BISBulletin

No71

Fiscalandmonetarypolicyinemergingmarketeconomies:whataretherisksandpolicytrade-offs?

AnaAguilar,CarlosCantúandRafaelGuerra

29March2023

ISSN:2708-0420(online)

ISBN:978-92-9259-644-6(online)

BISBulletinsarewrittenbystaffmembersoftheBankforInternationalSettlements,andfromtimetotimebyothereconomists,andarepublishedbytheBank.Thepapersareonsubjectsoftopicalinterestandaretechnicalincharacter.TheviewsexpressedinthemarethoseoftheirauthorsandnotnecessarilytheviewsoftheBIS.TheauthorsaregratefultoAgustínCarstens,HyunSongShin,ClaudioBorio,AlexandreTombini,BenoitMojon,JonFrost,FabrizioZampolli,DenizIgan,FiorellaDeFiore,AaronMehrotra,DanielReesandMarcoLombardiforthehelpfulcomments,andtoLouisaWagnerforadministrativesupport.

TheeditoroftheBISBulletinseriesisHyunSongShin.

ThispublicationisavailableontheBISwebsite

()

.

?BankforInternationalSettlements2023.Allrightsreserved.Briefexcerptsmaybereproducedor

translatedprovidedthesourceisstated.

BISBulletin1

AnaAguilar

Ana.Aguilar@

CarlosCantú

Carlos.Cantu@

RafaelGuerra

Rafael.Guerra@

Fiscalandmonetarypolicyinemergingmarketeconomies:whataretherisksandpolicytrade-offs?

Keytakeaways

?Since2021,monetarypolicyhastightenedgloballyinresponsetothesurgeininflation.Fiscalpolicieshavegenerallyremainedexpansionary,notablyasgovernmentsputinplacesubsidiesandtransferstoinsulatehouseholds,firstfromthepandemicandthenfromhigherenergyandfoodprices.

?Suchfiscalsupportincreasesgovernments’fundingneedsatatimewhentightermonetarypoliciesraisethecostofservicingdebts.Financialmarketsmayreassessfiscalsustainability,requesthigherriskpremiaorreducetheirholdingsofsovereignbonds.

?Althoughsucheffectscouldaffectbothadvancedandemergingmarketeconomies,thelatterhavehistoricallybeenmostvulnerabletoariseinthecostofinternationalfinancingandaweakerexchangerate.

Inlate2021,inflationsurgedtolevelsnotseeninmorethan20years.Policymakersrespondedbyincreasingratesandbyprovidingfiscalsupportandsubsidiestolessentheimpactofhigherenergyandfoodprices.Asaresult,fiscaldeficits–althoughlowerthanduringtheCovid-19pandemic–arestilllargeinmanyeconomies.Bothrisingratesandlargefiscaldeficits–eveniftheoptimalresponseintheshortrun–affectfinancialmarketsandcouldworsenpolicytrade-offsgoingforward,especiallyinemergingmarketeconomies(EMEs).

EMEsaremorevulnerabletochangesinfinancingconditions,especiallyexternalborrowing.Financingcostshavealreadyincreasedinlinewithhigherinterestratesworldwide.Still,concernsaboutthelackofsufficientfiscalconsolidation–andapossiblede-anchoringofinflationexpectations–mayleadtohighersovereignriskpremia,currencydepreciationandtighterdomesticfinancialconditions.Inaddition,fiscalconcernsmayexacerbatethedomesticimpactoftighterinternationalfinancialconditionsandraisetheriskofasuddenstopincapitalflows.

Thesepotentialdevelopmentswouldworsenthetrade-offsfacedbyfiscalandmonetaryauthorities.Formonetarypolicy,financialchannelsoffiscalimbalancesputpressureontheexchangerate,pushinginflationhigherandaffectingitsdynamics.Forfiscalpolicy,higherinterestratesincreasedebtservicecostsandweighonpublicdebt.

