Monday, August 17, 2015

BIS Workpaper: Bond Markets and Monetary Policy Dilemmas for Emerging Markets

In a new Bank for International Settlements (BIS) workpaper, the authors discuss a future problem that will have to be dealt with by central banks. This is not exactly a warning, but it does fall into the category of calling attention to a problem that could become serious as the world tries to figure out how to return to a more normal interest rate environment. 

It has enough cautions in it to add this to our list of IMF and BIS related warnings because it talks about how some bad things could happen "abruptly." It mentions the problem of money that has been invested in illiquid funds that promise investors they can redeem their money at any time.

Below I have pasted in the Conclusion to the report. Click here to read the full report.



"A near-zero ‘world’ real long-term interest rate for such a long time is unusual, and there is no consensus on the underlying factors behind it. Nevertheless, it is clear that changes in the term premium, rather than expected future short-term rates, have been key. The central role of the US dollar is underlined by the very big expansion in US dollar bond credit to non-banks outside the United States, with two-thirds coming from bond investors also outside the United States.

Large scale bond purchases by some major central banks did contribute to – but were not the only factor in – lowering the ‘world’ long-term real interest rate. Low long-term rates at the centre of the financial world helped to push foreign investors into local government bond markets in many EMs that offered higher yields. It has also encouraged increased EM borrowing on capital markets – corporations in foreign currency on international markets and governments in local currency on domestic markets.

Such bond markets are comparatively illiquid. The growth of an inventive asset management industry and the spread of many bond funds redeemable daily have made many segments seem liquid to end-investors. Easy borrowing conditions in global markets have pushed foreign investors to increase their exposures to interest rate risk, to EM currency risk and to liquidity risk. These developments have also helped to increase the size of the aggregate balance sheet of the domestic banking system in many EMs. Domestic bank credit did indeed expand sharply in the EMs in the post-crisis period, and bank lending conditions have eased.

At some point, all this will reverse – gradually or abruptly. The process of global monetary normalization, perhaps led by the United States, will affect the EMs through several new channels. One important factor will be how and when the Federal Reserve shrinks its huge balance sheet over the next 5 years or so. What happens in bond markets, international and domestic, will be key (see, eg, El-Erian (2015), Wigglesworth and Moore (2015) and Wolf (2015)). The policies of other monetary authorities will influence not only the ‘world’ long-term rate but also exchange rates. Note, however, that global non-monetary forces – some emanating from the EMs themselves – holding real long-term rates down may persist.

Changes in global debt markets will in turn shape conditions in domestic banking markets. Central banks may have to grapple with illiquid interbank markets, or worse. Monetary policy in the EMs has lost some traction as hard-to-influence long-term rates have become more important in their financial systems. The policy rate continues to be adjusted to meet domestic objectives: in this sense, monetary independence has been preserved. But central banks now have to take greater account of the impact of domestic policy rates on their bond markets, on the exchange rate and on their banks. As Obstfeld (2015) aptly puts it, “financial globalisation has worsened the trade-offs monetary policy faces in navigating between multiple domestic objectives”.

added note: I should mention that the BIS publishes this note on BIS workpapers:

"BIS Working Papers are written by members of the Monetary and Economic Department of the Bank for International Settlements, and from time to time by other economists, and are published by the Bank. The papers are on subjects of topical interest and are technical in character. The views expressed in them are those of their authors and not necessarily the views of the BIS."

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