You may hear a sigh of relief from emerging market watchers as we approach the end of the year. Yet, against the backdrop of a prolonged period of low interest rates in advanced economies, huge capital flows, and a slowdown in emerging market growth, 2015 promises to keep us all on our toes. Differences in the timing of exit from unconventional monetary policy in advanced economies will have a global impact. The IMF has been keeping a close eye on developments in emerging markets, providing analysis on issues such as how investors’ differentiate between emerging market countries, the impact of volatile markets, and the factors explaining the slowdown in growth.
In a recent paper, we take a look back at what happened before and during the tapering episode to draw out the key lessons for policymakers. Past experience is clear: decisions by major central banks can have sizable global spillovers. Announcements by the U.S. Federal Reserve, in particular, have been strongly correlated with asset price volatility and capital flows in emerging markets. With expectations of Fed tightening to begin in 2015, we think a better understanding of these events can better inform policymakers’ decisions.
Reading the taper tantrum tea leaves
In May 2013, when Fed chair Ben Bernanke began to talk about when and how to reduce the central bank’s bond-buying program, financial markets panicked. During this initial phase of acute and systemic market volatility, emerging markets were hit indiscriminately. Many emerging markets saw their currencies depreciate rapidly, while external financing premia increased, equity prices fell and capital flows slowed.
Fortunately, markets began to differentiate fairly quickly between countries with good fundamentals and those that had begun to accumulate economic imbalances..
What can emerging market policymakers do during the boom and bust cycles of capital flows?
Our work shows that economic fundamentals and early action by policymakers play a critical role in managing risk and building resilience to external shocks.
After the initial reaction, market pressures were more subdued in countries with:
- stronger fundamentals
- financial systems with more domestic services, products and liquid markets
- fewer foreign holders of domestic debt and
- better growth prospects.
We define better fundamentals as stronger current and fiscal account positions, lower inflation, and adequate international reserve buffers. Countries with tighter macroprudential policies and capital controls prior to the taper talk also coped better.
There are also actions that emerging markets can take once a shock hits.
Emerging market countries that acted early and decisively to address vulnerable aspects of their economies and financial systems fared better. Raising interest rates where inflation was high, intervening where foreign exchange reserves are adequate, and addressing current account deficits—all of these moves had a soothing effect on markets.
Emerging markets are not in this alone. International organizations such as the IMF have an obligation to help strengthen the global financial safety net through better cooperation with regional financial arrangements, facilitating swap lines between central banks to ensure sufficient liquidity, and directly helping with resources if requested.
Advanced-economy central banks and the broader international community can also play an important role to ensure global financial stability. Clear and effective communication concerning exit from unconventional monetary support is critical to help reduce the risk of excessive market volatility.
The Fed’s communication strategy improved after May 2013. That is one reason why markets have not overreacted to the end of U.S. unconventional monetary expansion.
Nevertheless, the normalization of monetary policy in the United States and other advanced economies is likely to cause some volatility in global markets. Emerging markets need to continue to strengthen fundamentals and be prepared for a swift and decisive policy response to eventual market jitters.