Goingforward,interestrateswillprobablycontinueincreasingandremainhighascentralbankscommittobringingdowninflation.Fiscalauthoritiesneedtobalanceprovidingsupport,ontheonehand,andkeepingdebtatmanageablelevels,ontheother.Expansionaryfiscalpolicyneedstobeperceivedassustainable,withaclearexitstrategythatleadstoconsolidationinthefuture.Itshouldbetemporary,targetedandtailored.Sofar,ithasbeenextended,extensiveandexpanded.

ThisBulletinassessesthefinancialrisksofEMEs’fiscalandmonetarypolicystancesinanenvironmentoftighterfinancialconditions,heterogeneousgrowthacrosscountriesandhighinflation.Italsoexploresthepolicytrade-offsandsideeffectsthatwouldprolongthedisinflationaryprocessforecastedbycentralbanks.

2BISBulletin

Changeinpolicyrate3(%)

FiscalandmonetarypolicystancesinEMEsintheaftermathofthepandemic

AttheonsetoftheCovidcrisis,fiscalandmonetarypoliciesactedtogetherandcomplementedeachother(AguilarandCantú(2020)andGraph1.A,bluedots).Intheaftermath,therecoveryhasbeenheterogenous.OutputgapsinmostEMEshaveclosedand,insomecountries,theyhavebecomepositive.Butastrongdemandandalargesupplyshockhavewidenedinflationgapsabruptlyandhaveledtodifferentresponsesfrommonetaryandfiscalauthorities.

Theglobalmonetaryresponsein2022wasforcefulandhighlysynchronisedasthesurgeininflation

wasofaglobalnature(BIS(2022)andGraph1.A,reddots).Thus,notonlyhavecentralbankswithdrawnmonetarystimulusbutmostEMEshavetakenrealpolicyratestopositiveterritory.Insomecases,realrateshavereachedlevelshigherthanthosebeforethepandemic.

1

EMEs’monetarypolicytightenedwhilefiscalpolicyremainedexpansiveGraph1

A.Monetarypolicytightenedandfiscaldeficitsnarrowed…1

12

9

6

3

0

–3

–6

–8–404812

Changeinfiscalbalance2(%ofGDP)

20202022

B.…butthefiscalstanceremainsexpansionary…4

%ofGDP

2

0

–2

–4

–6

–8

–10

2020

2022

2019

Cyclicallyadjusted

primarybalance

C.…whilefiscalconsolidationkeepsgettingpushedback4

%ofGDP

0

–2

–4

–6

–8

–10

192021222324252627

2019:2020:2022:

FiscalbalanceforecastCyclicallyadjusted

primarybalanceforecast

1EMEsinclude:BG,BR,CL,CO,HU,IN,ID,MY,MX,PE,PH,PL,RO,THandZA.2Changeinfiscalbalancefrom2019to2020andfrom2021to2022.3ChangeinpolicyratefromFeb2020toDec2020andfromAug2021toDec2022.4Considers23EMEs.MedianfiguresforpanelC.Dotsdenoteobservedbalancesfor2020and2021andforecastfiguresfor2022.

Sources:IMF;nationaldata;BIS.

Theresponseonthefiscalfronthasleftthepolicystancerelativelyexpansive.Afterthestrongrecoveryfromthepandemic,governmentshardlyreducedtheirfiscaldeficitsin2022(Graph1.A,reddots).Theseveresurgeinenergyandfoodpricesthatstartedinmid-2021derailedconsolidationplansandkeptthediscretionaryfiscalstanceexpansionary–atleastmorethanbeforethepandemic–inalmostallEMEs(Graph1.B).Governmentslessenedtheeffectsofthelossofrealincomeinflictedbytheseshocks–especiallytosegmentsofthepopulationwherefoodandtransportationrepresentalargeshareoftheirconsumptionbasket.AsshowninGraph1.B,the2022cyclicallyadjusteddeficitsremainsizeable.

