Vítor Constâncio: Divergent monetary policies and the world economy
Keynote address by Mr Vítor Constâncio, Vice-President of the European Central Bank, at the
conference on "Diverging Monetary Policies, Global Capital Flows and Financial Stability",
jointly organised by the Federal Reserve Bank of New York/European Central Bank/Federal
Reserve Bank of Dallas/Hong Kong Monetary Authority, hosted by the Hong Kong Monetary
Authority, Hong Kong, 15 October 2015.
* * *
I wish to thank M. Ca' Zorzi, G. Georgiadis, G. Strasser and L. Dedola, from the ECB staff for contributions in the
preparation of this speech.
Summary
We live in an increasingly globalised world. The responsiveness of financial markets to
monetary policy announcements is prima facie evidence that the exit from the zero lower bound
may have potent spillovers on other countries in the short run. The medium-term impact of
monetary policy spillovers is however much less clear-cut than frequently assumed in policy
debates. Looking forward, central banks play an important role in preserving price and financial
stability in their own constituencies, but also in stabilising the global financial system. However,
it would be a misconception to believe that central bank actions alone are enough. Central
banks have to respond to their own economies' fundamentals but "putting their house in order"
is not enough to ensure a suitable global economic environment. Global challenges require
domestic and global responses to make the financial system more resilient.
* * *
Introduction
Ladies and Gentlemen,
It is a pleasure for me to speak at this joint conference on "Diverging Monetary Policies, Global
Capital Flows and Financial Stability" hosted by the Hong Kong Monetary Authority.
The current international environment poses a number of important challenges to policy
makers, such as the decline in commodity prices, remaining global imbalances and a
synchronized growth slowdown in emerging economies with worldwide consequences. I could
continue this list even further. From a central banking perspective, however, an obvious
challenge in the coming months will be the divergence between the monetary policy stance in
the US and other major advanced economies.
When divergences reflect differences in fundamentals, as it is the case between the US and
the Euro Area, the traditional view was that no problems would be created to the global
economy. However, this time the divergences could have greater global repercussions than in
the past. This might be the case due to four momentous developments that the global economy
has witnessed over recent years. First, several emerging economies - China in particular -
have integrated in the global economy to an unprecedented degree. Second, the increasing
international fragmentation of production has given rise to tight links between countries along
the global value chain. Third, the liberalisation of capital flows and the rise of global banks have
brought about strong cross-border financial linkages. Fourth, the zero lower bound has
rendered central bank balance sheets and forward guidance crucial monetary policy
instruments.
There is compelling "prima-facie" evidence that monetary policy in major advanced economies
has significant spillovers to the global economy, at least in the short term. I refer here to the
high sensitivity of global bond yields and exchange rates to recent monetary policy
announcements in the US and the euro area. Likewise, the changes in market expectations
about the timing of US monetary policy tightening have given rise to bouts of financial market
volatility.1 However, over the medium term, considering the multiplicity of channels of monetary
policy transmission, the impact on other countries' macroeconomic outlook is much less
clearcut. It also critically depends on the economic fundamentals of the receiving countries, as I will
explain in more detail later.
The truth of the matter is that given the lack of historical precedents on what the impact of a
major economy departing from a zero lower bound environment is, market analysts and policy
makers do not have much of a choice other than "learning in real time". While recent work in
academia and policy institutions has improved our understanding of the transmission
mechanisms that give rise to global spillovers, we still live with more open questions than
answers.
In the remainder of my remarks, I would like to discuss the spillovers generated by monetary
policy in the US and in the euro area in more detail. I shall also briefly touch upon the
implications of a growth slowdown in emerging economies. I will then share my views on how
policymakers can deal with these spillovers. Finally, I will briefly touch upon policies that may
help increase the resilience of the international monetary system.
Monetary policy spillovers
International spillovers from the monetary policy of one country to other economies are a
corollary of globalisation. This entails that we, as policymakers, have to rise to the challenge
of conducting monetary policy in the presence of these unintended side-effects.
