UN: Risks and challenges posed by global monetary tightening Kanaga Raja

While inflation appears to be gradually moderating across most of the world, the aggressive monetary tightening – comprising both interest rate hikes and quantitative tightening (QT) – is creating significant policy challenges for both developed and developing economies, a United Nations report has said.

In its World Economic Situation and Prospects (WESP) 2024 report released earlier this month, the UN said for developed countries, risks of over-tightening and a recession in 2024 remain a possibility. This could complicate the policy choices for the monetary authorities.

Even without recession, a majority of developed economies will likely face weaker growth prospects in 2024 with tighter monetary conditions constraining credit growth and investment, it added.

For the developing countries, a tighter global monetary environment over a protracted period would likely restrict fiscal and monetary policy space, exacerbate debt sustainability risks, and impede much-needed investment in climate action and the pursuit of the Sustainable Development Goals (SDGs).

Presenting a rather sombre economic outlook for the near term, the UN’s flagship economic report projected global gross domestic product (GDP) growth to slow from an estimated 2.7 per cent in 2023 to 2.4 per cent in 2024, against a backdrop of lingering risks and uncertainties (see SUNS #9926 dated 16 January 2024).

RAPID MONETARY TIGHTENING

In a separate chapter in its WESP report highlighting the risks and challenges associated with global monetary tightening, the UN said the world economy has experienced rapid monetary tightening since mid-2022.

A quick turnaround from the decade-long ultra-loose monetary policy in major developed countries became unavoidable due to persistent inflationary pressures during the second half of 2021.

“Those were driven initially by a stronger-than-expected recovery in demand in the aftermath of the pandemic- induced shock in the face of prolonged supply-side constraints, and later by heightened energy and food prices caused by the war in Ukraine.”

The initial surge in inflation was viewed as transitory; monetary authorities did not intervene until consumer price inflation reached about 8.5 per cent in the United States of America and nearly 9 per cent in the euro area.

The response was rapid and persistent. The United States Federal Reserve raised the federal funds rate 11 times between March 2022 and July 2023, from near zero to 5.25-5.50 per cent, to bring down inflation.

The European Central Bank ended its eight-year-long negative deposit facility rate and increased it 10 times, from -0.5 per cent in July 2022 to 4 per cent in September 2023.

WESP 2024 said that the Federal Reserve, the European Central Bank and other developed country central banks also began to reduce money supply and liquidity and started quantitative tightening (QT) by reducing the assets on their balance sheets, which had grown explosively during previous episodes of quantitative easing (QE).

“The unwinding of QE programmes that injected trillions of dollars of liquidity from the 2008 global financial crisis (GFC) onward is proving particularly challenging, especially as financial markets also grew accustomed to near-zero policy rates for more than a decade.”

While some attempts were made to wind these down prior to the pandemic, monetary authorities in developed countries doubled down on QE during the pandemic – buying stocks and bonds totalling about $11 trillion – to stabilize asset prices and calm the financial markets, said the report.

It said that although economic activities came nearly to a standstill during the early pandemic period, the market capitalization of firms worldwide rose by $14 trillion between March 2020 and March 2021, marking the largest increase in financial asset prices in a single year in history.

Market capitalization of the 25 largest firms in the world increased by $5.8 trillion, while world output shrank by more than $3 trillion in the same period.

“During the pandemic, QE did stabilize financial markets, but it also pumped up asset prices to record levels, making its unwinding ever more difficult in the post-pandemic period.”

Many developing country central banks also began to implement QE – albeit on a much smaller scale and with a more limited scope – during the pandemic, said WESP 2024.

“The transition from QE to QT, in tandem with the unprecedented increases in short-term rates to tame inflation, is arguably weakening economic activity in developed economies. While these countries have largely evaded a recession in 2023, the risk of a prolonged slowdown still looms,” it cautioned.

The full impact of monetary tightening is yet to materialize, given the long and variable lag in monetary policy transmission to the real economy, which can range from 4 to 29 months, the report noted.

Other policy actions, such as fiscal adjustments, debt management and foreign exchange interactions, can interact with monetary tightening to expedite or delay transmission to the real economy, it said.

The pivot to QT – especially during a period of already high policy interest rates – is also posing additional risks and challenges for developing countries, many of which are yet to fully recover from the pandemic.

