REMARKS BY JAVIER GUZMÁN CALAFELL, DEPUTY GOVERNOR AT THE
BANCO DE MÉXICO. PANEL ON "END OF QE AND RISING INTEREST RATES:
IMPLICATIONS FOR ADVANCED AND EMERGING MARKET ECONOMIES". UBS
24TH RESERVE MANAGEMENT SEMINAR. Thun, Switzerland, June 26, 2018.1
I am very glad to have the opportunity to participate in another UBS Reserve
Management Seminar. I thank the organizers for their kind invitation.
Over the several years that have followed the outburst of the Global Financial
Crisis (GFC), Emerging Market and Developing Economies (EMDEs) have been
able to sustain a satisfactory pace of expansion, with 2018 expected to record
the third consecutive year of accelerating activity.
The expansion of EMDEs has been partly nurtured by the aggressive relaxation
of monetary policy stances in the Advanced Economies (AEs), which implied a
significant easing of external financial conditions, as evidenced by the vast
amounts of international funds made available to emerging markets at
historically low costs. For instance, bond spreads on EMDE sovereign debt
were around 137 basis points lower in 2010-2018 than in the years preceding
the GFC.
Given the prolonged period over which such a situation was sustained, as well
as the magnitude of the adjustment needed to accommodate the surge in
global liquidity, it comes as no surprise that this phenomenon has given rise to
a gradual, albeit significant, buildup of vulnerabilities in the global economy
and financial system. In fact, since the early stages of this process, warnings
have been made about its likely pernicious effects on the performance and
stability of EMDEs and their financial markets, including through the potential
acceleration of domestic credit cycles and appreciation of local asset prices
(notably exchange rates) beyond what fundamentals would suggest. Thus,
challenges have emerged as this process is reversed.
Since the onset of the global market correction of mid-April this year, the
accumulated portfolio flows (in both equity and debt) of foreign capital to
emerging markets have been negative. Portfolio flows exiting EMDEs
amounted to USD 17.1 billion over the 40-day period that followed the start of
the event, a figure comparable in magnitude to that observed in the equivalent
period after the 2013 "taper tantrum" and the 2016 US presidential election
(USD 18.7 billion and USD 18.8 billion, respectively).2 Furthermore, continuing
with the deceleration that has been registered since 2011, foreign direct
investment (FDI) inflows to EMDEs declined from 2.0 percent of GDP in 2016
to 1.8 percent in 2017, and a further reduction, albeit marginal, is expected
this year.
This has been the result of an atmosphere of uncertainty and a consequent
higher perception of risk deriving from a combination of factors.
To start with, the withdrawal of monetary stimulus in the US and other AEs,
either through the unwinding of their heavily-expanded balance sheets or
hikes in their reference rates, is exerting upward pressures on international
interest rates at all maturities. The situation is considered as particularly
perilous since the tightening of monetary policy in AEs may proceed at a faster
pace than currently anticipated by market participants. This is especially the
case of the United States, where fiscal stimulus measures are being
implemented in an economy that appears to be operating at, or very close to,
full capacity. In this context, any direct benefit to commodity-exporting EMDEs
of the recovery of commodity prices would be partially offset, as this would
also exert additional pressures on inflation in AEs.
Upward pressures on interest rates in the United States have been
accentuated by the rapid widening of the fiscal deficit in this country. In fact,
a number of analysts have noted that both the government's increased
borrowing and the expected increase in public debt are already increasing
long-term interest rates. The deficit of the Federal Government is projected to
rise by 3 percentage points of GDP from 2015 to 2022, and remain at elevated
levels thereafter. Consequently, the upward trend of public debt would
accelerate over the next decade, to 96.2 percent of GDP by 2028, nearly 20
percentage points above the level recorded last year.3 Notwithstanding the
short-term boost of these measures to economic activity, their potential to
accentuate vulnerabilities in both the US and the global economy is
substantial. In addition to the already mentioned challenges, the risk of a
future recession in the US cannot be discarded as the effects of the current
stimulus fade and the need for a fiscal correction accentuates.4
As a result of the above, and of other concurrent forces, long-term interest
rates in the US have recently displayed a marked, and generalized, upturn. For
instance, the yield on 10-year US Treasury bond has shown an increase of
about 160 basis points from a record low of just 1.37 percent nearly two years
ago. Although part of the adjustment associated to the electoral process of
2016 reverted in subsequent months, the above-noted upward trend in long-
term yields resumed in September last year. Since then, they have increased
by nearly a full percentage point. To add some perspective to these
developments, the corresponding figure during the "taper tantrum" episode
of 2013 amounted to some 130 basis points between May and September of
that year.
Not surprisingly, under a situation of pressures on interest rates from several
sources and a general environment of uncertainty, concern about the
potential decompression of term and other risk premia has increased.
Although a misalignment of term premia with economic fundamentals in the
United States is far from evident, the possibility of a sudden, significant
tightening of financial conditions is clearly present given the sensitivity of
those premia to expectations about inflation, growth and monetary policy.
The observed increase in interest rates in the United States, the prospects that
this trend will continue during this year and the next, and the materialization
of a higher risk-aversion environment, have led to an appreciation of the
dollar. In fact, since mid-April of this year emerging market currencies have
shown a generalized weakening. Naturally, the accompanying risks are
particularly manifest in those countries with a disproportionately large share
of foreign currency liabilities, currency mismatches and other vulnerabilities.
Uncertainty in the world economy has also been significantly affected by the
rising trend in trade protectionism. In addition to adversely affecting resource
allocation and economic activity, this may have an impact on confidence.
According to recent estimates, an escalation of tariffs up to legally-allowed
rates could translate into a decline in global trade flows of around 9 percent,
a drop similar in magnitude to the one recorded during the Global Financial
Crisis of 2008-2009.5 Other factors that have impinged on the perception of
risk include geopolitical tensions, notably in Asia and the Middle East, as well
as recent and upcoming electoral processes, both in advanced and emerging
market economies, given their potential implications for global economic
integration. As per some measures, economic policy uncertainty has
continuously increased during 2018, although it is still below the historical
maximum reached in 2016.6
Going forward, there is little doubt that external financial conditions faced by
EMDEs are set to tighten further. Obviously, projections for capital flows to
these countries in the next couple of years are subject to a lot of uncertainty.
However, recent estimates by the IMF provide an idea of the challenges faced.
According to this institution, portfolio inflows to emerging markets would
decline by about USD 40 billion on average per year over 2018-2019 under a
smooth Fed normalization scenario, and by up to USD 60 billion if policy
tightening were to be accompanied by a rise in risk aversion.7
Naturally, a substantial degree of heterogeneity underlies these projections,
as global investors can be expected to differentiate amongst individual
countries depending on the strength of their economic fundamentals. Indeed,
a number of EMDEs took advantage of benign conditions in international
financial markets to move in this direction. However, it is also true that even
for these economies the outlook may prove to be challenging in view of the
following:

