Manuel Sánchez: Emerging markets and the world's unusual monetary
conditions
Remarks by Mr Manuel Sánchez, Deputy Governor of the Bank of Mexico, at the GIC Central
Banking Series: Madrid, Madrid, 13 May 2015.
* * *
It is a pleasure to be in Spain, a country which has a close history and strong cultural and
economic ties with Mexico. I would like to thank BBVA for the invitation to participate in this
conference, and to share my thoughts with you on the challenges for emerging economies in
the current unique global scenario.
I will begin my presentation by reflecting on the extraordinarily loose monetary stances in
most advanced countries. Then, I will describe how these conditions affect emerging
economies and their policy options, and I will conclude by touching on Mexico's financial
developments. As usual, my remarks are entirely my own and are not necessarily the views
of the Bank of Mexico or its Governing Board.
Monetary policies in advanced countries
Since 2008, the central banks of advanced nations have implemented increasingly
expansionary monetary policies. This trend has shown at least three important facets: first,
authorities have resorted to unconventional tools never tried before; second, the degree of
monetary accommodation achieved is unprecedented; and third, the tendency has been
widespread, encompassing most major central banks, following the lead of the U.S. Federal
Reserve.
In particular, the traditional instruments, benchmark interest rates, have been reduced to
minimum levels, to virtually zero in the United States or even to negative values for policy
and or deposit rates in continental Europe. The liquidity growth has mainly reflected
significant augmentation of central banks' balance sheets, through large-scale asset
purchases, commonly referred to as quantitative easing.
The variety of securities bought has been ample, including, in some cases, private credit and
stocks. Forward guidance completes the toolkit, in an attempt at influencing market
expectations regarding the direction of future policy actions.
In the wake of the global crisis, the main aim of monetary policy was to normalize financial
conditions. Central banks implemented extraordinary measures to meet the increased
demand for liquidity amid a generalized rejection of assets, highly preferred during the
preceding boom, that were suddenly perceived as too risky.
This goal, which was at the core of the central bank role as lender of last resort, was attained
well. Financial stabilization benefited not only the countries where measures were
undertaken, notably the United States, the epicenter of the crisis, but, in light of the contagion
effect, also the world as a whole.
Even after financial markets stabilized, monetary expansion continued to deepen, although
through different paths across jurisdictions. While emphasis on objectives differed, each
central bank looking to its legal mandate, in general, looser monetary policies have sought to
support economic recovery and, at the same time, preserve price stability.
The contribution of monetary accommodation to growth since 2010 has been subject to
debate, particularly in the United States. Although evidence tends to confirm a positive effect
on economic activity, estimated results have sometimes turned out to be relatively modest.1
Regarding price stability, monetary actions in advanced countries have been motivated by
recurrent fears of deflation. While such an event cannot be ruled out, concerns about
possible implications should not be magnified. Neither theory nor history establish a clear
connection between deflation and poor economic activity. The only evident negative episode
seems to be the substantial deflation that occurred during the Great Depression. But at that
time prevailing monetary conditions were tight, and no precedent exists of significant
deflation under highly expansionary monetary conditions.2
Regardless of their effectiveness in attaining desired results, extremely loose monetary
policies may generate increasing risks and unintended consequences. Low interest rates can
result in excessive risk-taking, overleverage and the channeling of credit to projects with low
productivity. The discouragement of saving hurts retirees, as well as pension funds and
insurance companies, which could face difficulties meeting long-term liabilities.
Asset prices may reach levels inconsistent with underlying fundamentals. Inefficiencies
would hinder economic growth, and imbalances could endanger financial stability, something
that bears watching especially in light of the recent global crisis. Also, expansionary
monetary policies potentially reduce incentives to implement other needed reforms, such as
fiscal consolidation and productivity-oriented changes.3
In fact, during recent years, monetary measures have kept gaining ground relative to other
policies in attempts to support growth. However, expecting too much from monetary policy
may be counterproductive. Central banks have become crucial participants in new financial
arenas, including credit allocation, at the risk of distorting prices. Additionally, speculation
and news about possible central bank decisions have become the most important market
movers.
This activist role may have unintentionally weakened the public's confidence in the ongoing
recovery. The abnormal situation has resulted in the circumstance that financial participants
tend to react positively to weaker-than-expected economic data and vice versa.
The intention on the part of the Fed to begin unwinding its policy in the near future is a
welcome development. It will likely reflect stronger U.S. economic performance, which should
favor the world economy, especially those countries most closely linked to the United States.
