Monetary Policy Options and Tools
Agustín Carstens
As I understood, the objective of this panel is basically to address
three issues. One, to assess if countries other than the main advanced
economies have engaged in unconventional monetary policies, and
in a given case, what have been the strategies and tools they have
used. The second is to identify the main implications of unconventional monetary policies on other economies. And the third, what
have been the policy reactions of countries that have been affected
by unconventional monetary policies? By electing me as a speaker, I
think the organizers were trying to get the view from emerging markets, so that’s what I will do.
And I will start by addressing the following question: Is there a case
for unconventional monetary policies to have been applied by emerging markets in the recent crisis period? By and large, the emerging
markets have not been forced by events to modify in a significant
way their monetary policy stances and policy instruments. This is
because conventional approaches remained operational and effective.
We have not been constrained by the zero lower bound. Emerging
markets, for a change, were not the epicenter of the crisis. And even
though the impact of the crisis on growth, trade and financial stability
has been considerable, the side effects have been manageable mostly
with traditional instruments. In the handout, you can see in Chart
135
136
Agustin Carstens
Chart 1
Economic Growth and Inflation
Annual Percent Change, Average, 2009-2012
12
IND
10
Inflation
8
TUR
6
SAF
HUN
4
UK
2
EZ
NZ
NOR
CAN
US
SWE
SWI
JAP
CZR
0
-2
-2
BRA
INS
MEX
0
2
PHI
POL
KOR
COL
ISR
THA
CHL
AUS
MAL
4
GDP
PER
6
CHN
8
10
Note: The sample includes the following countries: Australia, Brazil, Canada, Chile, China, Colombia, Korea,
United States, Philippines, Hungary, India, Indonesia, Israel, Japan, Malaysia, Mexico, Norway, New Zealand, Peru,
Poland, United Kingdom, Czech Republic, South Africa, Switzerland, Sweden, Thailand, Turkey, euro area.
Source: International Monetary Fund.
1 a very simple scatter diagram, in which it is shown that emerging markets have been in a situation in which traditional monetary
policy tends to work, i.e., in a situation with moderate, but positive
inflation and growth. We are not as close to the origin as advanced
economies, so I think this is probably the main reason why we have
not been faced with the need to implement unconventional monetary policies. Advanced economies have also been forced to take very
unconventional fiscal policies, and I would like to remark that we
have not paid enough attention to this factor, nor to the relationship
between unconventional fiscal and monetary policies. For completeness, let me say that emerging markets have not been in a situation
where they needed to implement unconventional fiscal policies.
So let me move now to the second question, meant to assess the
impact of unconventional monetary policies on emerging market
economies. First, we have to say at the outset that it is impossible for
emerging markets economies to decouple from advanced economies.
The crisis that started in 2007 in the advanced economies has affected a very large percentage of the world’s GDP and the effect has
Monetary Policy Options and Tools
137
been felt by most economies. So, in Chart 2, you see the very close
correlation between world trade and world industrial production,
and then when you map these in a more detailed way to emerging
market economies, you see how world industrial production correlates extremely closely to exports from emerging markets, affecting
their growth rate. Certainly there have been some effects on financial markets, and I will address them later. The conventional wisdom
basically is that unconventional monetary policies have been very
effective in stabilizing financial markets, and somewhat effective in
stimulating economic growth, but with diminishing returns. These
achievements contained the spread of the negative consequences of
the crisis, enhancing financial stability and world economic growth.
In this sense, unconventional monetary policies have been favorable
for emerging markets. So this means that if there hadn’t been unconventional monetary policies, very likely the situation in emerging
markets would have been worse.
On the other hand, there also have been undesirable side effects
coming from unconventional monetary policies in advanced economies that have made the implementation and design of emerging
markets monetary policy very challenging. The main issue has been
the impact of unconventional monetary policies on capital flows. I
would say, in general, that unconventional monetary policies have
stimulated capital flows to emerging markets, in some cases generating mispricing in local asset markets, including the foreign exchange
market, and increasing financial stability risks. Reversals have happened and they could become much larger in the future as unconventional monetary policies exit strategies progress. Volatility of
flows has also been very pernicious, and to some extent unconventional monetary policies have affected such volatility. Here I would
like to call your attention to Chart 3, where I plotted weekly capital
flows to emerging markets. You can see how the volatility increased
dramatically at the outset of the crisis, and that it certainly has not
diminished; as a matter of fact, in May-June 2013 it is noticeable
that the outflows and volatility were larger than what we saw at the
outset of the crisis.
