By Tobias Adrian, Christopher Erceg, Simon Gray and Ratna Sahay
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Asset purchases can be an effective tool, but are critical to minimizing risks to central bank independence and price stability.
Over the past two decades, emerging market central banks have made substantial progress in developing the credibility to pursue countercyclical monetary policy. During the COVID crisis, many of these central banks not only slashed interest rates, but also implemented a variety of tools to help restore market function, including asset purchases. And while some of these central banks are now considering tightening monetary policy stances, the likely use of these policy tools again in the future deserves a closer look.
While asset purchases can help central banks achieve stated goals, they also pose significant risks.
In previous years, it would have been mainly the central banks of the advanced economies that made the purchases of public debt. However, for the first time on a significant scale, central banks in countries such as South Africa, Poland and Thailand broke new ground by using asset purchases to combat market dysfunction.
While their actions succeeded in reducing market tensions, policymakers in these and other emerging market and developing economies must examine other important considerations as they chart the way forward.
Chief among them is whether asset purchases should be seen as a one-off response to the COVID crisis, or as a more permanent addition to their policy tools. At the same time, it is necessary to navigate risks ranging from fiscal dominance and debt monetization to excessive risk-taking.
These and other issues are discussed in detail in a recent IMF staff paper. Below, we summarize the findings and provide preliminary guidance.
Buying assets: useful tools that carry risks
Central banks in many emerging market and developing economies have been reluctant to make asset purchases in past crises for fear of generating a negative market reaction. As it turned out, targeted asset purchases in these countries during the COVID crisis helped reduce financial market stresses without precipitating a notable capital outflow or exchange rate pressures.
This overall positive experience suggests that these central banks will also consider asset purchases in future episodes of market turmoil, as discussed in a recent Global Financial Stability Report.
However, while asset purchases can help these central banks achieve stated goals, they also pose significant risks.
One obvious risk is to central banks’ own balance sheets: central banks can lose money if they buy sovereign or corporate debt when interest rates are low on all maturities, and then official interest rates rise sharply. A weaker balance sheet may make the central bank less willing or able to deliver on mandated targets when policy tightening becomes necessary out of concern that the required policy actions will harm its own financial position.
A second risk is “fiscal dominance,” whereby the government puts pressure on the central bank to pursue government goals. Thus, while a central bank may initiate asset purchases, depending on its mandated targets, it may find it difficult to exit. It is possible that the government will get used to the cheap financing of central bank actions and put pressure on the central bank to continue, even if inflation rises and the objective of price stability calls for an end to purchases. The resulting loss of confidence in the central bank’s ability to keep inflation low and stable could precipitate periods of high and volatile inflation.
At a recent IMF roundtable on new monetary policy tools for emerging market and developing economies, Lesetja Kganyago (Governor, South African Reserve Bank), Elvira Nabiullina (Governor, Bank of Russia) and Carmen Reinhart (Chief Economist , World Bank Group) underscored the risks posed to central bank balance sheets and fiscal dominance, but also drew attention to other unintended side effects. In particular, while asset purchases could reduce tail risks, such policies could have unintended effects, such as encouraging excessive risk-taking and eroding market discipline. And a more active role of the central bank in market making could inhibit financial market development.
Principles for the purchase of assets
Our recent paper on asset purchases and direct financing provides some guiding principles aimed at reaping the benefits of asset purchases while containing the risks. While we see scope for the use of these tools by central banks in emerging market and developing economies, including to help alleviate severe bouts of financial market distress, a sound and credible policy framework provides a foundation. essential.
A fundamental principle is that the central bank should be free to adjust its policy rate as necessary to achieve stated objectives. This is critical. Central banks pay for the assets they buy by issuing reserves. These additional reserves could generate large inflationary pressure unless the central bank can sterilize reserves by raising its policy rate to a level consistent with price stability.
A closely related principle is that any purchases made by the central bank must be on its own initiative and to achieve stated goals (rather than those of the government). The size and duration of asset purchases should be timed with those goals: Purchases made for financial stability should generally be modest in scale and taper when financial stress eases, while purchases to provide macroeconomic stimulus may be larger and smaller. more persistent.
The best way to achieve this principle is to ensure that central bank asset purchases are made in the secondary market, rather than “directly” through primary market purchases or an overdraft facility. Direct financing provides an easy route for the government to determine both the size of the central bank’s balance sheet and the interest rate it will pay, which tends to undermine fiscal discipline and increase debt monetization risks.
Clear communication about the objectives of asset purchase programs and the rationale for both entry and exit is also crucial.
Finally, our document emphasizes the importance of a strong fiscal position. In particular, the government should be able to provide fiscal support to cover any losses that may materialize. Such support is necessary to preserve the central bank’s financial autonomy, as well as to allow it to make policy decisions to fulfill its mandate, rather than basing decisions on concern for its (or the government’s) financial position. Furthermore, the fiscal authority is more likely to resist the temptation to seek cheap financing from the central bank if its own position is strong.
While asset purchase programs may be relatively new territory for central banks in emerging market and developing economies, these principles should help provide a solid foundation.