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BCC BLOG

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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. 

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    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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A tale of two shocks: financial stress and sovereign default risk during the Covid19 crisis - by Caterina Rho

1/7/2020

 

Caterina Rho, Economist at the DG Financial Stability of Banco de México

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The Covid19 pandemic is causing unprecedented stress on public finances. The virus is simultaneously hitting financial markets and the real economy, with potential disruptive effects on public finances in advanced (AEs) and especially emerging market economies (EMs). The health emergency called for sudden increases in fiscal spending, not only to assure adequate hospital care and protection to medical practitioners and coronavirus patients, but also to fund exceptional unemployment insurance programs and emergency support to the private sector, especially strategic firms and small and medium-sized enterprises. Higher public spending, combined with lower fiscal revenues as well as contracting GDP, is leading to increases in the government debt-to-GDP ratio, calling into question the sustainability of the current fiscal stance.  At the same time, the increase in uncertainty due to the effects of the virus and the duration of the epidemics hit financial markets. This caused a drop in stock market prices and a sudden stop in capital flows to EMs, with negative effects on domestic currencies, inflation expectations and balance sheets.
 
The contemporaneous impact of the Covid19 outbreak on the real economy and financial markets is significantly increasing the risk of sovereign default in many EMs. Financial stress can amplify the impact of fiscal vulnerabilities and deteriorating economic fundamentals on the probability of sovereign default through a variety of channels. First, financial stress may weaken markets’ ability to finance sovereign liabilities to the extent that it impacts risk appetite and market liquidity. Second, financial stress can act as a wake-up call that induces complacent or inattentive investors to pay more attention to hitherto-ignored weak fundamentals. Third, financial stress can shed new information on a country’s contingent liabilities that might inflate future public debt. To the extent that the impact of public debt on sovereign risk is non-linear and increasing, information on future upsurges of public debt should have a bigger impact on sovereign risk, the higher the level of current debt.
 
In a recent paper with Manrique Saenz (Rho and Saenz, 2020) I analyze how financial stress amplifies the negative effects of fragile macroeconomic fundamentals on the probability of sovereign default, a risk that may be underestimated in normal times. This is relevant in the context of the Covid19 crisis, where a contemporaneous negative shock increased both financial stress and the fragility of the real economy. We use a panel dataset of debt burden indicators, sovereign spreads and sovereign defaults that covers 113 Market Access countries, including AEs and EMs, over the period 1990-2014.
 
We consider two measures of sovereign risk: (i) the country’s 10-year sovereign bond spread with respect to the US-Treasury bond and (ii) the probability of sovereign default. The first measure has the advantage of capturing increases in vulnerabilities even when these are not big enough as to lead to sovereign default. We use an OLS model to estimate the impact of fiscal vulnerabilities on sovereign bond spreads in AEs and EMs and whether such impact is amplified during times of distress in financial markets. Our second measure of sovereign risk is estimated using a logit model based on a dummy for sovereign default episodes. This estimation applies only to EMs given the lack of sovereign default episodes among AEs.
 
Financial stress can originate from domestic or foreign causes, and we therefore, use two different indicators of private financial stress, a local one and a global one. The local stress indicator is the time series of systemic banking crises estimated by Laeven and Valencia (2018). We consider two alternative measures for the global indicator. The first is a dummy based on the growth rate of the broker-dealer leverage. The second is a dummy that signals excessive increases (higher than 2 standard deviations from the mean) in the VIX index.
 
We find that sovereign spreads increase with public debt, higher inflation and exchange rate overvaluation, but decrease with higher real GDP growth, GDP per capita, and global growth. We also find that at times of financial distress, the impact of public debt on sovereign spreads is significantly amplified. At times of local financial distress, the impact of other economic fundamentals on sovereign spreads is also amplified: GDP per capita and the level of international reserves (in percent of GDP) seem to matter significantly more for sovereign risk at times of local financial distress than during tranquil times.

Table 1: Average marginal effects of the macroeconomic indicators during tranquil and financial stress periods (Logit model, Emerging markets, 1990-2014)
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Table 1 presents the average marginal effects of our set of macroeconomic indicators on the probability of sovereign default in EMs, computed with the logit model. Columns (1) to (3) consider financial stress driven by a local shock, while columns from (4) to (9) consider financial stress from a global financial shock. Public debt is found to impact the probability of default of EMs, and its impact is also amplified significantly during periods of global financial stress. International currency reserves are found to mitigate the probability of default, particularly during times of local financial stress. Finally, a drop in GDP growth rate during times of local or global financial stress is also worsening the sustainability of sovereign debt. We can interpret the Covid19 pandemic as an exogenous global shock that increases financial stress in EMs. Our empirical results justify the current concern for sovereign debt sustainability in those markets.
 