The sign and magnitude of monetary policy spillovers is, a priori, less clear than assumed in
some economic debates. Consider, for example, the impact of a US dollar appreciation
resulting from a tightening in US monetary policy. On the one hand, to the extent that the
appreciation of the US dollar improves other economies' price competitiveness, expenditure
switching effects will shift US demand in favour of imported goods; at the same time, US goods
become more expensive abroad, leading to substitution by domestic goods there. Through this
expenditure switching channel, the spillovers from US monetary policy are expansionary for
other countries. However, as the tightening in monetary policy leads to a dampening in US
aggregate demand, contractionary spillovers will ensue through an overall import reduction in
the US. As a result, the sign of the spillovers through trade is ambiguous. Recent research has
emphasised that it depends on further complicating elements, such as the currency of trade
invoicing.2
While a traditional textbook would focus on trade as the main channel of monetary policy
spillovers, the literature suggests that financial channels - through exchange rates and capital
flows - are more important, especially when departing from a stylised world with frictionless
financial markets. In particular, in an international version of the financial accelerator with
foreign-currency debt, a US dollar appreciation would increase the local-currency value of
liabilities denominated in US dollar in the rest of the world. In turn, this would impair borrowers'
net-worth, at least in the absence of a matching cash-flow in US dollars.3 This is the root of the
classic "original sin"4 in international macroeconomics, which can affect both public and private
borrowers. The literature highlights a number of financial market imperfections that give rise to
excessive volatility and contagion in asset prices and capital flows, magnifying the spillovers
from monetary policy.5 It is this multitude of transmission channels, some of them going in
opposite directions, which calls for a cautious judgement of the sign and magnitude of the
spillovers from monetary policy. With this in mind, let me now discuss the empirical evidence
of monetary policy spillovers between the US, the euro area and emerging economies.
Spillovers from US monetary policy
Let me start with the international impact of US monetary policy. There is a broad consensus
that the spillovers emanating from the US are relatively large.6 This is rooted in the international
role of the US dollars, both in global financial markets and in international trade. In particular,
US monetary policy greatly affects risk premia, volatility of asset prices and global credit
growth. It has even been argued that monetary policy in the US is the driver of a "global
financial cycle". According to this view, contractionary US monetary policy results in tighter
financial conditions not only in the US but globally.7
The dominance of the US dollar in the invoicing of US trade makes spillovers from a US
monetary policy tightening, contractionary. On the one hand, because more than 90% of US
imports are invoiced in US dollar, US demand for foreign goods hardly rises in response to US
monetary policy through expenditure switching effects. On the other hand, as the share of US
exports invoiced in US dollars is 97%, an appreciation of the US dollar exchange rate may
trigger expenditure switching in the rest of the world away from US towards domestic goods.
Overall, the spillovers from a tightening US monetary policy to output growth through
expenditure switching are thus expansionary. In contrast, due to the stickiness of US dollar
import prices, US demand for foreign goods closely co-moves with US aggregate demand,
which contracts in response to the tightening in monetary policy. The dominance of the latter
effect renders the output spillovers from a tightening US monetary policy through trade,
contractionary. Furthermore, a high share of US exports invoiced in US dollar implies large
spillovers to inflation abroad.
These spillovers from US monetary policy differ across countries and regions. For example,
changes in the euro-US dollar exchange rate have a substantial impact on euro area export
competitiveness towards third countries whose exchange rate is linked to the US dollar, given
the prevalence of producer-currency pricing with a share of 70% among euro area exports.8
US monetary policy therefore affects the euro area through the relative export competitiveness
in the world markets and the competitiveness of US exports in the euro area. Import prices in
the euro area are partly shielded from the effects of fluctuations in exchange rates in what
concerns imports from countries other than the US, given that about 50% of aggregate euro
area imports are invoiced in euro.
However, the central channel of spillovers from US monetary policy appears to be via capital
markets.9 In fact, US monetary policy has large financial spillovers, especially to European
bond markets. German nominal bond yields, for example, follow the change of US bond yields
in response to a US monetary policy tightening by more than one third.10 Owing to the role of
the US dollar in emerging economies' integration with global financial markets, spillovers
through valuation effects, "original sin" and financial accelerator mechanisms, are much
stronger than in the euro area. Overall, the evidence even suggests that spillovers from US
monetary policy might be larger than the domestic effects in the US.11
The spillovers from unconventional US monetary policy, such as the Federal Reserves' asset
purchases, are harder to quantify than those from conventional monetary policy. As there is
not a single monitored policy variable, studies have to rely on indirect measures of
unconventional monetary policy surprises. Typically, a quantity that monetary policy appears
to target, such as corporate bond spreads or term premia, has been used to do so. One
difficulty in interpreting the results of this strand of the literature stems from the possibility that
interest rate spreads may reflect information that goes beyond what is captured by US
monetary policy. As a second caveat, I would like to add that almost all unconventional
monetary policy measures that were taken so far were expansionary. As available studies are
necessarily based on past data, they might not be informative regarding the effects policy
actions have in the opposite direction.
