BIS economists warn of emerging market policy dilemma

Emerging markets are increasingly finding the fate of their economies linked to movements in advanced-economy monetary policy, creating complicated policy trade-offs, research published today (August 7) by the Bank for International Settlements (BIS) warns.

The working paper presents the research of Jhuvesh Sobrun, an economist with the BIS, and Philip Turner, the deputy head of the BIS's monetary and economic department.

The authors dig deeper into questions discussed in the BIS's annual report relating to policy spillovers. They describe a mechanism whereby declining long-run interest rates, driven down by quantitative easing (QE) and other factors, pushes investors to buy emerging market bonds.

This has both immediate implications for financial stability, and longer-run effects, as an end to QE will affect emerging markets through "several" new channels, the authors say.

QE has had a well-documented impact on pushing down long-run interest rates in advanced economies, but the paper also points to "non-monetary" factors at play, including higher savings rates, greater demand for financial assets as populations age, increased maturity transformation by banks, and the "preferred habitat" of investors in safe, particularly dollar-denominated, assets.

This in turn has pushed investors to seek yield in emerging markets, and encouraged corporations in these countries to issue bonds denominated in foreign currencies – an estimated $1.2 trillion between 2010 and 2014.

The immediate impact has been to create larger – but "flighty" – bank deposits, and higher credit growth, while hedging by corporates has exposed banks to the risk of foreign exchange losses, heightening the need for central banks to pay attention to exchange rate moves.

Many central banks have intervened to resist currency appreciation, which is "not necessarily mercantilist", the authors say, but rather motivated by concerns over excessive borrowing that the appreciation can cause.

The problem is complicated by possible unintended consequences. Previous research has identified a link between forex purchases and rising credit to the private sector, even where interventions are sterilised.

Furthermore, the newly-created bond markets are less liquid than they appear, the BIS authors warn. "The growth of an inventive asset management industry and the spread of many bond funds redeemable daily have made many segments seem liquid to end-investors." But conditions could change suddenly.

Policy dilemmas

These forces have left emerging market economies closely tied to the monetary policy decisions of advanced economies, in particular the Federal Reserve. As the Fed reduces the size of its balance sheet, investors could start turning away from emerging markets.

This in turn is likely to raise the costs of funding for emerging market corporations, pushing some into insolvency. Faced with imperfect information about the strength of corporations, "foreign investors may react to turbulence by pulling back in an indiscriminate way", the authors say.

Emerging market central banks attempting to respond are faced with a dilemma. Either they raise rates to encourage the departing capital to stay, or they set policy on the basis of the domestic economy's needs, although those needs are clearly tied to external shocks. This is likely to take place against a background of financial instability.

"Central banks now have to take greater account of the impact of domestic policy rates on their bond markets, on the exchange rate and on their banks," the authors write.