## Spillovers from Unconventional Monetary Policy—Lessons for Emerging Markets, by Christine Lagarde, IMF Managing Director

_IMF News, March 17, 2015_

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## Bibliographic details
- Published: March 17, 2015

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### 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.*

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## References

- [India and the IMF](http://www.imf.org/external/country/IND/index.htm)
- [United States and the IMF](http://www.imf.org/external/country/USA/index.htm)
- [Speeches](https://www.imf.org/en/news/searchnews)
- [Christine Lagarde](https://www.imf.org/external/np/omd/bios/cl.htm)
- [PRESS CENTER](http://presscenter.imf.org/)
- [https://www.imf.org/en/home](https://www.imf.org/en/home)

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