Q&A Seven Questions about Policy Options for Emerging Market Countries
There has been a vibrant discussion about the policy options for emerging market countries to cope with the global financial crisis. What kind of countercyclical policies might be feasible? How can harmful balance sheet effects be avoided? What is the role for the International Monetary Fund? Based on the results of recently-issued IMF Staff Position Note by the authors along with Rex Ghosh and Jonathan Ostry,1 this article provides brief answers to seven commonly asked questions about how emerging market economies can best respond to the current global crisis.
Question 1: Are the policy options available to emerging market economies trying to cope with the current crisis different from those in previous crises?
There is an important distinction between emerging market economies that were ripe for a home-grown crisis associated with the end of unsustainable credit booms or fiscal policies, and those that were just bystanders caught up in the storm. For the first group, the options are fairly limited, and, as with previous emerging market economy crisis episodes, may entail painful adjustment measures. But a number of emerging market economies have taken advantage of the benign external environment prior to the crisis to make their economies more resilient by pursuing sound macro-economic policies. Thus, unlike in previous crises episodes, many emerging market economies now have room to pursue countercyclical policies, and we encourage them to explore their options.
On more specific points of departure, the Staff Position Note raises questions on the effectiveness of an interest rate defense of an exchange rate peg, which was once a common feature in IMF-supported programs (although tight monetary policy is still likely to be necessary in the aftermath of a devaluation in order to prevent an inflation-depreciation spiral; see Ghosh and others, 2002). On fiscal policy, the note makes the case for a countercyclical policy provided there is enough fiscal space to pursue it (which is often not the case for countries in the midst of a crisis).
Question 2: Does the Staff Position Note reflect a real change with respect to previous IMF advice and thinking on these issues?
IMF advice has evolved in response to changing conditions in the global economy. The IMF's policy advice has evolved not because it was wrong, although a few mistakes were made in the past (see IMF Independent Evaluation Office, 2003), but rather because the current crisis has many unique features, and conditions globally and among emerging market economies have evolved since the previous round of emerging market crises. As mentioned above, the pursuit of sound macroeconomic policies has created an unprecedented scope for countercyclical policies in many emerging market economies. And even countries facing a home-grown crisis can count on far greater levels of official assistance than would have been available in the past, thanks to recent changes in the IMF's lending framework. In most cases, this has allowed for adjustment under much less strict conditions than before.
Question 3: Insolvencies and debt overhangs seem to be critical constraints in many emerging market economies hit by the current crisis. What kind of policies are likely to help with this?
We see four potential elements to an effective approach. The first step is to ensure there is sufficient domestic currency liquidity to prevent liquidity problems from evolving into solvency concerns. In some cases, insolvencies can be avoided by the provision of foreign currency liquidity, particularly where there are concerns about the effect of exchange rate depreciation on domestic balance sheets. Another key factor is the institutional and legal framework for resolving corporate bankruptcies. For instance, Djankov and others (2008) have demonstrated that insolvency procedures across different countries currently vary significantly in quality and effectiveness. The inefficiencies associated with the least effective regimes are likely to be particularly costly for emerging market economies during the current crisis. Finally, some governments may have to provide fiscal support for debt restructuring, particularly where debt overhangs would otherwise imperil the banking system. This support could include the conversion of foreign currency banking system assets to domestic currency, or recapitalization of domestic banks.
Question 4: What is the appropriate balance between different macroeconomic policies such as exchange rate, monetary and fiscal policy?
There is no one-size-fits-all prescription, and the appropriate policy mix depends on the particular circumstances in each country. Except for countries already in a homegrown crisis, the basic thrust of macroeconomic policies should be towards easing. But there are a number of important trade-offs that should be taken into account. In easing monetary policy, for instance, central banks need to be mindful of the trade-off between the benefits of lower interest rates and a weaker exchange rate for economic activity, and the negative impact of depreciation on unhedged balance sheets. How much to let the exchange rate depreciate may depend on a number of factors—including initial overvaluation, the exchange rate regime, balance sheet effects, and the possible regional contagion and systemic implications. Similarly, fiscal easing may be counterproductive if it jeopardizes policy credibility and the sustainability of the public finances.
Given a targeted level of aggregate demand, a more expansionary monetary policy can compensate for a less expansionary fiscal policy—though both may be relatively ineffective if domestic credit markets are impaired. Substituting for monetary easing by fiscal expansion can be constrained by debt sustainability concerns, as both relatively higher interest rates and fiscal spending will worsen the debt dynamics.
Question 5: Can emerging market economies afford the same kind of fiscal stimulus packages that we've seen in some advanced countries?
