BIS Papers No 78
International financial spillovers: policy responses
Miguel A Pesce
The monetary and exchange rate policies of some economically significant countries
– especially those whose currencies are accepted as international reserves – have
large external effects over the rest of the countries who must take great care in
designing their domestic policies to address changes in external conditions. We
have seen in recent years that a significant portion of the financial spillovers
resulted from the impact on global risk aversion and the evolution of commodity
prices – which show a negative correlation with emerging economies (EEs)
sovereigns amplifying business cycles.
In spite of having more sensitivity to financial volatility, after the outbreak of
the subprime crisis, most (EEs), remained relatively unharmed due the
implementation of policies characterized by more flexible exchange rate regimes;
commercial surpluses; sound fiscal policies; less dependence on capital flows; more
solid financial systems; abundant levels of international reserves; and
macroprudential policies to avoid the negative impact of short-term capital flows.
That was the case of Argentina that before the 2007´s outburst implemented a
policy scheme which included a reserve requirement for short-term financial capital
flows, regulations on capital outflows and inflows and a currency-managed float
regime aimed at moderating exchange rate volatility and avoiding a leveraging
process. It also included an international reserves accumulation precautionary
policy, accompanied by an adequate sterilisation of any surplus resulting from
The recent global reversal of short-term capital flows has confirmed once again
that even when the appetite for EE risk is a function of both international (push) and
domestic (pull) factors, the former have a decisive weight. In fact, there is a strong
asymmetry between, on one hand, the spillover effects from monetary policy in
major advanced economies and, on the other, the focus strictly on domestic
fundamentals. Thus, attributing capital surges and sudden stops in EEs to internal
(pull) factors is a view that can be considered at least misleading, especially in the
case of short-term flows.
In the current scenario, monetary policy coordination between EEs and
advanced economies is essential to avoid the potentially deleterious effects of
abrupt changes in short-term flows and the potential side effects of the first stages
of tapering and should play a key role in facilitating a timely and smooth exit from
expansionary and unconventional monetary policies in order to avoid jeopardising
the global economic recovery. Capital flow reversal and greater financial and
Deputy Governor, Central Bank of Argentina.
exchange rate volatility could cause a tightening of domestic demand and thereby
affect economic activity. A good example of international coordination was seen in
2009 when, in the G20 framework, the IMF issued two rounds of Special Drawing
Rights (SDRs), and in the currency swaps agreements signed among trading
partners to enhance trade and financial cooperation.
Keywords: Central Banks and their policies, international financial policy, financial
transactions, capital controls, international policy coordination and transmission
JEL classification: E58; F38; F42
1. Effects of financial spillovers
The monetary and exchange rate policies of some economically significant countries
– especially those whose currencies are accepted as international reserves – have
large external effects. Countries experiencing those effects, and who do not issue
currency accepted as international reserve, must take great care in designing their
domestic policies to address changes in external conditions. This is the case for
most emerging economies (EEs), characterised as medium-sized economies
generally open to trade and capital flows.
In recent decades, trade openness, and the emergence of certain low-cost
manufacturing economies (primarily those of China and Southeast Asia), have had a
generally positive transmission effect on prices. By reducing costs, these countries
– aided by the buoyancy of international commerce – have helped to lower global
industrial prices, regardless of local monetary and fiscal policies. As a consequence,
increased international trade has helped to keep inflation low and to boost
international capital flows.
The literature relating to financial spillovers, policy responses to them, and the
need for international coordination is extensive. The International Monetary Fund
(IMF) has pointed out on several occasions that the results of financial spillovers
depend significantly on the nature of the policy. Direct purchases of long-term
government assets have been the main source of spillovers from the United States
and the United Kingdom, while in the euro area, bank intervention mattered.
results also suggest that a significant portion of the spillovers resulted from the
impact on global risk aversion and the evolution of commodity prices. By and large,
spillovers entailed a rise in equity prices and exchange rates, consistent with the
view that they both buoyed domestic activity and involved capital inflows.
In its 2012 Annual Report, the BIS stated that:
While prolonged monetary easing probably has only limited potency to rekindle
sustained growth in the advanced economies, its global spillover effects may be
substantial. Persistently large interest rate differentials … support capital and credit
flows to fast-growing emerging market economies and have put upward pressure on
their exchange rates. This makes it more difficult for emerging market central banks
to pursue their domestic stabilisation objectives. Interest rates have been raised only
hesitantly in response to buoyant domestic macroeconomic and financial conditions
out of concerns that this would widen interest rate differentials and further boost
capital inflows. …
The growing relevance of monetary policy spillovers suggests that central banks
need to take better account of the global implications of their actions. In a highly
globalised world, a more global monetary policy perspective is also called for to
ensure lasting price and financial stability.
