Monetary Policy in Emerging Markets: Key Current IT Themes Leonardo Leiderman Tel-Aviv University

1

Monetary Policy in Emerging Markets:

Key Current IT Themes

Leonardo Leiderman

Tel-Aviv UniversityE-mail:lleiderman@leoleiderman.com

OECD and CCBS/Bank of England Conference, Paris, Feb. 28, 2007

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Current Global Conditions Provide Strong Support for IT in

Emerging Markets Globalization has resulted in lower

inflation rates World interest rates have remained low Rapid growth and reforms have improved

EM’s fiscal stance EM external accounts have improved Capital mobility has contributed to

monetary/fiscal policy discipline A diminishing role of political

uncertainties for market movements?

3

A Marked Decline in EM Budget Deficits (% of GDP)

0%

1%

2%

3%

4%

1999 2007

Source: WEO 9/2006, IMF. The figures correspond to the central government budget deficit of “other emerging market and developing countries.” The figure for 2007 is an IMF forecast..

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Rapid GDP Growth Helped Reduce Public Debt to GDP

Ratios (% of GDP change from end 2001 to end 2005)

-8%

-6%

-4%

-2%

0%

2%

4%

6%

Total change Primary balance GDP growth Other

Source: WEO 9/2006, IMF. “Other” includes: exchange rate and interest rate effects, the stock-flow adjustment and statistical discrepancy

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Changes in Global Risk Aversion Have Been Key for

EEM Volatility in 2006

80

90

100

110

120

130

140

30/12/2005 30/06/2006 30/12/2006

Note: index for the EEM ETF (end of 2005=100).

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The Current Account/Monetary Policy Link: Larger Currency Depreciation Under Weaker

External Accounts(Mid ’06 Episode of Global Risk Aversion)

-5%

0%

5%

10%

15%

20%

25%

-10% -5% 0% 5% 10% 15%

RUSARGISR

BRL

THACZE

PLNHUN

ROM

TUR

Current account/GDP

Cu

rren

cy d

epre

ciat

ion

10.

5.06

-22.

6.06

7

The Main Risk Ahead

Slower economic growth and weaker fundamentals could make monetary policy in emerging-market economies more vulnerable to adverse shocks.

8

An Illustration of Current IT Themes Based on Israel’s

Experience

9

-3%

-1%

1%

3%

5%

7%

1.00 1.01 1.02 1.03 1.04 1.05 1.06 1.07

0 CPI YoY Official inflation targets

Inflation Volatility has Resulted in Deviations from IT…

10

-3%

-1%

1%

3%

5%

7%

1.00 1.01 1.02 1.03 1.04 1.05 1.06 1.07

0CPI YoYOfficial inflation targets12-month break-even inflation

…Yet Inflation Expectations Have Remained Within

Targets

11

-5%

-3%

-1%

1%

3%

5%

7%

9%

11%

1.97 1.98 1.99 1.00 1.01 1.02 1.03 1.04 1.05 1.06 1.07

0CPI YoYOfficial inflation targets12-month break-even inflation

Inflation Expectations Appear Now

Less Adaptive than in the Past

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-15%

-10%

-5%

0%

5%

10%

15%

20%

1.00 1.01 1.02 1.03 1.04 1.05 1.06

CPI YoY $/NIS - YoY

Although the Pass-through has Diminished, The Nominal Exchange Rate Still has a Dominant Role in

the Transmission Mechanism

13

ILS Recent Strength Resulted from Improved Current Account

Performance…(Israel’s current account surplus)

-3.2%

-1.6%

5.2%

2.9%

-0.6%

-5.2%-5.1%

-1.2%-1.1% -1.3%

1.4%

2.6%

-7,000

-5,000

-3,000

-1,000

1,000

3,000

5,000

199519961997199819992000200120022003200420052006

-7%

-5%

-3%

-1%

1%

3%

5%

$millions %of GDP

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…as well as from USD weakness

3.8

3.9

4.0

4.1

4.2

4.3

4.4

4.5

4.6

4.7

4.8

02/01/2006 27/03/2006 19/06/2006 11/09/2006 04/12/2006

0.70

0.72

0.74

0.76

0.78

0.80

0.82

0.84

0.86

USD/ILS USD/EUR

15

-3%

-1%

1%

3%

5%

1.04 1.05 1.06

CPICore inflation (excl. housing and energy)קו 3קו 4

Should the IT Rely on Core Inflation?

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Entering New Territory for Monetary Policy: The BoI Rate is Lower than the

FedFunds Rate…

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

1.02 1.03 1.04 1.05 1.06 1.07

BoI

Fed

Bank of Israel and Federal Reserve policy rates.

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0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

2002 2003 2004 2005 2006 2007

BoI interest rate12 months break-even inflationReal - ex-ante interest rate

…Yet Ex-Ante Real Interest Rates Remain Reasonable

Source: Bank of Israel.

18

Looking Back at the 2002 Monetary/Fiscal Policy

Mistake

Inflation target: 2-3%

Actual inflation: 6.5%

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0%

2%

4%

6%

8%

10%

12%

2000.01 2001.01 2002.01 2003.01 2004.01 2005.01 2006.01 2007.01

Expected RealNominal

Policy Rate: A Surprise Move to Easy Money in 12.2001

(central bank interest rates)

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The Budget Deficit in 2002:

Revising the Target Frequently

(Ratios of Budget Deficit to GDP)

0%

1%

2%

3%

4%

5%

Target 1 4.2001 Target 212.2001

Target 3 5.2002 Actual

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4.0

4.2

4.4

4.6

4.8

5.0

1/ 1/ 01 1/ 7/ 01 1/ 1/ 02 1/ 7/ 02 1/ 1/ 03 1/ 7/ 03

Fiscal and Monetary Expansion Resulted in Rapid ILS

Depreciation Against the USDUSD/ILS

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Concluding Remarks The need for flexibility in

implementing IT in emerging-market economies…

…yet credibility is especially needed in a ‘flexible’ IT regime

The need for defining the IT horizon “over the medium term”

Less benign global conditions and weaker fundamentals could pose more difficult tradeoffs for EM monetary policies ahead