MACROECONOMIC CHALLENGES IN FRONTIER AND EMERGING MARKET

ECONOMIES José De Gregorio

Universidad de ChilePeterson Institute for International Economics

March 2015

Agenda

1. Capital Flows Management and Macroeconomic Policies– Some conceptual and practical issues– Macroeconomic policies– The Chilean experience

2. Frontier and Emerging Market Economies and the Withdraw of the Stimulus in the US

3. Macroeconomic Policies and Commodity Prices4. Concluding remarks

1. MANAGING CAPITAL FLOWS AND MACROECONOMIC POLICIES

Why we care about capital flows? In particular massive inflows. Three main reasons

• They may create financial vulnerabilities making the financial system more prone to sudden stops, credit booms, and financial crisis.

• They may induce excessive exchange rate appreciation, resulting in some form of Dutch disease

• They can make the economy too sensitive to the global credit cycle (produced in the centre economies) reducing the ability to conduct independent monetary policy. “Trilemma versus dilemma”

On financial liberalization and regulation (Financial stability)• What come first: domestic or international financial liberalization.

First to have a strong domestic financial system. In capital markets important to have a large basis of domestic savers. They are less subject to run to safe heavens and more home bias (institutional investors).

• The composition of flows matter: FDI then Portfolio then Credit.• The perils of cross-border credit flows have to be handled

properly:– Do not allow foreign denominated debt, in particular in the non-tradables

sector (mortgages in emerging Europe).– How to treat foreign banks operating locally: it is preferable subsidiaries

over branches. Responsibility at the local level with constraints in operations with mother company.

– Equal treatment to local and foreign banks.– Be careful with public banks. They may be helpful, but also a source of

fragilities when operations and more politicized than technical.

On macroeconomic policies

• First of all a flexible exchange rate is the first line of defense for capital inflows. The increased valuation of domestic assets should temper inflows. Sustaining, or attempting to, an artificially weak currency may encourage inflows, specially when interest rates are high.

• This does not prevent from intervening to avoid extreme misalignments. Intervention allows to have a strong position of international liquidity. Having reserves is key to avoid extreme exchange rate volatility and acts as a deterrent of speculation against the home currency.

• How to avoid fear of floating? Currency-mismatches and credible low inflation reduces the pass-through from exchange rates to prices.

Detour on Latin America performance in different crisesGDP in three recessions: The debt crisis – the Asian crisis and the Global Financial crisis (index two years before the crisis=100)

1980 1981 1982 1983 1984 1985 1986 198790

100

110

120

130

140

150Latin America

Emerging Asia

Advanced Economies

1996 1997 1998 1999 2000 2001 2002 200390

100

110

120

130

140Latin AmericaEmerging AsiaAdvanced Economies

2007 2008 2009 2010 2011 2012 2013(f)90

100

110

120

130

140Latin AmericaEmerging AsiaAdvanced Economies

Flexibility was key: Exchange Rates during the Asian and the Global Financial Crisis (domestic currency per USD, period average=100)

Source: Bloomberg. Figures in brackets indicates depreciation from bottom to top. An increase indicates a depreciation of the currency.

01/9

802

/98

03/9

804

/98

05/9

806

/98

07/9

808

/98

09/9

810

/98

11/9

812

/98

01/9

902

/99

03/9

904

/99

05/9

906

/99

07/9

909

/99

10/9

911

/99

12/9

9

70

80

90

100

110

120

130

140

150Chile (25)Brazil (93)Mexico (32)Colombia (56)

01/0

802

/08

03/0

804

/08

05/0

806

/08

07/0

808

/08

09/0

810

/08

11/0

812

/08

01/0

902

/09

03/0

904

/09

05/0

906

/09

07/0

909

/09

10/0

911

/09

12/0

9

70

80

90

100

110

120

130

140

150Chile (59)Brazil (61)Mexico (58)Colombia (58)

On macroeconomic policies

• What is the effect of exchange rate flexibility on inflows? They reduce incentives for speculative capital as risks are higher. Short tem inflows, and portfolio, could be the ones that have the largest effects on the real exchange rate (Combes et al., 2012).

• A credible low inflation rate regime should help to mitigate the inflationary effects of inflows and exchange rate volatility.

• Fiscal policy must be supportive. Excess expenditure, financed externally, may have greater effects on the real exchange rate. Countercyclical fiscal policy is advisable.

Capital controls

• Many reasons to justify capital controls. Avoid appreciation of the exchange rate and affect volume and composition of flows.

• But, empirical evidence: small effects if any at all.• Capital controls are in general applied only to “volatile and speculative

flows,” but sectors that are not subject to controls can do arbitrage, in particular when profits from carry trade are significant.

• Large corporations can borrow in international capital markets and then behave as surrogate financial intermediaries (shadow banks). This has happened in some Asian countries with controls, but not in the US (Shin and Zhao, 2013), and Brazil, but not Chile (Caballero et al. 2014).

