Emerging Market Monetary Policy at a Time of Strengthening Dollar: Between a Rock and a Hard Place

I have previously written about the implications of the stronger dollar for emerging market economies and their policies, touching on the implications for their monetary policy. In this article, I take a deeper look at those implications for monetary policy.

Let me start off by saying that the discussion here generally transcends monetary policy frameworks and I won't be discussing such frameworks, or the merits of an inflation rate driven monetary policy. Narrowly focused monetary policy is a luxury only the major economies can afford. The fact that some central bankers in emerging markets (EM) are talking like the current situation is just business-as-usual may be the consequence of having too many PhDs educated in the developed countries that have yet to fully transition to the fact that they are now working in EM economies. Small open EM economies have a far higher level of complexity in the economic challenges they face compared to the developed countries, and have fewer resources to deal with them. This requires greater intellectual agility on the part of EM central banks. For small open economies, the exchange rate is a very important factor in determining economic and financial outcomes and therefore, must be an important part of policy considerations. That is why even inflation targeting EM central banks talk about ‘flexible’ inflation targeting. Central banks in small open economies cannot simply focus on the domestic price of their currency (i.e., inflation) and ignore what is happening to the external price of their currency (exchange rate).

I will also not discuss changes to the international monetary system to mitigate instability arising from the dominance of the dollar.?I have been hearing about such proposed changes my entire professional career without seeing much progress. The current situation may create fresh incentives to pursue that initiative but I am not very optimistic.

The monetary situation in developed countries

Despite the hand wringing and cries of anguish that we see in the media, interest rates are not ‘high.’ They are not high from the perspective of inflation levels, economic conditions or even from historical comparisons. They only appear high because interest rates have been so low for so long. Cheap money had distorted business and investment decisions. Instead of issuing equity, businesses chose to borrow?—?in fact, many piled on debt to buy back their own shares. The low interest rates also artificially made the prices of assets like houses seem affordable, incentivizing house buyers into bigger financial commitments than they can afford under more normal interest rates. Investors and savers earning almost nothing on traditional financial instruments sought out riskier investments to earn higher returns. There was a lot of 'financial innovation' going on to take advantage of the cheap and and plentiful foolish money. As interest rates rise, many of these distortions would now have to be rectified, as they should be. That is the hangover after the wild decade-long party. So, interest rates are not high but that does not mean they are not causing pain.

What does worry me is the speed at which interest rates are rising. Under normal circumstances, when central banks start seeing inflation breaching acceptable levels and the economy is showing signs of overheating, interest rates will be pre-emptively increased in small increments. That not only gives businesses and investors time to adjust but also provides a warning against excessive risk taking and leverage. That did not happen in the present situation — more then a decade of low interest rates created inertia that blindsided the major central banks when inflation made its appearance. What is happening now is that these central banks are way behind inflation levels, real interest rates are hugely negative, and policymakers are trying to make up for lost time. I support the objective of getting inflation under control but the rapid rise in interest rates will likely create an economic recession before inflation comes down. Another risk is the potential for a financial conflagration arising from the failure of highly-risked and over-leveraged entities.

Implications for the EM central banks

The rapid rise in interest rates in the major economies risks creating instability in the EM economies. It is worth remembering that although interest rates are rising, the?liquidity injected through the expansion of the major central banks’ balance sheets?is still out there swishing around the global financial system looking for profitable roosting opportunities. That has plenty of potential for creating destabilizing conditions for EM economies.

Now, I will never argue that raising interest rates alone would stabilize the exchange rate. However, here is the problem facing emerging market central banks. At current levels of inflation, if domestic real interest rates are too low or negative for too long, and the currency is depreciating rapidly against a major currency like the US dollar, it is not only the non-residents but also the residents that would be looking at the depreciating value of their local currency financial assets and wondering whether they can get better returns elsewhere.?Financial flows will generally gravitate towards places that offer higher returns. With a strengthening USD, dollar-earning exporters will obviously be benefitting while dollar-paying importers will suffer. However, the net impact on dollar liquidity in the country could be negative if the dollar-earning exporters and investors find creative ways to keep their export proceeds abroad and importers try to pre-emptively fund future dollar-based imports. Those with dollar-borrowings but no dollar-earnings will also be desperately seeking dollar liquidity. The reduction in dollar liquidity will put pressure on the exchange rate. Too rapid a depreciation could also hurt consumer and business confidence and worsen domestic inflation. So,?while increasing interest rates by itself is unlikely to substantially strengthen the exchange rate, it can potentially prevent a bad situation from getting worse by reducing the incentive to move out of local currency assets, and thereby providing support to the local currency.

If central banks are reluctant to raise interest rates, then they have to either?accept whatever depreciation of the national currency that occurs?or, they will need to?use their foreign exchange reserves to defend the local currency. I have in my past writings argued that the more open an economy is, the more foreign exchange reserves its central bank needs to hold. Now is a situation where that advice would have served well. Unfortunately, there is a cost to holding large foreign exchange reserves, especially when the income from investments in those reserve currencies is low. This was clearly the case when the central bankers in much of the developed world were going bonkers with their asset purchases, quantitative easing and low/negative interest rates. So, many EM central banks (assuming that their balance of payment allowed them to do so) were reluctant to build up too much reserves out of concern for the losses to the central bank. However, that sort of conservatism is now proving to be a sword of Damocles hanging over the heads of EM central bankers as they draw on their FX reserves to moderate the depreciation of the local currency against the USD. Official reserves have fallen in many countries since the dollar started strengthening. Even central banks in the developed countries have found it necessary in recent days to draw on their USD swap lines with the US Fed to seek fresh USD liquidity.