Spillovers from euro area monetary policy
Turning to the euro area, the evidence suggests that spillovers from euro area monetary policy
are smaller than those from the US, not least because of the dominance of the US dollar in
global financial markets.12
US inflation is shielded from exchange rate fluctuations in response to a euro area monetary
policy loosening due to its "privileged insularity", as almost all of US imports are invoiced in
dollar. By the same token, euro area exports to the US would not benefit much from a
depreciation of the euro vis-à-vis the dollar. At the same time, considering that a very large
share of US exports to the euro area are invoiced in US dollar, there is a larger potential for
real spillovers from euro area monetary policy to the US through expenditure switching away
from US goods in the euro area. In this context, however, I would like to stress that if our
monetary policy succeeds in stimulating euro area aggregate demand, then this will also
increase euro area demand for US goods, counteracting the loss in competitiveness for US
firms from the dollar appreciation. And as argued above, the income expenditure channel - in
this case an expenditure increase - appear to be quantitatively more important than the
expenditure switching channel.
As regards the spillovers from the euro area to emerging economies, given that about 70% of
extra-euro area exports to these countries are invoiced in euro, there is a potential for a large
impact through expenditure switching abroad. And due to the sheer size of the trade flows,
such expenditure switching could have noticeable spillovers in neighbouring economies in
Europe. In response to a euro area monetary policy loosening, this effect would be largely
contractionary to the extent that their currencies appreciate vis-à-vis the euro. But again, any
contractionary spillovers through expenditure-switching are likely to be undone by
expansionary effects through the strengthening in euro area aggregate demand. And there is
substantial empirical evidence that the latter dominate, in particular for neighbouring
economies in Europe.13
More recently, some studies have suggested that spillovers from the euro area might have
become larger, in particular those stemming from unconventional monetary policies and
operating through financial channels.14 Take the example of the ECB's announcement of the
Expanded Asset Purchase Program which triggered a concurrent decline in US bond yields,
despite speculation about an imminent increase in the US Fed Funds rate.15 The large size of
foreign assets and liabilities in the US and the euro area implies that the balance sheet effects
of an exchange rate or interest rate change can trigger larger spillovers from the euro area to
the US than we had been used to.
A brief digression on emerging markets
Allow me a brief digression on emerging markets. The linkages between emerging and
advanced economies are closely monitored at the present time. This is the case not only
because of concerns over the impact of monetary policy decisions in advanced countries but
also given that an economic slowdown in emerging economies may potentially compromise a
still fragile global recovery. The lack of synchronisation between the business cycle and
monetary policies in the US and the euro area may reduce the current impact of monetary
policy decisions in advanced countries on emerging countries as the effects tend to offset each
other.16 The growth outlook in emerging economies may matter more than in the past. This is
particularly evident if we consider that they account for more than 50% of world output, 40%
of world trade volumes and an increasing, albeit still small, share of global stock market
capitalisation or international bond issuance.17 China is increasingly becoming a global player,
whose decisions have increasingly relevant repercussions at the global level. Its share on
global GDP has risen substantially, it accounts for a larger share of global trade, and is
gradually liberalising its capital account and thereby integrating into global financial markets.
Nevertheless, developments in China still have less direct impact on the euro area than those
in the US. First, in 2014, the share of extra-euro area exports to the US in total exports was
almost twice as large as the corresponding share accounted for by China.18 Second, China's
demand for euro area exports is largely driven by global rather than by domestic demand. In
particular, a large share of euro area exports to China is made up of intermediate goods, which
are, in turn, used in the production of Chinese exports to the rest of the world. Third, due to the
remaining restrictions on China's capital account, financial integration between the euro area
and China remains limited. In 2013, the share of US foreign financial assets held by euro area
residents was more than 40 times as large as the corresponding share of Chinese foreign
13
See for example Jannsen and Klein (2011), Errit and Uusküla (2013), Falagiarda, McQuade and Tirpak (2015)
as well as Kucharcukova, Claeys and Vasicek (2014).
14
See Buitron and Vesperoni (2015) as well as IMF (2012, 2013, 2015).
15
See Bank of International Settlements (2015).
16
See He et al. (2015), Kim and Shin (2015) and Buitron and Vesperoni (2015).
17
See Haldane (2015).
