Developed economies reap the whirlwind

Crank up the irony meter as the international blame game enters the next stage.

The developed countries are now worried about how the slowdown in the emerging markets will hurt them through what is being described as policy spillbacks. This is in sharp contrast to the more common concerns voiced by policymakers in the emerging markets that aggressive quantitative easing by central banks in the developed economies was spilling over to the rest of the world.

Statements and guidance coming from the US Federal Reserve are once again sounding increasingly dovish and it appears that policy normalization will now take more time because of global factors.

What was worrying for policymakers in emerging market economies (EMEs) was—and it still is as a number of central banks are aggressively using unconventional monetary policy even now—that it will lead to asset price inflation, loss of competitiveness due to exchange rate appreciation and pose a risk to financial stability in case of a sudden reversal in flows. This risk did materialize during the period of the so-called taper tantrum in 2013 when a number of EMEs including India were affected because of a reversal in capital flows. Since some large central banks are still engaged in competitive easing and exchange rates seem to have become the primary source of transmission, the risks associated with spillovers have not abated completely for EMEs.

Reserve Bank of India governor Raghuram Rajan has been repeatedly warning against the limitations of such policies and associated risks for the global economy. However, on the issues and concerns raised by Rajan, which has implications for the entire global financial system and EMEs in particular, former chairman of the Federal Reserve Ben Bernanke has argued that the monetary policy adopted by the US central bank has helped and a stronger US economy is good for the world economy.

While the debate is not yet settled, the Federal Reserve is now beginning to acknowledge the risk and spillovers from the rest of the world. Federal Reserve chairperson Janet Yellen, in a speech last week, reiterated that the pace of rate hikes will be gradual and spent considerable time talking about global headwinds and issues related to adjustments in China. It is possible that the Federal Reserve does not want to do anything that will increase volatility in financial markets and affect the ongoing adjustment in China. Higher interest rate in the US would only accelerate capital outflows from China, which will complicate matters for the Chinese administration. Further, it is possible that the ensuing volatility because of uncertainty in China could hurt US financial markets and undermine economic activity.

To be sure, financial markets in the advanced economies are increasingly getting affected by what is happening in EMEs. The latest Global Financial Stability report of the International Monetary Fund shows that over one-third of variation in stock market returns and currency movement in advanced economies can be traced to spillovers from emerging markets. It further notes that about 70% to 80% of returns in equity and foreign exchange markets, both in emerging and developed economies, can be explained by global factors.

Since financial markets are so deeply integrated and policy moves cannot always be seen in isolation, what is perhaps needed at this stage is formal coordination and understanding among policymakers globally—something that Rajan has been advocating. But even as there is merit in the idea of coordination—it worked very well in the immediate aftermath of the financial crisis—it is difficult to foretell how exactly this can be pursued at this stage, as it might entail costs for some economies, at least in the short to medium term.

Also, policymakers, especially central bankers with an explicit domestic mandate, may not be willing to adjust domestic policies for international causes. A change will perhaps require an agreement at the political level, at least among large economies so that the spillover impact of policy is minimized. Till then, policymakers will have to depend on better monitoring of capital flows and excessive build-up of risk in financial markets.

Will policy coordination help reduce spillovers in financial markets? Tell us at views@livemint.com