Central Bank Balance Sheet Policies and Spillovers to Emerging Markets

IMF Working Papers, July 25, 2017

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The paper develops a theoretical model showing that, in the near future, the monetary policies of some key central banks in advanced economies (AEs) will have two dimensions—changes in short-term policy rates and balance sheet adjustments.
These AE policy dimensions will affect emerging market economies (EMs), especially those with a pegged exchange rate, because these EMs primarily use a single monetary policy tool: the short-term policy rate.
Changes in AE policy rates and balance sheet adjustments may differ in their respective financial spillovers to pegged EMs, making it difficult for EMs to mitigate different types of spillovers with a single monetary policy tool.
The model is used to show how EMs might use additional tools—capital controls and/or macro-prudential policy—to complement their monetary policy and financial stability toolkit.
The paper discusses how balance sheet adjustments that affect long-term interest rates may percolate to influence short-term interest rates via financial plumbing.

AE monetary policy has two distinct dimensions with potentially different spillover effects:
- Changes in short-term policy rates.
- Balance sheet adjustments (including asset purchases and other unconventional monetary policies).
Pegged EMs face constraints because they primarily operate with one monetary policy instrument—the short-term policy rate—limiting their ability to address multi-dimensional spillovers.
Balance sheet adjustments in AEs that affect long-term interest rates can transmit to short-term rates in EMs through interactions in financial markets ("financial plumbing"), amplifying spillovers beyond the direct effect on long-term yields.

Augment the monetary policy toolkit beyond the short-term policy rate to address differentiated spillovers:
- Use capital controls as a complementary instrument.
- Employ macro-prudential policy measures to bolster financial stability.
Recognize that a single policy instrument may be insufficient to offset distinct spillovers stemming from AE policy-rate changes versus AE balance sheet adjustments.

Financial spillovers operate through multiple channels:
- Direct interest rate channels (short-term and long-term).
- Market plumbing where long-term rate changes influence short-term interest rates.
- Cross-border asset flows influenced by AE asset purchases and balance-sheet operations.
Collateral and financial institutions play roles in transmitting balance sheet adjustments from AEs to EMs.

Balance of payments, Capital controls, Central bank policy rate, Collateral, Financial institutions, Financial services, Financial statements, Monetary policy, Public financial management (PFM), Unconventional monetary policies.
Keywords and technical terms used in the analysis include: AE agent, AE central bank, asset purchase, balance sheet, capital control, Capital controls, central bank, Central bank policy rate, collateral, excess reserves, fed funds rate, financial spillovers, Financial statements, General Collateral Finance (GCF rate), Global, macro-prudential, monetary policy, policy rate, quantitative easing, RRP (reverse repo program), Unconventional monetary policies, WP.

Central Bank Balance Sheet Policies and Spillovers to Emerging Markets, Manmohan Singh and Haobin Wang, IMF Working Papers, July 25, 2017.

Central Bank Balance Sheet Policies and Spillovers to Emerging Markets, WP/17/172, July 2017
- Central Bank Balance Sheet Policies and Spillovers to Emerging Markets, WP/17/172, July 2017 (Markdown version)
- Central Bank Balance Sheet Policies and Spillovers to Emerging Markets, WP/17/172, July 2017 (PDF)