References
 
Laeven, Luc and Fabian Valencia (2018). “Systemic Banking Crises Revisited”. IMF Working Paper 18/206, September
 
Rho, Caterina and Manrique, Saenz, (2020). “Financial Stress and the Probability of Sovereign Default”, submitted.
https://caterinarho.wixsite.com/home/research
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Exceptional measures for exceptional times - by Patrick Bolton, Lee Buchheit, Pierre-Olivier Gourinchas, Mitu Gulati, Chang-Tai Hsieh, Ugo Panizza, Beatrice Weder di Mauro

2/6/2020

 

Patrick Bolton, Lee Buchheit, Pierre-Olivier Gourinchas, Mitu Gulati, Chang-Tai Hsieh, Ugo Panizza, Beatrice Weder di Mauro*

Terrible times ahead, especially in emerging and developing countries
These are not normal times, and what the world is experiencing is not a normal recession. The IMF predicts that only 9 countries out of 190 will have positive per capita GDP growth in 2020 (and none of them will record a growth rate above 2%). To put this in context, at the peak of the global financial crisis more than 75 countries registered positive GDP per capita growth.
A downturn of this magnitude can cause tremendous long-term damage, especially so in emerging and developing economies with high degree of informality and weaker social and economic safety nets.
While many advanced economies are able to finance massive fiscal stimulus packages with super low interest rates, emerging and developing countries are hit by a double whammy as the COVID-19 crisis has led to a sudden stop in capital flows. According to estimates by the Institute of International Finance, non-resident portfolio outflows from emerging market countries amounted to nearly $100 billion over a period of 45 days starting in late February 2020. For comparison, in the three months that followed the explosion of the Global Financial Crisis, outflows were less than $20 billion.
This situation has led more than 100 countries to seek IMF help. As explained in an April 30, 2020 Op Ed by the Ethiopian prime minister Abiy Ahmed, many countries are facing a dilemma: continue to service their external debts or redirect resources to save lives and livelihoods?

The help so far – and its limits
On April 15, 2020, the G20 announced a debt service standstill on bilateral loans for a group of 76 low-income countries, but private creditors were not asked to participate in this standstill. The Institute of International Finance (an organization with a large membership of international banks and fund managers) had, on April 9, called for international coordination and broad creditor participation to support fair burden sharing in this standstill.  However, by May 1, it had backtracked, stating that participation of private creditors in the initiative would be on a voluntary basis and based on an assessment of NPV neutrality made by individual private creditors.
The idea that participation is on a voluntary basis, with each private creditor conducting its own NPV calculations, making individualized excuses about fiduciary duties and contractual complexities is a recipe for free riding. And the more free riders there are, the greater the likelihood that even those who were inclined to participate in the first place will back out. After all, no fund manager wants to look stupid in front of her investors. End result: The official sector – i.e., taxpayers – are going to bear the brunt of the cost unless something is changed in the current plan. 
To us, it seems pointless for the G20 to provide debt relief for developing countries if the freed resources are directly siphoned into the pockets of private creditors as opposed to going to fighting Covid-19. Nevertheless, an argument can be made that this is not an enormous problem for the countries targeted by the G20 action. In these countries nearly 90% of total long-term external debt is owed to official creditors (multilateral and bilateral).

Middle-income countries are different from low-income countries
By contrast, in upper middle-income countries more than 80% of total long-term external debt is with commercial creditors. Figure 1 compares the G20 action, which amounted to approximately $14 billion, with our estimates of the external long-term debt that needs to be serviced by lower and upper middle-income countries. Estimated debt service to private creditors for lower middle-income countries amounts to $48 billion and estimated debt service to private creditors for upper middle-income countries is close to $200 billion. This is where the real money is.
Figure 1: Debt rollover needs of lower middle-income countries, upper middle-income countries and the G20 action.
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Some middle-income countries will face choices similar to that highlighted by the Ethiopian Prime Minister and a standstill for these countries would be useless if it does not include all private creditors. But how can this be done without destroying the international debt market. This is the question that we address in a new report published in the CEPR Policy Insight series (Bolton et al. 2020).
What do to?
We propose that the official sector could coordinate such a standstill and propose a mechanism that would guarantee that the debt relief associated with it would be used for emergency funding related to the global pandemic. A multilateral institution such as the World Bank or other regional development banks could create for each participating country a central credit facility (CCF) allowing a country requesting temporary relief to deposit stayed interest payments for use for emergency funding to fight the pandemic. It is common sense that principal amortizations occurring during the standstill period should also be deferred, so that all debt servicing would be postponed. The CCF would be monitored by the multilateral institution to ensure that the payments that otherwise would have gone to creditors are used for emergency funding related to the global pandemic. Our assumption is that all funding from this emergency facility and associated deferred principal payments would eventually be paid back to creditors since it would be recognized as having the type of preferred creditor status typically associated with lending by a multilateral such as the World Bank or the IMF.
Our proposal is rooted in the doctrine of “necessity” from international law, under which nations are allowed to temporarily defer obligations during times of extreme crisis where they need to give priority to the needs of their populace. Past economic crises, whether in the US or elsewhere, have sometimes led to political interventions to suspend debt payments or to make other modifications to the terms of debt contracts. Such interventions do not automatically undermine credit markets. In some instances, they have actually had the opposite effect, resurrecting debt markets following the intervention. The reason why debt markets recovered was that creditors had anticipated widespread default in the absence of any modification of the repayment terms, and were pleasantly surprised by the intervention that had the effect of reducing the risk of default.
For many reasons most debt contracts are highly incomplete and do not contain provisions prescribing how the parties will react to contingencies such as a global pandemic that would merit lowering debt obligations in this event. Ex post it is easier, of course, to identify the contingency. The political intervention in debt contracts in these events serves the role of completing incomplete debt contracts.     
Not all interventions are beneficial in this way. It is important that they take place only in verifiably unusual and urgent circumstances that are outside the debtor’s control. Unusual circumstances are precisely the ones that are hard to describe and to include in a debt contract. By certifying that such an event has occurred and by acting accordingly, the G-20 would ensure that contract terms will be modified only when absolutely necessary and when the modifications are likely to support credit markets.