138
Agustin Carstens
Chart 2A
World Trade and Industrial Production
Annual Percent Change*
24
18
12
World trade
6
World
industrial
production
0
-6
-12
-18
Jan. 2006
Nov. 2007
Sep. 2009
-24
May 2013
Jul. 2011
*Seasonally adjusted data
Source: CPB Netherlands.
Chart 2B
Emerging Economies’ Exports and World Industrial Production
Annual Percent Change of Three-Month Moving Average
70
20
India
15
50
Korea
10
5
0
10
Mexico
-10
-5
Brazil
-30
-10
-50
-15
World industrial production
-20
Jan. 2006
30
China
Apr. 2007
Jul. 2008
Oct. 2009
Source: CPB Netherlands, Haver Analytics and INEGI.
Jan. 2011
Apr. 2012
-70
Jul. 2013
Monetary Policy Options and Tools
139
Chart 3
Emerging Economies: Weekly Capital Flows
Billions of Dollars
Debt
Equity
3
8
2
6
1
4
0
2
-1
0
-2
-2
-3
-4
-4
-6
-5
-8
-6
-10
-7
Jan. 2002 Dec. 2004 Nov. 2007 Oct. 2010 Aug. 2013
-12
Jan. 2002 Jan. 2005 Jan. 2008 Jan. 2011 Aug. 2013
Source: Emerging Portfolio Fund Research.
It would be unfair to blame unconventional monetary policy for
all this volatility. We are in a major crisis, and that plays a significant
role. But without doubt unconventional monetary policies have affected the evolution of the crisis. As the crisis has evolved, advanced
economies have faced sequential episodes with high probability of
them being associated with catastrophic events and widespread contagion, which in turn have triggered capital outflows from emerging markets economies. In most of these episodes, unconventional
monetary policies helped to stabilize markets. A very clear example
is what happened when the European Central Bank announced its
outright monetary transactions in the summer of 2012.
On the other hand, under a crisis environment, typical macroeconomic relationships and models break down, making the situation
akin to navigating in a storm without sufficient instruments. In this
setting, it is unavoidable for authorities to articulate prompt policy
responses in the face of a shock or development in a crisis without
full information or an inappropriate reference framework, a scenario
that often leads to mistakes and/or insufficient responses. Based on
this, it is difficult to rule out the possibility of unconventional monetary policies in some instances to have contributed to augment the
volatility of capital flows.
140
Agustin Carstens
Chart 4
Country Allocation of Bond Fund Flows, 2009-2013
Accumulated Flows in Billions of U.S. Dollars
Latin America
Asia
Jul-13
Jan-13
Jul-12
Jan-12
Jul-11
Philippines
Jan-11
Malaysia
India
Jul-10
South Korea
Thailand
Jan-10
Indonesia
Jul-09
16
14
12
10
8
6
4
2
0
Jan-09
Jul-13
Jul-12
Jan-13
Jul-11
Peru
Jan-12
Jul-10
Colombia
Jan-11
Brazil
Jan-10
Chile
Jul-09
Jan-09
16
14
12
10
8
6
4
2
0
Mexico
Source: Emerging Market Portfolio Fund Research.
Chart 5
Daily Implicit Volatility on One Month at the Money Options
Percent
80
70
60
50
Korean Won
40
Singapore Dollar
Indian Rupee
Hong Kong Dollar
Chinese Renminbi
30
Russian Ruble
Mexican Peso
20
10
Jan. 2006
Source: Bloomberg.
Nov. 2007
Sep. 2009
Jul. 2011
0
May 2013
Monetary Policy Options and Tools
141
For emerging markets, these flows are very important. Most of these
economies have adopted a floating exchange rate regime. Given that
they are small open economies, the exchange rate is a very important
component of the monetary policy transmission mechanism. Therefore, having enhanced volatility in exchange rates (see Chart 5) as a
result of more volatile capital flows makes the design and implementation of monetary policy very challenging. Despite the high foreign
exchange rate volatility, I would say that the very low interest rate environment in advanced economies, together with frictions in financial
markets, have generated persistent opportunities for relatively long
periods of time for uncovered interest rate arbitrage. This factor has
opened up opportunities to market participants to implement massive carry trade strategies, inducing large short-term speculative capital
inflows to emerging markets, which have deepened the mispricing in
local markets and increasing the risk of substantial reversals, as we have
seen recently. As you can see in Chart 6, it is remarkable the persistence
of these opportunities, and at the same time, their volatility which by a
large extent is explained by the very short term, massive capital inflows
and outflows into emerging markets.
