Caught Between "Conventional" and Forced "Unconventional" Policymaking

Caught Between “Conventional” and Forced “Unconventional” Policy-making Manuel Balmaseda CX Economics

Eighth Annual Rocky Mountain Economic Summit Jackson Hole, July 2016

Tapering: costless strategy?

A difficult Fed exit, nothing new Monetary policy normalization will have costs regardless the way it is implemented Oct. 13

1) Disorderly exit

2) Too late/too soon exit

Long term inflation expectations disanchoring

Permanent vs. transitory effect of financial crisis on potential growth • Sunk costs: Fixed income bubble?

Any other bubbles?

3) Right in time exit

• Coordinated or uncoordinated (first mover disadvantage) • Inefficient allocation of resources • Impact on EMs -2-

19

Central Banks: from “lenders of last resort” to “buyers of first resort” Central banks’ balance sheets Billions USD, EUR 5.0 4.5 4.0 3.5 3.0

(assets) Trillions JPY 500

FED

BOJ

20%

450 400

64%

(right axis)

1.5

350 300 250

2.5

17%

2.0

ECB

• Unusually dominant role of central banks in financial markets in recent years

200 150

1.0

100

0.5

50

0.0

0

• Potential build-up of financial imbalances in the form of excessive risk-taking and growing indebtedness since the crisis • Possible overvaluation of assets • Risk of unleashing a chain reaction of financial instability?

Source: FED, ECB and BoJ

Unwinding of extraordinary lax policies may be complex and risky in terms of price and financial stability Fed: FIFO -3-

Central Banks: At different stages of monetary easing Short-term rates (%) 0.6

• US, when will it raise rates again?

Fed Funds 0.4

• Euro Area and Japan, will they ease further?

0.2

• Divergent monetary policies in a highly economically and financially integrated world?

0 -0.2

• Volatility of capital flows and uncertainty about the implications for exchange and interest rates

3m Euribor

-0.4

Feb-18

Nov-17

Aug-17

May-17

Feb-17

Nov-16

Aug-16

May-16

Feb-16

Nov-15

Aug-15

May-15

Feb-15

Nov-14

Aug-14

May-14

Feb-14

Nov-13

Aug-13

-0.6

Source: Bloomberg

Volatility and uncertainty resulting from monetary policy divergence could further accentuate the perception of risk Federal Reserve, more reluctant in this environment to “normalize” monetary conditions -4-

Is the sky the limit? Monetary policy as a XXI century economic snake-oil Stock of government bonds with negative yields Rest of the world 7.5

Japan Euro area

Trillion USD

• Too many unknowns in the equation: • Limits of monetary policy close to the zero lower bound • Declining trend in real interest rates, structural or cyclical?

5.0

• Negative rates. Will benefits outweigh costs? Unchartered waters (banking system, money market-funds, insurance companies, savers in general)

2.5

• Why not go farther into unchartered territory? Long-term interest rate targeting and/or fiscal deficit monetary financing

0.0

Source: BIS

Returns to expansionary policies seem to be decreasing. Loss of credibility?

-5-

Fed is what matters for EMs Ratio of total foreign currency debt to GDP (USD billion) 45

Other currencies

40

EUR USD

35

• Divergence hardly provide some breathing space for EMs (dominance of the US dollar in international financial markets) • Impact of US shocks in EMs is much larger than other shocks

30 25

• Indirect effects of divergence:

20

• Fed may delay normalization

15

• Big countries, as China, moving away from US peg (significant impact on financial markets)

10 5 0

Latin America

Asia

Other EMEs

China

Source: BIS

Expectations of Fed policy is what drives EMs, but those expectations are affected by other Central Banks’ actions -6-

Fed policy and channels of transmission to EMs Impact of Fed tightening • Trade effect (+)

1. Exchange rate channel

USD appreciation vs EMs currencies

• Balance-sheet effect (-) • Risk of pass-through?

2. Effect on international financial conditions

3. US domestic demand channel

• Impact on capital flows, term premia, asset valuations • Usually associated with higher market volatility and risk aversion

• A concern particularly for countries with large financing needs and/or imbalances

Rate hikes justified by a underlying strength of US economy => mitigate negative impacts

External factors also play a role (China) -7-

How much farther can the Dollar go?

