Monetary Policy in Emerging Markets
Questioning the Effectiveness of Monetary Policy in Emerging Markets
May 15, 2008
How does monetary policy work in emerging market countries? Does it differ from how monetary policy works in advanced economies? The central banks in emerging market countries have been confronting these questions for many years.
Now, new research from the Bank for International Settlements (BIS) may help shed some light on this important topic. The BIS has identified key mechanisms, or channels, through which a central bank’s policy objectives eventually have an impact on the economy.
Recently, the IMF's Monetary and Capital Markets Department hosted BIS economist Philip Turner, who shared the latest BIS research on monetary policy transmission with IMF Staff. Based on observations in twenty-one countries, the results—while not unexpected—offer further insights into what emerging market countries might expect over the course of the ongoing global economic slowdown.
To understand how monetary policy works in emerging markets, it is necessary to first look at what has been happening with risk premiums, incomes, the operation of the financial system, and the effects of globalization on financial markets. This is because all these factors are fundamental for the transmission channels.
- Lower risk premiums
The cyclical nature of investors’ risk tolerance—which is subject to both global and local influences—makes analysis of the impact of changing risk premiums difficult. But research suggests that risk premiums for EM assets have fallen largely because of better policy frameworks in the countries. When risk premiums are very large, some financial products simply do not exist—for example, uncertainty about future inflation rates impedes the development of markets based on long-term nominal interest rates. - Higher income Real per capita incomes have risen. Demand for financial services is sensitive to changes in income, so the financial system infrastructure comes under pressure to change as real incomes rise.
- More liberal financial system
Financial transactions have become more market-based, moving away from government-directed credit and local bank lending. This has allowed a more liberal financial system—ones that resemble those in industrial countries—to emerge. - Globalization of financial markets
Domestic financial markets have become more open to international influences. The relationship between the interest rates at different maturities, or the yield curve, in local markets is now more closely linked to those in foreign markets than in the past.
Also important is the restructuring of balance sheets that has occurred in recent years, given that size and structure of balance sheets heavily affects the transmission mechanisms. Among the significant developments are the burgeoning balance sheets of EME central banks, whose reserves now exceed $5 trillion; an increase in the size of household bank debt, which has been necessary to finance the much higher value of housing; the expansion of bank credit resulting from the increased volume of liquid bank assets as well as substantial capital gains accruing to banks as a result of falling bond yields; and falling corporate leverage ratios combined with improved access to global capital markets (which may have reduced the responsiveness of business investment to changes in domestic interest rates).
The BIS research focuses on five channels of transmission and examines how they have changed within the context of broad developments affecting not only the EMEs, but global financial markets as well.
Interest channel (short-term rates)
As financial systems have liberalized, the price mechanism has taken on more importance in the allocation of bank credit. As a consequence, the pass-through for policy rates to bank lending and deposit rates has increased. At the same time, with the advent of lower risk premiums, volatile risk premiums—which in the past had been brought on by high inflation—no longer dominate the pricing of debt. Now, when rates on bank loans are lowered, aggregate demand is influenced directly via increased demand for consumer goods and business investment, but also indirectly—and increasingly so—via asset prices. However, it is not yet entirely clear whether short-term or long-term rates have the greater effect on asset prices.
One drawback to the increased pass-through is that those central banks in EMEs that are concerned about increased capital inflows fuelling currency appreciation may be more reluctant to increase policy rates to address inflation threats than are central banks in industrial countries.
Long-term interest rates and asset prices
Since the mid-1990s, a radical change in many EMEs has been the development of long-term market-determined interest rates as bond markets have developed. Perhaps the only consensus regarding the, rather complex, link between local monetary policy and long-term interest rates in EMEs is that there is no clear consensus. Yet at a recent BIS meeting, the sense was that changes in policy rates did lead to a change in long-term rates in the same direction, but with the acknowledgement that such an effect had often proved to be temporary.
