## CHAPTER 2 EMERGING ANd FRONTIER MARkETS: A GREATER SET OF POLICY OPTIONS TO RESTORE STABILITY

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### Chapter 2 at a Glance — FX interventions and reserve operations
- FX interventions, including through forward contracts, were widespread in March during the COVID-19 sell-off as policymakers sought to insulate their economies from external movements in the pricing of risk.
- In absolute size many countries intervened, surpassing recent stress episodes, but use of reserves (as a share of total international reserves) was about two-thirds the magnitude observed during the global financial crisis for the median country.
- The limited and short-lived use of reserves likely reflects a relatively short duration of the stress episode due to a quick turnaround in global risk sentiment, which reduced the need for capital flow management measures.
- IMF staff analysis indicates global factors—Federal Reserve rate cuts and global risk appetite (proxied by the VIX)—played a significant role in driving currency surprises during the COVID-19 sell-off; domestic policy rate cuts and FX interventions had a relatively insignificant impact in this episode.
- By contrast, the 2015 sell-off was more specific to emerging markets and domestic FX interventions and policy rate cuts had a more significant effect then.

### Chapter 2 at a Glance — Central bank asset purchase programs (APPs)
- At least 18 emerging market central banks adopted APPs targeting government or private sector bonds in local currency during the COVID-19 crisis.
- APPs were used for three broad purposes:
  - Central banks with policy rates well above zero used APPs to improve bond market functioning and provide liquidity to the financial sector (examples: India, Philippines, South Africa).
  - Central banks with policy rates near the lower bound used APPs to ease financial conditions, provide additional monetary stimulus, and influence longer maturity yields (examples: Chile, Hungary, Poland).
  - Some central banks explicitly used APPs to temporarily ease government financing pressure amid the pandemic (examples: Ghana, Guatemala, Indonesia, Philippines via repurchase agreement).
- In several cases purchases were sterilized, alleviating downward pressure on exchange rates.
- Central bank purchases helped domestic investor bases absorb much of local-currency bond outflow pressure and addressed increased government financing needs. Example: in Poland between end-February and June the central bank purchased more than 2 percent of GDP in government bonds in the secondary market compared with outflows of 0.7 percent of GDP, alongside an increase in net domestic issuance of 4.4 percent of GDP.
- Where APPs were not launched, debt managers sometimes limited local bond supply or relied on alternative financing (examples: use of cash buffers in Brazil; increased external issuance in Mexico; pension funds in some Latin American countries; back-loaded issuance).

### Quantified overview of selected APPs (total purchases and features)
- Total purchases (percent of GDP) and notable program features (estimated March through latest available as of late September):
  - Colombia: 1.1 percent of GDP; government and private sector bonds; secondary market.
  - Chile: 2.9* percent of GDP; bank, central bank, and government bonds*; $16 bn target; secondary market; Mar.–present.
  - Croatia: 4.9 percent of GDP; government bonds; secondary; Mar.–Jun.
  - Ghana: 1.4 percent of GDP; government bonds; primary; 5.5 bn (up to 10 bn) announced.
  - Guatemala: 1.9 percent of GDP; government bonds; both primary and secondary.
  - Hungary: 1.4 percent of GDP; government and mortgage bonds; both (only MBs in primary).
  - India: 1.0 percent of GDP; government bonds; secondary; Mar.–present.
  - Indonesia: 3.8** percent of GDP; government bonds; both primary and secondary; includes a 397.6 tn burden sharing agreement.
  - Malaysia: 0.6 percent of GDP; government bonds; secondary; Mar.–Jun.
  - Philippines: 4.3 (7.3)*** percent of GDP; government bonds including repurchase agreement; both primary and secondary; repurchase amount ~850 bn; Mar.–present.
  - Poland: 4.6 percent of GDP; government and SOE bonds; secondary; Mar.–present.
  - Romania: 0.5 percent of GDP; government bonds; secondary; Mar.–present.
  - South Africa: 0.7 percent of GDP; government bonds; secondary; Mar.–present.
  - Thailand: 1.0 percent of GDP; government and central bank bonds; secondary; Mar.–Apr.
  - Turkey: 1.6 percent of GDP; government bonds; secondary; OMO portfolio limited to 10 percent of balance sheet.
- Notes reported in the chapter:
  - Total purchase amounts are estimates of March through latest available as of publication process (late September).
  - Poland purchases include bonds from State Development Bank (BGK) and State Development Fund (PFR).
  - Chile’s figure excludes a Nov. 2019 debt buyback program; Chile’s central bank did not have legal ability to purchase government bonds until August 12.
  - **Indonesia includes staff estimates of secondary market purchases, primary market purchases prior to July, and the full 397.6 tn July burden sharing agreement, though only about 60 percent of the agreed purchases had been completed through mid-September.
  - ***Philippines includes staff estimates of secondary market purchases and the three-month repurchase agreement of 540 bn (3.0 percent of GDP) with the central government added in parentheses; BSP opened purchase window in March prior to written public announcement in April.

