Monetary Challenges in Emerging Markets

Guillermo Calvo Columbia University

Biennial Conference 2016, South African Reserve Bank, October 27-28.

•  EMs  cannot  issue  Reserve  Currencies,  •  which  forces  them  to  painful  adjustment  if  subject  to  large  cut  in  capital  inflows  (Sudden  Stop).  

•  Sudden  Stops  are  the  Damocles’  sword  of  EMs,  

•  and  have  become  more  frequent  as  a  result  of  Financial  GlobalizaGon.  

•  Crises:  Tequila  (1994/5),  Asia/Russia  (1997/8),  Dotcom  (2001/2),  Lehman  (2008)  ...  

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(EMBI sovereign spread & Current Account Balance in EMs, millions of USD, last four quarters)

External Financial Conditions for EMs

Note: Includes Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Slovak Republic, South Africa, Thailand, Turkey and Venezuela.

Cur

rent

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I spr

ead

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Tequila Crisis

Russian Crisis

Asian Crisis

Systemic  Crises  •  These  crises  have  been  systemic  and  costly.  •  From  the  perspecGve  of  most  individual  EMs,  these  crises  stem  from  external  factors.  

•  The  importance  of  external  factors  in  LaGn  America  has  been  widely  documented.  

•  This  does  not  imply  that  EMs  can  do  nothing  to  assuage  the  impact  of  these  crises.  

•  Research  and  policy  experience  show  that  EMs  can  resort  to  a  variety  of  effec6ve—but  not  fully  effec6ve—precau6onary  measures.  

Research  Findings  

•  Systemic  crises  have  a  large  random  component,  which  is  due  to  the  existence  of  self-­‐fulfilling  prophesies.  (Will  Brexit  give  rise  to    systemic  crisis?)  

•  However,  we  have  found  some  robust  regulariGes  linking  the  probability  of  SS  for  individual  economies  condiGonal  on  systemic  crisis.  

SS  condi6onal  on  Systemic  Crisis  

Calvo,  Izquierdo,  Mejía  (2008  revised  in  Calvo  2016)  claims  that  the  probability  of  SS  for  an  individual  country  increases  as  a  funcGon  of:  •  Current  Account  Deficit  •  Mismatch  of  currency  denominaGon  between  LiabiliGes  and  Assets,  especially  if  the  mismatch  takes  place  in  the  domesGc  banking  system  (labeled  DLD,  DomesGc  Liability  DollarizaGon).  

Interna6onal  Reserves  •  DLD  implies  that  the  probability  of  condiGonal  SS  declines  with  the  stock  of  InternaGonal  Reserves.  

•  This  is  discussed  in  Calvo,  Izquierdo,  Loo-­‐Kung  (2013).  

•  This  methodology  suggests  that  South  Africa  exhibited  a  shorcall  of  InternaGonal  Reserves  in  2010.  

•  Issue  seems  to  persist.    The  2016  ArGcle  IV  states:  “Directors  encouraged  authoriGes  to  seize  opportuniGes  to  increase  reserves.”  

Interna6onal  Reserves  

Source:  Calvo,  Izquierdo,  Loo-­‐Kung,  “OpGmal  Holdings  of  InternaGonal  Reserves:  Self-­‐  Insurance  Against  Sudden  Stop,”  Monetaria,  CEMLA,  Jan-­‐June  2013.  

Floa6ng  and  Reserves  •  Why  should  “floaters”  hold  IReserves?  •  A  key  reason  is  that  Interna6onal  transac6ons  must  be  seCled  in  terms  of  reserve-­‐currency  liquid  instruments  (USD,  €,  ¥).  

•  Absence  of  IReserves  may  exacerbate  exchange  rate  vola6lity,  and  seriously  interfere  with  financial  transac6ons  and  trade.  

•  This  helps  to  explain  why  Calvo  et  al  (2013)  empirical  results  show  that  “floa6ng”  has  no  impact  on  op6mal  IReserves  holding.  

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SPAIN ITALY

start of subprime crisis---->

Current  Account  (%  of  GDP)  Accelera,on  before  Crisis!!  

Source: WEO, IMF, April 2011

Emerging  Markets:  AcceleraGon  and    BidirecGonal  Flows  

LAC 7: INVESTMENT (LAC-7, s.a. Investment, 1998.II=100)

Annualized growth: 10.6% 2002.IV-2004.III

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Russian Crisis

Annualized growth: 7.4% 1990.I-1998-II

Annualized growth: - 4.1% 1998.II-2002-IV

Annualized growth: 5.5% 2002.IV-2004.III

LAC 7: GROWTH (LAC-7, s.a. GDP, 1998.II=100)

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Russian Crisis

Annualized growth: 4.4% 1990.I-1998.II Annualized growth: 0.2%

1998.II-2002.IV

•  In  1998,  EMs  were  len  on  their  own.  •  No  internaGonal  Lender  of  Last  of  Resort,  LOLR,  came  to  their  rescue.  

•  In  contrast,  in  the  Lehman  episode  the  Fed,  BOE,  ECB,  BOJ,  went  out  in  force.  

•  These  natural  experiments  suggest  that  there  is  an  important  role  for  a  Global  LOLR  in  shielding  EMs  from  Systemic  Sudden  Stop.  

TED Spread

17 Source: Bloomberg

External Financial Conditions for EMs (daily data, EMBI+, bps, last value 22-Nov-10)

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Greenspan’s “conundrum” testimony

Source: Datastream.