18
12% versus 6.9% according to IMF Direction of Trade Statistics data. Notice that in order to account for
competition faced by euro area companies in foreign markets from exporters based in third countries the weight
of the renminbi in the euro effective exchange rate departs from the direct bilateral export linkages. In the case
of China, the "double" export weight amounts to 16% compared to a direct export weight of 7%, over the period
2010-12 (see ECB Economic Bulletin 6, 2015).
financial assets held by euro area residents.19 And finally, a slowdown in China's domestic
demand lowers global commodity prices, which acts as a stimulus to commodity importers like
the euro area.20 Having said that, the ECB is carefully monitoring events in emerging
economies, as their effect on the rest of the world might turn out to be larger if
mutuallyreinforcing neighbourhood effects materialise.21
Coping with monetary policy spillovers
To cut a long story short, the global economy has become more vulnerable than ever before
to very large real and financial spillovers. Global factors drive asset prices and cross-border
flows. And in some cases, the ability of domestic monetary policy to achieve its mandate might
be more limited than we used to think, in particular in emerging economies. What measures
should be taken to manage the risks associated with the rise in global financial integration
while not forsaking its benefits?
One influential view in policy circles, close to being the conventional wisdom until some time
ago, is that "putting your own house in order" is the main and best line of defence against
external influences. Another view, that is rapidly gaining ground, surmises instead that global
problems also require global solutions.
The first view seems to find some support in the fact that while recent bouts of financial market
volatility typically occurred in response to global shocks, not all economies were affected to
the same extent. This is consistent with evidence suggesting that global push factors explain
capital surges in general but domestic pull factors determine in which country they end up.22
Unfortunately, the debate about precisely which fundamentals mitigate economies'
vulnerability to abrupt capital flows episodes is not settled. Some studies find that emerging
economies with better institutions were less affected by unconventional monetary policy
measures in advanced economies, for example. Other evidence suggests that countries that
had allowed their current accounts to run into large deficits and their exchange rates to
substantively appreciate displayed larger capital flow volatility during the taper talk in 2013.
And one study that will be presented at the conference finds that emerging economies, that
were less vulnerable across a range of fundamentals, displayed a less pronounced
deterioration of financial conditions during the taper tantrum.23 At the same time, a number of
papers fail to confirm these findings concerning the relevance of fundamentals for mitigating
spillovers.24
Nevertheless, it is good news that many emerging economies have reduced their vulnerability
along a number of dimensions, including having reduced current account deficits and adopted
more flexible exchange rates. However, there remain worrisome pockets of vulnerability. The
latter includes the level of corporate indebtedness and high stocks of foreign-currency debt in
a number of emerging economies.25 A deterioration in the global growth outlook combined with
19
13% versus 0.3% according to IMF Coordinated Portfolio Investment Survey data.
20
See IMF (2015).
21
See IMF (2014).
22
See Ghosh et al. (2014).
23
Fratzscher, Lo Duca and Straub (2013), Eichengreen and Gupta (2014), Ahmed et al. (2015) as well as Chen
et al. (2015).
24
See Forbes and Warnock (2012), Forbes (2014), Cerutti et al. (2015), Aizenmann et al. (2014) and Eichengreen
and Gupta (2014). Fratzscher, Lo Duca and Straub (2013) find no evidence consistent with the hypothesis that
a flexible exchange rate regime or capital account restrictions helped economies to insulate from unconventional
monetary policies abroad.
25
See Pitterle et al. (2015).
over-leveraged borrowers might pose significant challenges and non-trivial policy trade-offs for
monetary policy.
The second view, pointing to the need for global solutions, rests its case on a growing strand
in the literature that argues that financial conditions around the world are driven by a global
financial cycle in risk appetite, the leverage of global banks and capital flows. A particular role
in the transmission of this financial cycle across the world is assumed by global banks and
international bond issuance more recently, as also highlighted by two papers that will be
presented at the conference.26 As already mentioned, US monetary policy is argued to have a
substantial influence on the global financial cycle.27 According to this increasingly popular view,
a striking policy implication of the global financial cycle is that individual countries, especially
emerging economies, face much starker trade-offs than those arising from the classic trilemma
in international macroeconomics - the "impossible trinity" (a hypothesis that is also discussed
by one of the papers that will be presented at the conference).28 The predicament of many
economies would in fact be better described by a dilemma between imposing capital controls
on the one hand and forsaking domestic stabilisation on the other.