### Local Stress Index (LSI): measurement and findings
- The chapter introduces the local stress index (LSI) summarizing local bond and currency market liquidity and stress indicators (bid-offer spreads, realized volatility, other risk premium measures) to guide central bank decisions on interventions.
- Key LSI findings:
  - The level of stress in local markets during the COVID-19 sell-off, as measured by the LSI, was comparable to that of the global financial crisis but the period of stress was considerably shorter.
  - Aggregate LSI was well above previous episodes such as the 2013 taper tantrum and 2014–15 stress episodes, but markets normalized faster in 2020.
  - A large part of the increase and subsequent partial reduction in stress in local bond markets originated from developments in global financial markets.
  - Spillovers in FX markets from the United States and the European Union rose sharply, but spillovers to local bond markets were more pronounced in this episode, reflecting larger nonresident participation in local bond markets since the global financial crisis.
  - The stress in FX markets was lower than during 2008–09, with less noticeable demand for dollar liquidity.

### Central Bank Asset Purchases through August — overview and empirical evidence
- APPs in emerging markets differ in scope, size, and duration from those in advanced economies and are often used with higher policy rates.
- The size of announced APPs in emerging markets has been small overall (except in Chile, Indonesia, the Philippines, and Poland) and short-lived, as shown by the slowdown of asset purchases since May for most countries.
- Indonesia primary market purchases reported in panel 1 include only the share of the burden sharing agreement completed through August, not the entirety of the 397.6 trillion plan.
- Primary market purchases for the Philippines refer to the 300 bn (~1.6% of GDP) repurchase agreement in April 2020, which was repaid in September.
- Sovereign purchases for Poland in one panel include those from BGK and PFR, which are excluded in another panel. Purchases for Chile include only those under Special Asset (June) and Bank Bond (March) Purchase Programs. Asset purchases in Hungary did not begin until May.
- Empirical findings (panel data from 13 emerging markets at daily frequency from January to mid-May 2020):
  - APP announcements reduced long-end bond yields in a significant and persistent way.
  - The size of the impact of domestic APP announcements on yields ranges from 20 to 60 basis points and is statistically significant within one standard error confidence interval.
  - APP announcements had a corresponding sharp reduction in government bond yields and term premiums, with relatively limited impact on currencies.
  - APP announcements reduce long-end bond yields even after controlling for Federal Reserve actions (including the Federal Reserve APP announcement on March 23) or changes in global risk appetite (VIX) and domestic rate cuts.
  - A 1 percentage point domestic policy rate cut does not appear to have a significant effect on long-end yields when controlling for APPs and other factors.
  - The Federal Reserve APP announcement on March 23 and improvement in global risk appetite also had a significant and persistent impact on lowering long-end yields; magnitudes of the effect of emerging market APPs and the Federal Reserve APP are broadly similar.
  - Announcements of APPs did not lead to a significant depreciation of emerging market currencies; APPs had relatively limited and short-lived effects on EM currencies.
- Timing and role:
  - APP announcements in the second half of March did not have an immediate impact on local stress indices due to very tight global financial conditions, illiquidity, strong risk aversion, and fiscal concerns.
  - As external conditions improved in April and APP implementation stepped up, local stress indices showed improvement and differentiation; much of the improvement was in market liquidity measures (e.g., bid-offer spreads and intraday volatility).
  - APP announcements likely served as a circuit breaker at the height of the crisis by signaling central banks’ readiness to stand as buyer of last resort.