1. Exchange rate channel Exchange rate vs USD since Aug-2015 51%

ARG MEX EGY UK RUS CHN MY TUR IND COL POL PER ISR DOM PHL BRA THA CR HUN SWI IDN EURO CZE CRO JAP

-20% Depreciation vs the USD Source: Datastream

The Mexican peso has been the worst performing currency among the flexible exchange rates

0%

20% Appreciation vs the USD -8-

Balance-sheet effect: too much corporate debt in foreign currency ?

1. Exchange rate channel Corporate debt %

• Contrary to other crisis, no signs of severe currency mismatches in the banking sector and/or government borrowing (lessons from other crisis)

(% of GDP)

Mexico Indonesia S. Africa

In USD

India

Rest

• The main pressure point could be offshore foreign-currency borrowing by emerging market corporations

Brazil Turkey Russia Malaysia Korea China 0

50

100

150

200

Source: BIS

Difficult to see how large is the risk associated to corporate debt - 10 -

Risk of pass-through to inflation reduces the autonomy of monetary policy 1. Exchange rate channel Inflation and CB´s target range 12

Average inflation (last 3months)

• Exchange rate pass-through heightens the inflationary risk

Central bank´s target range

10

• Traditional dilemma: above target inflation and slow growth

8 6

• The magnitude of the pass-through in several countries suggests that output gap was less negative than previously thought

4 2 0

PER

Source: National Central Banks

BRA

CHL

MEX

COL

• In Mexico, no sign of pass-through despite the large depreciation. Positive impact of structural reforms in prices (telecom, electricity, gasoline).

Pass-through to inflation? Yes in some. Not in others, but be aware - 11 -

Higher exposure of those countries with higher financing needs 2. International financial conditions Current account balance (% of GDP)

10

• In some countries (Brazil, Chile) the current account adjustment is quite advanced (imports contraction)

8 6 4

• In others (such Colombia) it is clearly a source of risk

2 0

• In Mexico, no room for comfort (downward pressure from oil balance will continue – production weakness – and fiscal adjustment is proceeding too slowly -)

-2 -4 -6

KOR

RUS

MLY

CHI

IND

CHL

IDN

MEX

BRA

SAF

TRK

PER

COL

-8

Source: IMF

EMs central banks could be required to become “unconventional” - 14 -

How can EMs central banks deal with this situation? Pseudo-independent Central Banks • EMs should:

Mexico: International Reserves

• monitor closely their monetary policy stance relative to advanced economies, to minimize the potential of capital outflows

(Billion USD) 300

IMF’s Flexible Credit Line

250

• strengthened macroeconomic fundamentals and structural reforms to compensate the decompresion of term premia

200

150

International Reserves

100

• Global safety nets are insufficient to deal with massive capital outflows (work to be done on this).

2016

2015

2014

2013

2012

2011

2010

2009

2008

2007

0

2006

50

• Large FX reserves accumulation by Ems (complemented, in some countries, with the IMF´s FCL).

Source: Banco de Mexico

Reserves cannot be the ultimate solution, but they can buy time Monetary policy in EMs conditioned by Fed policy - 15 -

How about Banxico?

17-12-15

+25bp following the FED hike

Anticipated

17-02-16

Discretionary intervention in FX markets End of regular USD auctions +50 bp

Non anticipated Not scheduled meeting

30-06-16

+50 bp

Non anticipated

• Part of a “Coordinated” response to “strengthen fundamentals” • Volatility in MXN accentuated by automated mechanisms for high-frequency trading • Banxico becomes unconventional

1. Despite “apparently” sound economic fundamentals, the Mexican peso has been the worst performing currency this year • No significant impact of FX depreciation on exports (integrated value chains, weak US demand) • Non-negligible share of corporate-debt in USD • No pass-through to inflation, yet (producer prices are increasing)

2. Vulnerability of Mexico to financial distress episodes • Very open and highly integrated financial market (use as proxy to emerging market) • Large share of government bonds in hands of non-residents (%) • Fiscal consolidation still ongoing - 16 -

Caught Between Forced “Unconventional” and “Conventional” Policy-making Manuel Balmaseda CX Economics

Eighth Annual Rocky Mountain Economic Summit Jackson Hole, July 2016