Normalization, in turn, is a precondition for containing the accumulation of possible
vulnerabilities that could eventually jeopardize global economic improvement.
In any case, the future likely scenario for advanced nations is one of divergent monetary
paths. While the United Kingdom will perhaps be next after the United States in unwinding
stimulus, the European Central Bank, the Bank of Japan and other major central banks could
further loosen monetary stances. The pace in each direction is highly uncertain.
1
For an estimation of real effects of unconventional monetary policy, see, for example, Engen, E.M., et al.
(2015), "The Macroeconomic Effects of the Federal Reserve's Unconventional Monetary Policies," Board of
Governors of the Federal Reserve System Finance and Economic Discussion Series 2015-005, January; and
Wu, J.C. and F.D. Xia (2014), "Measuring the Macroeconomic Impact of Monetary Policy at Zero Lower
Bound," Chicago Booth Research Paper 13-77, July.
2
Two analyses on the possible real consequences of deflation are: Atkeson, A. and P.J. Kehoe (2004),
"Deflation and Depression: Is There an Empirical Link?" American Economic Review, 94 (2); and Ryska, P.
(2014), "Deflation and Economic Growth in Long-Term Perspective," Charles University in Prague, Institute of
Economic Studies Working Paper 18/2014.
3
For a review of possible risks from prolonged monetary expansion, see Hannoun, H. (2015), "Ultra-Low or
Negative Interest Rates: What They Mean for Financial Stability and Growth," Speech at the BIS Eurofi
HighLevel Seminar, April.
Effects on emerging economies
Unconventional monetary policies in developed countries have had significant bearing on
emerging markets. Financial stabilization in a U.S. economy overwhelmed by the global
turbulence was clearly positive, as it mitigated significant outward contagion. To the extent
that a larger collapse was avoided, other countries benefited, a comment that can also be
extended to the subsequent U.S. economic rebound.
The search for yield stemming from abundant liquidity since 2010 has translated into
substantial capital flows, especially portfolio funds, to emerging economies. Benign financial
conditions have helped stock and debt issuers in both local and foreign currencies. In as
much as productive opportunities have been exploited, this environment has helped growth.
At the same time, vulnerabilities may have surfaced in some countries. These include the
overheating of specific sectors, high indebtedness and excessive exposure to foreign
currencies, as well as asset overvaluations that may not be sustainable, especially once
easy liquidity conditions are reversed.4
These fragilities might have been made worse by the fact that emerging economies have
generally loosened their monetary stances in reaction to the expansion in advanced nations.
Indeed, policy rates have tended to remain below what is suggested by different versions of
the Taylor rule.5
In any case, concerns related to the aforementioned risks have shaped defensive measures
in emerging markets. Obviously, the actions announced and undertaken by the Fed have
played a crucial role.
Before the taper tantrum in May 2013, as portfolio capital moved more steadily and strongly,
the main focus of policy makers was probably how to discourage or slow down the entrance
of these funds. Strategies in many countries included capital restrictions, official foreign
exchange purchases to avoid currency appreciation, and interest rate cuts by central banks.
Evidence regarding the net effect of these tools is mixed.6
During the last two years, as capital flows have contracted and later resumed with less vigor,
a policy shift has apparently occurred towards how to protect financial stability. In some
countries, the change has implied the reversal of previous measures, for example, lifting
controls, using international reserves to fight currency depreciation, and hiking interest rates.
In particular, monetary policy was tightened in economies exhibiting large domestic and
external imbalances as well as climbing inflation.
Facing uncertainty in emerging markets
Portfolio capital flows largely exploit carry trades. If a determinant of the trade changes,
investor decisions can be expected to change as well. The possible reduction of lax
conditions would largely depend on expectations, including those regarding central banks'
reactions in emerging markets. In such a scenario, a sudden stop or reversal of capital flows
cannot be ruled out.
The rise in global risk aversion and the significant financial volatility triggered by the taper
tantrum may be an indication of how markets could react to a surprising move by the Fed.
Currently, a lot of speculation has centered on the date of the first hike, but this and other
details on U.S. monetary unwinding cannot be known in advance, simply because, as the
Fed itself has stated, the whole process is data dependent.
