COVID-19 in emerging markets

Emerging market economies faced a severe economic and financial shock following
the onset of the
COVID-19 pandemic. To contain the spread of the virus, many EME governments
implemented public health measures, including quarantines, social distancing
and travel restrictions. The significant reduction in economic activity from
this response has been compounded by heightened economic uncertainty, weak
external demand and supply disruptions. EMEs dependent on tourism and/or commodity
exports were particularly hard hit by travel restrictions and a sharp fall
in commodity prices. Financial conditions in emerging markets tightened significantly
reflecting the severity of the economic shock and tighter global financial
conditions. Government bond yields rose sharply, equity prices declined, there
were substantial capital outflows and exchange rates depreciated (which tends
to tighten financial conditions in many EMEs).

Central banks in EMEs implemented a broad range of measures to ease financial
conditions, restore market functioning and support their economies (Table 1).
In contrast to some previous crises, almost all EME central banks significantly
reduced their policy rates during the early months of the pandemic. All central
banks injected liquidity through market operations, most intervened in the
foreign exchange market to limit currency depreciation, some launched new
facilities to support the flow of credit to business and households (through
term funding schemes), and a few entered into bilateral swap line agreements
with advanced economy central banks. A number of EME central banks embarked
on asset purchase programs for the first time, while a small number engaged
in direct financing of governments.

This article provides an overview of the policy response by EME central banks
to the
COVID-19 crisis. The first section describes how aspects of the
COVID-19 crisis, as well as longer-run improvements in policy design
and financial market development in EMEs, have allowed EME central banks
to respond forcefully to this crisis. This is followed by a discussion of
each of the policy tools implemented, placing particular emphasis on the
specific role of each tool and how the considerations faced by EME central
banks differ from those of advanced economies.

How has this episode been different from previous ones for EME central banks?

Historically, many EME central banks have had less capacity than their advanced
economy counterparts to ease monetary policy settings when economic conditions
deteriorate. One concern has been that this could lead to an exchange rate
depreciation. While a depreciation typically supports the economy through
net exports, it can also lead to large and persistent increases in inflation
when inflation expectations are not well anchored. In addition, a depreciation
in the exchange rate can cause EMEs’ financial conditions to tighten
if the depreciation increases the cost of servicing and repaying unhedged
foreign currency debt. A third concern is that sharp depreciations can induce
large capital outflows if foreign investors with unhedged EME local currency
assets sell their holdings in an attempt to limit their losses.

A couple of key developments over recent decades have reduced the relevance
of some of these concerns. First, improved institutional arrangements of EME
central banks have helped to reduce the risk that monetary easing leads to
large and persistent increases in inflation (Aguilar and Cantú 2020).
Since the early 2000s, many EMEs have adopted inflation targeting frameworks
and central bank independence has been enhanced through legislative changes
(Gelos, Rawat and Ye 2020). In the time since, EME central banks have established
the credibility of their targets and frameworks. These changes have helped
to anchor inflation expectations, such that depreciations induced smaller
and less persistent increases in inflation. Central banks therefore faced
less need to keep policy rates high during the
COVID-19 crisis.

Second, financial market development in EMEs over recent decades has enabled
EME central banks to respond more effectively to this crisis. Encouraged by
a range of policy decisions by EME authorities, capital markets have grown,
local government bond markets have deepened and foreign exchange derivative
markets have been established. The size of financial markets in some countries
within emerging Asia are approaching those in advanced economies (Alston et al 2018). This development has helped EME governments and
corporations increase their use of local currency borrowing, enhance their
management of foreign exchange risk and gain better access to credit (Alston
et al 2018). Taken together, these developments have reduced
concerns about the effect of exchange rate depreciations on EME financial
conditions, and so reduced the trade-offs associated with monetary policy
easing.

Separately to these longer-term developments, the nature of the
COVID-19
crisis and the policy response from advanced economies has provided EME central banks
with greater scope to ease policy. Unlike some other crisis episodes affecting
EMEs, the
COVID-19 pandemic has reduced economic activity in a sudden and synchronised
fashion across advanced and emerging economies. This has contributed to inflation
falling significantly in 2020 in many EMEs, because of the decline in consumer
spending and because EMEs entered the crisis with output below its potential
(Graph 1). Furthermore, large-scale easing of monetary policy in advanced
economies and fiscal policy support globally have helped calm global financial
markets, which has meant that interest rate differentials between advanced
economies and EMEs have remained more stable even with EME central banks easing
policies.
These factors have also limited currency depreciation and capital outflow
pressures in EMEs.

Policy tools used in response to the
COVID-19 crisis

EME central banks responded with multiple policy tools to help address different
facets of the crisis. A number of the policy actions were designed to restore
the orderly function of financial markets, consistent with the role of central
banks in providing emergency assistance to financial institutions and averting
a sudden disruption to the flow of finance to the real economy. Short-term
funding markets for financial institutions were supported through an expansion
in the liquidity provided via central bank market operations, as well as the
use of US dollar swap line agreements with the US Federal Reserve. At
the same time, central banks intervened in foreign exchange markets to avoid
disorderly depreciation, and purchased government bonds to restore liquidity
conditions.

Reductions in central bank policy rates were the primary tool used for easing
domestic financial conditions more broadly and supporting the economy in EMEs.
In some economies, term funding schemes have also been used to provide additional
support for the economy by further lowering rates paid on bank loans. In a
small number of emerging market economies, central banks have provided finance
directly to the government to assist with financing the fiscal deficit.