For the management of monetary policy, an additional complicating factor has been the simultaneity through most of the period
of increasing but volatile capital flows with an underlying upward
trend in world commodity prices (Chart 7). This has presented a difficult dilemma in the management of monetary policy for emerging
markets because commodity prices have often affected inflationary
expectations which would have required higher interest rates as a response. At the same time, the massive net capital inflows that emerging markets have experienced called for lower interest rates. Several
countries have been hesitant to allow the downward adjustment of
interest rates given that inflationary expectations were high due to
commodity prices. The side effect of this reaction has been increased
capital inflows, more pressure on the exchange rate and the buildup
of potential financial instability due to the potential of larger reversals. So this has been a major problem. At the end of the day, this
problem facing emerging markets’ central banks is one of insufficient
credibility. If they had a longer record in keeping inflation in line,
and thus their commitments would be credible, probably they would
142
Agustin Carstens
Chart 6
Returns of a Three-Month Carry Trade Investment Strategy,
2010-2013
Percent
100
80
60
Chile
Mexico
40
20
0
Colombia
Turkey
-20
Korea
-40
Peru
Poland
-60
-80
Brazil
-100
Jan. 2010 Jun. 2010 Nov. 2010 Apr. 2011 Sep. 2011 Feb. 2012 Jul. 2012 Dec. 2012 May. 2013 Aug. 2013
Notes: The returns of the carry trade strategy are the percentage change in the exchange rate between periods t and
t-h (h = three months) plus the three month return of the JP Morgan Government Bond Index-Emerging Markets
(GBI-EM) for each country minus the three month T-Bill quarterly rate. These returns are annualized.
Source: Estimated by Banco de México with data from JP Morgan.
Chart 7
Commodity Prices Index
Index: Jan. 3, 2006=100
410
380
Metals
350
320
290
260
Agricultural
230
200
170
140
Energy
Total
2000
2001
2003
Source: Standard & Poor’s.
2004
2006
110
80
50
2007
2009
2010
2012
20
2013
Monetary Policy Options and Tools
143
Chart 8
Emerging Economies: Volatility of Monthly Inflation
24-Month Moving Standard Deviation*
1.0
0.9
India
0.8
0.7
0.6
Chile
0.5
0.4
Korea
Brazil
0.3
0.2
Mexico
South Africa
Colombia
Jan. 2006
Jul. 2007
Jan. 2009
Jul. 2010
Jan. 2012
0.1
0.0
Jul. 2013
*Seasonally adjusted data.
Source: Estimated by Banco de México with data from Haver Analytics.
not have faced an important impact of higher commodity prices on
inflation. All this has also resulted in an increasing volatility in inflation (Chart 8), which by the way makes it more difficult to anchor
inflation expectations through monetary policy.
Given the above, the question for emerging market economies has
been how to respond to large, potentially destabilizing capital net inflows, in an environment in which monetary policy might be facing
more than one objective (for example, financial and price stability)
and multiple challenges. I am afraid there is no overall good answer.
Orthodoxy would prescribe an adjustment in the policy mix, calling for a tighter fiscal policy stance, in combination with an easier
monetary policy. The fiscal restraint would induce a real exchange
rate depreciation, which in combination with lower interest rates,
could provide room for the resulting appreciation pressures coming
from capital inflows, and reduce the incentives for such flows. But
the problem is that this option (in particular, the fiscal tightening)
is very difficult to implement politically, more so in today’s environment in which economic growth in emerging market economies has
been slowing.
144
Agustin Carstens
Looking for other options, here is where emerging market economies (EMEs) have in a way innovated, adopting some unconventional policies, moving basically into the territory of what has been
called macroprudential policies in a broad sense. They have been
used mostly pursuant to three objectives:
To limit capital inflows, some EMEs have imposed capital controls, and they have taxed either the inflows or their returns; other
countries have demanded higher reserve requirements on commercial banks’ liabilities derived from borrowing abroad or deposits by
foreigners.