“Tighter global financial conditions are increasing borrowing costs, triggering capital outflows, depreciating exchange rates, reducing access to international capital markets, and exacerbating debt sustainability risks, even as economic slowdowns in export markets are already threatening economic growth.”

At the same time, past experiences indicate that unanticipated adverse impacts – due to stresses in financial systems, for example – can also be significant. These are particularly concerning at a time when developing economies need additional external financing to stimulate investment and growth, address climate risks and accelerate progress towards the SDGs, said the report.

The lag effects of monetary tightening, however, present an opportunity for many developing countries to undertake pre-emptive measures – such as improving capital account management and strengthening macro-prudential regulations – to minimize the adverse effects of monetary tightening, it added.

SPILLOVER EFFECTS OF QE

WESP 2024 undertook a comprehensive review of QE programmes and their international spillover effects, as well as the challenges posed by the transition from QE to QT.

Central banks have typically relied on conventional monetary policy tools – including a policy interest rate – to stimulate or dampen aggregate demand in the economy, it said.

However, changing the policy rate has little effect on real economic activities when an economy is confronted with a systemic financial crisis, market liquidity drying up, and default risks threatening significant portions of the economy, as witnessed during the GFC in 2008.

It said central banks also face a natural constraint – the so-called zero lower bound – in using policy rates to stimulate the economy.

“While a negative policy rate is possible and has been observed in practice, it is not usually desirable to a central bank, as negative interest rates can reduce the net interest margins of banks, encourage cash hoarding, impair credit channels, and discourage investment.”

When facing the zero lower bound, central banks can turn to alternative and unconventional tools to provide liquidity, restore confidence and stimulate the economy, said the report.

One such tool – known as QE – involves central banks buying assets from the financial sector, particularly asset- backed securities and government bonds, to inject liquidity into the banking system.

In 2001, the Bank of Japan became the first central bank to implement QE when it purchased government bonds and other financial assets to inject liquidity after it had lowered its policy rate to zero in response to a prolonged period of economic stagnation and deflation.

In September 2008, the United States federal funds rate was already relatively low at 2 per cent, having been steadily reduced over the previous year to mitigate the effects of a collapsing real estate bubble. At this time, Lehman Brothers – one of the largest investment banks – failed to roll over its debt and collapsed.

As a financial crisis became all but inevitable, the Federal Reserve slashed the policy rate to zero and rolled out quantitative easing to provide liquidity to the financial sector and restore the balance sheets of the too-big-to-fail banks, said WESP 2024.

“Many of these banks held trillions of dollars of mortgage-backed securities (MBS) that lost value as the crisis unravelled. The write-off of these assets would have depleted their regulatory capital, wiped out liquidity, and triggered widespread panic and bank runs.”

The Federal Reserve recognized that lowering policy interest rates, though necessary, would not alone solve the balance sheet challenges faced by the banks that held these securities. With rising risk aversion, market liquidity froze, and there were no buyers for these securities that were rapidly losing value.

The report said the sharply falling MBS prices pushed up long-term interest rates. The Federal Reserve began buying these MBS – securities that no market participant wanted to buy and hold – to clean up the balance sheets of the banks and reduce long-term interest rates.

As the financial contagion spread, other developed country central banks – notably the European Central Bank and the Bank of England – followed the lead of the Federal Reserve and moved forward with QE to support their financial sectors during the crisis.

Even after the GFC had subsided and the immediate objective of financial stabilization had been achieved, QE remained the dominant monetary policy tool for developed country central banks, the report noted.

Between September 2008 and December 2019, the combined balance sheet of the four major developed country central banks expanded from $3.4 trillion to $14 trillion.

The ultra-loose monetary policy – a combination of low interest rates and high liquidity – became the new normal in developed economies, making the unwinding of QE difficult. The central banks became not only the lender of last resort, but also the main source of liquidity for the financial market, said the report.

Developed country central banks implemented QE to pursue two major objectives – to restore financial stability and to boost investment and economic growth by lowering long-term borrowing costs, it added.

It said that QE interacted with the real economy through multiple channels. First, it increased money supply and liquidity with a view to easing financial market stress and preventing liquidity shortages, particularly during the immediate crisis phase.

Second, by lowering long-term interest rates, QE changed the relative prices of financial assets and encouraged investors to re-balance their portfolios and hold long-term assets.