* The authors are at Columbia University and Imperial College (Bolton), University of Edinburgh (Buchheit), University of California Berkeley (Gourinchas), Duke University (Gulati), University of Chicago (Hsieh), and The Graduate Institute Geneva (Panizza and Weder di Mauro). Parts of this blog post draw from a VoxEU piece titled “Necessity is the mother of invention” https://voxeu.org/article/debt-standstill-covid-19-low-and-middle-income-countries
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Wage Growth and Inflation in Europe: A Puzzle? - by Raju Huidrom, Petia Topalova, and Richard Varghese,

11/5/2020

 

Raju Huidrom, Petia Topalova, and Richard Varghese,
International Monetary Fund

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Does wage increase fuel inflation? While this wage-price linkage has long been at the heart of macroeconomic analysis, it appears to have waned in recent years. Specifically, over the last few years, until the outbreak of the COVID19 pandemic, wages were rising faster than productivity in many advanced economies. We would have expected this to lead to inflation pressures, yet signs of underlying consumer price pressures remained limited. This was especially the case in Europe where wage growth – adjusted for productivity – exceeded inflation during 2017-19. Economic theory suggests that if real wage growth exceeds productivity gains, the higher labor costs faced by businesses should eventually raise the prices of the products and services they provide. The apparent disconnect between wage and price developments in the last few years is thus puzzling. To shed light on this puzzle, in recent research (Boranova et al. 2019), we examine the link between wage growth and inflation using a sample of 27 European countries over 1995-2019. While our research focuses on Europe, the forces that we consider apply more broadly, and our findings are informative also for non-European countries.
 
Weaker passthrough from wage growth to inflation in recent years
 
We assess the transmission of shocks to wages into prices using a panel vector autoregression (PVAR) analysis. Our results show that, historically wage growth has led to higher core inflation, as shown by the orange line in the figure below. The impact of a wage shock on inflation is rather small initially, but builds up over time, peaking around six quarters before slowly dissipating. The passthrough--defined as the ratio of the cumulative change in inflation at the end of three years to the respective cumulative change in wage growth--is about one-third.
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However, the passthrough of labor costs to inflation has weakened since 2008, as shown by the blue line. Our analysis using an interacted panel vector autoregression (IPVAR) framework suggests that since the global financial crisis the passthrough is one-third weaker than it was beforehand. We examine three factors that could explain this observation--the role of inflation and inflation expectations, domestic and foreign competition, and corporate profitability. The results of our analysis are summarized in panels A-H in the figure below that presents the extent to which wage shocks are transmitted to prices. Panel A indicates that this passthrough has decreased since 2009, as pointed above.
 
Expectations of low inflation
 
In a world where persistently low inflation feeds into lower expectations of future inflation, the price-setting behavior of firms might have changed. If firms expect low inflation, they may be reluctant to pass higher labor costs onto consumers since they expect their competitors to hike their prices only moderately. Thus, price stability, for example due to improved inflation expectations anchoring, is likely to reduce the sensitivity of inflation to wage growth. We examine this stylized narrative using two complementary exercises. First, we test whether the link between wage growth and inflation depends on the prevailing inflation rate in the economy. While a crude proxy of inflation expectations, this analysis allows us to overcome data limitations inherent in the second approach where we directly examine the role of inflation expectations anchoring as measured in Bems et al. (2018). Both of these exercises confirm our prior—the passthrough from wage growth to inflation is lower in a low-inflation environment (panel B) or when inflation expectations are firmly anchored (panel C).
 
Rising competitive pressures
 
We formally examine the role of competition by decomposing aggregate price into goods and services prices, and analyzing how the wage passthrough differs across goods and services. Why does this matter for the competition channel we propose? Import penetration—a proxy for foreign competition—is around 60 percent in the manufacturing sector but less than 5 percent in services. We find that the passthrough from wages to prices is stronger for services as opposed to industrial goods (panel D). This is consistent with the idea that higher exposure to competition leads to a lower passthrough from wage growth to inflation. A complementary exercise using more granular sectoral data confirms that higher exposure to foreign competition is directly associated with lower growth in producer prices.  Finally, we find that the passthrough of wage growth to inflation is marginally higher in countries with higher domestic regulatory barriers in product markets, and hence lower domestic competition (panel E).
 