Another important question concerns asset prices, which are influenced not only by short-term rates (and therefore subject to monetary policy decisions), but also by long-term rates. Of course, the present value of any asset is inversely related to the long-term interest rate, but disentangling the relative roles of short- and long-term rates is a delicate matter. Central banks will need to form a view on how far changes in policy rates affect asset prices—both directly and via any influence on long-term rates. They will also need to measure the impact of higher asset prices on wealth, on the market value of firms in relation to the replacement cost of capital, and on the value of capital for borrowing. One plausible conclusion is that asset price movements in general reflect real—rather than monetary—factors, notably changing assessments about the uncertain prospects of investment. In this case, monetary policy should not attempt to impede the big increases in real asset prices that are justified by fundamentals.
Exchange rate channel
Better monetary policies and more effective inflation control in EMEs have reduced the earlier dominance of the exchange rate in the formation of inflation expectations. In this sense, the exchange rate channel has been weakened. However, now there is more predictability about what exchange rates will do when interest rates change. On the other hand, some studies have found that exchange rate pass-through to domestic prices has actually declined—a finding at odds with the intuitive idea that increased globalization should have led to an increase.
Bank lending channel
This channel exists when the supply of bank credit is rationed through non-price mechanisms. It has been important when banks are subject to restrictions such as credit controls or directed credit programs. In many countries—China and India being notable exceptions—the importance of bank credit has declined although it remains more important than in industrial countries.
Generally, there is likely to be a bank credit channel whenever shocks lead to a shift in bank supply of credit—even when policy rates are constant. For EMEs as a whole, there is strong statistical evidence that bank credit has a significant effect on investment.
Expectations channel
This channel is usually seen as key for the workings of monetary policy. The greater credibility of central banks throughout EMEs has made the expectations channel more important. Credibility has helped to better anchor inflation expectations, which allows central banks to be less aggressive in raising interest rates when headline inflation rises. This greater flexibility could play an important role in the current context of very large increases in food prices.
The reaction of financial markets to central bank policy announcements is also important to watch. As financial markets come to better anticipate central bank policy, some of the impact of expected future policy rate changes is brought forward. This affords the central banks greater flexibility in reducing the size of policy rate adjustments. As money market and bond rates move in anticipation of policy rate changes, the markets, in effect, do some of the central bank’s work.
Final Observations
Analyzing the developments over the past decade, monetary transmission mechanisms have in general tended to converge with those in the main industrial countries. Of the differences that do remain, three are important:
• Large weight of food in the consumption basket. Because food has a large weight in the consumption basket, the impact on headline inflation in EMEs has been much greater than in industrial countries. Monetary policy at the country level has virtually no influence on the global rise in food prices. If policy rates are raised by a larger amount in low-income countries (where headline inflation is most inflated by higher food prices) than in high-income countries, then the exchange rates of low-income countries would tend to appreciate relative to those of high-income countries.
• Many EMEs do not accept the market exchange rate. Over the past few years, several major EMEs have intervened in foreign exchange markets on a massive scale to resist currency appreciation. As part of this policy orientation, the interest rate channel could become blocked in a tightening direction. In addition the large expansion in banks’ balance sheets associated with intervention could well make the bank lending channel more potent.
• Very short history of markets for long-term interest rates. In EMEs local currency debt markets originated only recently, and therefore, there is less history to serve as a moderating force. These markets are also still comparatively illiquid and potentially subject to a lot of volatility. Moreover, the links of these new markets with global and local monetary policies are not well understood. The interpretation of asset prices is also difficult—but greater wealth and increased borrowing possibilities have probably made this transmission mechanism more important.
Monetary policy transmission mechanisms are heavily dependent on the structure of the financial system. Yet many gaps remain in understanding the links between monetary policy, the local financial system, and international markets. Central banks will need to continue with research to better understand transmission mechanisms as the financial system continues to evolve.