Issues for Implementation in Developing Economies

Analysis of the effectiveness of unconventional monetary policy so far has been conducted almost entirely on the US and Japanese economies, which are relatively closed, have large and well-developed domestic financial markets, independent central banks, and floating exchange rates. The question arises as to how relevant the experiences of these economies might be for developing economies in Asia and elsewhere. Unfortunately, there is almost no research on this subject. One recent report that touches on this area is Ghosh et al. (2009).

Possible factors that could constrain the implementation of unconventional monetary policy measures in developing economies include:

1. an insufficiently developed government bond market that limits the central bank's ability to buy such bonds;
2. an insufficiently developed corporate bond market, which limits its capacity to be a source of corporate funding even if it is functioning normally;
3. legal restrictions on central bank purchases of government assets and other securities;
4. a high degree of “dollarization” of domestic liabilities that limits the lender-of-lastresort function of the central bank;
5. an exchange rate peg that limits monetary policy flexibility;
6. insufficient credibility on inflation fighting that might cause adoption of unconventional policy measures to be perceived by the market as a loss of inflation discipline; and
7. related to (vi) above, vulnerability of the currency to capital outflows.

Calvo (2007) noted that the central bank of an emerging market may need to switch policy modes during periods of “sudden stops,” i.e., foreign-currency-based capital outflows. Specifically, he recommended that it should switch to exchange rate targeting rather than using the policy interest rate as a target. However, he did not discuss exchange rate policy in conjunction with other unconventional policy measures. As noted above, a policy of deliberate currency depreciation could be an effective macroeconomic stabilization tool.

In countries with large stocks of foreign short-term capital inflows, the currency could react very sensitively to changes of market perception about monetary policy and inflation risk, thereby complicating the task of the monetary authorities. Of course, if an economy is experiencing deflation, some currency depreciation could be beneficial, but the risk of overshooting is serious. This risk points to the need for high levels of foreign exchange reserves as an insurance policy, both for foreign exchange intervention and for supplying foreign currency liquidity. Ghosh et al. (2009) advocated provision of foreign currency liquidity in situations where a sharp depreciation of the currency could be damaging because of large domestic liabilities denominated in foreign currencies. For example, if domestic banks cannot roll over existing sources of foreign currency credit, the central bank could step in to provide such credit to maintain domestic credit lines and draw out the adjustment process. This has been an important measure in countries such as the Republic of Korea, as is discussed below.

Regarding quantitative easing policy (and presumably credit easing measures as well), Ghosh et al. (2009: 17) argued that “…QE should only be attempted by countries with a history of low inflation and macroeconomic stability, with central bank independence and credibility.” Again, an exchange rate peg or concerns about exchange rate instability would limit policy options in this area.

A more general issue is that the dichotomy of “standard” and “unconventional” monetary policies does not necessarily apply to emerging markets, where markets are typically less developed and the monetary policy transmission mechanism works less smoothly. Another issue is whether policies have impacts on creating winners and losers. It is desirable to have neutrality in this dimension in order to avoid undesirable political implications of central bank policies.

In Asian emerging economies, unconventional measures have been adopted by the Bank of Korea, Monetary Authority of Singapore (MAS), Reserve Bank of India (RBI), and Central Bank of the Republic of China (CBC). Perhaps the most significant unconventional policy measures in the region outside of Japan have been those involving provision of foreign currency liquidity via the Fed swap arrangements with other central banks in order to offset the shortage of US dollars arising from capital outflows. For example, the Fed and the Bank of Korea announced the implementation of a US$30 billion swap agreement on 29 October 2008. This appears to have been effective in easing the shortage of dollar funds in the Korean market. Figure 14 [ PDF 23.7KB | 1 page ] shows that the spread between the Korean one-year interbank rate and the one-year Treasury bill rate spiked upward from mid-2008 at the same time that foreign securities holdings (presumably mainly US Treasuries) of the Bank of Korea dropped sharply. However, once the holdings of foreign securities began to rise again in December, presumably as a result of the loan by the Fed, the spread shrank rapidly again. It appears that the Bank of Korea (BoK) made full use of the Fed's swap line, since total foreign securities holdings rose by W40.8 trillion (roughly US$29 billion) during that period. The Bank of Korea also significantly expanded its won-yen swap agreement with the Bank of Japan from US$3 billion equivalent to US$20 billion equivalent, and established a won-yuan swap with the People's Bank of China of up to CNY180 billion, although it seems not to have made use of these.

The Bank of Korea has taken a number of other unconventional actions, including broadening the list of eligible counterparties and collateral for repurchase operations, providing funding support to those financial institutions contributing to the Bond Market Stabilization Fund, and providing funding support to the Bank Recapitalization Fund in order to facilitate banks' expansion of their equity capital (Bank of Korea 2009a). It also contributed funds to the Korea Credit Guarantee Fund to enable it to offer payment guarantees for the principal and interest of the loans (up to 10 trillion won) provided to the Fund through the Korea Development Bank, expanded the range of firms qualified for foreign currency loans secured by export bills from small and medium enterprises to all enterprises in order to encourage foreign domestic banks in the Republic of Korea to finance export trade (Bank of Korea 2009b).

The MAS was the only other central bank in the region aside from the Bank of Japan, the Bank of Korea, and the Reserve Bank of Australia to establish such a swap line with the Fed. The MAS's holdings of foreign securities rose by about US$7 billion in November of 2008, suggesting that it made some use of the Fed swap line, but this is not conclusive. However, interest rate spreads were much lower than in the Republic of Korea, so the impact of the increase in reserves on spreads is not obvious.

The RBI adopted a number of unconventional measures aimed at increasing the availability of both rupee and foreign currency liquidity. Unconventional measures aimed at expanding rupee liquidity included a special repo window under the liquidity adjustment facility for banks for lending to mutual funds, non-bank financial companies, and housing finance companies, and a special refinance facility that banks can access without any collateral. The RBI also set up a special purpose vehicle to provide liquidity support to non-banking financial companies (Reserve Bank of India 2009). However, the degree of unconventionality of these measures was modest.

The Central Bank of the Republic of China (Taipei,China) also adopted a number of unconventional measures in September and October 2008, including expanding the eligible counterparties for its repo operations; extending the term of such operations from 30 days to 180 days; expanding eligible collateral to include certificates of deposit; and linking the interest rates on central bank reserve deposits to market rates (CBC 2008a, 2008b). These operations seem to have been effective in reducing interbank spreads relative to policy rates by about 30–40 basis points during that period.

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