WhileEMEs’governmentsshouldaimforatailored,targetedandtemporary(“triple-T”)response,thecurrentapproachhasbeenperceivedbymarketsandanalystsasexpanded,extensive(broad-based)andextended(“triple-E”).EMEgovernments’responsetolimitthepass-throughofenergyandfoodpricesexpandedbeyondpricesubsidiestoincludesuspensionofimportdutiesandreductionsinvalue-addedtaxesandexcises(Amaglobelietal(2022)).Thesepolicieswerenotexplicitlytailoredtolow-incomehouseholdsastheywereextendedtothewholeeconomy.Forsomeoilexporters,thesepolicieswouldcompletelyoffsetthegovernment’srevenuegainsfromhighoilprices.Otherpoliciesdidnottarget

1Ananalysiswithexanterealinterestratesconfirmsatighteninginmonetarypolicy.

BISBulletin3

specificpricesbutinsteadexpandedincome,forexample,directcashtransfersandlowerincometaxes.Finally,despiteadesirefortemporarypolicies,somesupportprogrammeswereextendedpasttheiroriginalexpirationdate–evenaftertheoriginalshockhadreverted.

Thecurrentfiscalstanceandhighlevelsofdebtstresstheneedforafiscalsustainabilityplan,buttheactualfiscaldeficitfiguresandforecastshavecontinuedwideningsince2020(Graph1.C).Thisimpliesthattheexpansionhasbeenlargerthanexpectedandthatthefiscalconsolidationhasbeenpostponedforacouplemoreyears.Thefiscalsupporthasdivergedfromthetriple-Tapproachthatwouldguaranteeanexitstrategyandleadtoconsolidationoncetheshockhaspassed.Instead,thetriple-Eapproachmakesconsolidationharderandnegativelyaffectsthedebtoutlook.Moreover,higherdeficitspileuponalreadyhighdebt-to-GDPratios.Inanenvironmentofhigherinterestrates,debtissuanceisexpensive,andrefinancingcostsarehigher.Italsomakesoverallfinancialresourcesmorecostlyinanalreadytightmarket.

Whatarethefinancialrisks?

Highlevelsofdebtanddeficitscantriggeradversefinancialmarketreactions.Inacontextoftighterglobalfinancialconditions,alackofclearsignsoffiscalconsolidationcanputpressureonfixedincomemarkets,especiallyforsovereignbonds,andpushupsovereignriskpremia.EMEs’accesstointernationalfundingmarketsisparticularlyvulnerablewhenthereareworriesaboutdebtincreases(Reinhartetal(2003)).Whengovernmentsannouncebigspendingpackagesorlargetaxcutswithoutaclearcommitmenttofuturefiscaldiscipline(egthroughafiscalrule),financialmarketsmayreactnegatively.Atthesametime,negative

marketsignalsfromsovereigncreditratings,governmentbondyielddifferentialsandsovereigncreditdefaultswaps(CDS)spreadscouldsignificantlyconstrainfiscalpolicy.

2

Inaworstcasescenario,anexpansionarypolicycouldendupbeingnotexpansivebutcontractionary.

LoosefiscalpolicyraisestheriskpremiumandputspressureontheexchangerateGraph2

A.Fiscaldeficitsraisesovereignrisk1

bp

150

100

50

0

–50

–100

012345678

Quarters

Responseof5YCDSspreadsto1stddevofprimarydeficit

1Seeannexfordetails.

Sources:InstituteofInternationalFinance;BIS.

B.Riskweakensexchangerates1

%

^ld

epre

ciati

on

2.0

1.5

1.0

0.5

0.0

–0.5

012345678

Quarters

Responseofexchangerateto100bpof5YCDSspreads

C.EMEshavenotfullyconqueredoriginalsin

Share%oftotalbondsinLC

100

30

80

24

60

18

40

12

20

6

0

0

TRCOPLIDMXZABRMYKRTH

GovernmentShareofforeign

debtin(lhs):holdersinLCbonds

Localcurrency

Foreigncurrency

Thesovereignriskpremiumisakeychannelthatconnectsfinancialmarketswithfiscalpolicy.Governmentsfacestringentlendingconditionsininternationalmarketsaspublicdebtexpandsandconcernsaboutfiscalsustainabilitygrow.Thisisbecauseinvestorsrequireahigheryieldontheir

2Arecentepisodethatshowsthatadvancedeconomiesarenotimmunetotheseeffectswasthe“mini-budget”incidentintheUK(Greene(2022)).