Comfortable profit margins
 
The analysis on the role of competition leads us to ask how firms might absorb wage growth without passing them on to price increases. We start by examining the role of an obvious candidate—corporate profitability. To the extent that firms have comfortable profit margins they may be able to absorb higher wage costs without increasing prices. We find some support for this line of reasoning. When the economy-wide corporate sector profit share is relatively high, a significantly smaller share of wage growth finds its way into consumer prices inflation (panel F). Labor share of income, which mirrors corporate profitability, too affects the passthrough—low labor share implies wage developments matter less for inflation (panel G). Our analysis regarding the role of competition and corporate profitability when taken together, however, may seem incompatible. But this is not necessarily so. Many factors—cheaper intermediate inputs, lower taxation, or financing costs, and new technologies—may support corporate profitability in the face of increased competition even as wages rise. Indeed, we find the passthrough from wages to inflation to be lower during times of low relative prices for machinery and equipment (panel H).
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All these factors that we discuss as determinants of the post-crisis decline in the passthrough suggest that robust wage growth, prior to the outbreak of the COVID19 pandemic, likely had a muted effect on inflation.
 
The views expressed herein are those of the authors and should not be attributed to the IMF, its Executive Board, or its management.
 
References
 
Bems, Rudolfs, Francesca Caselli, Francesco Grigoli, Bertrand Gruss, and Weicheng Lian. 2018. “Expectations’ Anchoring and Inflation Persistence”. IMF Working Paper 18/280, International Monetary Fund, Washington, DC.
 
Bobeica, Elena, Matteo Ciccarelli, and Isabel Vansteenkiste. 2019. “The Link between Labor Cost and Price Inflation in the Euro Area.” ECB Working Paper No. 2235, European Central Bank, Frankfurt am Main.
 
Boranova, Vizhdan, Raju Huidrom, Sylwia Nowak, Petia Topalova, Volodymyr Tulin, and Richard Varghese. 2019. “Wage Growth and Inflation in Europe: A Puzzle?”  IMF Working Paper No. 19/280.
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The economic impact of the Covid19 on emerging economies: what do we know, and what are the challenges? - by Cedric Tille

18/4/2020

 

Cédric Tille, Graduate Insitute of Intenational and Development Studies, Director, BCC programme

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The Covid19 epidemic represents a major shock for the global economy. Early indicators of economic activity point to a contraction well above the 2008-2009 crisis, and on par with the Great Depression. While growth should resume in 2021, the pace will not be enough to offset the ground lost in 2020. In this blog I review the prospects for the next two years, as well as recent developments in international financial markets. I then consider the policy response, and outline some challenges for the medium run.
 
The IMF forecasts released this week make for somber reading. Figure 1 illustrates the sharp revision of the forecast by showing the difference between the GDP level from the most recent April 2020 forecast and the previous October 2019 forecast (in percent of the GDP level in the earlier forecast), both for 2020 (stripped bars) and 2021 (solid bars).
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The world economy is expected to contrast massively this year. While growth should resume in 2021, it will be too limited to make up for lost ground and world GDP will still stand 4 percentage points below the level that was expected in the October 2019 forecast (solid blue bar). In addition, the forecasts are characterized by a degree of uncertainty that is larger than usual and could be revised down further. The contraction should be larger in advanced economies (green bars) than in emerging and developing ones (red and orange bars). This offers cold comfort however, as emerging economies will still face a sizable contraction of activity, and this will be persistent as the GDP gap in 2021 (compared to the earlier forecast) won’t be so different from the one for advanced economies. In addition, the situation is quite heterogeneous: while emerging Asia should experience a smaller recession, emerging Europe and Latin America are faced with a sizable contraction and in 2021 are expected to have the worst GDP gaps.
 
Emerging economies are affected both by the direct domestic impact of the epidemic and the required health measures and by the contraction through international linkages. Figure 2 shows the revisions in the export volumes forecasts, and is constructed in the same way as figure 1. Global trade should experience a contraction even larger than during the global financial crisis. While the impact is larger in advanced economies, it remains sizable in emerging ones.
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In addition to the sudden stop in trade flows, emerging economies are experiencing a sharp sudden stop in capital flows as investors retreat to the relative safety of advanced economies’ markets. As a result, emerging economies have seen their currencies weaken and the spread on their bond yields increase substantially (Hofmann et al. 2020).
 
Historically, countries with higher levels of foreign exchange reserves and clearer policy frameworks have been better able to handle the fluctuations in global markets. The question remains whether these factors will be enough in the face of a shock of unprecedented magnitude. In addition, the international spillovers are substantial, which makes domestic policies alone hard-pressed to absorb them. Kohlscheen et al. (2020) estimate that about half the economic contraction in emerging economies reflects the spillovers from recessions in the rest of the world.

Given this uncertainty, and the global nature of the shocks, several measures have been taken by multilateral institutions. These include suspending the scheduled debt repayments for the poorest countries, as well as activating the IMF support for several economies. The IMF has already granted support to several countries through the Rapid Credit Facility and the Rapid Financing Instrument, which can be activated without putting a full-fledged program in place. So far, the support totals 4.5 billion SDR (about $ 6.1 billion). In addition, the IMF put in place a new liquidity line specifically tailored to assist countries coping with the epidemic.
 