What does this mean for monetary policy in EMs?

First, EM central bankers do not have the luxury of thinking that they are in a beauty contest where they can choose the most beautiful/optimal monetary policy stance. There is none. It is now a?choice between the least ugly policy options. Anything the central bank does will have negative consequences. Yes, beyond a point, higher interest rates could hurt the domestic economy by curtailing demand, creating bad loans, increasing unemployment. However, a substantially weaker exchange rate could also have the same effects by undermining confidence, encouraging speculative outflows, pushing up inflation (which hurts the poor the most) and eroding spending power among consumers. Already, there are a number of emerging market economies that are finding that their weaker exchange rate is making it too expensive to import sufficient food to feed their people.

Interest rates in EM countries?do need to rise, but not in the magnitude of the developed countries because interest rates in most EM countries did not go to the low levels of the developed countries. The possible exceptions are EM countries that have their currencies linked to a major currency such as the USD. Interest rates need to rise to moderate domestic demand in the face of higher inflation, allow the unwinding of financial imbalances, and to provide support to the domestic currency. How much those interest rates need to rise to achieve these outcomes would be dependent on the characteristics of each economy and what else is being done by policymakers. Furthermore, in the same manner that having too low real interest rates creates systemic risks, especially in the financial system, having too high real interest rates can also create systemic risks. Acting pre-emptively will minimize the likelihood that central banks will have to push interest rates to systemically risky levels.

Why are some EM central banks being conservative in the use of interest rates?

The first reason relates to what I have already discussed, which is concern about the?potential negative impact of higher interest rates on the economy. However, for economies that still have low or substantially negative real interest rates, when you hear central banks arguing that raising interest rates will affect economic growth and employment, they are inadvertently admitting the fragility of the local economy. So, the first thing to ask them is the nature of these vulnerabilities and the sectors of the economy that they believe are most vulnerable. Second question to ask is whether they think having negative real policy rates over long periods is healthy from the perspective of promoting sustainable growth and avoiding financial imbalances.

Another reason restraining the interest rate hand of some central banks could be the potential?implications of higher interest rates for financial stability. For instance, financial institutions that have been aggressively lending without adequate attention to credit risk could have difficulties. Similarly, financial institutions that have been happily extending fixed rate loans may need to start thinking about fresh capital if interest rates were to rise even moderately. This is where the financial regulators and supervisors will have to step up and pre-emptively start managing financial institutions that are likely to have difficulties. I have always believed that monetary policy must also keep an eye on financial stability. A belief that has led me to be highly critical of the super-easy monetary policy pursued by central banks in the developed countries. Having said that, I also believe that it is not the task of the monetary policy committee to do the job of regulators. If some financial institutions have been less prudent in their lending, it is for the regulators to look into this. It should not put undue constraints on the monetary policy committee.

An additional restraint could be political pressure from the government due to concerns about the?impact of higher interest rates on fiscal spending plans and the cost of financing that spending. This is playing out in a number of EMs. (Turkey immediately comes to mind, where despite high inflation and a bad BOP situation, the central bank is being restrained from raising interest rates. As a consequence, the Turkish lira has nose-dived and is exacerbating the already bad situation.) It is also not the time for fiscal policy to be inflationary.?At times like this, monetary policy and fiscal policy need to work together to share the burden and ensure a more balanced and effective policy response to the challenging situation. Taking the Malaysian situation as an example, the recent Malaysian budget was not very helpful. I support the efforts to buffer the livelihoods of the vulnerable groups, but there was also plenty in the budget that would add fuel to inflationary pressures, and possibly weaken the balance of payments. So, fiscal policy must play its role now in helping mitigate inflationary pressures by restraining unnecessary expenditures. When the major economies go into recession next year, any available fiscal space could then be usefully deployed to support the economy. For EM governments generally, pressuring the central bank to not do what it needs to do is not a wise move from the perspective of national interest.

To conclude

EM central banks face the?unenviable task of making choices between unattractive policy options. In making those choices, it is important to remember that aside from selecting the appropriate policies and instruments, policymakers also need to find the correct timing. Any policy deployed too late is unlikely to be as effective. If central banks are going to raise interest rates, then it is better to do so while they have the potential to help the situation. Wait too long and they will have either missed the opportunity to effectively use this policy instrument, or they will have to use it more aggressively, with greater cost to the economy. That is a hard lesson that the central bankers in the developed world are now learning, and EM central banks should not make the same mistake. A tighter monetary policy now, when the exchange rate is weakening and inflation is trending up, would be less damaging compared to doing so once the situation has deteriorated further.

One thing we know from the Asian Financial Crisis, and other previous EM crisis situations:?when the central bank's reserves hit a level where it can no longer afford to intervene, the game is over?as far as defending the exchange rate is concerned. When that happens, interest rates will no longer have a meaningful impact on the exchange rate. The policy options would be severely?limited: either approach the IMF for assistance or undertake measures to substantially limit outward foreign currency flows. National policymakers need to choose wisely today to ensure that their country does not face that eventuality. Of course, everything I have previous said relating to non-monetary measures to strengthen the resilience of the economy are necessary.

Within the ASEAN+3 region, there is a?regional resource pooling arrangement?in the form of the?USD240 billion ASEAN+3 Chiang Mai Initiative Multilateralisation (CMIM) that is intended to provide liquidity support to regional economies in times of external stress. It would not be a bad time for this arrangement to start warming its engines. I am sure that ASEAN+3 Macroeconomic Research Office (AMRO), the regional surveillance organization backing the CMIM, is already consulting national policymakers and being alert to any incipient signs of regional contagion.