The sharp reversal in the monetary policy stance in major advanced economies since the end of 2021 has had ripples far beyond their national borders. While the more than expected recent falls in inflation, particularly in the US and the Eurozone, may signal slowing down of interest rate hikes, it is clear that global liquidity will remain restrained for the foreseeable future.
Author: Professor Gulcin Ozkan
Published: 7 March 2023
The sharp reversal in the monetary policy stance in major advanced economies since the end of 2021 has had ripples far beyond their national borders. While the more than expected recent falls in inflation, particularly in the US and the Eurozone, may signal slowing down of interest rate hikes, it is clear that global liquidity will remain restrained for the foreseeable future.
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Tightening global financial conditions has always been challenging for emerging economies (EE), and this is especially true now that it has come after a decade of loose monetary policy. Favourable borrowing conditions over such an extended period – combined with the substantial surge in spending during the Covid-19 pandemic and subdued economic growth – resulted in the ballooning of debt ratios in these countries. This, in turn, has made EEs even more vulnerable to fluctuations in international financial markets, a major source of risk for the global economy at present. Examples include China, Brazil, South Africa and Turkey with notable rises in debt ratios in recent years in addition to Egypt, El Salvador, Pakistan and Tunisia with sovereign debt trading at distressed levels and Argentina, Sri Lanka, Ecuador and Lebanon who have already defaulted on their obligations since 2020. Indeed, the external debt stock of developing countries now stands at levels that are five times higher than they were in 2000.
The purpose of this piece is (i) to provide an account of why the current conjuncture is so challenging for EEs; and (ii) to assess whether macroprudential policy (MaPP) can help these countries navigate the new global financial landscape more successfully.
Why is the current tightening particularly worrying for emerging markets?
The answer to the above question is tightly nested in the way EEs differ from other economies. These are countries featuring consistently higher growth rates than other developing nations, facilitated by significant integration with the global economy particularly through financial flows. This close and virtuous relationship between capital inflows and economic activity, coupled with underdeveloped domestic financial systems is the source of EEs reliance on foreign capital.
When global liquidity is plentiful, capital flows into these countries, boosting economic activity hence growth rates. In bad times, however, this relationship becomes a vicious circle when the sudden stop of capital inflows depresses output, further tightening credit conditions and hence resulting in significant contraction in national income. Given the cyclical nature of and fluctuations in capital flows, such reliance on external finance generates the widely observed boom-and-bust cycles in these countries.
What can EE policymakers do to respond to negative financial shocks?
Standard macroeconomic theory – conventional Mundell-Fleming model – would suggest that an obvious way to offset the unfavourable consequences of a negative capital flow shock is through exchange rate adjustment. The fall in financial inflows puts pressure on the domestic currency, the depreciation of which improves competitiveness boosting net exports and output, hence insulating the domestic economy against the external shock.
Unfortunately, the channel of transmission from exchange rates to economic activity is fraught with difficulty in EEs. It is not surprising therefore that despite the major changes in monetary policy regimes over the last three decades, many countries continue to opt for limited exchange rate flexibility (Ilzetzki et al. 2019) – a phenomenon widely referred to as the fear of floating since Calvo and Reinhart (2000).
There are good reasons why policymakers in EEs pay such close attention to exchange rate changes. First, EEs still exhibit sizable liability dollarization – bank, firm and/or government borrowing in foreign currency terms – raising the risk of exchange rate fluctuations considerably. Under such circumstances depreciation magnifies the domestic currency value of dollar denominated obligations, wreaking havoc in the exposed sectors with wide ranging effects on the economy – commonly known as the balance sheet effects (Bernanke et al. 1995). Second, the dominant use of the dollar in international trade invoicing and financing significantly amplifies the effects of exchange rate changes (Shousha, 2019). Third, pass-through from exchange rates to domestic prices is still higher is EEs, establishing a strong link between the depreciation of the domestic currency and inflation, further deteriorating economic outcomes (Bussiere et al. 2014).
Role of macroprudential policy
The above listed factors underlying the fear of floating behaviour seriously restrict the room for counter-cyclical monetary policy the absence of which is an important empirical regularity for EEs (Kaminsky et al. 2004).
This inability to conduct appropriate stance of monetary policy is another reason why MaPP is particularly important for EEs.
