than was the case five years ago.
Thank you.