How Emerging European Economies Found a New Monetary Policy Tool

IMF News, September 29, 2021

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Canonical URL: How Emerging European Economies Found a New Monetary Policy Tool

Authors: William Lindquist, Nadeem Ilahi, and Jaewoo Lee; IMF European Department.
Date: September 29, 2021.
Context: Amid the financial market turmoil at the start of the pandemic, central banks in Croatia, Hungary, Poland, Romania, Serbia, and Turkey rolled out asset purchase programs (APPs), buying up local currency bonds issued by governments but also by the private sector in the case of Hungary.
Primary finding: New IMF research suggests that asset purchases in emerging Europe contributed to the relief of financial market dysfunction, without signs of destabilizing effects.
Policy implication: With this goal achieved and to support the transmission of higher policy rates to the longer end of the yield curve, central banks in emerging Europe should taper or end asset purchase programs once monetary policies are tightened.

Scale and duration:
- Compared to APPs employed by advanced economy central banks during the pandemic, most APPs in emerging Europe were smaller in scale, though with significant differentiation within the region.
- They were also generally limited to the immediate period following the onset of the pandemic, except in Hungary and Poland, where asset purchases continue.
Policy context and objectives:
- The limited scale and duration is consistent with goals to mitigate financial market dysfunction, provide liquidity, and repair monetary policy transmission mechanisms.
- These APPs are set apart from quantitative easing in advanced economies, which aimed to provide additional stimulus when policy interest rates were at or near the effective lower bound.
- APPs in emerging Europe were mostly implemented alongside or even preceded conventional monetary policy easing.
- Example: Romania’s asset purchase program essentially concluded during the summer of 2020, but the policy interest rate only reached its low of 1.25 percent in January 2021.

Market functioning:
- IMF research suggests APPs in emerging Europe were successful in alleviating market dysfunction in the immediate aftermath of the pandemic shock.
- Using an event study approach, the research finds evidence that APP announcements led to an easing of bond market liquidity pressures and a reversal in the surge in term spreads.
Exchange rates and liquidity management:
- The research found no evidence that these APPs led to currency pressures.
- Possible explanations include the mostly limited duration and scope of APPs and central bank actions to absorb added liquidity from purchases.
- Examples of liquidity-draining measures:
- The central bank of Poland issued its own securities.
- The central bank of Hungary used a deposit facility to drain liquidity created by purchases.

General recommendation:
- After successfully alleviating initial market dysfunction, most APPs in the region have already concluded.
- For ongoing APPs in Hungary and Poland, central banks should consider the goals and their role in monetary policy tightening, which has already begun in Hungary.
- Increases in policy rates should be accompanied by a tapering or discontinuation of APPs, which would support the transmission of higher policy rates to the longer end of the yield curve.
Recent country actions:
- In August, the National Bank of Hungary announced that it would begin to gradually reduce its purchases of government bonds.
- The National Bank of Poland has not yet raised interest rates, but the pace of purchases has slowed significantly from the spring months.

Uncertainty about future use:
- While APPs in emerging Europe were successful during the pandemic and now appear to be part of the toolkit, less clear are the conditions in which to use them in the future.
- Their future use may depend on global circumstances; the nearly universal easing of monetary policies during the pandemic created more conducive conditions for EMs to employ such tools.
- It remains to be seen whether APPs could be employed by EMs in response to idiosyncratic shocks without triggering reactions such as currency depreciation.
Fiscal dominance risk:
- One concern is that APPs in EMs could abet fiscal dominance if they help support deficits that cannot be financed by conventional means.
- Mitigating factors include a strong track record of macroeconomic stability and credible economic institutions.
- EU membership: The structure and discipline provided by EU membership make these risks less acute, potentially enhancing future scope for APPs in these countries.

IMF European Department, September 29, 2021.