4BISBulletin

investmentiftheyperceivetheprobabilityofasovereigndefaulttobehigher.Anempiricalexerciseprovidesevidenceofthischannel.Apanelestimationfor19EMEsshowsthatariseintheprimarydeficitraisessovereignrisk.Onaverage,aonestandarddeviationexpansionoftheprimarydeficitincreasesthefive-yearCDSaround50basispoints(Graph2.A).Hikesinsovereignriskpremiatendtoputpressureontheexchangerate.Ahigherriskpremiumraisesthecompensationtoforeigninvestorsandreducestheirdemandfordomesticassets,thuscausingthedomesticcurrencytodepreciate(Aguilaretal(2022)).Basedonthesameempiricalmodel,a100basispointriseinfive-yearCDSspreadscouldcauseadepreciationoflocalcurrenciesagainsttheUSdollarofaround1%(Graph2.B).

ThelinkbetweenthesovereignriskpremiumandtheexchangeratehitsEMEsharderiftheyareexposedtoFXborrowingoriftheshareofforeigninvestorsinlocalcurrencydebtishigh.Despiteprogressindevelopinglocalcurrencydebtmarkets,therearestillEMEswithalargeshareofdebtdenominatedinforeigncurrency(Graph2.C).Signsoffiscalunsustainabilitywouldhaveadoubleeffectonforeigndebtbyraisingboththeyieldrequiredandthedebtburdeninlocalcurrency.Alargershareofborrowinginforeigncurrencyiscorrelatedwithhighervolatilityofcapitalflowsandwithlowercreditratings(Eichengreenetal(2023)).Evenifdebtisdenominatedinlocalcurrency–thuseliminatingso-calledoriginalsin–countriesremainexposedtoabruptchangesinglobalfinancialconditions.Currencyriskshiftstointernationalinvestorsholdinglocalcurrencydebtwhorespondmoreaggressivelytochangesininternationalfinancialconditions–so-calledoriginalsinredux(CarstensandShin(2018)).InternationallendersfindithardertohedgecurrencyrisksasEMEstendtohaveshallowdomesticfinancialmarketsandlackarobustdomesticinvestorbase.

Unsustainablepublicdebtcanreduce

capitalinflows

Graph3

A.Fiscaldeficitsandfundflowsduring20221

B.Higherdebtraisestheprobabilityofreversalsincapitalinflows2

Densityfunctionoffour-quarter-aheadcumulativecapitalflows

y=2.2where

+3.92xR2=0

.235

20

Fundflows(USDbn)

0.030

0.025

0

0.020

–20

0.015

–40

0.010

–60

0.005

–80

0.000

–10–8–6–4–202–20–100102030405060

Fiscalbalance(%ofGDP)

%ofpotentialGDP

Centredatmeanvalues

Impactofa1stddevincreaseofgovernmentdebt

1Totalportfolioflowsduring2022forEMEs.2Seeannexfordetails.

Sources:Aguilaretal(2023);EPFR.

