COVID-19 in emerging markets: Escaping the monetary policy procyclicality trap
Emerging markets and developing economies (EMDEs) have long suffered from procyclical macroeconomic policies.1 Expansionary policies during boom times have often led to unmanageable credit expansions and a significant buildup of vulnerabilities. Conversely, contractionary policies in bad times have turned busts into major recessions – the ‘when it rains, it pours’ phenomenon (Kaminsky et al. 2004).
Végh and Vuletin (2012a, 2012b) refer to the ‘fear of free falling’ as the critical factor as to why monetary policy has been procyclical. In emerging markets and developing countries, downturns are typically accompanied by large capital outflows and significant currency depreciation, which often yield higher inflation and distressed public and private balance sheets (due to foreign exchange mismatches). Hence, faced with a sharp currency depreciation, central banks may have to raise the policy rate in order to defend the home currency.
However, over the past two decades, a significant number of emerging markets and developing countries have transitioned to countercyclical monetary policies. This transition has been supported by better inflation performance and strengthened monetary policy frameworks. Inflation in emerging markets and developing countries has declined significantly, to a median of 2.7% in 2019, compared to 7.4% in 2000. The decline in inflation has been broad-based across country groups, and is reflected in headline, core, energy, and food price inflation (Ha et al. 2019). It has been accompanied by the move to more flexible exchange rate regimes, the adoption of inflation targeting frameworks, greater central bank transparency and independence, and a stronger focus on price stability within central bank mandates (Figures 1 and 2).
Figure 1 EMDE inflation, central bank transparency, and inflation targeting
Source: International Financial Statistics, Dincer et al. (2019)
Figure 2 EMDE central banks with “price stability” in their objectives
Source: IMF’s Central Bank Legislation Database, Khan (2017).
Unlike previous episodes, where emerging market economies tended to tighten policy to avoid rapid capital outflows and the inflationary effect of exchange rate depreciations, in the current COVID-19 crisis, central banks in emerging economies and developing countries have been able to react with countercyclical monetary policy. This is more in line with the policy responses of advanced economies (Mühleisen et al. 2020). Compared to the policy response in other recent large stress events (notably the Global Crisis and the Taper Tantrum episode), the distributions of rate cuts have shifted to the right, implying that more countries were able to cut rates, and to a larger extent overall (Figure 3). Since using short-term money market rates may be affected by changes in risk premia (Kalemli-Ozcan 2019), we use policy rate changes from the IMF policy tracker which records policy responses to the COVID-19 shock.
Figure 3 Monetary policy rate cuts in stress periods
Source: IMF Policy Tracker, Monetary and Financial Statistics, authors’ calculations.
The countercyclical response in the current crisis is strongest in, but not limited to, countries with an inflation-targeting framework. In fact, out of the 79 economies that cut their rates, approximately 70% have monetary frameworks other than inflation targeting (Figure 4). Nonetheless, an overwhelming majority (approximately 83%) of countries with an inflation targeting framework have ‘eased’ in the current crisis, with the average cut of 120 basis points (32% of their pre-crisis interest rate level). The extent of easing is significantly greater for inflation targeting countries compared to countries with other monetary policy frameworks, especially when initial interest rate levels are taken into account. Hence, emerging markets and developing countries with inflation targeting frameworks seem to have overcome the ‘fear of free falling’ most successfully.
Figure 4 COVID-19 crisis: Policy rate cut and monetary policy framework
Source: IMF Policy Tracker, author calculations.
Several factors are important in the quest of emerging markets and developing countries to escape the procyclicality trap. When hit by a crisis, economies with less credible monetary frameworks and weaker fundamentals may find themselves ‘between a rock and a hard place’. In these countries, capital outflows can put heavy pressure on the exchange rate, with the twin risks of a disorderly adjustment (currency crisis) and a persistent upsurge in prices (if inflation expectations are poorly anchored and pass-through from the exchange rate is high). Next, we assess which of these factors are most relevant to policy rate cuts.
Countries with a higher level of initial inflation were less able to cut rates in response to the COVID-19 crisis. The rate cuts in emerging markets and developing countries are also positively correlated with both central bank transparency, and, to a lesser degree, independence. This finding reflects the importance of institutional factors (Figure 5).
Figure 5 COVID-19: Policy rate cut and initial conditions2
Source: International Financial Statistics, IMF Policy Tracker, Dincer (2019), Garriga (2016).
Regression analyses underscore the role of initial inflation and central bank transparency in shaping the policy response. We find robust evidence that higher initial inflation is associated with smaller monetary policy rate cuts in response to the crisis. Further, countries with an inflation targeting framework have cut rates more aggressively, but this relationship breaks down once we control for central bank transparency. Hence, it is the enhanced governance and independence that inflation targeting frameworks espouse, and not the framework itself, that explains larger rate cuts. It should be noted that this finding is in line with Gelos and Ustyugova (2017). More generally, the importance of institutional quality echoes the results found in Végh and Vuletin (2012a, 2012b).3
In summary, we find strong evidence that emerging markets and developing countries have increasingly been able to conduct countercyclical monetary policy to respond to adverse shocks. This is particularly the case for the current COVID-19 shock where most countries have cut rates. While the initial inflation level is an important determinant of the space to further cut rates, institutional factors (most notably higher central bank transparency) can enhance the ability to conduct countercyclical monetary policy.
In light of these findings, it should also be noted that in order to help member countries measure transparency, facilitate communication with stakeholders, contribute to better policymaking, and to help central banks better explain what they do, the IMF has recently developed a Central Bank Transparency Code (Adrian et al. 2020).
Authors’ note: The views expressed are those of the authors and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.
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Dincer, N, B Eichengreen and P Geraats (2019), “Transparency of Monetary Policy in the Post Crisis World”, in Mayes, D, P Siklos and J-E Sturm (eds) Oxford Handbook of the Economics of Central Banking, New York, NY: Oxford University Press.
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International Monetary Fund (2020), “Policy Responses to Covid-19”, International Monetary Fund, 10 July.
Ha, J, M A Kose and F Ohnsorge (2019), “Inflation in Emerging and Developing Economies: Evolution, Drivers and Policies”, Washington, DC: World Bank.
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Mühleisen, M, T Gudmundsson and H Poirson Ward (2020), “COVID-19 Response in Emerging Market Economies: Conventional Policies and Beyond”, IMF Blog.
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Végh, C A and G Vuletin (2012a), “Overcoming the Fear of Free Falling: Monetary Policy Graduation in Emerging Markets”, NBER Working Paper 18175.
Végh, C A and G Vuletin (2012b), “Graduation from monetary policy procyclicality”, VoxEU.org, 22 August.
1 We examine the monetary policy response of 149 countries, 59 of which are low-income economies.
2 Of the 131 countries without a hard peg, 48 countries did not change their interest rates.
3 Presumably, the fact that the shock was global in nature also mitigated concerns about capital flight which often is associated with lower interest rates and depreciation (Reinhart 2020).