Pre-Asian Crisis Spread

Pre-Asian Crisis Yield

ENRON Effect

Spreads

Yields

Beginning of improvement in international financial conditions

Fears of FED tightening

Δ=-43%

Lehman Brothers files for bankruptcy

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04 0

500

1000

1500

2000

2500

(EMBI sovereign spread & Current Account Balance in EMs, millions of USD, last four quarters)

External Financial Conditions for EMs

Note: Includes Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Slovak Republic, South Africa, Thailand, Turkey and Venezuela.

Cur

rent

Acc

ount

(mill

ions

of U

SD)

EMB

I spr

ead

(bas

is p

oint

s)

Tequila Crisis

Russian Crisis

Asian Crisis

Advanced  Economies:  Running  out  of  Ammo?  

•  Advanced  economies,  AEs,  are  slowly  and  hesitantly  coming  out  of  recession.  

•  DeflaGon  is  a  constant  threat.  •  Credit  Sudden  Stop  has  been  and  s6ll  is  a  major  factor  in  AEs  slump.  

•  But  AE  central  banks  keep  pulling  at  the  usual  levers,    – now  with  a  trembling  hand  because  QE  and  negaGve  interest  rates  are  “unconvenGonal”,  although  for  me  they  look  more  of  the  same.  

   Eurozone:  Credit  Flow  Sudden  Stop  

Great  Recession  

Note:  Credit  Flow  to  Private  Non-­‐Financial  Sector  as  share  of  GDP,  %.  

   USA:  Credit  Flow  Sudden  Stop  

Note:  Credit  Flow  to  Private  Non-­‐Financial  Sector  as  share  of  GDP,  %.  

Great  Recession  

HERE  IS  WHERE  CENTRAL  PROBLEM  LIES  !!  

EMs  and  AE  Low  Interest  Rates  

•  The  iniGal  easy-­‐money  AE  policy  helped  quick  recovery  in  EMs.  

•  However,  low  AE  interest  rates  are  a  concern,  especially  as  the  US  seems  on  its  way  to  keep  raising  the  Federal  Funds  rate.  

•  The  2013  “Taper  Tantrum”  is  a  natural  experiment  that  suggests  that  further  hike  of  Fed  rates  may  wreak  chaos  in  EMs.  

MACROPRU  •  Given  these  condiGons,  IReserves  acquires  further  relevance.  

•  But,  in  addiGon,  the  government  should  go  through  “crisis  drills”  to  ensure  effec6ve  use  of  IReserves,  and  not  become  just  outlets  for  Capital  Flight.  

•  Keep  an  eye  on  banks’  wholesale  funding,  and  non-­‐bank  intermediaries  (e.g.,  auto  retailers).  – The  associated  liabiliGes  are  much  quicker  to  suffer  a  run  than  convenGonal  bank  deposits.  

EM  Monetary  Policy  

•  There  are  pracGcally  no  “pure  floaters.”  •  Not  even  the  US  or  EU  are  pure  floaters  if  you  take  into  account  Currency  Swaps.  

•  The  USD  is  the  Sun.    All  other  currencies  are  satellites.  

•  Especially  EM  currencies.  •  Therefore,  EM  central  banks  keep  a  close  eye  to  the  USD  exchange  rate.  

•  In  the  1980s  and  1980s,  Exchange  Rate  Based  StabilizaGon  programs  were  in  vogue,  but  many  failed.  

•  Nowadays,  InflaGon  TargeGng  is  in  vogue,  and  it  may  be  berer  because  E  has  a  weak  link  with  the  P,  which  is  more  relevant  than  E  for  wage  negoGaGons.  

•  The  instrument  of  choice  is  i.    •  However,  i  has  a  weak  link  with  P  if:  

– domesGc  capital  market  is  shallow  – credibility  is  low.  

•  Unfortunately,  the  larer  may  give  rise  to  unwanted  effects  (unemployment,  appreciaGon  of  the  real  exchange  rate),  and  undermine  credibility.  

•  Thus,  it  is  common  for  central  banks  to  resort  to  exchange  rate  interven6on  when  the  laCer  gets  off  track,  even  in  absence  of  terms-­‐of-­‐trade  shocks  menGoned  at  the  start.  

•  Borom  Line:  Dirty  floa6ng  dominates,  which,  among  other  things,  militates  against  trade  among  EMs.  

Monetary Challenges in Emerging Markets

Guillermo Calvo Columbia University

Biennial Conference 2016, South African Reserve Bank, October 27-28.

Infl  Target  with  i  –  Low  Credibility  

Source:  Calvo,  NBER  WP  13177,  June  2007.      

unemployment,  currency  apprecia6on  and  rising  infla6on  

References  •  Calvo,  G.,  2016,  “From  Chronic  InflaGon  to  Chronic  DeflaGon:  Focusing  on  ExpectaGons  and  Liquidity  Disarray  Since  WWII,”  NBER  Working  Paper  22535.  

•  Calvo,  G.,  2016,  Macroeconomics  in  Times  of  Liquidity  Crises:  Searching  for  Economic  Essen,als,  Cambridge,  MA:  MIT  Press,  forthcoming  

•  Calvo,  G.,  A.  Izquierdo,  and  L.F.  Mejia,  2008.    “Systemic  Sudden  Stops:  The  Relevance  of  Balance-­‐Sheet  Effects  and  Financial  IntegraGon,”  Credit  from  Systemic  Financial  Crisis,”  NBER  Working  Paper  No.  14026.    

•  Calvo,  G.,  A.  Izquierdo,  and  R.  Loo-­‐Kung,  2013.  “OpGmal  Holdings  of  InternaGonal  Reserves:  Self-­‐insurance  against  Sudden  Stops,”  Monetaria,  CEMLA,  January-­‐June,  pp.  1-­‐35.    Dran  version,  NBER  Working  Paper  18219,  July  2012.