Monetary Policy in Emerging Markets: Bringing a knife to a gun fight?

By     Jesús Badiola,       Class of 2018

By Jesús Badiola,      Class of 2018

Oh, how far we’ve come.

It’s been three years since Professor Raghuram Rajan was pronounced Governor of India’s Reserve Bank, and what a journey it’s been for emerging markets (EM) in recent years.

After the 2008 financial crisis, Bernanke introduced the Quantitative Easing program  which flooded the market with liquidity. A lot of the cash flow was directed at emerging economies, which enabled them to bounce back strongly from the Great Recession.

But, as every MBA student knows, no easy-flowing-liquidity party can keep on going forever.  

In 2013, after the announcement that the QE program would be scaled down, EM experienced a sharp reversal of capital flows. This fleeing of money from EM started creating inflation pressures on countries that were starting to reveal their stagnant growth realities. Professor Rajan, and most of his central banks counterparts, have all had a busy schedule these past years, deciding how to use their monetary policy levers to both maintain their currency acquisitive power and support growth.

When Professor Rajan started as governor, India's inflation was around 11%. Today it's around 4.31%

When Professor Rajan started as governor, India's inflation was around 11%. Today it's around 4.31%

Unfortunately, this has not been an easy task. A recent study by Aoki, Benigno and Kiyotaki notes that, given the heavy interconnectivity of EM and industrialized nations, an increase in the foreign interest rate (i.e. the U.S.) leads to a strong depreciation of EM currencies, given investment switching channels and the lower intermediation capacity of EM banks exposed to foreign currency liabilities.

So, with strong macroeconomic forces depreciating EM currencies, countries with the objective of fighting inflation (such as Brazil, Indonesia and India) encountered a policy trade-off decision: either depreciate their currency, boosting inflation, or fight to maintain the acquisitive value of their currency and experience lower GDP growth. Some countries have been more successful than others. This year, Brazil is expected to see prices rise by 8.5% (above target), Indonesia by 3.07% and India by 5.05% (both around` target).  

In these three years, there’s also been an insurgence of another force in currency market: greater financial globalization. With the emergence of currency-trading hedge funds essentially flooding the currency market with readily movable capital, EM currencies have been subject to strong capital shocks from short term profit-seekers.

To counter these external threats, many EM have tried to gather defenses to fend off possible capital shocks looking to make a run on their currencies. For example, the Mexican Central Bank has held $179 billion USD in official reserve assets, and also hold an undrawn, unconditional credit line provided by the IMF for $73 billion, to counter monetary shocks that might be drawn against the Mexican Peso.

So what do EM Central banks do with their ongoing conundrum? Do they fight for more macroeconomic stability, using both their interest rates and reserves to maintain their currencies acquisitive value in an era of growing short term profit-seeking in currency markets and scarify financial stability? Or do they use their policies to support greater growth, at the expense of seeing inflation soar?

Jesus is a Mexican first year student on a daily fight against FOMO