• FDI can also become a surrogate financial intermediary by increasing the initial committed investment, or by anticipating flows and leave them deposited in the domestic financial market.

Capital controls or prudential policies? Summing up

• Most emerging markets weathered the financial crisis successfully, with unprecedented performance and use of appropriate macro policies.

• No example of a single country that succeeded because had capital controls.

• But, unfettered financial markets is unwise. After many crisis, financial markets in emerging markets are quite conservative, heavily regulated, and hence, more resilient.

Chile: Real Exchange Rate (1986=100)

Source: Banco Central de Chile. 1986

19871988

19891990

19911992

19931994

19951996

19971998

19992000

20012002

20032004

20052006

20072008

20092010

20112012

20132014

60

70

80

90

100

110

120

Chile: Real Exchange Rate (1986=100)

Source: Banco Central de Chile. 1986

19871988

19891990

19911992

19931994

19951996

19971998

19992000

20012002

20032004

20052006

20072008

20092010

20112012

20132014

60

70

80

90

100

110

120

• Capital controls• Exchange rate band• Reserve accumulation• Very high interest rate

• No capital controls• Flexible exchange rate• Inflation target• Interventions in 2008 and 2011• Very high commodity prices

Chile: Copper Price and Current Account19

9019

9119

9219

9319

9419

9519

9619

9719

9819

9920

0020

0120

0220

0320

0420

0520

0620

0720

0820

0920

1020

1120

1220

1320

14

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

-6

-4

-2

0

2

4

6Current Account (right axis)

Copper Price (left)

Dol

lars

of 2

014

per p

ound

Perc

ent o

f GD

P

Source: Central Bank of Chile and WEO-IMF database.

Chile: Real Monetary Policy Rates

(*) Estimation of the of the real MPR, calculated as the nominal MPR minus CPI inflation for the U.S from January 1992 to February 2011. CBC used a real MPR up to August 2001. From that date onwards the real rate is calculated as the nominal MPR minus CPI inflation. For the U.S. figure for March 2011 based on Bloomberg median consensus market survey. For Chile, figure for April 2011 shows the CPI estimated in April’s Economic Expectations Survey. Sources: Central Bank of Chile and Bloomberg.

-4

-2

0

2

4

6

8

10

12

92 94 96 98 00 02 04 06 08 10

-4

-2

0

2

4

6

8

10

12

United StatesChile

2. US TIGTHENING AND IMPLICATIONS FOR FRONTIER AND EMERGING MARKET ECONOMIES

The Issues

• Global implications– Increase in long-term rates– Weak commodity prices– Reduced flows available for FE and EMEs

• Policy implications and challenges

On Monetary Policy Independence

• There has been recent work pointing to the inability of small open economies to have independent monetary policy regardless the exchange rate regime (Rey, 2013). The trilemma becomes a dilemma. Credit and financial shocks in the center economy (US) transmit to the global economy and no monetary policy would be available for economies financially integrated.

• I already mention the role of flexible exchange rate in the crisis. • In addition, Obstfeld (2014) shows that indeed countries with flexible

exchange rate are less affected by global financial shocks, but are not completely insulated.

• After tapering tantrum interest rates increased, but exchange rates depreciated, which is expected to happen.

• Role of foreign investors in domestic capital markets. They may add volatility

Source:Bloomberg

Expected Timing of First Fed Rate HikeJa

n-13

Jan-

13Fe

b-13

Feb-

13M

ar-1

3M

ar-1

3Ap

r-13

May

-13

May

-13

Jun-

13Ju

n-13

Jul-1

3Ju

l-13

Aug-

13Au

g-13

Sep-

13O

ct-1

3O

ct-1

3N

ov-1

3N

ov-1

3D

ec-1

3D

ec-1

3Ja

n-14

Jan-

14Fe

b-14

Mar

-14

Mar

-14

Apr-

14Ap

r-14

May

-14

May

-14

Jun-

14Ju

n-14

Jul-1

4Au

g-14

Aug-

14Se

p-14

Sep-

14O

ct-1

4O

ct-1

4N

ov-1

4N

ov-1

4D

ec-1

4Ja

n-15

Jan-

15Fe

b-15

Jul-14

Sep-14

Nov-14

Dec-14

Feb-15

Apr-15

May-15

Jul-15

Sep-15

Oct-15

Dec-15

Expected Month of the First Fed Hike

Change in interest rates and depreciation after tapering (may 2013-November 2013)

-0.5 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0-10

-5

0

5

10

15

20

14.5394916643892

19.9139079635134

6.46260754467246.46923170287656

-5.0756422880673

6.5304755525787 5.975087582717

2.26631650617645

-2.91246250340876

4.22607345765019

7.07905314872718.88261483331523

US

Change in 5Y Govt. Bonds (local currency) Interest Rates (percentage points)

Depr

ecia

tion

of th

e ex

chan

ge ra

te (%

)

Source: Bloomberg

Foreign participation in local bonds market (% of GDP): Redemption

Peru

maly

sia

Hungary

Pola

nd

Mexi

co

South

Afr

ica

Indonesi

a

Rom

ania

Turk

ey

Bra

zil

Thaila

nd

Com

obia

Chile

0

15

30

45

60

Source: central Bank of Chile based on IMF and World Bank data, first quarter 2012.