Given the depth and the duration of the recession, it is likely that more help would have to be deployed, possibly stretching the resources of multilateral institutions. A proposal to alleviate the problem is an additional Standard Drawing Rights issuance that would allow for larger IMF support to affected countries. Such an issuance would requires the approval of the IMF largest shareholders, and is thus vulnerable to political considerations.
 
In addition to its impact over the next two years, the epidemic could lead to persistent changes in the global economy. It has in particular highlighted the risks of relying on only a few countries as sources of goods that are in high demand in a crisis, such as medical supplies. Production capacities can then be stretched when they are most needed, and disruptions in trade can hinder the shipment of goods. The pattern of global trade could then be altered. One possibility is that countries decide to produce a larger share of goods deemed important domestically, which would weigh on trade at the expense of emerging economies. Another possibility is that countries continue to import, but do so from a broader range of sources. While this would be detrimental to countries that had a prominent position as global suppliers before the crisis, it could raise demand from other emerging economies, as short-term production efficiency is traded off against diversification. Another potential change in the medium run is that consumers could perceive some goods and services to be riskier and re-orient their purchases towards other goods. Tourism is a sector that could face a persistent reduction of demand due to such concerns.
 

Hofmann, Boris, Ilhyock Shim,  and Hyun Song Shin (2020). “Emerging market economy exchange rates and local currency bond markets amid the Covid-19 pandemic”, BIS bulleting 5
https://www.bis.org/publ/bisbull05.htm
 
Kohlscheen, Emanuel, Benoit Mojon, and Daniel Rees (2020). “The macroeconomic spillover effects of the pandemic on the global economy” BIS bulletin 4
https://www.bis.org/publ/bisbull04.htm

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Interacting with International Financial Institutions: Insights from the BBC course - by Andres Murcia

13/4/2020

 

Andres Murcia, Director of the International Affairs Unit, Central Bank of Colombia

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The importance and nature of the International Financial Institutions (IFI’s) and the type of interactions that national authorities have with them are constantly evolving, and central banks have to adjust to those changes. Indeed, one of the key objectives of the recently created Unit of International Affairs at the Central Bank of Colombia is precisely to manage the relations with IFI’s. This one of the key initiatives in the strategic plan of the Bank.

Against this background, I truly recommend BCC’s online course “Interaction with IFI’s” to anyone involved in managing such relations. The course covers both economic analysis and negotiation techniques. The potential impact of enhancing the analytical and technical expertise is quite significant. I want to highlight particularly four features of the course: the negotiation techniques, the lessons about effective communication, the simulation exercise and the online nature of the course.

The lessons about negotiation techniques were extremely valuable and I was able to apply them shortly after the course. Colombia is currently closing the negotiations for a renewal of the IMF Flexible Credit Line. This negotiation had many complex elements and actors, and I found that to achieve the best agreement it was necessary to apply some of the negotiation techniques we covered in the course. As part of the team of the Central Bank that negotiated with the IMF, I saw that the technical aspects must go hand in hand  with effective negotiation skills. Being able to put into practice the lessons learned proved the importance of this kind of technical assistance to strengthen the capacity of the Central Bank in these types of interactions.

The effective communication skills are key for addressing and achieving the objectives proposed. In my day-by-day duties I have to communicate to audiences with different technical and cultural backgrounds. When presenting to different types of audiences I used to focus on the message that I wanted to deliver, but not in the best way to do so. However, through the course I learned the importance of identifying the type of audience, in order to use the best techniques for engaging with them. For instance, using a top down or a bottom up structure with different types of audience has helped me to achieve my objectives in a much easier way.

During the course, a simulation of a negotiation with the IMF took place. The exercise was a situation where a country had to negotiate a credit facility with the IMF, some were part of the central bank of the country and the others of the IMF. In this sense, we had to build a view of the economic and financial situation of the country, identify the macroeconomic variables that were useful and determine which information was important. The most valuable aspect of this process was working with people from other backgrounds and learn from the different perspectives. It was necessary to identify which kind of policies (e.g. fiscal, monetary, financial) were more appropriate to apply.

Finally, it is necessary to highlight the online nature of the course. This allows greater flexibility especially for people with high constraints on their time availability. The videos, documents and presentations were prepared for a vast public with different types of backgrounds and are particularly interesting and of an outstanding quality. These materials were designed in a good way, taking into account the time restrictions that a person who takes an online course has. I would like to highlight the feedback and attention received by the BCC staff. A friendly platform and the high-level comments on the essays that we prepared are aspects that made the course unique and especially valuable. I consider that it is crucial to develop the skills needed to interact in a higher degree through digital channels.
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Should disaster risk and climate change be introduced in macroprudential regulation and supervision? - by Gregorio Belaunde

25/2/2020

 

Gregorio Belaunde, Independent Risk Management Consultant

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Should central banks care about climate risk?

When the new President of the ECB, Christine Lagarde, said on December 2, 2019 that fighting against climate change was a critical mission for the ECB, she was met with comments that this not being ECB’s mandate and that it could even affect its independence. According to Jerome Powell, Chairman of the U.S. FED, climate change is not a job for the Bank. Similarly, for a long time, the Basel Committee on Banking Supervision (BCBS) did not seem to think that it had a role to play in this field as a standards-setter.

