Spillovers from Unconventional Monetary Policy—Lessons for Emerging Markets, by Christine Lagarde, IMF Managing Director
IMF News, March 17, 2015
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- Published: March 17, 2015
Introduction and context
- Speech as prepared for delivery, Reserve Bank of India, March 17, 2015.
- Focus: risks from unconventional monetary easing in large advanced economies and spillovers to emerging markets, and policy lessons for minimizing adverse effects.
- Noted backdrop: the United States may raise short term interest rates later this year for the first time since 2006, with potential volatility in financial markets.
State of the global economy and key challenges
- Global growth and regional outlook
- Global growth: about 3.5 percent this year, picking up modestly next year to 3.7 percent.
- Advanced economies: rebound in the United States and the United Kingdom; euro area and Japan—domestic demand, credit to private sector, and investment have yet to recover fully.
- Emerging markets and developing countries: growth projected to pick up from less than 4.5 percent this year to a little more next year; outcomes will vary widely across countries.
- India-specific observations
- India benefited from a sharp drop in oil prices and policy improvements under the new government; latest GDP statistics suggest a strong pace of economic activity this year and next.
- Two challenges highlighted for India and emerging markets
- Strengthening of the U.S. dollar driven by a relatively strong U.S. recovery and divergence in monetary policy paths:
- Pressure on countries with exchange rate regimes linked to the dollar and on sovereigns with heavy foreign currency borrowing.
- Balance-sheet pressures for banks, firms, and households borrowing in dollars but earning in other currencies.
- India’s corporate sector debt has nearly doubled in the last 5 years to about US$120 billion.
- Prospective U.S. monetary policy normalization risks:
- Potential for financial market and capital flow volatility and sudden increases in interest rate spreads as U.S. interest rates begin to rise.
Spillovers from unconventional monetary policies — findings and historical evidence
- Role of unconventional monetary policies since 2007 global financial crisis
- Positive effects: helped avert a deeper global depression, avoided financial market meltdown, supported recovery in advanced economies and elsewhere.
- Negative effects: contribution to a build-up of vulnerabilities in emerging markets through large capital inflows and asset price appreciation.
- Capital flow and asset price magnitudes
- Between 2009 and end-2012, emerging markets received about US$ 4½ trillion of gross capital inflows, roughly one half of global capital flows.
- India received about US$470 billion of these inflows.
- Empirical insights
- Fund staff work suggests spillovers to asset prices and capital flows from expansionary unconventional policies were greater than from earlier conventional policies.
- Vulnerabilities built up during accommodative policy periods can unwind suddenly when policy is reversed, creating substantial market volatility.
- Example: the “taper tantrum” episode in May and June of 2013 caused indiscriminate capital outflows from most emerging market economies, including India.
- Timing and pace of U.S. interest rate lift-off can surprise markets; portfolio rebalancing out of emerging markets and volatility are possible as advanced-economy conditions improve.
Lessons and policy recommendations for the international community and emerging markets
- For advanced economies and international cooperation
- Clear and effective communication of policy intentions can reduce the risk of very large market volatility.
- There is scope for greater international policy cooperation to minimize negative spillovers.
- For emerging markets: pre-crisis preparedness
- Evidence: economies that addressed vulnerabilities before the taper tantrum fared better during market volatility episodes.
- Factors that helped dampen volatility:
- Higher GDP growth.
- Stronger external current account positions.
- Lower inflation.
- More liquid financial markets.
- More resilient financial sectors.
- Recommendation: pursue reforms that strengthen fundamentals and financial sector resilience with urgency and speed.
- For crisis response
- Central banks should be ready to act if market volatility materializes:
- Temporary—though aggressive—domestic liquidity support to certain sectors or markets may be necessary.
- Targeted foreign exchange interventions can be used to limit disruptive currency movements.
- Cross-country foreign currency swap lines have proven helpful to access foreign exchange liquidity during market stress.
- Examples of successful policy responses
- Korea: reduced banks’ short term external debt by half—to 27 percent—between 2008 and 2013, improving financial sector resilience.
- Brazil, Uruguay, Indonesia: used some form of capital flow management measures to discourage short term inflows and reduce risk build-up.
- Peru: temporary direct intervention in the foreign exchange market to limit excessive volatility.
- India (RBI actions during and after the taper tantrum):
- Provided foreign currency liquidity support to key sectors.
- Allowed the rupee to depreciate and provided judicious foreign exchange interventions.
- Arrested surge in gold imports, narrowed current account deficits sharply, and began rebuilding foreign exchange reserves.
- Conclusion from these experiences: decisive and swift policy responses, together with good fundamentals, helped countries contain market volatility.
Rethinking financial development — tradeoffs and policy design
- Overall message
- Continue building a safe and inclusive financial system to support broad-based growth in good times and provide a buffer for financial stability in bad times.
- Findings from IMF work on financial development
- Many emerging markets, including India, can still reap benefits from further financial development—greater depth, efficiency, and access to financial services.
- There are “speed limits” to financial deepening:
- Rapid deepening can increase instability by encouraging greater risk-taking and high leverage, especially under weak regulation and supervision.
- This elevates the importance of strong institutions, regulatory frameworks, and supervision.
- India’s recent policy moves:
- Progress in addressing bad loans in public sector banks.
- Development of sound regulatory and supervisory regimes for banks, insurance, and securities markets.
- India is well ahead of many countries in implementing Basel III standards.
- Government announcement to introduce legislation on a new Indian Financial Code to simplify and revamp financial regulatory architecture.
- Regulatory priorities and tradeoffs:
- The IMF study finds a small subset of regulatory principles that are critical for both financial development and financial stability.
- Examples include regulations related to capital buffers, non performing loans, financial disclosures, and compensation.
- Implication: little or no conflict between promoting financial stability and financial development when the right regulations are prioritized.
Conclusion — outlook for India and policy priorities
- India displays economic vibrancy and strong prospects for higher, sustainable, and inclusive growth.
- The world is looking to India to help lead the path to such growth.
- Continuing reforms to strengthen macroeconomic management, improve financial sector resilience, broaden access to formal finance, and implement targeted regulatory priorities remain critical.
Spillovers from Unconventional Monetary Policy—Lessons for Emerging Markets, by Christine Lagarde, Managing Director, International Monetary Fund, March 17, 2015.