3. MACROECONOMIC POLICIES AND COMMODITY PRICES

The commodity price boom and the end of the super-cycle

• Commodity prices has responded mostly to demand and supply factors. Some minor effects premium from investment funds.

• Baseline: with strong dollar, relatively less strong China and emerging markets, commodity prices in the medium term will stay weak and probably weaken further.

• This will result in relatively weaker currencies in commodity exporters.

The commodity price boom and the end of the super-cycle

• The most important macroeconomic implication is regarding fiscal policy:– The rule is save the windfalls to spend it when prices are low. Accumulate in the

boom according to some long-term rule, based on long-term prices.– For the time being it is safer to plan with weak commodity prices. Too difficult to

forecast, and future prices are not good predictors, specially they do not capture turning points.

– Still there is scope for medium term investment as commodities will always be demanded. FDI

– In the fiscal front: time to eliminate subsidies on fuel and this should help to ameliorate fiscal impact.

• Flexible or pseudo-flexible exchange rate. Allow for currency depreciation, this should help competitiveness and external adjustment.

• Let´s review the facts.

Commodity Prices(index average period =100)

Source: Bloomberg. Food is the average of wheat, maize, sugar, coffee and soybean.

Dec

-99

Dec

-00

Dec

-01

Dec

-02

Dec

-03

Dec

-04

Dec

-05

Dec

-06

Dec

-07

Dec

-08

Dec

-09

Dec

-10

Dec

-11

Dec

-12

Dec

-13

Dec

-14

0

50

100

150

200

250

Copper

Oil

AFood

Commodity prices, average 2011-13=10001

/14

01/1

401

/14

02/1

402

/14

02/1

403

/14

03/1

404

/14

04/1

404

/14

05/1

405

/14

05/1

406

/14

06/1

406

/14

07/1

407

/14

07/1

408

/14

08/1

409

/14

09/1

409

/14

10/1

410

/14

10/1

411

/14

11/1

411

/14

12/1

412

/14

01/1

501

/15

01/1

502

/15

02/1

5

40

50

60

70

80

90

100

110

120

CoffeeCopperOilSoybeanIron Ore

Source: Bloomberg

Issues for monetary policy under flexible inflation target• What are the implications of commodity price shocks

(CPS) on monetary policy? • Should monetary policy target core inflation (CI) or

headline inflation (HI)? • What is the role of CI on monetary policy? • What can we learn from recent evidence? • How strong is the transmission from energy and food

inflation to core inflation (second round effects)?

Target should be in terms of headline inflation• Easy to communicate. • There is a need of consistency with other price indices used

for other policy purposes (Bank of Korea). This could also be the case of minimum and public sector wages

• Using core inflation may induce volatility in expected headline inflation, relevant for wage setting.

• The original idea for targeting core inflation: exclude highly volatile products, subject to shocks that have very short duration. It is not clearly the recent case of food and energy.

• Still CI is a good predictor of inflationary pressures.

Commodity prices and monetary policy: How should MP react to CPS?• Consider a negative CPS

– Direct effects on inflation and inflationary pressures. Loosen MP– Increases full employment output (energy). Loosen MP– Demand shock. For commodity exporters decline-> loosen, for non

commodity exporters positive income effect: tighten

• Effects on expected inflation, should decline.• Transitory shocks should be absorbed within the time horizon

of the IT• Open economy effects: exchange rate changes depend on

whether the country is net exporter o importer of commodities.• Dynamic second round effects impact optimal reaction of MP.• But a negative inflation due to a fall in commodity price fall is

not deflationary spiral.

Empirical evidence on headline and core inflation

• A 10 percent increase in oil prices raises headline inflation by about 1 to 1.4 percentage point. A 10 percent increase in food inflation raises headline inflation by about 2.5 percentage points.

• During the first episode of the boom food inflation affected core inflation. At least half of the increase in headline inflation would be due to propagation from food to core inflation. The output gap is only significant in episode 1.

• There is some evidence, somewhat puzzling, that economies with less restrictions to foreign trade had less inflation during episode 1.

• In addition, more variability of inflation before the episodes, as a crude measure of credibility-performance of monetary policy, resulted in higher inflation.

Refs: Pistelli and Riquelme (2010) and Pedersen (2011).

4. CONCLUDING REMARKS

• Realistic exchange rate is essential, if it floats it is better.• Deep and well regulated financial systems are

necessary to be resilient, but also a big basis of domestic savings is useful to provide greater stability.

• Strong fiscal policy and credible monetary policy. Particularly important is to build buffers for commodity price fluctuations.

• Current conditions in Frontier commodity exporter economies to absorb inflows are less strenuous as low commodity prices weakens the currency and economic activity, so less risk of excessive appreciation and activity boom, but also less incentives to invest.