### APPs — risks, trade-offs, and operational recommendations
- Risks and caveats:
  - Institutional and central bank credibility may be weakened; credible monetary policy frameworks and sound governance are prerequisites.
  - Increased balance sheet exposure to long-term debt may raise concerns about the central bank’s ability to raise interest rates when conditions warrant or to achieve price stability.
  - Large-scale, especially open-ended, APPs may invite fiscal dominance concerns, distort market dynamics, impair price discovery (especially in primary markets), and impede financial market development.
  - APPs may intensify capital outflow pressure in countries with weaker fundamentals and may put downward pressure on long-term yields and foreign exchange rates.
  - Effectiveness varies with market structure, liquidity, availability of high-quality domestic assets, extent of foreign investor participation, and the level of financial sector development.
- Design and operational recommendations:
  - Transparency and clear communication are crucial; APPs should be limited in time and scale and linked to clear objectives.
  - Purchases should preferably be made in secondary markets; purchases in primary markets or at below-market rates can disrupt price discovery and invite fiscal dominance.
  - Programs should aim to affect segments of the yield curve that serve as effective pricing benchmarks to maximize transmission to the real economy.
  - Consider the portfolio balance channel and investors’ ability to allocate to other domestic assets; absence of alternatives could prompt investor exit and increase exchange rate sensitivity to APPs.
  - Develop efficient money market frameworks, strengthen primary market practices, bolster market liquidity (including repo facilities for local dealers), and develop robust market infrastructure (including local clearing and settlement).
  - Where legal and market infrastructure permit, enable settlement and clearance of local currency debt in international capital markets to access wider liquidity pools.
  - Continued evaluation is needed as more data become available on unconventional monetary policy effectiveness in emerging markets, especially for open-ended programs.

### Frontier market economies — debt vulnerabilities, creditor composition, and restructuring implications
- Pre-pandemic vulnerabilities:
  - Frontier market economies entered the pandemic in a vulnerable position, with a number of countries already deemed at high risk of debt distress and with relatively little policy space compared with major emerging market economies.
- Shift toward private financing:
  - The postcrisis period of easy global financial conditions allowed frontier market economies to raise unprecedented amounts of capital in private markets, increasing rollover risk.
  - Frontier economies have become more dependent on private sector debt in recent years.
- DSSI (Debt Service Suspension Initiative) and market reaction:
  - The G20 announced the DSSI to temporarily ease financing constraints of the poorest countries by freeing up scarce money to mitigate the human and economic impact of COVID-19.
  - Some countries have been reluctant to participate due to fears of loss of market access.
  - Markets are not pricing in a significant risk from DSSI participation; on average, spreads of countries eligible for the DSSI have outperformed those of other frontier countries (even excluding eligible countries that do not intend to participate).
  - Currently the initiative provides relief primarily through a moratorium on bilateral debt, while private sector groups have begun assessing potential ways to assist.
- Creditor shares and upcoming debt service:
  - Bilateral creditors represent about one-third of debt payments owed by countries eligible for the DSSI over the next few years.
  - For many countries, private sector debt represents a much larger proportion of their external debt.
- Debt restructuring dynamics and spread implications:
  - If a country requires a given overall debt reduction, and one class of creditors is treated as senior, other creditors must bear a greater burden.
  - Stylized example: issuer requiring a total 40 percent haircut with debt evenly split; variants show 50 percent senior share, 33 percent senior share, 20 percent senior share, 0 percent senior share.
  - Panel example assumptions: a bond with an 8 percent coupon and 10-year maturity; overall debt reduction of 40 percent required, with senior debt holders accepting only a 20 percent haircut.
  - A model for sovereign bond spreads indicates investors expect a larger haircut for private creditors than for bilateral creditors.
  - Model-consistent expectation: bilateral creditors would take a 30 percent haircut in the case of a country that requires an overall 40 percent haircut.
  - Markets appear to perceive that, in a default situation, private creditors would be forced to take a larger haircut than bilateral creditors would.

