International financial spillovers: policy responses and coordination

BIS Papers No 78

International financial spillovers: policy responses

and coordination

Miguel A Pesce

1

Abstract

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

monetary issues.

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

1

Deputy Governor, Central Bank of Argentina.

88 BIS Papers No 78

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

BIS Papers No 78

89

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.

2

The

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.

3

2

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.

3

See BIS, 82nd Annual Report, June 2012, pp 45 and 47.

90 BIS Papers No 78

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

4

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

4

Among advanced economies, Switzerland provides an example of exchange rate intervention.

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certain capital inflows (financial sector and nonfinancial private sector financial

liabilities).

5

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

international reserves.

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,

6

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-

5

In response to Executive Order no 616/2005, issued by the Ministry of Economy; and Central Bank

of Argentina communication no A 4359.

6

The Federal Reserve has already begun the reduction of its large-scale asset purchase programme.

92 BIS Papers No 78

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.

7

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

7

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.

BIS Papers No 78

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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

asset bubbles.

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

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) – 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.