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The BCC blog is a space of exchange among BCC stakeholders about topics of interest in the realm of central banking. It offers a space where latest trends can be discussed, practical experiences be shared, and a BCC community be developed.
The BCC programme, funded by SECO and implemented by The Graduate Institute, Geneva aims to support partner central banks in emerging countries in building the analytical and technical expertise to conduct effective monetary policy, promote stable and efficient financial sector, and be more operationally sustainable.
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Spillovers of foreign monetary policy on the foreign indebtedness of Colombian banks and corporations - by Paola Morales-Acevedo
In an increasingly interconnected world, spillovers from the monetary policies of advanced economies onto emerging ones, such as Colombia, present a major challenge. These spillovers can have destabilising effects on financial stability through their impact on commercial banks and corporations via changes in asset prices, inflation and credit availability. In a recent paper I analyse the impact of foreign monetary policy — from a broad range of countries — on the foreign indebtedness of Colombian banks and corporations, and evaluate whether capital controls can help to mitigate these spillover effects.
The analysis uses a panel of cross-border lending data to assess the impact of foreign monetary policy on Colombia. The data cover all foreign loans granted by foreign-located financial institutions – for instance in the United States, Germany and the Bahamas – to (i) financial and (ii) non-financial companies located in Colombia, respectively.
The results identify spillover effects of foreign monetary policy on the type of cross-border loan. In particular, periods of foreign monetary policy easing are associated with an increase in cross-border lending to Colombian banks, but a reduction in lending to non-financial corporations (as the new foreign lenders direct their flows to banks). These effects are accompanied by decreases in the interest rates on loans to Colombian banks and corporations. A mirror pattern is observed during periods of foreign monetary policy tightening, with a decrease in cross-border lending to Colombian banks, an increase in lending to corporations, and with rising interest rates to banks and corporations.
The paper also finds that capital controls play an important role in mitigating these spillover effects. However, their effectiveness depends on the stance of both foreign and domestic monetary policy. In particular, a reduction in the foreign monetary policy rate beyond a threshold (60 basis points) cancels out the effects of capital controls, resulting in a net increase in the foreign indebtedness of Colombian banks. The effects of the capital controls are also cancelled out by an increase in the domestic monetary policy rate (beyond 180 basis points). In addition, capital controls are more effective in mitigating the effects of the cross-border lending to banks than to non-financial corporations. Overall, when capital controls are in place, the interest rates on loans to Colombian banks and corporations are less sensitive to periods of foreign monetary policy tightening.
FULL RESEARCH PAPER
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Eric M. Leeper, University of Virginia
Macroeconomists have long understood that monetary and fiscal policies at times can work at cross purposes. Sargent and Wallace (1981) offer a dramatic example of a game of chicken between the two policy authorities, with potentially bad outcomes. Fiscal policy maintains a constant primary deficit financed by new bond sales, while monetary policy independently chooses to hold the money stock fixed. Both authorities understand there will come a time in the future when the private sector refuses to absorb further bonds. Something has to give: either the government reforms fiscal policy to convert deficits to surpluses or the central bank generates seigniorage revenues to finance the deficit and interest payments on the bonds.
Many readers take only a very narrow message from Sargent and Wallace: irresponsible fiscal policy can force inflationary monetary policy. The equally narrow policy lesson is to give central banks specific inflation targets and forbid the government from interfering with monetary decisions. But there is a more subtle and more general message: the impacts of monetary policy always depend on fiscal behavior. In fact, in their example, when fiscal policy runs constant deficits tighter monetary policy today leads to higher future, and possibly even current, inflation.
In recent years, European countries, both in and out of the euro area, have been running unprecedentedly expansionary monetary policies to lift a stubborn inflation rate toward target. Policy interest rates have been negative: in the euro area since June 2014; in Switzerland since December 2014; in Sweden since February 2015. Inflation in all three regions remains below target. Why does monetary stimulus seem so ineffective?
Many explanations have been offered, from increased globalization to low world real interest rates to “bad shocks.” I offer an alternative explanation that applies the more general message about monetary-fiscal policy interactions. Fiscal policies in these European regions may be undermining monetary efforts to inflate.
When the global financial crisis hit in 2008, many countries in the euro zone adopted fiscal stimulus measures. Government debt grew during the recession—as debt always does in recessions—and with that growth came hysterical calls for drastic fiscal consolidation. By 2010, though, the crisis was declared over, and those same countries reversed their fiscal stances. The euro area fiscal stance moved from a 3.4 percent primary deficit in 2010 to a 1.3 percent surplus in 2018. Germany government debt fell from 82 to 61 percent of GDP in the same period. Switzerland has run positive primary surpluses since 2006—even during the global financial crisis. Sweden has also been raising surpluses to retire outstanding debt.
How does fiscal contraction conflict with monetary expansion? The answer lies in understanding how monetary and fiscal policies must interact for the central bank to successfully target inflation. Monetary policy actions always have fiscal consequences. When the central bank combats inflation by raising interest rates, it also raises interest payments on outstanding government bonds. Those interest payments raise the wealth of bond holders, which raises the demand for goods. Higher demand tends to push up goods prices, counteracting the central bank’s goal. Fiscal policy can eliminate this wealth effect by raising taxes to cover higher interest payments.
This fiscal backing for monetary policy operates symmetrically. When the central bank seeks to raise inflation by lowering interest rates, fiscal policy eliminates the negative wealth effect of reduced interest payments by cutting taxes.
Negative interest rate monetary policies in Europe are reducing interest payments on outstanding government debt. Instead of cutting taxes to offset the negative wealth effects of the monetary policies, governments are raising primary surpluses: both monetary and fiscal policies are acting to reduce private-sector wealth. Lower wealth tends to reduce demand for goods and, therefore, consumer prices.
European governments are simply following the fiscal rules their countries have adopted. Those rules, unfortunately, give precedence to reducing government indebtedness without incorporating the key economic insight that successful inflation targeting requires appropriate fiscal backing for monetary policy. Fiscal rules can be designed to both stabilize debt and back monetary policy.
 Wallace (1981) formally establishes this point and Tobin (1980) applies similar reasoning.