Third, QE signalled the central banks’ commitment to stabilizing financial markets and supporting the real economy.

With the swapping of bank reserves for financial assets on bank balance sheets, QE injected liquidity, made it easier to meet regulatory capital requirements, and strengthened the ability of banks to resume lending activities.

However, the report said while QE prevented a prolonged financial crisis and supported aggregate demand at crisis onset, its long-term impact on investment and growth is less clear.

The continued use of QE in the decade following the GFC had a limited impact (if any) on additional investment.

For example, it said in the United States, gross fixed capital formation in 2013 remained below 2006 levels in constant dollar terms despite three rounds of QE during the period 2009-2012.

One major reason is that while the acquisition of assets by central banks increased deposits and money supply, it did not necessarily accelerate credit creation. Although the monetary base grew sharply, broad money grew at a much slower pace, as commercial banks placed an increasing share of deposits as excess reserves on the balance sheets of the central banks.

Total excess reserves held in the Federal Reserve increased from $760 billion in December 2008 to $3.2 trillion in 2020. Before the GFC, excess reserves in the Federal Reserve were near zero. A similar trend is observed for the total excess reserves held in the European Central Bank.

“The QE-induced excess liquidity did not increase credit growth, as most of the excess liquidity was turned into excess reserves.”

Many banks preferred to retain their resources in their reserve accounts at the central bank rather than lending them out with a low margin to fragile businesses during uncertain economic time, said the report.

The introduction of the Dodd-Frank Wall Street Reform and Consumer Protection Act in the United States and the accelerated implementation of the Basel III reforms after the GFC also constrained credit growth, as banks faced the challenges of meeting the new regulatory capital requirements.

“Additionally, while small firms continued to face liquidity and credit constraints, big firms often used bank credits to purchase their own shares rather than make new investments. This boosted their stock prices but not necessarily their investments.”

Against this backdrop, major developed economies experienced a slowdown in capital formation growth after the GFC, as well as weakening or stagnating productivity growth, said WESP 2024.

While QE largely eased financial stress during the crisis phase, its continued use for an extended period led to the build-up of new financial risks, it added.

It said the search for higher yields in a period of prolonged low interest rates may have steered investors towards unsafe and less liquid high-yield securities, leading to a deterioration in the quality of their asset portfolios and, where institutional players were involved, increased systemic risk. With term premia being compressed, standard sources of bank profitability would have also come under pressure.

The QE-supported ultra-low interest rate environment was also associated with expanded borrowing by both the public and private sectors. Public debt in the developed economies rose sharply after the Federal Reserve began to implement QE at the end of 2008.

For example, the report said that public debt in the United States increased from 62.7 per cent of GDP in 2007 to 105.9 per cent in 2019 and rose further, to 126 per cent of GDP, in 2020. Private debt also increased in tandem.

The ongoing monetary tightening and the unwinding of QE pose significant risks for the elevated levels of public and private debt, as rising interest rates and tighter liquidity conditions will inevitably increase debt-servicing costs and amplify financial distress and defaults, it cautioned.

The net interest payment of the United States Government, for example, increased by 35 per cent between 2021 and 2022 against the backdrop of higher levels of public debt and rising interest rates. The average interest rate on public debt in the United States increased from 1.6 per cent in 2021 to 2.1 per cent in 2022.

Ultra-loose monetary policies in developed countries affected developing countries through multiple channels, said WESP 2024.

The policy decisions of the Federal Reserve, in particular, had significant international spillover effects, given the dominant role of the United States dollar as the reserve currency in the global financial and trading systems.

“In a world of increasingly integrated financial markets, QE boosted global liquidity (financial channel) and reduced borrowing costs, tending to increase external debts for both public and private sectors in a majority of developing countries.”

Moreover, as QE reduced long-term bond yields in developed countries, investors looked for higher risk-adjusted returns and purchased assets in developing countries, which in turn lowered yields in developing countries and pushed up asset prices (portfolio re-balancing channel).

The report said that it is also the case that QE affected the exchange rates in developing countries, especially those with fully convertible currencies, often leading to exchange rate appreciation and reductions in export competitiveness (exchange rate channel).

On balance, while QE increased capital inflows and eased credit constraints in developing economies, continued and pro-cyclical capital inflows in the ensuing years overheated many of these economies, boosted consumption, increased inflationary pressures, and led to exchange rate appreciation, it added.