### Policy guidance for recovery and resilience
- Use of policy measures during the pandemic:
  - Unprecedented policy measures by advanced and emerging market policymakers after COVID-19 onset averted worst outcomes and helped stabilize domestic financial conditions.
  - Emerging market central banks actively used available and new tools to soften the blow from the spike in global risk aversion and to smooth excess volatility of domestic currencies.
- Role of FX intervention and macroprudential tools:
  - Appropriate use of FX intervention, macroprudential policies, and capital flow management measures in the face of shocks can contribute to financial stability and enhance monetary policy autonomy.
  - Global factors played a more important role in driving currencies than FX intervention did during the pandemic; short-lived FX intervention is consistent with using the currency as a shock absorber when other vulnerabilities are in check.
  - Countries with shallow FX markets may experience macroeconomic destabilization after shocks; FX interventions to lean against market illiquidity can be appropriate.
- APPs as part of the toolkit:
  - Many emerging and frontier market central banks for the first time embarked on APPs to ensure smooth functioning of bond markets and provide accommodation in an environment of very low policy rates; apparent success in reducing bond yields without risking financial stability so far suggests APPs have a role but are not a panacea.
  - APPs appear more effective when used jointly as part of a broader macroeconomic policy package.
- Debt management and restructuring:
  - Frontier market economies with unsustainable debt dynamics, limited market access, and high external financing requirements should preemptively and cooperatively seek debt resolution with their creditors.
  - Countries that maintain market access at reasonable rates should decrease rollover risks as part of their debt management strategy.

*Source: Chapter 2 at a Glance, Global Financial Stability Report: Bridge to Recovery (October 2020).*

### Chapter 2 at a Glance

### Chapter 2 at a Glance

### FX interventions and reserve operations
- FX interventions, including through forward contracts, were widespread in March during the COVID-19 sell-off as policymakers sought to insulate their economies from external movements in the pricing of risk.
- In absolute size many countries intervened, surpassing recent stress episodes, but use of reserves (as a share of total international reserves) was about two-thirds the magnitude observed during the global financial crisis for the median country.
- The limited and short-lived use of reserves likely reflects a relatively short duration of the stress episode due to a quick turnaround in global risk sentiment, which reduced the need for capital flow management measures.
- IMF staff analysis indicates global factors—Federal Reserve rate cuts and global risk appetite (proxied by the VIX)—played a significant role in driving currency surprises during the COVID-19 sell-off; domestic policy rate cuts and FX interventions had a relatively insignificant impact in this episode.
- By contrast, the 2015 sell-off was more specific to emerging markets and domestic FX interventions and policy rate cuts had a more significant effect then.

### Central bank asset purchase programs (APPs) — the "new game in town"
- During the COVID-19 crisis, at least 18 emerging market central banks adopted unconventional policies via asset purchase programs (APPs) targeting government or private sector bonds in local currency.
- Motivations and scope varied; APPs were used for three broad purposes:
  - Central banks with policy rates well above zero used APPs to improve bond market functioning and provide liquidity to the financial sector (examples cited: India, Philippines, South Africa).
  - Central banks with policy rates near the lower bound used APPs to ease financial conditions, provide additional monetary stimulus, and influence longer maturity yields (examples: Chile, Hungary, Poland).
  - Some central banks explicitly used APPs to temporarily ease government financing pressure amid the pandemic (examples: Ghana, Guatemala, Indonesia, Philippines via repurchase agreement).
- In several cases purchases were sterilized, alleviating downward pressure on exchange rates.
- Central bank purchases helped domestic investor bases absorb much of local-currency bond outflow pressure and addressed increased government financing needs. Example: in Poland between end-February and June the central bank purchased more than 2 percent of GDP in government bonds in the secondary market compared with outflows of 0.7 percent of GDP, alongside an increase in net domestic issuance of 4.4 percent of GDP.
- Where APPs were not launched, debt managers sometimes limited local bond supply or relied on alternative financing (examples: use of cash buffers in Brazil; increased external issuance in Mexico; pension funds in some Latin American countries; back-loaded issuance).