Fiscalimbalancesalsohaveanegativeeffectoncapitalflows.Oneimportantdriverofcapitalflows,especiallybankingflows,iscountryrisk(Koepke(2019)).Publicdebtcanaffectcapitalflowsthroughitsimpactoninvestorconfidenceandperceivedrisk.Forinstance,capitalmaystopflowingintoacountryifinvestorsseeksaferinvestmentopportunitieselsewhere.Also,investorscouldretrenchtheirflowsatminorsignsofdomesticvulnerabilities.In2022,alargerfiscaldeficitwaspositivelycorrelatedwithnegativeportfolioflows(Graph3.A).Finally,recentempiricalevidenceshowsthathigherdebtcouldshiftthefuturedistributionofcapitalinflows,byshiftingtheleftsideofthedensitycurvefurthertotheleft,implyinga

BISBulletin5

Medianof5yCDSinEMEs(bp)

y

higherprobabilityofcapitalflowsreversals.Thisshiftisconsistentwithagreaterprobabilityofcapitalstops(Graph3.B)(Aguilaretal(2023)).

Risksrelatedtothefiscalstancetendtobehigherwhenglobalfinancialconditionsaretighter.InterestrateshaveriseninsyncinEMEsandadvancedeconomies(AEs)ascentralbankstackleinflationandfinancialconditionstighten(Graph4.A).Episodesoftighterfinancialconditionscouldfuelthesovereignriskpremiumchannel.Higherinternationalratesandastrongdollarcouldboostcountryriskduetosignificantsharesofpublicdebtinforeigncurrencies–evenifreducedlately–creatingafeedbackloop(Graph4.B).Inaddition,pushandpullfactorsthatexplaincapitalflowmovements(eginternationalanddomesticmonetarypolicyrates)seemtoberelatedtoastrongerdollar,thuscreatingastrongassociationbetweentheprobabilityofoutflowsandtighterfinancialconditions(Graph4.C).

TightfinancialconditionscompoundfinancialrisksoffiscalpolicyGraph4

A.Financialconditionsaretight1

Jan2020=100

103

102

101

100

99

98

2020

EMEs:

20212022

AEs:

Median

Interquartilerange

B.USdollarappreciationcorrelatedwithhighersovereignriskpremium2

150

125

100

75

2

.4x

50

reR

=0.5

51

25

9095100105110115

USdollarindex(units)

=-

whe

246

+3

C.Historicalprobabilityofoutflowsassociatedwithastrongdollar

Index

020610141822

Probabilityofcapitaloutflows3USdollarindex(lhs)

114

45

108

40

102

35

96

30

90

25

84

20

78

15

72

10

Units

1GoldmanSachsfinancialconditionsindices.EMEs=BR,CL,MX,ID,IN,KR,MY,PH,TH,CZ,PLandZA.AEs=AU,CA,GB,EA,US,NO,NZandJP.Anincreaseofindicesdenotesatighteningoffinancialconditions.2Five-yearCDSspreadmedianvaluesconsideringBR,CL,CO,MX,PE,ID,IN,KR,MY,PH,TH,CZandZAsince2017.AnincreaseoftheUSdollarindexdenotesanappreciation.3Seeannexfordetails.

Sources:Aguilaretal(2023);Bloomberg;IHSMarkit;BIS.

Whatarethepolicytrade-offs?

Anexpansionaryfiscalstanceappearsparticularlyunsuitableatthecurrentjuncture.First,fiscalexpansionstimulatesdomesticdemand,whichworksatcrosspurposestocentralbankeffortstoreinininflation.Second,largefiscaldeficitsmaytriggerrepricingbyfinancialmarkets.Doubtsaboutpublicdebtsustainabilitywillweakendomesticcurrencies,whichmayinturnpushinflationhigher,especiallyincountrieswithamorevulnerableposition(Banerjeeetal(2022)).Bothsovereignriskpremiaandcapitalflowsexplainthiseffect.Moreover,erodinginvestors’confidencemayconstraingovernments’accesstointernationalfundingmarkets,callingforlargerfiscalconsolidationandfurthermonetarypolicytightening–implyingahighercostintermsofeconomicactivity.Finally,higherriskpremiacanputpressureontheneutralrateofinterest(r*)sinceinEMEstherisk-freerateinmostcasesisconsideredtobetheUSgovernmentbondyieldplusthecountry’screditriskpremium(CavallinoandSandri(2019)).Thus,inthemediumtermthecurrentfiscalstancecomplicatesbringinginflationtotarget.Persistentinflationandupwardrevisionstoinflationexpectationsmaycallforeventightermonetarypolicyandforratestostayhighforlonger.