In general, no. Fiscal space is often much more constrained in emerging market economies than in advanced economies. Given generally weaker budgetary processes, many emerging market economies have far less scope than advanced countries for fiscal expansion without undermining confidence in debt sustainability, and hence facing higher borrowing costs. In fact, fiscal policy in many emerging market economies has tended to be procyclical, since the business cycle is often driven by capital flows, and when inflows dry up, financing an expansionary fiscal stance becomes much more difficult.
Nor is it clear that emerging market economies would derive as much benefit from a looser fiscal stance as advanced economies. The limited empirical evidence available suggests that fiscal policy tends to have smaller and more transient stimulative effects in emerging market economies (Spilimbergo and others, 2009; Ilzetki and Vegh, 2008; Ghosh and Rahman, 2008). This likely reflects the fact that these economies are typically more open, more constrained in their ability to support the fiscal expansion with a looser monetary stance, and more subject to market fears over debt sustainability. Many emerging market economy governments will also need to devote substantial fiscal resources to dealing with the debt overhang and banking sector problems discussed earlier. This will leave few resources available for other fiscal policy measures.
Having said this, where fiscal policy options are available, emerging market economy governments can and should use the tools at their disposal to offset the growth impact of the crisis. Automatic stabilizers—which typically generate fewer concerns over debt sustainability than discretionary measures—are a clear example. Discretionary measures need to be clearly targeted: for example, protecting the poor would not only have a stimulative impact (as the poor have a high marginal propensity to consume), but would also help to strengthen the social safety net.
Question 6: What about monetary policy? Do central banks in emerging market economies need to resort to unconventional policies?
While conventional policies should be used first, they may have a limited effect on credit markets if the standard monetary policy transmission mechanisms are impaired (for example, if the policy interest rate approaches the zero nominal bound, or if greater bank liquidity fails to translate into additional lending). Structural impediments to monetary transmission, such as excessive reserve requirements, should be reduced with prudence. If credit markets remain unresponsive to lower interest rates, or the central bank needs to engage in lender-of-last-resort operations in a systemic banking crisis, then the bank could resort to unconventional policies. For example, central banks can extend liquidity by increasing the range of accepted collateral assets, by purchasing (and selling) specific assets with a view toward decreasing their yields (credit easing) or, albeit advisable only in extreme situations such as when the policy rate is already set to zero, by expanding their balance sheet to purchase assets such as longer-maturity government bonds (quantitative easing). Likewise, stabilizing the exchange rate in the midst of global deleveraging may only be possible through direct sales of central bank reserves in the foreign exchange market. Finally, the country could as a last resort regulate capital transactions—though these carry significant risks and long-term costs Ariyoshi and others (2000) provide a comprehensive review of countries' experiences with capital controls; other evidence for and against their use is provided by Kaplan and Rodrik (2002) and Dornbusch (2002).
Question 7: One feature of the crisis has been widespread cross-border deleveraging by banks. How can emerging market economies make sure that bank credit does not dry up?
The decline in the availability of credit from domestic subsidiaries of foreign parent banks has been a pervasive feature of the current crisis, as during some previous episodes. In general, the greatest risks are posed to countries where credit growth has been particularly rapid, so that corporate and household borrowers face significant rollover needs and hence a real risk that illiquidity could rapidly translate into insolvency. A key issue is whether deleveraging reflects liquidity needs at parent banks (in which case funds will typically be pulled out of the better-performing, most liquid, markets first) or concerns about deteriorating asset quality in the emerging market economy in question. In the former case, policies to limit the fall-off in credit could have a positive impact; in the latter, they are more likely to make things worse.
Where appropriate, the provision of central bank liquidity, including foreign currency liquidity, can help, although there is also a risk that the additional liquidity simply facilitates capital outflows. We would expect that conventional monetary policy measures (e.g., reducing the policy interest rate) would have only a limited impact on credit markets where the credit contraction is driven mainly by forced deleveraging resulting from liquidity needs at foreign parents. Unconventional monetary policy measures, such as credit easing, could help to reduce specific spreads, such as that on inter-bank lending, although there is no real evidence that these measures have anything more than a transitory effect. Finally, where the authorities have to resort to bank recapitalization measures, they could use their equity stake to ensure that recapitalized institutions to maintain credit lines. However, weak institutional quality in many emerging market economies, which has been associated in the past with financial suppression and corrupt or inefficient directed lending policies at state-mandated institutions, suggests that this kind of government involvement in credit allocation decisions is in general best avoided, except as a temporary measure.
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