The debate is rapidly moving, however. Mark Carney, while at the helm of the Bank of England and of the Basel-based FSB led efforts to include climate change as a key issue for central banks and financial regulators. This inspired the creation in December 2017 of a group of central banks and supervisors, the Network for Greening the Financial System (NGFS), which issued in April 2019 a Call for Action with, as 1st Recommendation, “Integrating climate-related risks into financial stability monitoring and micro‑supervision”. The BCBS joined this network in June. In its October 2019 Global Financial Stability Report the IMF mentioned climate change as a key issue, just after joining the NGFS. This January, the BIS released its first paper on this, a book called “The Green Swan”, where it states that “Central banks can have an additional role to play in helping coordinate the measures to fight climate change”. So, the answer to the question laid out at the beginning is now a clear Yes. This said, both the IMF and the BIS stress that integrating climate change into financial stability monitoring is a significant challenge, due to radical uncertainties. So, the complete answer is rather: Yes, but how exactly?

I think that the problem is even more relevant and urgent for emerging and developing countries and their financial regulators/supervisors, in coordination with Ministries of Finance due to their fiscal risk management role. This particular relevance stems from the fact that the impacts of climate change and related hazards on their GDP, and therefore on the quality of the credit exposures, are inevitably much higher, given the smaller size of their economies, as international experience shows. Concurrently, those countries should not forget that the problem is not only climate change, but also disaster risk, which considers a broader range of events than weather-related ones, notably earthquakes. This has been reminded in a Standard and Poor’s study of 2015 about the impact that “natural” disasters could have on sovereign ratings, and in different studies concerning the serious “disaster-insurance gap” that those countries face. Both factors combined can cause steep increases in non-performing loans (NPLs), with a systemic impact if several significant disasters hit in a short period of time, or in case of a large-scale disaster.

Therefore, the financial regulators/supervisors should urgently integrate climate change and disaster risk into their macro-prudential regulation and supervision, with a related translation into micro-supervision, in the same way as they include risks related to borrowings and loans in foreign currency, for instance. A broad range of very concrete measures can be adopted rapidly. These include, inter alia, and as those that should be prioritized:
  1. stress scenarios on credit exposures of financial institutions (FIs), based on simulations of large expected disasters or continued increased losses due to climate change, leading to possible additional Pillar 2 capital charges in case of need
  2. inclusion into the FIs rating and scoring systems of the evaluation of good and bad disaster risk management practices of their customers, including business continuity planning/disaster recovery planning (BCP/DRP) and degree of insurance uptake
  3. strengthening of regulation and supervision standards for BCP/DRP: more practice, more trials and tests, more “embedding” into the whole organization, stronger incorporation of country-relevant disaster risk scenarios
  4. more stringent provisioning requirements when insurance does not really protect the customer himself and is limited to the loan’s outstanding amount
  5. developing metrics, as part of financial stability reports, about evolution of disaster insurance penetration among FI’s customers
The challenges posed by the uncertainties of the impacts of climate change should not keep the regulators/supervisors from taking rapid steps to at least address in a systemic and preventive way the very real financial risks stemming from natural disasters, which have always existed and proved a substantial source of increased NPLs in the past, and are not limited to weather-related hazards. This should have been done before in a number of developing and emerging countries more heavily exposed to disaster risk. Climate change, with its potential to worsen frequency and impacts of hazards, as well as the rapid and disorderly urbanization with its rise in vulnerabilities and in potential impacts, only increase that urgency.
 
REFERENCES and FURTHER READING
BIS (2020), “The Green Swan - Central banking and financial stability in the age of climate change”, Book - January 2020. https://www.bis.org/publ/othp31.htm
BIS (2019), Research on climate-related risks and financial stability: An "epistemological break"?, Speech by Luiz Awazu Pereira da Silva, 23 May 2019. https://www.bis.org/speeches/sp190523.htm
Carney, Mark (2015). “Breaking the Tragedy of the Horizon—Climate Change and Financial Stability.” Speech delivered at Lloyd’s of London, September 29. https://www.bankofengland.co.uk/speech/2015/breaking-the-tragedy-of-the-horizon-climate-change-and-financial-stability
Grippa, Pierpaolo; Schmittmann, Jochen and Suntheim, Felix (2019), “Climate Change and Financial Risk”, IMF - Finance and Development, December 2019. https://www.imf.org/external/pubs/ft/fandd/2019/12/climate-change-central-banks-and-financial-risk-grippa.htm
IADB (2019), “Climate Risk and Financial Systems of Latin America - Regulatory, supervisory and industry practices in the region and beyond”. Technical Note No IDB-TN-01823. December 2019. http://dx.doi.org/10.18235/0002046
NGFS (2019), “A Call for Action - Climate change as a source of financial risk”, First Comprehensive Report, April 2019. Paris: NGFS Secretariat. https://www.ngfs.net/en/first-comprehensive-report-call-action
Reuters (2019), “ECB's Lagarde will struggle to fulfill self-imposed climate mission”, Article 4 December 2019. https://www.reuters.com/article/us-climate-change-ecb-analysis/ecbs-lagarde-will-struggle-to-fulfill-self-imposed-climate-mission-idUSKBN1Y81QS
Standard & Poor’s (2015), “Storm Alert: Natural Disasters Can Damage Sovereign Creditworthiness”. Ratings Direct. September 10, 2015. https://unepfi.org/pdc/wp-content/uploads/StormAlert.pdf
The Geneva Association (2014), “The Global Insurance Protection Gap—Assessment and Recommendations”. Research Report. November 2014. https://www.genevaassociation.org/sites/default/files/research-topics-document-type/pdf_public/ga2014-the_global_insurance_protection_gap_1.pdf
UNISDR and CRED (2018), “Economic Losses. Poverty and Disasters, 1998-2017”. https://www.undrr.org/publication/economic-losses-poverty-disasters-1998-2017
Von Peter, Goetz. et al., “Unmitigated Disasters? New Evidence on the Macroeconomic Cost of Natural Catastrophes”. BIS Working Papers, No. 394, December 2012. https://www.bis.org/publ/work394.htm
Webb, Ian, David Baumslag, and Rupert Read (2017), “How Should Regulators Deal with Uncertainty? Insights from the Precautionary Principle.” Bank Underground. https://bankunderground.co.uk/2017/01/27/how-should-regulators-deal-with-uncertainty-insights-from-the-precautionary-principle/
World Economic Forum (2019), “The Global Risks Report 2019”. 14th Edition. https://www.weforum.org/reports/the-global-risks-report-2019
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Spillovers of foreign monetary policy on the foreign indebtedness of Colombian banks and corporations - by Paola Morales-Acevedo