### Quantified overview of APPs (selected country program totals and features)
- The chapter reports total purchases (estimated March through latest available as of late September) and program characteristics for a set of emerging market APPs. Total purchases (percent of GDP) and notable program features include:
  - Colombia: 1.1 percent of GDP; government and private sector bonds; secondary market.
  - Chile: 2.9* percent of GDP; bank, central bank, and government bonds*; $16 bn target; secondary market; Mar.–present.
  - Croatia: 4.9 percent of GDP; government bonds; secondary; Mar.–Jun.
  - Ghana: 1.4 percent of GDP; government bonds; primary; 5.5 bn (up to 10 bn) announced.
  - Guatemala: 1.9 percent of GDP; government bonds; both primary and secondary.
  - Hungary: 1.4 percent of GDP; government and mortgage bonds; both (only MBs in primary).
  - India: 1.0 percent of GDP; government bonds; secondary; Mar.–present.
  - Indonesia: 3.8** percent of GDP; government bonds; both primary and secondary; includes a 397.6 tn burden sharing agreement.
  - Malaysia: 0.6 percent of GDP; government bonds; secondary; Mar.–Jun.
  - Philippines: 4.3 (7.3)*** percent of GDP; government bonds including repurchase agreement; both primary and secondary; repurchase amount ~850 bn; Mar.–present.
  - Poland: 4.6 percent of GDP; government and SOE bonds; secondary; Mar.–present.
  - Romania: 0.5 percent of GDP; government bonds; secondary; Mar.–present.
  - South Africa: 0.7 percent of GDP; government bonds; secondary; Mar.–present.
  - Thailand: 1.0 percent of GDP; government and central bank bonds; secondary; Mar.–Apr.
  - Turkey: 1.6 percent of GDP; government bonds; secondary; OMO portfolio limited to 10 percent of balance sheet.
- Notes (as reported in the chapter): total purchase amounts are estimates of March through latest available as of publication process (late September). Poland purchases include bonds from State Development Bank (BGK) and State Development Fund (PFR). Chile’s figure excludes a Nov. 2019 debt buyback program; Chile’s central bank did not have legal ability to purchase government bonds until August 12. **Indonesia includes staff estimates of secondary market purchases, primary market purchases prior to July, and the full 397.6 tn July burden sharing agreement, though only about 60 percent of the agreed purchases had been completed through mid-September. ***Philippines includes staff estimates of secondary market purchases and the three-month repurchase agreement of 540 bn (3.0 percent of GDP) with the central government added in parentheses; BSP opened purchase window in March prior to written public announcement in April.

### Local Stress Index (LSI): measuring stress in local bond and currency markets
- The chapter introduces a novel market conditions indicator—the local stress index (LSI)—that summarizes local bond and currency market liquidity and stress indicators (bid-offer spreads, realized volatility, other risk premium measures) to guide central bank decisions on interventions.
- Key LSI findings:
  - The level of stress in local markets during the COVID-19 sell-off, as measured by the LSI, was comparable to that of the global financial crisis but the period of stress was considerably shorter.
  - Aggregate LSI was well above previous episodes such as the 2013 taper tantrum and 2014–15 stress episodes, but markets normalized faster in 2020.
  - A large part of the increase and subsequent partial reduction in stress in local bond markets originated from developments in global financial markets.
  - Spillovers in FX markets from the United States and the European Union rose sharply, but spillovers to local bond markets were more pronounced in this episode, reflecting larger nonresident participation in local bond markets since the global financial crisis.
  - The stress in FX markets was lower than during 2008–09, with less noticeable demand for dollar liquidity.

### Policy implications and considerations
- Asset purchases helped lower government bond yields, did not lead to FX depreciation, and eventually reduced market stress; APPs may have a role going forward but require ongoing evaluation of risks.
- The LSI can help guide central bank decisions on the need for interventions to support local market functioning, focusing on local market liquidity and stress rather than on broader financial conditions indices that conflate funding costs and external spreads.
- Strategies to address debt distress in frontier markets should account for how the expected treatment of different creditors in future restructurings affects investor perception of risk.
- The apparent absence to date of capital flow management measures during the COVID-19 crisis and China’s policy challenges in maintaining supportive financial conditions are noted as areas for further examination (see Online Annex Boxes referenced in the chapter).

*Source: Chapter 2 at a Glance, Global Financial Stability Report: Bridge to Recovery (October 2020).*

### 1. Central Bank Asset Purchases through August

### 1. Central Bank Asset Purchases through August

### Overview of asset purchase programs in emerging markets
- Asset purchase programs (APPs) in emerging markets differ in scope, size, and duration from those in advanced economies and are often used with higher policy rates.
- Central bank purchases helped offset portfolio outflows during the crisis period in some economies.
- The size of announced APPs in emerging markets has been small overall (except in Chile, Indonesia, the Philippines, and Poland) and short-lived, as shown by the slowdown of asset purchases since May for most countries.
- Indonesia primary market purchases reported in panel 1 include only the share of the burden sharing agreement completed through August, not the entirety of the 397.6 trillion plan.
- Primary market purchases for the Philippines refer to the 300 bn (~1.6% of GDP) repurchase agreement in April 2020, which was repaid in September.
- In panel 1, sovereign purchases for Poland include those from the state development bank (BGK) and the state development fund (PFR), which are excluded in panel 2. Purchases for Chile include only those under Special Asset (June) and Bank Bond (March) Purchase Programs. Asset purchases in Hungary did not begin until May.