See IMF, 2011 Spillover Report and 2012 Spillover Report, various issues; and IMF, Global Financial
Stability Report, April 2013, Chapter 3, “Do central bank policies since the crisis carry risks to
financial stability?”, pp 93–126. See also Tamim Bayoumi and Andrew Swiston, “Foreign
entanglements: estimating the source and size of spillovers across industrial countries”, IMF
Working Paper,no 07/182, 1 July 2007.
See BIS, 82nd Annual Report, June 2012, pp 45 and 47.
After the outbreak of the subprime crisis, the EEs, especially in Latin America,
remained relatively unharmed. This was because of several factors: more robust
fundamentals and better commodity prices and terms of trade together with more
flexible exchange rate regimes; commercial surpluses; sound fiscal policies; less
dependence on capital flows; more solid financial systems; and abundant levels of
international reserves. Indeed, a large number of countries have implemented a
currency-managed float regime
along with a policy of accumulating international
reserves. It is said that this combination generates costs associated with the
monetary sterilisation process. However, in the absence of an international lender of
last resort, it has been proven that these countries correctly chose these policies as
insurance against eventualities, since the benefits might outweigh the costs.
In particular, prior to the 2007–10 crisis, Argentina implemented a multifaceted
monetary policy scheme. It includes a reserve requirement for short-term financial
capital flows, regulations on capital outflows and inflows and a currency-managed
float regime aimed at moderating exchange rate volatility. It also includes an
international reserves accumulation precautionary policy, accompanied by the
sterilisation of any surplus resulting from monetary issues, so that it is compatible
with the liquidity needs of the economy.
The accumulation of international reserves acts as insurance when a country is
faced with temporary changes in international financial conditions. It promotes
macroeconomic stability, which has a number of important advantages – it increases
financial independence; raises confidence in the domestic currency; helps to avoid
asset bubbles; and, in some EEs, helps to reduce the impact of foreign shocks and
the cost of public and private financing. In addition, it reduces sovereign risks and
foreign financing costs, making it possible to meet external payments in times of
crisis, when such funding is non-existent or prohibitively costly.
The managed float exchange rate regime also helped to mitigate fluctuations
not associated with macroeconomic fundamentals. This is important because, in an
economy with some level of currency substitution, excessive volatility could severely
affect financial stability.
In addition, the introduction of measures to discourage short-term capital
inflows and reduce sudden outflows is an alternative way of reducing foreign
exchange market volatility in EEs. In order to diminish the negative effects of short-
term capital flows and avoid a leveraging process, Argentina since mid-2005 has
successfully taken a series of measures tending, directly or indirectly, to regulate
and discourage short-term capital flows:
New financial borrowing or trading in the domestic foreign exchange market,
as well as rollovers of residents’ nonfinancial private sector and financial sector
external liabilities, must be made and kept within the system for at least
365 consecutive days (under the earlier regulation, the term was 180 days).
These loans cannot be paid before the maturity date, regardless of the
settlement modality and whether or not it involves access to the domestic
foreign exchange market.
In response to the increasing amount of capital inflows, the Central Bank of
Argentina established a one-year interest-free deposit equivalent to 30% of
Among advanced economies, Switzerland provides an example of exchange rate intervention.
certain capital inflows (financial sector and nonfinancial private sector financial
This deposit applies basically to portfolio investments in secondary
securities markets and foreign loans allocated to investments in financial assets;
it is aimed at reducing part of the yield of local assets in order to discourage
short-term financial investments.
Furthermore, the macroprudential measures regulating capital flows
significantly limited the external risk of the Argentine economy. They were
supported by a number of other policies, such as external debt reduction with the
private sector policy and the previously mentioned prudential accumulation of
Finally, in reviewing capital flows, it is critical to differentiate foreign direct
investment (FDI) from speculative short-term capital flows. The former has a
permanent positive effect, leading to more robust economic growth with more solid
fundamentals; the latter boosts the economy only in the short term and, moreover,
increases asset volatility and weakens the local economy’s ability to withstand
external shocks. Hence, prudential regulations should be focused on deterring
speculative short-term flows without affecting those associated with FDI and import
and export financing.