19/12/2019

 
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​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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Fiscal backing for monetary policy - by Eric Leeper

16/12/2019

 

​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.[1] 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.
 
 
REFERENCES 
  • Sargent, Thomas J. and Neil Wallace (1981), “Some Unpleasant Monetarist Arithmetic,” Federal Reserve Bank of Minneapolis Quarterly Review, Fall.
  • Tobin, James (1980), Asset Accumulation and Economic Activity, Chicago: University of Chicago Press.
  • Wallace, Neil (1981), “A Modigliani-Miller Theorem for Open-Market Operations,” American Economic Review, 71:3.


[1] Wallace (1981) formally establishes this point and Tobin (1980) applies similar reasoning.
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BCC Technical Workshop on Financial Stability Framework and the Role of Central Banks - by Robert Sheehy

17/11/2019

 

Robert Sheehy, BCC external expert and moderator of the workshop

The central banks’ financial stability mandate has become more important over the last decade, with the development of a battery of macro-prudential tools aimed at preventing imbalances. To share experiences on the use of these tools among the BCC countries, a technical workshop on “The general financial stability framework, with special emphasis on macro-prudential policies and instruments for which the Central Bank is responsible” was held in Bogotá, Colombia, in October 2019. The event was under the sponsorship of the Banco de la República and the BCC programme. Participants from the central banks of Albania, Colombia, Peru, Tunisia and Ukraine discussed a wide range of issues relating to financial stability and agreed on several basic principles. These are discussed below.
 
The institutional framework should ensure that relevant data is shared and that financial stability risks are identified and analysed. In addition, it should promote the building of consensus among policymakers on those risks, as well as on the actions needed and the appropriate mix of macroeconomic, micro-prudential and macro-prudential policies to address risks. It is important that the institutional arrangements counter the bias to inaction or delay and ensure that policymakers can act. Policymakers should be enabled to implement corrective measures by clear decision making and the necessary policy tools.
 
Central banks must have a key role in financial stability due to their responsibility for monetary policy, their status as lender of last resort, and their management of systemic liquidity.[1] Some central banks are also the micro-prudential regulator and supervisor, while others provide back-up funding for the payments systems that underpin the financial sector. Most central banks have well-established expertise in the identification and analysis of systemic risk, capabilities often not available elsewhere.
 
Some financial stability risks cannot be adequately addressed by traditional macroeconomic or micro-prudential policies owing to externalities particular to the financial system. These include the tendency of financial firms to amplify shocks due to leverage and limited capital, the pro-cyclical feedback between asset prices and credit, and the increasing structural linkages among financial institutions. Many of these externalities are directly relevant for the effectiveness of central bank policy actions. The purpose of macro-prudential measures is to address these and other externalities not covered by traditional policy instruments.
 
Macro-prudential policies should promote economic efficiency and limit distortions by focusing on specific externalities not addressed by other measures. Tools that allow adjustment through prices are usually more efficient than quantitative restrictions. The general level of knowledge about the impact of macro-prudential measures is still expanding rapidly and their effects are likely to vary considerably among countries. This implies that adjustment costs should be mitigated by phasing in new measures over time, and that careful monitoring of the impact of macro-prudential policies is necessary to assess their effectiveness and calibration.
 
The identification, analysis and measurement of systemic risk requires the monitoring of data for a wide range of variables. The early warning characteristics of each variable should be evaluated and the most reliable indicators followed on an ongoing basis, with particular attention to signs of emerging liquidity risk. It is useful to summarize the results, but important to do so in a manner that preserves intuitive value so as to facilitate communication with senior policymakers and the general public. The overall vulnerability index employed by the Banco de la República is one way to do so.[2] More sophisticated tools to evaluate systemic risk - such as credit-gap or growth-at-risk analysis - are a useful supplement to the monitoring exercise.[3] Regular reporting to policymakers and the public on developments in systemic risk (e.g., through a periodic financial stability report) should be undertaken.
 
