How could monetary policy normalization in developed countries affect capital flows on Latin American countries?

Latin America - May 29 2019
  • #credit risk
  • #esg
  • #gdp

How could monetary policy normalization in developed countries affect capital flows on Latin American countries?

After the 2008-2009 Global Financial Crisis (GFC), the United States (US) Federal Reserve (Fed) and the European Central Bank (ECB) cut their monetary policy rates in order to boost their economies. Since then, they have applied an accommodative monetary policy to promote growth by increasing the monetary supply.  

Ten years after the GFC, central banks as the Fed in the US have already started to increase their monetary policy rates (see Figure 1), because of the evolution of economic fundamentals, more specifically the reduction of unemployment (see Figure 1) and increase in growth and inflation. New projections on unemployment could lead to more hikes of the Fed interest rate.

Figure 1. US Federal Funds Target Rate & Unemployment rate

Source: Datastream and Bureau of Labor Statistics

What does a turning point on the monetary policy (from expansionary to contractionary) in the US mean for emerging markets and developing countries and in particular for Latin American Countries (LAC)?

To answer to this arduous question, it is important to keep in mind that economies are interlinked via financial and trade transactions. On the financial side, capital flows move from one market to another based on returns and risk perceptions. In general, after financial crises abate, global risk perception tends to stay at low levels for some time and capital flows are ready to find better markets to invest. After the GFC, LAC have experienced an extraordinary increase in their net capital inflows.

However, a turning point for the US monetary policy, could cause the opposite effects, by diminishing the global liquidity, raising risk premia, notably for emerging markets (EM) countries and then increasing the cost of borrowing for those markets. This external situation could have negative impacts on EM countries growth, depending on the domestic fundamentals and external buffers (i.e., foreign reserves).

Why do sudden stops matter for LAC? According to the IDB report, a sudden stop -measured as the decrease on the net capital flows by more than 2 standard deviations- has occurred 3 times over the last three decades, during: (i) the Tequila crisis (1990), (ii) the Asian and Russian financial crisis (1999) and  (iii) the GFC in 2008-2009. According to their estimates, net capital flows have diminished recently in the region and they remain on the same levels of the pre-GFC period. It suggests that LAC are not yet into a sudden stop situation, though it is important for LAC to be more resilient to potential changes in the global capital markets. (see Figure 2)

Figure 2. Net Capital Flows to Latin America and the Caribbean

Source: IDB (2019) Building Opportunities for Growth in a Challenging World. Macroeconomic Report.

Sudden stop episodes are considered as external factors (push factors) for EM countries, and they are harmful for the economic output. However, domestic factors (pull factors) could be important to build resilience and to diminish the potential cost of a future sudden stop situation. In this perspective, the IDB report estimated the probability of preventing a sudden stop in net capital flows in LAC. To calculate this probability, they consider four macro-economic fundamentals: (i) fiscal surplus, (ii) current account balance, (iii) liability dollarization and (iv) foreign reserves.

They found that on average, the probability of prevention of a sudden stop situation was 24% in 1997 before the Asian and Russian financial crisis, 52% in 2007 before the GFC thanks to improved domestic fundamentals, whereas it is estimated to be 40% in 2017. The last estimation is an improvement over 1997 but is less favourable compared to 2007.

One additional factor analysed by the IDB report is the role of offsetting gross inflows and gross outflows in order to prevent a sudden stop on net capital flows. They argue that EM countries have suffered more volatile net capital flows because of a lack of the mentioned offsetting and not because gross inflows were more volatile. Since the foreign assets accumulation by residents in the region has increased in recent years, then those assets could be repatriated to balance a fall in gross inflows. However, it will depend on the country’s capability to entice domestic investors to bring their resources in a context where global capital markets motivate investors to withdraw their capital from EM countries.

To sum up, LAC must to be prepared to deal with potentially abrupt falls in capital inflows due to US monetary policy normalization: their effects on output will depend on the “pull factors” and resilience they are able to build. Prevention is always better than cure.

Gabriela Aguilera-Lizarazu, Analyst
Source: IDB, Beyond Ratings

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