2. Policy responses and coordination
Determining a country’s actual economic outlook and the relationship of that
outlook to the country’s fundamentals is the starting point for assessing the
potential effects of their chosen policies.
A key question, especially for EEs and small advanced economies, is the
relationship between short-term interest rates and exchange rates. With US
monetary conditions becoming less expansionary,
keeping the policy rate
unchanged could put upward pressure on the exchange rate. Although this may
provide some stimulus to the economy, a very sharp depreciation could be
unwelcome for reasons of both macroeconomic and financial stability. Large swings
in exchange rates could heighten financial risks in the presence of currency and
maturity mismatches, especially in EEs. Another constraint that central banks could
face is the degree of maturity transformation and, as a consequence, the credit
growth that a widening term spread could entail. In highly dollarised economies,
this effect is even more heightened.
The ability to decouple is diminished in EEs when financial deregulation is
excessive, especially when it coincides with full capital account openness and within
a framework of asymmetric financial architecture.
It is precisely the difference between advanced economies and EEs in respect to
development and depth of the financial systems in advanced economies that makes
EEs highly sensitive to financial volatility. Thus, the recent global reversal of short-
In response to Executive Order no 616/2005, issued by the Ministry of Economy; and Central Bank
of Argentina communication no A 4359.
The Federal Reserve has already begun the reduction of its large-scale asset purchase programme.
term capital flows has confirmed once again that even when the appetite for EE risk
is a function of both international (push) and domestic (pull) factors, the former
have a decisive weight. In fact, there is a strong asymmetry between, on one hand,
the spillover effects from monetary policy in major advanced economies and, on the
other, the focus strictly on domestic fundamentals. Thus, attributing capital surges
and sudden stops in EEs to internal (pull) factors is a view that can be considered at
least misleading, especially in the case of short-term flows.
From a medium-term perspective, the consolidation of EE financial instruments
as attractive assets during the past decade initially reflected a scenario of
decreasing interest rates in international markets and, until 2008, a rising appetite
for higher yields. With EEs recording high growth rates, this in turn supported a
strong rising trend in commodity prices during the period 2002–08. In fact, a recent
working paper by the Central Bank of Argentina describes a growing negative
correlation between EE sovereign spreads and commodity prices and shows that it
is mainly explained by the international financial framework.
This result poses serious challenges for commodity exporters like Argentina and
illustrates the additional dangers created by financial integration in countries with a
non-diversified export structure. In these cases, financial and commercial shocks
would tend to be positively correlated and amplify business cycles. This is so
because, first, during the upside phase of the economic cycle, commodity prices
tend to improve markedly and EE sovereign spreads tend to reduce sharply; then, in
the downside phase, EE sovereign spreads would probably increase at the precise
moment when commodity prices start to fall. However, financial markets have not
paid enough attention to the possibility that, under this framework, financial and
commercial shocks might be positively correlated, for various reasons. Among these
are a better international environment along with a general improvement in EE
macroeconomic fundamentals (a strengthened fiscal situation, better debt profiles,
increased international reserves); this leads to a perception of lower risks that allows
for a sustained increase in EE asset prices.
Rising asset prices were accompanied by increasing capital flows to EEs, led by
both FDI and a volatile contribution of portfolio flows. Even though these flows
were interrupted at the peak of the international crisis, in 2008–09, they eventually
resumed, this time with more dynamic portfolio flows in relative terms. More
significantly, portfolio flow dynamics in recent years have shown a higher
correlation with push factors, as evidenced by periods of outflows mainly related to
episodes of high volatility in international markets.
All these concerns emphasise the fact that unregulated financial openness
amplifies financial volatility in EEs. Since variables such as growth rates, employment
and GDP sector composition in these countries continue to be more sensitive to
financial volatility, it is necessary for them to establish the prudential regulation of
cross-border capital flows.
The hint in mid-May 2013 of less US monetary accommodation (tapering of
bond purchases) initiated a reversal of capital inflows, which affected mainly some
emerging market and advanced economies that were significantly dependent on
See Diego Bastourre, Jorge Carrera and Javier Ibarlucía, “Commodity prices: structural factors,
financial markets and non-linear dynamics”, Central Bank of Argentina Economic Research
Department, BCRA Paper Series, no 201050, 2010.
market-based external financing. A scenario of capital flow reversal and greater
financial and exchange rate volatility could cause a tightening of domestic demand
(reducing current account deficits) and thereby affect economic activity. The impact
would be worse for countries with fragile macroeconomic conditions and large
current account deficits.
