Are EMs reaching the limits of monetary policy? - Capital Economics
Emerging Markets Economics

Are EMs reaching the limits of monetary policy?

Emerging Markets Economics Update
Written by Edward Glossop
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If faced with a steep downturn, most EM central banks would be able to cut interest rates substantially in order to cushion their economies. Interest rates in a handful of countries are close to the zero bound, but these are typically economies with strong balance sheets and credible central banks, making unconventional monetary policies – as well as large fiscal stimulus packages – a possibility.

  • If faced with a steep downturn, most EM central banks would be able to cut interest rates substantially in order to cushion their economies. Interest rates in a handful of countries are close to the zero bound, but these are typically economies with strong balance sheets and credible central banks, making unconventional monetary policies – as well as large fiscal stimulus packages – a possibility.
  • Many DM central banks are reaching the limits of conventional monetary policy, with benchmark rates already at very low levels and negative in a number of places. The good news is that most EM central banks are not facing the same constraints.
  • Our simple average of EM policy rates stands at 6.50%. (See Chart 1.) Of course, the transmission from monetary policy to the real economy in EMs is typically weaker than in DMs, with academic research suggesting that EMs need to cut rates by roughly twice as much as DMs to get a similar impulse. Even so, Chart 1 would still imply that EM central banks have more ammunition than their DM counterparts.
  • Admittedly, policy rates are close to the zero bound in a handful of countries. (See Chart 2.) That said, strong balance sheets and credible central banks in the likes of Thailand, Korea, Taiwan and the Czech Republic would give policymakers scope to cut rates to zero and adopt unconventional monetary policies.
  • Of course, just because EM central banks are not reaching the limits of monetary policy, this doesn’t mean that they would necessarily slash policy rates in the event of a downturn. Central banks of countries with large current account deficits and/or large FX debts – Turkey, Indonesia, Colombia, Ukraine, and Pakistan – may have less room to cut rates if a slowdown were accompanied by weaker capital flows. Some of these central banks might even hike rates.
  • Central banks of countries with stronger macroeconomic fundamentals (lower FX debts and/or smaller current account deficits) would be more willing to slash rates, but they would still face constraints. Many major EM central banks, such as those in Russia, Brazil, Mexico and South Africa, are still in the process of building their credibility, which is hard-won and easily lost. So unless deflation became a real threat, which would be highly unlikely, we doubt that policymakers would cut rates much below inflation. That would imply a floor on nominal policy rates of 3-5%.
  • Finally, while central banks in those countries with the strongest balance sheets (much of Emerging Asia and Central Europe) could cut rates all the way to zero, some may be reluctant to undertake unconventional monetary policies given their mixed track record in the in the developed world. QE and negative rates appear to have had limited success in boosting growth and inflation. They have also had some unintended negative consequences. (See here and here.) The good news is that these economies, as a result of their strong government balance sheets, could afford to let fiscal policy do some of the work.

Chart 1: Synthetic Policy Interest Rates*
(%, Simple Averages)

Chart 2: Policy Interest Rates
(%)

Sources: Refinitiv, Capital Economics

Sources: Refinitiv, Capital Economics


Edward Glossop, Emerging Markets Economist, +44 20 7808 4053, edward.glossop@capitaleconomics.com