Indeed, EEs experience of MaPP has a longer history than that of the advanced economies. This is not surprising in light of the arguments above, given EEs greater exposure to volatile capital flows, commodity price shocks and other risks. (Claessen et al. 2013).
Following a series of emerging market crises during the 1990s – including the Mexican crisis in 1994, the Asian crisis in 1997, the Russian default in 1998, and the turmoil in Brazil in 1999 and the currency crises in Turkey and Argentina in the early 2000s – EEs adopted a string of macroprudential measures. These included capital and reserve requirements, limits on borrowing and lending (particularly in FX), tax on financial institutions and limits on interbank exposures (Cerruti et al. 2017).
So by the time the global financial crisis (GFC) hit in 2008-09, EEs had already accumulated crucial experience on the effectiveness of a range of prudential measures, which provided important guidance for the AEs in their policy decisions in responding to the crisis. Still, the frequency of MaPP adoption has increased in both EEs and AEs after the GFC (Kim et al. 2019).
Effectiveness of macroprudential policy in EMs
Has the adoption of MaPP in EEs served its purpose? The wealth of empirical evidence to-date suggests that the answer to this question is affirmative. For example, it is consistently shown that prudential measures aimed at borrowers such as LTV and DTI ratios have been effective in (i) reducing the procyclicality of credit and hence the vulnerabilities in the banking system (Claessen et al. 2013); (ii) reducing housing credit growth (Akinci and Olmstead-Rumsey, 2018); and (iii) curbing house price growth (Zhang and Zoli, 2016). FX based measures appear to be particularly effective in EEs in controlling the capital flow volumes (Frost et al. 2020). MaPP works best when it is complementary to monetary policy rather than when targeted in opposite directions (Kim et al. 2019; Bruno et al. 2017).
Moreover, MaPP is found to reduce the sensitivity of domestic GDP growth to the fluctuations in global financial conditions, paving the way for countercyclical monetary policy. MaPP also reduces US monetary policy spill-overs onto the domestic economies of EEs (Coman and Lloyd, 2022). Interestingly, existing evidence also reveals that tightening capital controls is not nearly as effective and hence does not offer a substitute to MaPP (Bergant et al. 2020). While capital controls may help spur the development of domestic financial markets and improve the composition and maturity of capital inflows, there is no evidence that they are used countercyclically (Fernandez et al. 2015; Chinn and Ito, 2006). Similarly, MaPP is more effective than monetary policy in dampening the fluctuations in domestic economic activity in the face of financial shocks hitting the economy (Ozkan and Unsal, 2020).
Overall, there is clear evidence that targeted policies work best, with MaPP aimed at the housing market such as LTV restrictions as good examples. By responding to the fluctuations at their source, the narrower focus of targeted policies helps limit the associated costs. A recent example is the easing of lending restrictions in China, including a rise in LTV ratios from 60 to 80 percent in some cities.
Lessons and caveats
While the evidence suggests that MaPP can certainly be effective in shielding EEs against the downturn in global financial conditions, past experience also provides some important warnings. The first is related to the possibility of leakages from prudential measures through avoidance and circumvention. Inevitably, prudential controls have a greater impact on domestic institutions than on foreign ones with domestic subsidiaries, making circumvention a significant challenge. Indeed, a greater usage of MaPP is associated with increased cross-border borrowing, signalling avoidance (Cerruti et al. 2017). This suggests that tightened regulation pushes financial activities outside the jurisdiction of such regulation. Similarly, the longer the MaPP is in place the greater are the costs associated with activities directed to circumventing the regulation possibly including corruption and favouritism, pointing to decreasing marginal returns from regulation. MaPP is also less effective in financially more developed and open economies (Cerruti et al. 2017).
It is also possible that regulation may shift the vulnerability in the economy without significantly reducing it. For example, financial regulation is shown to lower the sensitivity of the banking sector to exchange rates but not necessarily the sensitivity of the wider economy, viewed as ‘shifting the snowbanks’ from one location to another (Ahnert et al. 2021).
These caveats call for judicious calibration of prudential regulation with proper consultation and harmonisation across countries. Given that external finance remains a key engine of growth in EEs, MaPP will continue to play a crucial role in safeguarding these countries from the capricious nature of international capital flows.