In this scenario, a failure by some major economies to overcome the obstacles
to external financing might reduce their domestic demand and the growth rate of
the global economy. This effect would be greater now that emerging economies
have a greater weight in the global production of goods and services.
Monetary policy coordination between EEs and advanced economies is
essential to avoid the potentially deleterious effects of abrupt changes in short-term
flows and the potential side effects of the first stages of tapering. However,
coordination alone is not enough. It is also important to regulate short-term capital
flows with a special focus on avoiding carry trade flows.
When the next round of exit policies are implemented, the resulting interest
rate shock will most likely have an asymmetrical effect on EEs, since external
positions have a significant impact on borrowing conditions. Also, most EEs have
decreased their levels of foreign debt exposure over the past decade, which
significantly reduces the potential negative effects of financial shocks. Countries
with large current account deficits and low export dynamism might be severely hit
by an interest rate shock, but many other EEs, even a majority, might not be so
affected. In particular, countries with large stocks of international reserves may not
necessarily be as deeply affected by an interest rate shock. Whether they have
current account deficits or current account surpluses with low private sector
indebtedness in foreign currencies, the large stocks of international reserves will act
as a safeguard against interest rate shocks.
From the point of view of EEs, some important progress has been made.
Nonetheless, it is still very important to monitor excessive increases in current
account deficits, especially when they are the counterpart of short-term financing
and are correlated with real exchange rate increases and consumption booms or
3. Some thoughts for the next couple of years
In the short and medium term, it does not seem highly probable that there will be a
sudden reversal in credit flows attributable to an abrupt hike in interest rates. This is
because, according to the latest projections, the major advanced economies will not
raise their target interest rates at least until early 2015.
International coordination should play a key role in facilitating a timely and
smooth exit from expansionary and unconventional monetary policies in order to
avoid jeopardising the global economic recovery. Until now, EEs have been
instrumental in helping to lead the way out of the crisis, and a disorderly
deployment of exit strategies could potentially be harmful to the current level of
A good example of international coordination was seen in 2009 when, in the
G20 framework, the IMF issued two rounds of Special Drawing Rights (SDRs) – a
general allocation and a special one – for a total of SDR 161.2 billion, equivalent to
94 BIS Papers No 78
$244 billion. The issue and allocation of SDRs emerged as one of the main tools for
strengthening the financial capabilities of small and medium-sized economies,
supporting their domestic activities and expanding global demand; the result
boosted economic growth worldwide. Moreover, the issue and allocation of SDRs is
an important mean for liberating reserves from the security nets that EEs have been
building, thus freeing assets to finance production, investment and consumption, or
to reduce their debt.
This behaviour is also consistent with the IMF’s original purpose, namely that of
being an international coordinator capable of assisting its members in the event of
balance of payments crises. In this regard, to help countries that may be suffering
from sudden capital flow reversals, the IMF could consider establishing automatic
mechanisms that would help to avoid unnecessary fluctuations in these economies.
Such mechanisms could take the form of special direct credit lines, which should not
be subject to conditionality.
Another coordination mechanism that has gained importance throughout the
world is the use of currency agreements between countries, mainly to promote the
trade of goods and services in local currencies. One of the principal instruments of
such agreements is currency swaps among trading partners. China has been a key
player in promoting such arrangements, not only among its main trade and
geographical partners but around the world.
China has recently promoted the use of its currency as a monetary unit in the
world’s main financial centres, seeking to establish the renminbi on an equal footing
with the US dollar, sterling and the yen. But the conditions under which a currency
gains international stature still exist. One of those conditions is that the home
economy must be large and stable enough to absorb external shocks without
affecting the rest of the international financial system. This is a necessary condition
to avoid relinquishing the reserve currency requirement in pursuit of domestic
goals. During the last international financial crisis, some countries that were issuers
of currencies with international stature rapidly abandoned that implicit role in order
to address domestic difficulties. In some cases, this had undesirable side effects for
the rest of the international financial system. Also, an incomplete and disorderly
process of economic and financial integration could be another source of instability
for these countries’ currencies, diminishing their ability to become widely accepted
as reserve currencies and sparking instability in the global economy.