Moreover, it said that large fluctuations in capital flows into developing countries exacerbated financial risks.

“In the aftermath of the global financial crisis, Governments and public- and private-sector entities in developing countries joined the bandwagon of borrowing from the international capital market, hoping to take advantage of the ultra-low interest rates.”

During the period 2010-2019, the total external debt stock of developing countries increased by $3.8 trillion – growing at a rate much higher than that reflected in the increase of $628 billion between 1998 and 2007.

The total debt of Governments, financial corporations and non-financial corporations increased from less than $5 trillion before the financial crisis to more than $23 trillion in 2019.

While most of the outstanding debts of developing countries were issued in their domestic markets, those issued in the international markets more than quadrupled in the decade after the GFC, said the report.

It also said QE did not reduce the borrowing costs for all developing countries. Recurrent shocks impaired the ability of some to repay debt. Some countries continued to pay high and rising risk premia during QE, in part due to limited and shrinking opportunities (relative to their needs) to borrow on concessional terms from multilateral development banks.

Excessive borrowing in developing countries did not lead to higher levels of investment. It supported domestic consumption in these countries, often leading to a higher volume of imports and worsening trade balances, the report added.

“Deteriorating trade balances would have led to the depreciation of exchange rates and would have boosted exports from developing countries. However, large QE-induced capital flows prevented such adjustments and kept the exchange rates overvalued, which also adversely affected their balance of payments.”

The report said while domestic consumption remained strong in many developing countries, investment remained weak.

The annual growth rate of gross capital formation fell from 16.7 per cent during the period 2000-2007 to 4.6 per cent during the period 2011-2019. Fixed investments declined in absolute terms in many developing countries, it added.

TRANSITION FROM QE TO QT

Sustained inflation since 2021 necessitated a reversal of accommodative monetary policy, but the timing and pace of QT remained hard to determine, said the report.

It said the first attempt at implementing QT took place in 2013 as the Federal Reserve indicated that it would reduce its bond purchases. This triggered the taper tantrum, with sharp drops in equity and government bond prices.

Within about a month, the Standard and Poor’s (S&P) 500 stock price index dropped by over 5 per cent, while the yield on 10-year United States government bonds shot up by over 50 basis points.

The impact was also quickly felt by developing countries, in particular those with larger external financing needs and macroeconomic imbalances, such as Brazil, India, Indonesia, Turkiye and South Africa.

On average, the sovereign bond yields in these countries rose by 2.5 percentage points, equity markets fell by 13.8 per cent, exchange rates depreciated by 13.5 per cent, and reserves declined by 4.1 per cent between May and August 2013.

The major developed country central banks, with the exception of the Bank of Japan, have started quantitative tightening and there are some commonalities in their QT approaches, said the report.

It said all of these central banks signalled the start of QT and announced their QT plans months in advance. In their announcements, the central banks emphasized that QT would be predictable, gradual and orderly, and they would maintain discretion over adjusting their QT plans based on financial and economic conditions.

“In the aftermath of the GFC, central banks were confronted with weak demand and the rising risk of financial instability. That is not the case for 2023 or 2024.”

Given the current high but moderating inflationary environment, central banks are facing a difficult balancing act between taming inflation, supporting growth, and ensuring financial stability, said WESP 2024.

It said while maintaining price stability and supporting economic growth remain a priority for the central banks, financial dominance – when monetary policy is constrained due to concerns about financial stability – will likely determine the pace and intensity of monetary tightening, including QT operations.

Financial instability risks have hindered QT implementation over the past two years. The collapse of the Silicon Valley Bank in the United States in March 2023, for instance, exposed significant duration risks in the financial sector.

The report said that rising short-term rates are reducing the price of long-term bonds held by banks and other investors. This is leading to balance sheet losses and triggering financial stress, especially when financial intermediaries are forced to sell their long-term bond holdings to minimize losses.

Another risk that developed country central banks face in tightening their monetary policy stance relates to the effectiveness of the policy. In the United States, for example, the central bank raised policy rates from near zero to 5.5-5.75 per cent in a little over a year.

While the increase in the policy rate managed to bring down inflation, it did not reduce personal consumption expenditure or increase household savings. The household savings rate actually fell with the rising interest rate.

