The impact of monetary policy normalisation on Asia
Speech by Mr Agustín Carstens, General Manager of the BIS, at the Beijing Financial Street Forum 2021, 20 October 2021.
I want to thank the organisers, and in particular the People's Bank of China and SAFE, for inviting me again to join this prestigious annual Financial Street Forum.
Policy normalisation is coming
Today I want to talk about policy normalisation following Covid-19, and the effect this is likely to have on Asia and emerging market economies in general.
Stepping back to the early months of 2020, as it increasingly became clear that we faced a global pandemic, policymakers responded forcefully. Central banks and fiscal authorities worked in close concert to prop up their economies. For central banks, this often meant cutting policy rates to all-time lows and using so-called unconventional policy tools. Some emerging market central banks bought government bonds for the first time. Fiscal authorities also reacted strongly, backstopping incomes in struggling industries with measures that, together, amounted to more than a fifth of GDP in some cases.
These policy measures have clearly had their intended effect: they put a floor under economic activity and laid the basis for the hoped-for recovery. But they have also contributed to exceptionally accommodative financial conditions. We've seen this reflected in booming stock markets, exceptionally low credit spreads and accelerating real estate prices across many markets.
Now some countries are starting to move towards "policy normalisation", including in North America and Europe. Compared with many emerging market economies (except China), they suffered from the pandemic relatively early on but have generally made more progress with vaccinations, which has relieved pressure on healthcare facilities. They have been enjoying a faster than usual recovery and above-target inflation, to the point of raising questions about inflation persistence.
The improvement in the economic fortunes of these advanced economies has been broadly positive for emerging markets: stronger global growth has increased demand for their exports, especially of manufactured products, while rising commodity prices have provided a further boost to commodity exporters.
Normalisation may tighten global financial conditions
But policy normalisation – when it comes – could have a large impact on Asia, and on emerging market economies more generally. We know that financial conditions in emerging markets move with the global ones. And we see evidence of this in regional markets' sensitivity to the expected speed of monetary policy tightening in the United States and elsewhere.
The main reason is that monetary policy affects global financial conditions. We've already remarked on the rapid rise in asset prices, seen worldwide. Much of this has been backed by increasing debt levels, which raises concerns about financial stability. Especially where debt increases occur in the non-bank financial sector, there can be "hidden leverage" and liquidity mismatches lurking beneath the surface. Archegos Capital Management provides a good example.
It held large and concentrated positions based on derivatives contracts and reportedly lost 20 billion US dollars in just two days, before being closed in March this year. This resulted in large losses for leading international banks. Closer to home, financial markets continue to monitor the developments surrounding Evergrande Group.
Of course, the issue is not about any individual company, since businesses failing is a fact of economic life. Instead, it is about the systematic growth of debt that we've seen across economies, and indeed the world.
Just how vulnerable are emerging markets to tightening global financial conditions? Well, that depends. The "taper tantrum" of 2013 – when there were signs that the Federal Reserve would reduce its quantitative easing programme introduced in the wake of the Great Financial Crisis – provides one example of this. It saw capital outflows from many emerging markets, large exchange rate depreciations and a sharp rise in funding costs.
Policymakers can help to protect emerging market economies from tightening financial conditions
So are we destined to see a repeat – a taper tantrum 2.0 – this time? Not all such episodes are alike: the consequences of policy normalisation depend on both underlying economic conditions and the policy responses.
Today, emerging markets are better placed to withstand tightening global financial conditions than in the past. First, many have higher foreign exchange reserve buffers, which can provide a certain degree of comfort in the face of capital outflows. Relatedly, some countries, especially in Asia, have persistent current account surpluses, providing a steady stream of foreign currency income.
Second, central banks and regulatory authorities have been actively using both micro- and macroprudential policies to make their financial systems more resilient. Last, but by no means least, monetary policy frameworks in emerging markets are much stronger than in the past. During the pandemic, these have delivered "good" macroeconomic outcomes, helping to assure the anchoring of inflation expectations and increasing the room for manoeuvre for central banks.
But there are some lingering causes for concern. Many countries are running large fiscal deficits, and public debt is rising, although much of this is due to necessary pandemic measures. Even when this debt is issued in local currency, economies could face heightened capital flow volatilities when market sentiment weakens, especially if a large portion of the debt is held by foreign investors. I've referred to this elsewhere as "original sin redux".1
In addition, corporations in emerging market economies continue to issue debt in foreign currencies. Policy normalisation is likely to see a strengthening of the dollar and euro against regional currencies, potentially challenging the debt servicing and refinancing capacity of heavily indebted corporates. Household debt has also been rising rapidly in many economies, in part fuelled by booming real estate markets. History suggests that this tends to raise downside economic and financial stability risks over the medium term.2
So what can central banks do to manage the fallout from normalisation? The exact mix of tools and their sequencing will be country-specific. But clear and timely communication is crucial for all. Emerging market central banks can draw on their experience with a broad set of tools, as outlined in recent BIS working group reports.
First, foreign exchange intervention can serve as a line of defence against excessive currency volatility, supported by capital flow management tools if needed.
Second, balance sheet operations can help to stabilise financial markets, and provide an extra degree of freedom when policy rates are low.
Third, refinancing operations for financial institutions, including non-bank financial institutions, can be used to restore market functioning if necessary.
Finally, macro- and microprudential measures can complement monetary policy in stabilising domestic financial conditions and bolstering financial resilience.
In the longer term, there are additional measures that can help to facilitate an efficient allocation of resources and ensure robustness. These include the development of deeper domestic financial markets to reduce reliance on external financing, and the greater adoption of best-practice international regulatory and supervisory standards.
Conclusion
The bottom line is that the pandemic's end will bring a fresh set of policy challenges. In many ways, China is in the vanguard, as one of the first economies to rebound from its Covid-induced slump. We look forward to continuing to learn from your experiences here as normalisation continues.
Thank you for inviting me to share my thoughts with you. I wish you all the best for your discussions over these three days. While the questions are different from those of last year's forum, what hasn't changed is my desire to join you in person soon.
1 See A Carstens and H S Shin, "Emerging markets aren't out of the woods yet", Foreign Affairs Magazine, March 2019.
2 See BIS, Annual Economic Report, June 2021, Box 1.A, "House prices soar during the Covid-19 pandemic".
