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Flexible policies foster resilience

by Mario Marcel


The 2008 financial crisis pushed emerging markets centre stage in the world economy. While a few had been closing the gap with advanced economies for some time, during the financial crisis, emerging markets not only exhibited considerable resilience but, in a few cases, undertook expansionary policies that helped mitigate its impact.

In the case of Latin America, the financial crisis was the first occasion so many countries behaved in a countercyclical manner, increasing their resilience in the face of a major external shock. As the cycle moved on, it became clear that many emerging markets depended on robust commodities markets throughout the crisis. This meant, when the commodity super cycle ended in 2013-14, structural weaknesses in public finances, financial markets and the current account began to emerge.

Flexible policy frameworks mean emerging markets are in a better position to deal with volatility. One impending question is whether they will be able to take full advantage of a more dynamic global economy, or suffer more in the light of monetary policy normalisation in advanced economies.

Strengthened defences
In 2017 the US Federal Reserve signalled that it would begin to slim its $4.5tn balance sheet, and the European Central Bank announced it would downsize its asset purchase programmes. Unlike the market volatility exhibited during the May 2013 taper tantrum, the response of asset prices in emerging markets was relatively muted.

The main factor behind this is the set of successive upward corrections to global growth forecasts, which offset the negative effects of tighter conditions in the US and euro area. Improvements in how central banks communicate and signal their policy outlooks likewise help mitigate volatility.

The announcements by the Fed and ECB come at a time when emerging markets have improved their defences to shocks by hoarding reserves. This means they are better positioned to withstand tighter international financial conditions. Some external vulnerability metrics for emerging markets, such as gross financing needs and non-resident holdings of general government debt, have also improved. Policy frameworks are, on average, more flexible, granting exchange rates a larger role as an absorber of idiosyncratic shocks, thereby reducing the impact on the real economy.

Unforeseen responses
Some issues remain that could derail a smooth adjustment process. One is inflation volatility in advanced economies. The risk of significant deviations above or below the expected path for inflation may lead to unforeseen policy responses and engender financial market turmoil. If an unexpected shock shifts the inflation outlook upwards for advanced economies, policy-makers are likely to respond with an even steeper tightening path.

Alternatively, advanced economy central banks may maintain too loose a policy for too long, further fuelling asset prices and exacerbating financial stability risks in the long run.

Another risk factor to monitor carefully is the possibility of additional upward corrections to longer-term premiums. Even though central banks effectively determine short-term rates, longer-term yields appear to be influenced by spillovers from highly expansionary monetary policy across advanced economies. In this context, expansionary policy in other advanced economies may be maintaining longer-term US rates at a low level, despite rising shorter-term rates. If central banks in advanced economies concurrently adopt tighter policies, financial markets could face the risk of a generalised snap-back in longer-term yields.

The final issue emerging markets must follow carefully is the relationship between tighter monetary policy in advanced economies, commodity prices and exchange rates. Monetary tightening could support a country’s currency, but at the cost of curbing economic activity, while loose monetary policy could exacerbate feedback loops.

Mario Marcel is Governor of the Banco Central de Chile.