Spill Over

Author:Jiaqian Chen, Tommaso Mancini-Griffoli, and Ratna Sahay

Spill Over Finance & Development, September 2015, Vol. 52, No. 3

Jiaqian Chen, Tommaso Mancini-Griffoli, and Ratna Sahay

The Federal Reserve’s recent unconventional monetary policies seem to have affected emerging markets more than traditional policies

When the United States sneezes, the saying goes, the rest of the world catches a cold. This adage is not mere folklore. The recent global financial crisis drove home the importance of the United States to the world economy—for both good and bad.

On the positive side, the crisis helped illustrate the power of U.S. monetary policy to prevent a global depression. But those same policies also had important side effects, especially raising asset prices and flooding emerging market economies with capital inflows. Policymakers in these economies expressed concern about the so-called spillover effects of U.S. policy, which increased market volatility and exacerbated related financial stability risks.

We will examine these spillover effects, with a view to gauging what policies best mitigate the risks of destabilizing spillovers.

Unconventional policies neededThe global economy would likely have suffered more had central banks not followed so-called unconventional monetary policies that relied on such innovations as buying nongovernment bonds (widely dubbed “quantitative easing”) to pump up the economy when traditional policies, such as cutting interest rates, were no longer feasible. Nominal interest rates were brought to nearly zero early in the global recession—and have been kept at that minimum level since (the so-called zero bound). Unable to lower rates further, central banks resorted to asset purchase programs that massively increased central bank balance sheets.

As the period of accommodative monetary policy continued, policymakers in emerging markets began to voice concerns. They claimed that the monetary expansion in advanced economies had spilled over into their economies, causing a surge in capital inflows, especially into debt instruments such as bonds (see Chart 1). Their currencies appreciated and their asset prices rose rapidly. Emerging markets’ policymakers worried about painful adjustments imposed by large shifts in the exchange rate on exporters and on firms that compete with imports. They worried about growing liabilities in temporarily cheaper foreign currencies that risked suddenly becoming a lot more expensive (called balance sheet mismatches). Vulnerabilities to financial systems also stemmed from rapidly rising asset prices, a buildup of credit bubbles, and heavy and rising corporate borrowing. Many policymakers recalled earlier episodes of surging capital inflows, when attempts to dampen bubbles by raising interest rates to increase the cost of borrowing failed because the higher rates attracted more capital inflows and stoked currency appreciation.

An even sharper wave of criticism from emerging market policymakers erupted after the Federal Reserve, the U.S. central bank, dropped hints that it was considering reducing the pace of asset purchases (or “tapering” in the jargon). When former Fed Chairman Ben Bernanke mentioned this possibility in May 2013, there was a spike in market volatility in emerging markets (see Chart 2) as asset prices dropped...

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