The quiet revolution of emerging market central banks

Piroska Nagy-Mohacsi Interim Director, Institute of Global Affairs, London School of Economics and Political Science

Central banking in emerging markets (EMs) has undergone a quiet revolution during the COVID pandemic. Unlike in the past, EM central banks have been able to mimic what advance country central banks are doing: counter-cyclical policies with quantitative easing (QE), asset purchases in local currency, lowering interest rates and monetising government deficits in support of their government’s crisis response. In the past such policies would have invariably led to inflation and exchange rate pressures. But not this time. Except for a few central banks in trouble already before the pandemic, EM central banks have managed to do QE, thereby increasing their countries’ policy room to flight the pandemic. The main reason for this is advance country central bank policy: spillovers from the ongoing massive advance country QEs and the expansion of currency swap arrangements. However, EMs are more vulnerable in the areas of financial stability and governance.

What has enabled QE in emerging markets? The credibility of emerging market central banks is certainly an important factor. However, in the past credibility alone never allowed EM central banks to pursue sustainable QE. The real reason for EM QE are the policies of advanced country central banks: • Positive spillovers from advanced country central bank QE; • Enlargement of currency swaps and foreign exchange repurchase (repo) operations by a few key central banks, which we can call the globally systemic central banks (GSCB): the

US Federal Reserve, the European

Central Bank (ECB) and the People’s

Bank of China (PBoC).

Advance country interest rate cuts and huge liquidity injections have spilled over to emerging markets in search of yield. After an initial market stumble in March 2020, capital flows returned to EMs. EMs could reduce their interest rates too. At the same time, EM central banks have started purchasing local currency denominated assets in markets where the market for such issuance is sufficiently large (Arslan et al, 2020).

Exchange rate pressures have been eased by the expansion of currency swaps by key central banks. Currency swap lines act as safety nets to avoid foreign currency shortages in local domestic markets. Facing the pandemic, the US Federal Reserve first reactivated currency swap arrangements with its most trusted five advance country central banks and extended the maturity of those swaps; then also extended the swaps to several, mainly advanced country, central banks.

We have seen such measures during the global financial crisis a decade ago. But this time the Fed has gone far beyond what it did then by offering a new additional temporary repo facility for foreign and international monetary authorities (FIMAs) at the end of March 2020. This allows central banks and monetary public institutions around the world to use their existing stock of U.S. treasury bills to get access to U.S. dollar liquidity with the help of the Fed. Although repos are not a genuine currency swaps – i.e., swaps between the dollar and a local currency — because the FIMAs must have U.S. dollar denominated assets as collateral to get U.S. dollar liquidity, these are still powerful for market confidence. Repos do not need to be used actually: they serve as safety nets and their mere availability can be enough to reassure markets. Moreover, repos can also be a precursor to true currency swap arrangements, as the example of ECB repo operations with Poland and Hungary showed in 2009.

The ECB and the PBoC have also expanded swaps lines and repos in their respective monetary sphere of influence since the start of the COVID crisis. Exchange rate risks in EMs have been effectively slashed as a result. As Boris Vujcic, the Governor of the Croatian National Bank recently noted, the ECB’s generous currency swap line has helped Croatia manage and then avoid foreign exchange market volatility – market participants do not wish to go against the ECB, the CNB’s proxy.

In the face of the world-wide COVID shock, the GSCBs, for the first time, have acted in crisis in a way that is commensurate with their global systemic role in international liquidity. The Fed’s monetary policy has created

global dollar financial cycles as Helene Rey pointed out already in 2013. The ECB also has its own euro “mini” financial cycles in emerging Europe. The PBoC’s share in international reserves and transactions is much smaller, but its global impact comes from the financial arrangements around China’s mammoth Belt and Road Initiative (BRI), its lending to developing countries, and its large number of currency swaps – more than 40 - with developing and EM central banks. The objective of the latter may differ the from those of the Fed or the ECB, yet it has increased the use of the RMB in bilateral trade between China and its currency swap partners (Bahaj and Reis, 2020).

Will Emerging Market QE last? This can last as long as monetary policy remains sufficiently expansionary in advanced economies. The chances for this is quite good for the coming years. Advanced country central banks have not been able, for one reason or another, to exit from QEs they created a decade ago, even after growth and employment had recovered. The Federal reserve has recently changed its mandate that will likely require continued QE for quite some time. Several central banks are formally committed to obtain maximum level of employment, as well as as keeping interest rates very low or even negative, and central bank digital currencies could make this technically relatively easy to implement. All this means that emerging market central banks are likely to continue to enjoy monetary policy spillovers from their advance country peers in the foreseeable future.

However, EMs may soon face the unintended consequences in other

areas: financial stability and governance. QE and prolonged recessions will inevitably hit the balance sheets of companies, households, and eventually of banks. Bankruptcies and non-performing loans will soar. EM countries still have much less fiscal space than their advanced country peers to deal with these problems. Governance issues will also likely surface: asset purchases by central banks beyond government papers raise concerns over the lack of transparency and accountability of the underlying process. These may become issues in advanced countries too, but their fiscal space and institutional arrangements are more robust. EM vulnerabilities are likely show up soon in the areas of domestic financial stability and governance. ◆

Note: this article was published in Project Syndicate, 18 August 2020.

Arslan, Y, Drehmann, M and Hofmann, B, Central bank bond purchases in emerging market economies, BIS Bulletin No. 20. (2020)

Avdjiev, S and Takats, E, The currency dimension of the bank lending channel in international monetary transmission, BIS Working Papers 600 (2016)

Benigno, G, Hartley, N, García-Herrero, Rebucci, A and Ribakova, E, Credible emerging market central banks could embrace quantitative easing to fight COVID-19, VoxEU (June 2020)

Bahaj, S and Reis, R, Jumpstarting an international currency, Bank of England Staff Working Paper No. 874 (June 2020)

1. Based on the author’s article in Project Syndicate, August 18, 2020

Piroska Nagy-Mohácsi is a macroeconomist and Interim Director of the Institute of Global Affairs (IGA) and its Global Policy Lab at the School of Public Policy of the London School of Economics and Political Science (LSE). Previously she was Policy Director of the European Bank for Reconstruction and Development (EBRD) overseeing strategic directions in Emerging Europe, Central Asia and North Africa as well as major policy initiatives (2008-2015); and beforehand worked in senior positions for the International Monetary Fund (IMF) (1986-2008).