### Market stress dynamics: FX versus local bond markets
- The COVID-19 shock led to significant market dysfunction comparable to that of the 2008 global financial crisis.
- Stress dissipated faster than in previous episodes but remained elevated.
- FX markets normalized more quickly than local bond markets:
  - Measures such as risk reversals were more muted relative to past episodes.
  - The wider cross-currency basis—a measure of dollar funding liquidity stress—was more short-lived.
  - Rapid establishment of central bank swap line facilities and bond repo facilities by the Federal Reserve and the European Central Bank helped ease dollar funding stress.
  - Structural shifts in FX market operations since the global financial crisis (including increased turnover in emerging market currencies, electronic trading, and a larger set of market-making institutions) contributed to quicker normalization.
- Local bond markets remained more dysfunctional, triggering APPs. Contributing factors included:
  - High local bond supply risks that weigh on yields through risk premiums.
  - Weak foreign flows to local bond markets, negatively impacting liquidity.
  - Relatively limited depth of local currency government bond markets; domestic banks often acted as sole liquidity providers in times of stress in markets with a shallower domestic investor base.

### Timing and role of domestic APPs during the crisis
- APP announcements in the second half of March did not have an immediate impact on local stress indices due to very tight global financial conditions, illiquidity, strong risk aversion, and fiscal concerns.
- As external conditions improved in April and APP implementation stepped up, country-level local stress indices showed improvement and differentiation; much of the improvement was in market liquidity measures (e.g., bid-offer spreads and intraday volatility).
- APP announcements likely served as a circuit breaker at the height of the crisis by signaling central banks’ readiness to stand as buyer of last resort.

### Empirical findings on APP effectiveness
- Event studies and local projections analysis (panel data from 13 emerging markets at daily frequency from January to mid-May 2020) find:
  - APP announcements reduced long-end bond yields in a significant and persistent way.
  - The size of the impact of domestic APP announcements on yields ranges from 20 to 60 basis points and is statistically significant within one standard error confidence interval.
  - APP announcements had a corresponding sharp reduction in government bond yields and term premiums, with relatively limited impact on currencies.
  - Intraday data for selected countries show sharply declining government bond yields but relatively less impact on currencies.
- Two empirical specifications were used to isolate APP effects:
  - Specification controlling for the Federal Reserve APP announcement (March 23) and domestic rate cuts.
  - Specification controlling for the VIX as a proxy for global risk appetite and domestic rate cuts.
  - Both specifications show APP announcements reduce long-end bond yields even after controlling for Federal Reserve actions or changes in global risk appetite.
- By contrast, domestic rate cuts (1 percentage point domestic policy rate cut) do not appear to have a significant effect on long-end yields when controlling for APPs and other factors; this may reflect that rate cuts were already priced in or that risk premiums remained high.
- The Federal Reserve APP announcement on March 23 and the improvement in global risk appetite also had a significant and persistent impact on lowering long-end yields; magnitudes of the effect of emerging market APPs and the Federal Reserve APP are broadly similar.
- Announcements of APPs did not lead to a significant depreciation of emerging market currencies; APPs had relatively limited and short-lived effects on EM currencies.

### Policy implications, risks, and trade-offs
- The experience with emerging market APPs has been largely positive so far: APPs catalyzed lower local-currency government bond yields without indications of immediate risks to financial stability.
- Central bank communication about the scope, timing, and temporary nature of APPs was essential to containing perceived risks of fiscal dominance that could have led to higher bond yields and weaker currencies.
- In some cases, APPs may have intermediated an orderly exit of investors from local-currency bond markets to preserve investor confidence and avoid more widespread market disruptions.
- Further expansion of APP duration or size could create risks and warrants ongoing evaluation of risks; large-scale, especially open-ended, APPs may negate their initial effectiveness and raise risks (for example, fiscal dominance concerns).
- The positive pandemic-era experience may motivate more emerging market central banks to consider unconventional monetary policy where conventional policy space becomes limited.