Themonetarypolicyreactiontohighinflationcouldcomplicatelifeforfiscalauthorities,butitwouldbeevenworseiftherewerenomonetarypolicyresponse.Tightmonetarypolicyreinforcesthecostsof

6BISBulletin

expansionaryfiscalpolicies.Thepolicyreactionwouldpushupdebtservicecostsandraisepublicsectorfinancingrequirements.Theriseininterestpaymentcostswouldincreasefiscaldeficits.Finally,highercostsofservicingdebtwouldfurtheracceleratetheneedforconsolidation,inanenvironmentwhereitmayberesistedinsomeEMEs.Still,higherfiscalcostsshouldnotdistractcentralbanksfromtheirfightagainstinflation.Withoutastrongmonetarypolicyresponse,thecostsintermsofgrowthandriskpremiumwouldbehigher.

Thegeneralpicturehighlightstheimportanceofstrikingtheappropriatebalancebetweenfiscalandmonetarypolicyatatimewhencentralbanksaretryingtotameinflation.Morepressingistheriskthatsustainedfiscaldeficitstiecentralbanks’hands,wheretheycannotincreaseinterestratesbecauseitwouldunderminepublicdebtsustainability.ThiswouldendangerthecredibilitythatmostEMEcentralbanksacquiredthankstotheirindependence,theadoptionofinflationtargetsandatrackrecordoflowandstableinflation.Toavoidthisrisk–whichcould,inturn,constrainfiscalpolicytoconsolidateabruptlyinepisodesoflargecapitaloutflows–fiscalauthoritiesshouldsecuresoundfiscalaccounts(Reis(2019)).

References

Aguilar,AandCCantu(2020):“Monetarypolicyresponseinemergingmarketeconomies:whywasitdifferentthistime?”,BISBulletin,no32.

Aguilar,A,CCantuandCRamirez(2022):“Ittakestwo:fiscalandmonetarypolicyinMexico”,BISWorkingPaper,no1012.

Aguilar,A,RGuerraandFZampolli(2023):“Assessingcapitalflowsriskbalancestoemergingmarketeconomies”,BISWorkingPapers,forthcoming.

Amaglobeli,D,EHanedar,GHeeHongandCThévenot(2022):“Fiscalpolicyformitigatingthesocialimpactofhighenergyandgoodprices”,IMFNote,no2022/001.

Banerjee,R,AMehrotraandFZampolli(2022):“FiscalsourcesofinflationrisksinEMDEs:theroleoftheexternalchannel”,presentedattheTwelfthBISConsultativeCouncilfortheAmericasResearchConferenceon“StructuralchangesininflationandoutputdynamicsafterCovidandothershocks”,MexicoCity,November.

BankforInternationalSettlements(BIS)(2022):“Oldchallenges,newshocks”,AnnualEconomicReport2022,ChapterI.

Carstens,AandHSShin(2019):“Emergingmarketsaren’toutofthewoodsyet”,ForeignAffairs,15March.

Cavallino,PandDSandri(2019):“Theexpansionarylowerbound:contractionarymonetaryeasingandthetrilemma”,BISWorkingPapers,no770.

Eichengreen,B,RHausmannandUPanizza(2022):“Yetitendures:thepersistenceoforiginalsin”,OpenEconomiesReview,/10.1007/s11079-022-09704-3.

Greene,M(2022):“UKmarketturmoilisaharbingerofglobaleventstocome”,FinancialTimes,11October.

Koepke,R(2019):“Whatdrivescapitalflowstoemergingmarkets?Asurveyoftheempiricalliterature”,JournalofEconomicSurveys,vol33,no2,pp516–40.

Reinhart,C,KRogoffandMSavastano(2003):“Debtintolerance”,BrookingsPapersonEconomicAc