It seems reasonable to assume that the Federal Reserve will continue to use forward
guidance as cautiously as possible, especially in light of its experience with the taper
tantrum. In that sense, if monetary changes are anticipated and gradual, international
volatility resulting from such actions may be contained. Presumably, markets would price in
those changes in advance, without much over- or undershooting of asset prices and,
perhaps, of portfolio adjustment.
Indeed, the Fed has revealed its preference for incremental moves, stating that the policy
rate may stay at levels lower than those consistent with full achievement of its mandate for
some time even after those goals have been attained. This expectation, along with the
assumption that other advanced nations may further deepen their monetary expansion, could
keep world liquidity conditions relatively ample for some time.
However, gradualism cannot be assured. In the event of a surprise tightening of the U.S.
labor market, for instance, the monetary authority may be forced to change gears more
significantly than initially planned.
Also, other countries may end up taking monetary postures less loose than currently
envisioned. For example, extreme unconventional monetary policies have resulted in
negative interest rates for a wide array of maturities in a number of European countries. If
they prevail too long, we do not know what impact these rates may have on financial stability
or economic efficiency. That territory has never been explored, and its possible
consequences can hardly be estimated.
In such an uncertain scenario, an effective way for emerging economies to shield themselves
against external shocks is by strengthening their macroeconomic fundamentals. At the same
time, authorities must remain vigilant to detect factors that may endanger financial stability
and react in a timely manner.
Financial developments in Mexico
Like other emerging economies, during the last few years, Mexico has been the destination
of considerable portfolio capital flows. Substantial external resources have been channeled
to the domestic markets, and financing in foreign currencies has been successfully tapped by
the government and corporates.
Mexico's capital account openness has facilitated these inflows. The most noticeable impact
has been observed in nonresidents' holdings of peso-denominated government bonds, which
rose since 2010 to reach approximately 37 percent of the total outstanding.7
It is worth noting that Mexico's banks are not large recipients of capital flows. They enjoy an
ample, low-cost domestic funding base in pesos. Also, prudential bank regulation,
established in the 1980s and 1990s as a result of macroeconomic crises, imposes stringent
foreign currency restrictions in terms of limitations for opening deposit accounts, caps on net
liabilities and open positions, as well as a minimum liquidity ratio.
Obviously, Mexico has not been immune to changes in global risk aversion. The clearest
recent impact has been felt in asset prices, especially through movements in the exchange
rate. In particular, the currency's weakening and volatile trend since the middle of last year
has mostly mirrored the generalized appreciation of the U.S. dollar, in addition to the fall in oil
prices. In contrast, medium- and long-term interest rates have increased moderately since
the taper tantrum, resulting in steepening of the yield curve, slightly more than that of the
United States.
Furthermore, since 2013, nonresident holdings of peso-denominated government securities
have remained roughly stable as a proportion of the total outstanding. Throughout these
months, composition has changed, with long-term bonds gaining a higher share at the
expense of zero coupon short-term securities, which may reflect a cleaning-up of highly
speculative positions.
Mexico's relative resilience to external shocks seems to be based on a solid economic
foundation, including prudent fiscal management, monetary policy focused on controlling
inflation, and a sound regulatory and supervisory framework for financial institutions.
Additionally, a broad reform agenda may be contributing to a positive perception of the
economy.
Nevertheless, recent financial developments are no guarantee of future tranquility. The
challenges ahead are faced by other emerging markets as well. Mexico can further
differentiate itself through commitment to an announced multiyear reduction of public debt,
the convergence of inflation to the permanent target, and a profound implementation of
ongoing structural reforms. These measures should foster financial stability and long-term
economic growth.
Concluding remarks
The likely divergent monetary paths of advanced nations pose challenges for emerging
economies. The proximity of the liftoff of rate hikes in the United States is encouraging, as it
will reflect a strong economic performance that should favor the world recovery. The
intended gradualism by the Fed, and the possible continuation of monetary expansion by the
European Central Bank and the Bank of Japan, may suggest that the global economy will still
see abundant liquidity, with relatively benign financial conditions for emerging markets.
However, uncertainty surrounding the pace of U.S. normalization and of monetary actions in
other countries may give rise to episodes of international financial volatility. In particular,
market sentiment towards emerging economies could change. The best strategy for
countries to shield themselves against external shocks is to strengthen economic
fundamentals, while at the same time authorities remain on alert for factors that would put
financial stability at risk.
Finally, Mexico can potentially remain attractive to investors by assuring public debt
sustainability, consolidating convergence of inflation to the target, and implementing ongoing
structural reforms in a deep-seated, effective manner.