A decompression of term premia in the United States may have
important global ramifications, given their close correlation with those
in other major advanced economies.
 A significant overvaluation of risky assets across a wide spectrum of
market segments is observed.

Recent structural changes and rapid growth in the asset management
industry may be leading to an underpricing of liquidity risks, increased
interconnectedness and, in general, accentuate financial stability
challenges.

Crossover investors not specialized in emerging economies have
enlarged their presence in the markets for these countries' instruments,
thereby increasing the potential for wide fluctuations in these assets'
prices.
 For the already noted reasons, the balance of risks for the world
economy is clearly tilted to the downside, especially in the medium and
long terms.
One must add to the above the emergence of vulnerabilities in a number of
EMDEs. One of the most important among them is the protracted rise of debt
owed by these countries, which has been heavily concentrated in, and thus
largely driven by, their non-financial corporate sectors. Although the situation
varies considerably from one country to another, non-financial corporate debt
in EMDEs as a group is at present comparable in magnitude to that of these
countries' sovereigns as, by some accounts, it has risen from about 60 percent
of GDP in 2006 to 86 percent in 2017, reaching an all-time maximum at levels
considerably above pre-crisis levels. Although the bulk of the increase is
explained by China, whose corporate sector debt rose from 107 to 163 percent
of GDP during the same period, a similar trend is observed in many other
EMDEs.8
The increased leverage of EMDE non-financial corporates acquires particular
relevance as a source of concern for at least a couple of reasons. First, global
factors (such as low interest rates and compressed risk premia) have been
more important drivers of this development than firm- or country-specific
ones.9 Second, the contribution from foreign currency-denominated debt has
been sizable, at around half of the observed growth since 2010.
Thus far, notwithstanding the generalization of financial volatility among
EMDEs, the presence of severe problems has been concentrated in a few of
them. Overall, international institutions remain relatively optimistic about the
prospects for the group in coming years. For instance, in its baseline scenario,
the IMF is projecting growth in EMDEs in the medium term at close to the
levels observed in 2018-19.10 However, it is clear that these projections are
surrounded by considerable uncertainty. Furthermore, even in the absence of
a major disruption to world economic activity, average potential growth in
EMDEs over the next decade is expected to be slower than during 2013-17.11
What should EMDEs do?
In my view, the adage "there are no easy answers but there are simple
answers" seems to apply, underscoring the appropriateness of looking at what
we have learnt from the past and putting into practice the lessons from
episodes such as the GFC. Indeed, most of the conclusions derived from these
experiences remain valid today, i.e. strong macroeconomic foundations, solid
financial systems, flexible policy frameworks and a firm basis for sustained
growth are the best antidote to an adverse external environment. In fact, the
current episode of volatility is once again showing that rather than looking for
magic formulas, countries should concentrate on meeting these requirements.
Furthermore, the need to adhere to this path is far more evident at present,
since the complexities of external conditions, if anything, are likely to
accentuate in coming years.
Having said this, it is also clear that the responsibility for overcoming the
current difficulties, and more generally for ensuring a healthy evolution of the
world economy, does not lie on EMDEs only. In fact, we should bear in mind
that the challenges faced by the world economy today are mostly a result of
actions undertaken in AEs. Indeed, these countries have a fundamental
responsibility in ensuring that their monetary policies are properly
implemented and communicated; in avoiding inadequate fiscal-monetary
policy mixes; in adopting any measures needed to increase productivity and
the potential for growth; in properly taking into consideration the
international repercussions of their policy actions in the monetary and other
fronts; and in leading by example to continue with the push towards a more
integrated world economy. In the face of financial turmoil resulting
fundamentally from policy measures in the AEs, like the current one, it could
hardly be argued that the implications of such actions should not be
exaggerated.