Global policy conundrum

More monetary accommodation can lead to higher risks

The global economy is losing momentum. The International Monetary Fund (IMF) in its latest update scaled back its global growth forecast for the current year by 10 basis points to 3.2 per cent. The global economy expanded by 3.6 per cent in 2018. Consequently, large central banks are expected to turn more accommodative. The US Federal Reserve is expected to cut interest rates later this week for the first time since the financial crisis. The European Central Bank has also expressed its willingness to undertake more stimulus measures.

These developments can complicate policy choices for an emerging-market country like India. For one, slower global growth could affect exports, which are anyway not growing at a desired pace. Second, the global search for yields can lead to higher capital flows, which can put upward pressure on the rupee, affecting both imports and exports. Further, higher inflow of debt capital can increase the risk to financial stability.

Reserve Bank of India Governor Shaktikanta Das has done well to highlight some of these issues in his remarks last week. Though the subject has been at the fore, at least since the global financial crisis, the risks have somewhat increased due to the feeble recovery in many parts of the developed world and the renewed danger of a slowdown. Differently put, large global central banks may have to start supporting growth with policy accommodation without having been able to unwind the previous stimulus. This could significantly increase leverage and risk in the global financial system. As Mr Das rightly noted: “It is important in the backdrop of slowing global growth that policies of monetary and fiscal authorities are well-calibrated so that they support growth without further build-up of leverage and asset price bubbles.”
 

However, experience shows that large central banks are more focused on their own economies, and not particularly worried about spillovers to emerging markets. There has been a significant build-up of leverage in emerging markets over the last decade. So, the real question is: What should emerging markets, which tend to witness a surge in inflows and sudden stops, do in such a situation? Among other things, this increases volatility in the currency market, which directly affects the broader economy.

In the absence of a robust global coordination mechanism, the best option is to intervene in the currency market and accumulate reserves, as some of the emerging-market economies have been doing. But it is important to note that intervention has costs and higher reserves can attract more inflows, making currency management difficult for an emerging-market central bank. Furthermore, it can also affect its monetary policy objectives. Therefore, reserve accumulation should be handled with care. In this context, countries with large reserves can reassess and prioritise the kind of foreign capital they need.

However, the larger issue global policymakers need to address is: If the world economy is losing momentum despite a relatively accommodative policy environment, would more monetary stimulus help lift economic growth? Yields on bonds worth about $13 trillion are in negative territory. Therefore, it is possible that further monetary accommodation will have diminishing returns in terms of stimulating growth and can end up increasing risks for the global financial system.