The debate about the dominance of the global financial cycle has re-ignited an old debate on
the use of capital controls. In particular, a wave of theoretical work has emerged - one of these
papers will be presented at the conference29 - that rationalises the use of capital account
restrictions as the welfare-optimising policy in a context in which large global shocks to capital
flows lead to over-borrowing and financial vulnerability due to financial frictions.30 This work
has also contributed to the IMF's revision of its view on capital flow management.31 However,
it is important to stress that the unilateral imposition of capital account restrictions can itself
result in spillovers and externalities, in a suboptimal race to shift the burden of adjustment to
global shocks from one country to others.32
Global responses
One might argue that the importance of common factors in global financial markets and the
imperfect ability to shield the domestic economy against their impact implies a case for
international policy co-ordination.33 However, there are good reasons why binding forms of
such co-ordination are difficult to implement in practice in the case of monetary policy.
In particular, each central bank draws its legitimacy from a domestic political process. Each
central bank operates within its own specific circumstances, which include its own institutional
set-up, mandate and economic/financial market environment. Reaching a common
understanding on what the issues are, the policy responses and the gains from engagement,
in view of the great uncertainties on how the global economy operates, would be a major
challenge. Central banks clearly need to continue their dialogue and remain ready for swift
coordinated action in exceptional circumstances. Central banks play an important role in helping
stabilise the global financial system. In the aftermath of the global financial crisis, central banks
were swift in extending swap lines to countries in need, on a discretionary basis. Our efforts
26
See He et al. (2015) as well as Kim and Shin (2014).
27
See Cetorelli and Goldberg (2012), Bekaert, Hoerova and Lo Duca (2013), Miranda-Agrippino and Rey, (2014)
and Bruno and Shin (2015b).
28
See Georgiadis and Mehl (2015), Rey (2013) and Rey (2015).
29
Davis and Presno (2015).
30
See Jeanne and Korinek (2013), Mendoza and Bianchi (2011) and Brunnermeier and Sannikov (2015).
31
See IMF (2012) as well as Ostry and Ghosh (2013).
32
See Forbes et al. (2012).
33
See Rajan (2013) and Ostry and Ghosh (2013).
contributing to the stabilisation have evolved into a standing swap facility among six major
central banks. This contributes to stabilisation in a globalised world economy while respecting
the mandates and independence of central banks.
It would be a mistake, however, to believe that central banks can solve all problems. Central
bank actions aim at providing liquidity, ensuring the proper transmission of monetary policy
and contributing to financial stability. They are not aimed at providing balance of payment
support or at preserving the solvency of a state. This is a remit where I see much more scope
for international co-ordination. But a global system of safety nets must also preserve the
incentives to pursue responsible domestic policies and ensure prudent financial market
behaviour to avoid a crisis in the first place. Safety nets should be designed so that they do
not encourage moral hazard and excessive risk taking.
Clearly, we need to make the global financial system more resilient. At the global level, the
biggest innovation over the past few years has perhaps been the introduction of specific
precautionary arrangements, the Flexible Credit Line and the Precautionary Liquidity Line by
the IMF.34 There have been, however, other major improvements in the global financial safety
net. In Europe, we now have a fully operational European Stability Mechanism to help countries
in need. There is now also a Single Resolution Fund to support the resolution of banks that will
be progressively fully financed by the banking industry. These are important steps ahead and
Europe is not alone in improving its safety net. The Chiang Mai Initiative Multilateralisation
(CMIM) in East Asia has doubled in size to USD 240bn. And in July this year, the BRICs
launched a Contingent Reserve Arrangement among themselves to the tune of USD 100bn.
Furthermore, there has been progress in the inclusion of enhanced Collective Auction Clauses
into newly issued international sovereign bonds to reduce the disruptiveness of sovereign debt
restructuring.
Nevertheless, with huge amounts of debt in US dollars being created around the world without
liquidity backstops, we are still far from having a global lender of last resort adequate for our
times. Without properly addressing this issue at the global level, we run the risk of a durable
fragmentation of the international system.
Conclusion
Let me conclude. Global challenges require both domestic and global responses to ensure that
the global financial system becomes more resilient. Important steps in the right direction have
recently been taken on both fronts, albeit admittedly, many of these innovations have not yet
been fully tested. We should not be complacent. In many ways, the present challenges to the
global economy place the monetary and financial system at a sort of crossroads. We should
not underestimate the challenges of living in the ever more closely interconnected global
economy.
I thank you for your attention.
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