_Italic: IMF staff calculations and analysis from Chapter 2, "Emerging and Frontier Markets: A Greater Set of Policy Options to Restore Stability," Global Financial Stability Report: Bridge to Recovery (October 2020)._

### CHAPTER 2 EMERGING ANd FRONTIER MARkETS: A GREATER SET OF POLICY OPTIONS TO RESTORE STABILITY

### CHAPTER 2 EMERGING ANd FRONTIER MARkETS: A GREATER SET OF POLICY OPTIONS TO RESTORE STABILITY

### Asset Purchase Programs (APPs): Objectives and Suitability
- APPs may be suitable for countries:
  - constrained by their own effective lower bound,
  - with inflation expectations steady,
  - where the concern over capital outflows and FX depreciation is low,
  - or where the domestic absorption capacity of new bond supply is limited.
- Primary goal in these cases: exert control over the medium- to long-end of the yield curve to lower government financing costs and temporarily ease pressure on domestic investors amid increased issuance or foreign investor outflows.
- Caveats:
  - Longer-term yields play a less central role in most emerging market economies than in advanced economies.
  - Fragilities behind higher short-term rates may limit the scope to lower longer-term yields.

### APPs: Risks and Considerations
- Institutional and credibility risks:
  - Institutional and central bank credibility may be weakened.
  - Credible monetary policy frameworks and sound governance are prerequisites for effective unconventional policy actions such as APPs.
  - Increased balance sheet exposure to long-term debt may raise concerns about the central bank’s ability to raise interest rates when conditions warrant or to achieve price stability.
- Fiscal dominance and market functioning:
  - Asset purchases may invite concerns about fiscal dominance when central banks become buyers of last resort with large-scale and open-ended APPs in economies with weak monetary and fiscal policy frameworks, potentially resulting in higher risk premiums and steeper government bond yield curves.
  - The lasting presence of central banks as buyers in the local currency bond market may distort market dynamics, impair price discovery (especially in primary markets), and impede development of the financial market.
  - Consider effects on collateral availability in the banking system and impact on policy rate transmission; risk of possible overvaluation of assets.
- Capital flow and exchange rate pressures:
  - APPs may intensify capital outflow pressure, especially in countries with weaker fundamentals.
  - Expectations of large-scale APPs may put downward pressure on long-term yields and foreign exchange rates, risking capital flows during risk-off periods.
  - Excessive gaps between domestic and peer-group risk premiums can induce portfolio rebalancing away from the country.
- Market structure and investor base:
  - Effectiveness varies with structure and liquidity of capital markets, availability of high-quality domestic assets, extent of foreign investor participation, and level of financial sector development.
  - Depth of domestic institutional investor base and ability to repatriate foreign assets affect the need for APPs.

### APPs: Design and Operational Recommendations
- Scope and communication:
  - Transparency and clear communication are crucial, especially for central banks with weaker institutional frameworks.
  - APPs should be limited in time and scale and linked to clear objectives.
  - Continued evaluation is needed as more data become available on unconventional monetary policy effectiveness in emerging markets, especially for open-ended programs.
- Market implementation:
  - Programs should aim to affect segments of the yield curve that serve as effective pricing benchmarks to maximize transmission to the real economy.
  - Purchases should preferably be made in secondary markets; purchases in primary markets or at below-market rates can disrupt price discovery and invite fiscal dominance.
  - Consider the efficacy of the portfolio balance channel and investors’ ability to allocate to other domestic assets (corporate or covered bonds); absence of alternatives could prompt investor exit and increase exchange rate sensitivity to APPs.
  - Experience with advanced economy exit strategies may inform emerging market central banks, particularly when program size is meaningful.
- Domestic market development to mitigate APP side effects:
  - Develop efficient money market frameworks.
  - Strengthen primary market practices to enhance transparency and predictability of issuance.
  - Bolster market liquidity, including use of repo facilities for local dealers in times of stress.
  - Develop robust market infrastructure, including local clearing and settlement and other services.
  - Where legal and market infrastructure permit, enable settlement and clearance of local currency debt in international capital markets to access wider liquidity pools.

