Emerging Markets Central Bank Asset Purchases Can Be Effective …

(MENAFN- Caribbean News Global)

By Tobias Adrian, Christopher Erceg, Simon Gray and Ratna Sahay

Over the past two decades, central banks in emerging markets have made substantial progress in building the credibility necessary to conduct countercyclical monetary policy. During the COVID crisis, many of these central banks not only cut interest rates sharply, but also deployed a range of tools to help get the market working again, including asset purchases. And, although some of these central banks are now considering tightening monetary policies, the likely use of these policy tools again in the future deserves further consideration.

In previous years, it was mainly the central banks of advanced economies that bought government debt. However, for the first time on a large scale, central banks in countries like South Africa, Poland and Thailand have innovated by resorting to asset purchases to combat market dysfunctions.

While their actions have been successful in reducing market tensions, policymakers in these and other emerging and developing countries must consider other important considerations as they chart the way forward.

Foremost among them is whether asset purchases should be seen as an exceptional response to the COVID crisis, or a more permanent addition to their policy toolkits. At the same time, risks ranging from fiscal dominance and debt monetization to excessive risk-taking need to be contained.

These and other issues are discussed in detail in a recent IMF staff paper. Below, we summarize the results and provide some preliminary advice.

Asset purchases – useful tools that come with risk

Central banks in many emerging markets and developing countries have been reluctant to resort to asset purchases in past crises for fear of triggering a backlash from the market. Targeted asset purchases in these countries during the COVID crisis have been found to have helped ease tensions in financial markets without precipitating notable capital outflows or pressure on exchange rates.

This overall positive experience suggests that these central banks will also consider asset purchases during future episodes of market turmoil, as discussed in a recent Global Financial Stability Report.

However, while asset purchases can help these central banks achieve their goals, they also present significant risks.

One obvious risk concerns the balance sheet of central banks: central banks can lose money if they buy sovereign or corporate debt when interest rates are low on all maturities, then key interest rates. increase sharply. A weaker balance sheet can make the central bank less willing or able to meet its mandated goals when a policy tightening is needed because of fears that the required policy measures will harm its own financial position.

A second risk is that of “fiscal domination”, whereby the government puts pressure on the central bank to pursue government objectives. So while a central bank may initiate asset purchases – in line with its mandate goals – it may find it difficult to exit. The government may well get used to the cheap funding of central bank stocks and pressure the central bank to continue, even as inflation rises and the goal of price stability would require ending the market. purchases. The resulting loss of confidence in a central bank’s ability to keep inflation low and stable could precipitate periods of high and volatile inflation.

At a recent IMF roundtable on new monetary policy tools for emerging markets and developing economies, Lesetja Kganyago (Governor, South African Reserve Bank), Elvira Nabiullina (Governor, Bank of Russia) and Carmen Reinhart (chief economist, World Bank Group) highlighted the risks to central bank balance sheets and fiscal dominance, but also drew attention to other unwanted side effects. In particular, while asset purchases could reduce tail risks, such policies could have unintended effects such as encouraging excessive risk-taking and eroding market discipline. And a more active role of the central bank in market making could hamper the development of financial markets.

Principles for asset purchases

Our recent document on Asset Purchases and Direct Funding provides some guiding principles to harness the benefits of asset purchases while limiting the risks. As we see the potential for these tools to be used by central banks in emerging and developing economies – including to help alleviate severe episodes of financial market distress – a strong and credible policy framework provides a critical foundation. .

A fundamental principle is that the central bank should have the flexibility to adjust its policy rate as needed to achieve its mandated objectives. This is critical. Central banks pay for the assets they buy by issuing reserves. These additional reserves could generate significant inflationary pressures unless the central bank can sterilize reserves by raising its policy rate to a level compatible with price stability.

A closely related principle is that any purchases made by the central bank should be made on its own initiative and to achieve its mandated objectives (rather than those of the government). The size and duration of asset purchases should match these objectives: purchases undertaken for financial stability should generally be small and end when financial strains ease, while those intended to provide macroeconomic stimulus may be more important and more persistent.

This principle can best be achieved by ensuring that central bank asset purchases are made in the secondary market, rather than “directly” through primary market purchases or an overdraft facility. . Direct financing allows the government to easily determine both the size of the central bank’s balance sheet and the interest rate it will pay, which tends to undermine fiscal discipline and increase the risks of debt monetization.

Clear communication about the objectives of asset purchase programs and the rationale for both entry and exit is also crucial.

Finally, our article emphasizes the importance of a strong fiscal position. In particular, the government should be able to provide budget support to cover losses that may materialize. Such support is necessary to preserve the financial autonomy of the central bank, as well as to enable it to make political decisions to fulfill its mandate – rather than basing its decisions on concerns about its (or the government’s) financial position. . In addition, the budgetary authority is more likely to resist the temptation to seek cheap funding from the central bank if its own position is strong.

While asset purchase programs may be relatively new territory for central banks in emerging and developing economies, these principles should help provide a solid foundation.

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