This suggests that the recent bout of high inflation in the developed countries was largely caused by supply-side factors, including supply chain disruptions during the pandemic and the war in Ukraine, said WESP 2024.

“Monetary policy tools – especially policy rate increases – may not constitute the most effective approach to addressing supply-side shocks that have divergent economic impacts within a relative short period of time due to lag effects.”

The report also said that quantitative tightening is posing significant challenges to developing economies.

“Synchronized monetary tightening – including interest rate hikes and QT – in the major developed countries is expected to reduce global liquidity and increase global risk aversion, leading to capital outflows, currency depreciations, increased risk premia, widening sovereign spread, and heightened debt sustainability risks.”

The 2013 taper tantrum offers some valuable lessons, though economic conditions in developing countries today are very different from what they were a decade ago, said the report.

On 22 May 2013, the initial hints of tapering by former Federal Reserve Chairman Ben Bernanke surprised market participants.

WESP 2024 said the changes in policy expectations reduced their tolerance for risk and triggered a reassessment of the risk-adjusted returns from investments in developing countries. With the abrupt rise in global long-term interest rates, many developing countries experienced a sharp withdrawal of private capital inflows, totalling about $60 billion in the third quarter of 2013.

It said monetary tightening significantly exacerbated global financial conditions in 2022 and 2023, increasing borrowing costs for developing countries. For instance, it said the yield of Brazil 10-year Treasury bonds increased from just below 11 per cent in January 2022 to 13.7 per cent in June 2022, while the yield of Kenya 10-year government bonds rose from 12.9 per cent in January 2022 to over 16 per cent in October 2023.

Tightened financial conditions also widened credit spreads in many developing countries, particularly in Africa and Latin America.

In the six months after the Federal Reserve stopped QE in March 2022, emerging market currencies collectively depreciated by about 9 per cent against the United States dollar. The currencies of a few developing countries – including Argentina, Venezuela, Colombia, Egypt, Ghana, Lao People’s Democratic Republic, Malawi, Pakistan, South Africa and Turkiye – depreciated by over 20 per cent.

Rising interest rate spreads and currency depreciations have also exacerbated debt sustainability risks for many developing countries. Countries that have yet to fully recover from the pandemic crisis – including many LDCs – are particularly vulnerable to debt default risks, said WESP 2024.

It said that while fiscal revenue in developing countries stagnated or even shrank, their debt-servicing burden as a percentage of government revenue continued to rise during the post-pandemic period.

Higher interest rates in developed countries will continue to increase the debt-servicing burden of developing countries particularly those with high levels of dollar- or euro-dominated public debt. The LDCs are especially vulnerable; as at August 2023, 36 of the 69 countries covered by the Debt Sustainability Framework for Low-Income Countries – including 23 LDCs – were in debt distress or at high risk of experiencing debt distress.

Developing country central banks face the additional challenge of shrinking policy space for discretionary policy adjustments when their developed country counterparts implement rapid monetary tightening, said the report.

It said that slowing economic activities, tightening global financial conditions, deteriorating external balances, falling international reserves, and the risk of sudden capital outflows often constrain the ability of central banks in developing economies to implement growth-enhancing or growth-stabilizing monetary policy.

“Developing countries are exposed to the risks and uncertainties of global monetary policy cycles. While they embraced capital account and financial market liberalization following the Washington Consensus, many did not put in place the regulatory frameworks and macro and prudential measures necessary to protect their economies against volatile capital flows.”

As developed economies shift from QE to QT, the need for effective capital and financial account management is greater than ever for many developing countries, said WESP 2024.

In the current global monetary tightening environment, developing countries can consider a range of available policy options to minimize the impact of external shocks, it added.

Developing countries need to maintain strong economic fundamentals to minimize their vulnerability to external shocks. Strengthening economic fundamentals typically involves a broad range of reforms, including scaling up investments in human capital, upgrading the quality of institutions, improving financial institutions and markets, and addressing climate risks.

Least developed and resource-rich countries also need to diversify their economies to broaden their sources of revenue, create jobs, and enhance resilience, it added.

The report said research shows that pre-emptive and precautionary deployment of these policies in developing countries could create buffers, insulating them from the adverse spillover effects of monetary policy shifts in the developed economies.

(This article was published in SUNS #9928 on 18 January 2024)