### Frontier Market Economies: Debt Vulnerabilities and Creditor Composition
- Pre-pandemic vulnerabilities:
  - Frontier market economies entered the pandemic in a vulnerable position, with a number of countries already deemed at high risk of debt distress and with relatively little policy space compared with major emerging market economies.
- Shift toward private financing:
  - The postcrisis period of easy global financial conditions allowed frontier market economies to raise unprecedented amounts of capital in private markets, increasing rollover risk.
  - Frontier economies have become more dependent on private sector debt in recent years.
- DSSI and market reaction:
  - The G20 announced the Debt Service Suspension Initiative (DSSI) to temporarily ease financing constraints of the poorest countries by freeing up scarce money to mitigate the human and economic impact of COVID-19.
  - Some countries have been reluctant to participate due to fears of loss of market access.
  - Markets are not pricing in a significant risk from DSSI participation; on average, spreads of countries eligible for the DSSI have outperformed those of other frontier countries (even excluding eligible countries that do not intend to participate).
  - Currently the initiative provides relief primarily through a moratorium on bilateral debt, while private sector groups have begun assessing potential ways to assist.
- Creditor shares and upcoming debt service:
  - Bilateral creditors represent about one-third of debt payments owed by countries eligible for the DSSI over the next few years.
  - For many countries, private sector debt represents a much larger proportion of their external debt.

### Debt Restructuring Dynamics and Spread Implications
- Distributional effects of seniority:
  - If a country requires a given overall debt reduction, and one class of creditors is treated as senior, other creditors must bear a greater burden.
  - Stylized example: issuer requiring a total 40 percent haircut with debt evenly split; variants show 50 percent senior share, 33 percent senior share, 20 percent senior share, 0 percent senior share.
- Spread consequences:
  - Panel example assumptions: a bond with an 8 percent coupon and 10-year maturity; overall debt reduction of 40 percent required, with senior debt holders accepting only a 20 percent haircut.
  - Investors pricing a larger required haircut in case of default could meaningfully impact spreads.
  - A model for sovereign bond spreads indicates investors expect a larger haircut for private creditors than for bilateral creditors.
  - Model-consistent expectation: bilateral creditors would take a 30 percent haircut in the case of a country that requires an overall 40 percent haircut.
  - Markets appear to perceive that, in a default situation, private creditors would be forced to take a larger haircut than bilateral creditors would.

### Policy Guidance for Recovery and Resilience
- Use of policy measures during the pandemic:
  - Unprecedented policy measures by advanced and emerging market policymakers after COVID-19 onset averted worst outcomes and helped stabilize domestic financial conditions.
  - Emerging market central banks actively used available and new tools to soften the blow from the spike in global risk aversion and to smooth excess volatility of domestic currencies.
- Role of FX intervention and macroprudential tools:
  - Appropriate use of FX intervention, macroprudential policies, and capital flow management measures in the face of shocks can contribute to financial stability and enhance monetary policy autonomy.
  - Global factors played a more important role in driving currencies than FX intervention did during the pandemic; short-lived FX intervention is consistent with using the currency as a shock absorber when other vulnerabilities are in check.
  - Countries with shallow FX markets may experience macroeconomic destabilization after shocks; FX interventions to lean against market illiquidity can be appropriate.
- APPs as part of the toolkit:
  - Many emerging and frontier market central banks for the first time embarked on APPs to ensure smooth functioning of bond markets and provide accommodation in an environment of very low policy rates; apparent success in reducing bond yields without risking financial stability so far suggests APPs have a role but are not a panacea.
  - APPs appear more effective when used jointly as part of a broader macroeconomic policy package.
- Debt management and restructuring:
  - Frontier market economies with unsustainable debt dynamics, limited market access, and high external financing requirements should preemptively and cooperatively seek debt resolution with their creditors.
  - Countries that maintain market access at reasonable rates should decrease rollover risks as part of their debt management strategy.

*Source: CHAPTER 2 EMERGING ANd FRONTIER MARkETS: A GREATER SET OF POLICY OPTIONS TO RESTORE STABILITY (provided content).*

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_Source: https://www.imf.org/-/media/files/publications/gfsr/2020/october/english/ch2.pdf_