To control the impact of flows on the exchange rate, some EMEs
have relied on heavy intervention in the foreign exchange market,
accumulating large international reserves.
To prevent asset price bubbles, some countries have adjusted loan
to value for specific credits, established debt to income limits on potential borrowers, increased risk weights on some banks’ assets and/
or adopted time varying dynamic loan-loss provisioning.
It has been a good start, but the evidence is still inconclusive about
the effectiveness of such macroprudential policies. At the same time,
we need to understand better how these policies work, and establish
best practices in their implementation. In a few cases, “beggar-thyneighbor” policies were adopted under the umbrella of macroprudential policies; this is clearly unacceptable. Macroprudential policy
actions should be tailored to address well-identified distortions and
should be preferable short-lived.
To conclude, I would say that the most pressing challenge that
emerging economies are currently facing and will face in the coming
months is how to react to the implementation of the exit of unconventional monetary policies by some major central banks. Since last
May, we have seen turbulence in financial markets around the world,
once the “tapering talk” started, that is once the possibility increased
that the Fed would soon taper its asset purchases. As a result of this,
we have seen impressive capital reversals from emerging market economies’ as shown in Chart 3, a substantial upward shift in the yield
curve of several countries (Chart 9), and a sharp depreciation of their
Monetary Policy Options and Tools
145
Chart 9
Yield Curves of Selected Emerging Market Economies
Jan. 2 to Aug. 15, 2013
(percent)
Aug. 15, 2013
10 years
30 years
30 years
10 years
7 years
5 years
3 years
12
10
8
6
4
2
0
10 years
5 years
3 years
5 years
United States
Turkey
Source: Bloomberg.
5 years
30 years
20 years
10 years
5 years
3 years
8
6
4
2
0
2 years
10
12
10
8
6
4
2
0
South Africa
12
10
8
6
4
2
0
20 years
Indonesia
12
Brazil
12
10
8
6
4
2
0
2 years
30 years
20 years
10 years
5 years
3 years
Mexico
12
10
8
6
4
2
0
10 years
Rates range
146
Agustin Carstens
currencies against the U.S. dollar. Countries with relatively weaker
economic fundamentals, basically with higher fiscal and current account deficits, have been affected the most. This has come at a time
when economic growth in emerging markets has been slowing.
So what can we do to prevent the situation from getting worse, in
a way to prevent it from getting out of control? First, in advanced
economies it would be desirable for them to implement a gradual
and predictable exit from unconventional policies. Better communication by the Fed, to speak in one voice, would be very important
at this time as well. Advanced economies’ central banks should also
mind the spillover effects of their actions. Otherwise the lingering
crisis will be reactivated, but probably with new actors. In the case of
emerging market economies, they need basically to strengthen their
economic fundamentals. In particular, it is important to maintain
sovereign risk under control, to reduce inflation risk premiums and
to enhance the resilience of domestic financial institutions. In short,
they need to build up the credibility of their macroeconomic framework, assuring markets that such frameworks will be resilient enough
to withstand the removal of the favorable winds that they have enjoyed for a while in the forms of a very expansionary monetary policies in advanced economies. Many of them should consider the use
of credibility enhancement mechanisms, such as the IMF Flexible
Credit Line.
There is a very good paper that was prepared by the IMF for the
April meeting which establishes in a credible way that two-thirds of
the spread compression that took place between 2008 and early 2013
in emerging markets could be explained by external factors.1 And the
main external factor has been the unconventional monetary policies
pursued by advanced economies. Only one-third is explained by internal sources. Now that such external factors will be reverted, it is
to be expected that some decompression of spreads will take place.
Therefore the main issue is how can emerging market economies
buffer such decompression; the only answer for me is by enhancing
their internal strength through structural reforms to enhance growth.
Monetary Policy Options and Tools
147
Finally, central banks of emerging markets should be ready to perform as “market makers of last resort,” in exceptional circumstances,
mostly to smooth volatility and avoid incomplete markets which
could lead to bad market equilibria in turbulent times
148
Endnote
Global Financial Sector Report, IMF, April 2013.
1
Agustin Carstens