The design of macro-prudential policies should take into account the specific circumstances of the financial sector concerned. There is no one-size-fits-all solution, as the financial structure and associated externalities vary widely among countries. Given the developing state of understanding of the individual and cumulative effects of macro-prudential measures, it is not generally necessary to use sophisticated models to design and calibrate such tools. A more intuitive and flexible approach, supplemented by careful ongoing monitoring and analysis, is likely to be more efficient and effective.
 


[1] Historically, central banks were initially established mainly to promote financial stability.

[2] Banco de la República (2019), Reporte de Estabilidad Financiera – I semestre de 2019, Bogotá.

[3] A good description of credit-gap analysis can be found in Drehmann, Mathias, and Kostas Tsatsaronis, “The Credit-to-GDP Gap and Countercyclical Capital Buffers: Questions and Answers”, Bank of International Settlements, BIS Quarterly Review, March 2014, pp. 55-73. See Prasad, Ananthakrishnan, et al., Growth at Risk: Concept and Application in IMF Country Surveillance, International Monetary Fund, Working Paper WP/19/36, February 2019, for a general explanation of the growth-at-risk methodology and its application.
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The size of fiscal multipliers and the stance of monetary policy in developing economies - by Jair Ojeda-Joya and Oscar Guzman

17/11/2019

 

Jair N. Ojeda-Joya, Banco de la Republica, Colombia
Oscar E. Guzman, National Department of Planning, Colombia

How does fiscal policy impact overall economic activity in emerging economies? This effect – the so-called fiscal multiplier – is a major element for Planning Departments and Finance Ministries to compute the expected impact of higher (or lower) government consumption on Gross Domestic Product (GDP) at various time horizons. For instance, a fiscal multiplier equal to 1 implies that changes in government consumption are translated one to one on GDP.
In this paper, we compute flexible estimates of the fiscal multipliers over a panel of 23 developing economies using quarterly data from 2000 until 2017. Our work extends the literature on fiscal multipliers in developing economies along two main dimensions. First, we allow the fiscal multipliers to differ across alternative monetary-policy stances, namely, expansive and contractive episodes. Second, we perform counterfactual exercises in which we calculate the effect of fiscal policy on GDP, controlling for the monetary policy reaction to the fiscal shock through interest rates. Both exercises provide us with a better understanding of the interaction between fiscal and monetary policies during fiscal shocks.
Our estimates rely on a Panel Vector Autoregression (PVAR). We consider the following variables: government consumption, monetary policy rate, GDP, real money balances (M2), inflation and real exchange rates. The identification of shocks is performed through the Choleski decomposition using the same ordering of variables, so that policy related variables have a lagged reaction to macroeconomic news. This helps to identify fiscal shocks and exclude government consumption movements that do not correspond to exogenous fiscal policy, following the approach of Blanchard and Perotti (2002). In addition, we construct a country-specific classification of periods of expansive and contractionary monetary policy based on the real interest rate relative to its estimated natural level. The estimation is performed using a GMM approach following Abrigo and Love (2016).
A fiscal stimulus has a stronger impact when the monetary policy stance is expansive. Our main results show that the estimated size of the fiscal multiplier crucially depends on the monetary-policy stance at the time of the shock. Specifically, the multiplier is equal to 0.39 during expansive episodes (10 quarters after the fiscal shock) compared to 0.16 during contractionary ones. On the other hand, the counterfactual simulations show that the multiplier is not much affected by the interest reaction to the fiscal shock. Taking out that interest-rate reaction only reduces the multiplier from 0.39 to 0.36 during expansive stances.
Our paper brings a clear message on policy coordination lesson for developing economies with flexible exchange rates, namely that fiscal stimulus is enhanced by an expansive monetary policy stance that facilitates credit access by household and firms. However, the estimated multipliers are still low when compared with those obtained for economies with a fixed exchange rate regime. A related point is made by Huidrom et al (2019) who document the role of fiscal positions on the size of the multiplier.
 
References
  • Abrigo, M. R., and I. Love. “Estimation of Panel Vector Autoregression in Stata,” The Stata Journal, 16(3), 2016, 778-804.
  • Blanchard, O., and R. Perotti. “An Empirical Characterization of the Dynamic Effects of Changes in Government Spending and Taxes on Output,” Quarterly Journal of Economics, 117, 2002, 1329-1368.
  • Huidrom, R., Kose, M., Lim, J., and Ohnsorge, F. “Why Do Fiscal Multipliers Depend on Fiscal Positions?” Journal of Monetary Economics, in press, https://doi.org/10.1016/j.jmoneco.2019.03.004
  • Ojeda-Joya, J., and O. Guzman. “The Size of Fiscal Multipliers and the Stance of Monetary Policy in Developing Economies” Contemporary Economic Policy, 37(4), 2019, 621-640. 

​FULL REPORT HERE
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