Many of the actions taken in 2020 by EME central banks were familiar features
of the central banking toolkit in those economies. In contrast, the purchase
of government bonds by many EME central banks was a notable innovation.

Policy rate reductions

Central banks in EMEs lowered their policy rates substantially between March
and July 2020 to ease financial conditions and support economic growth. The
scale of these declines in EME policy rates in 2020 was in contrast to the
Asian Financial Crisis, Global Financial Crisis (GFC) and the 2013 ‘Taper
Tantrum’ when EME policy rates were generally increased at times when
large-scale capital outflows were already causing a tightening of financial
conditions for emerging markets (Graph 2).

The reductions in policy rates, as well as expectations that rates would remain
low for some time, have contributed to lower borrowing costs across EMEs.
Local currency government bond yields have declined to historic lows in many
EMEs, while financing costs for household and business have also generally
fallen. That said, pass through from central bank policy rates to borrowing
rates is generally weaker in EMEs than in advanced economies, in part due
to less developed financial markets and weaker banking systems (Mohanty and
Turner 2008). The impact of declining financing costs on economic activity
can also be more muted in EMEs with underdeveloped financial systems and large
informal sectors.

In contrast to the majority experience, a few EMEs such as South Africa and
Turkey continue to face borrowing costs that are substantially higher than
at the start of 2020, reflecting elevated concerns about their economic outlooks,
sustainability of their finances, and the capacity of policymakers in those
economies to respond to any further significant
shocks.

Since July 2020 most EME central banks have kept policy rates little changed
at accommodative levels and this is continuing to provide substantial support
to the economic recoveries. Unlike in advanced economies, policy rates generally
remain well above zero in most EMEs, and in weighing whether to lower rates
further in the time since July 2020, EME central banks have cited a range
of concerns (Table 2). The majority of EME central banks have been most
concerned about the effects of further rate cuts on the exchange rate. Notwithstanding
the improvements in inflation anchoring and financial market development discussed
above, challenges remain with the impact of exchange rate depreciations on
financial conditions for some EMEs. For EMEs with substantial unhedged foreign
currency debt, like Indonesia and Turkey, a depreciation increases concerns
around financial stability as the cost of servicing and repaying debt increases.
Relatedly, in EMEs like South Africa and Russia where foreign investors make
up a substantial portion of participants in their capital markets, there have
been heightened concerns about capital outflows that can arise when there
is an exchange rate depreciation.

A few EME central banks have framed the downsides of further monetary easing
in other ways. The central bank of Thailand has stated that they are maintaining
rates unchanged – at a level a little above zero – so as to preserve
some policy space in case conditions deteriorate further. A few EME central
banks such as India and Turkey have cited high inflation as their major concern
with further rate cuts, because inflation is above central bank targets in
both economies. In contrast to other EMEs, Turkey’s central bank has
raised its policy rate above pre-pandemic levels because Turkey experienced
a large depreciation of the exchange rate and high inflation.

Foreign exchange intervention

EME central banks intervened extensively in the foreign exchange market during
the most acute phase of the
COVID-19 crisis. EME currencies faced substantial depreciation pressure,
though without the concurrent monetary policy easing in advanced economies
it may have been even greater (Graph 3). Central bank interventions dampened
financial stability risks that can arise from sudden increases in the value
of unhedged foreign currency obligations, and supported financial conditions
more broadly by limiting the portfolio outflows that are commonly associated
with sharp depreciations. Since capital markets in EMEs are not as deep as
those in advanced economies, EMEs are more sensitive to outflows that can
significantly tighten financial conditions.

Estimates from the International Monetary Fund (IMF) suggest that, while the
scale of intervention in March was the largest in US dollar terms since
the GFC, the accumulation of reserves over the past decade meant that it was
a less significant event when measured relative to the total stock of available
reserves (IMF 2020a) (Graph 4). As conditions in emerging markets stabilised,
intervention to support currencies was scaled back, while some EMEs, particularly
in the Asian region have been intervening to limit the appreciation of their
currencies, resulting in an expansion of their foreign exchange reserves.

A key motivation for the expansion in reserve holdings over recent decades
was to give central banks more capacity to intervene and mitigate the financial
stability risks described above (Kohlscheen, Moreno and Domanski 2016). The
experience of many EMEs during the GFC and Taper Tantrum episodes suggests
that having relatively large reserves resulted in smaller exchange rate depreciations
(Arslan and Cantú 2019).

Despite experiencing large scale capital outflows during the
COVID-19
crisis, most EME governments did not rely heavily on measures to restrict the flow
of capital. In the past, some EMEs have placed restrictions on capital outflows
to reduce currency depreciation pressures but these measures can also reduce
the availability of external financing over the longer term.

Policy tools to support domestic market functioning

In March, global financial markets became severely dislocated as foreign investors
rapidly reduced their exposure to riskier assets in favour of highly liquid
and low-risk instruments (Vallence and Wallis 2020). This led to sharp declines
in liquidity and significant increases in local currency bond yields in EMEs
(Graph 5). In some cases, EME government bond auctions were cancelled
due to limited demand.

Liquidity and lending operations

EME central banks intervened in money markets to help meet the sharp increase
in demand for liquidity. Most EME central banks expanded short-term open market
repurchase operations and some lengthened the duration of repurchase agreements
to ease stresses in longer-term funding markets (IMF 2020b).

Against the backdrop of capital outflows, exchange rate depreciation and stresses
in US dollar funding markets, a couple of EME central banks also entered
into bilateral swap lines with the US Federal Reserve during March to gain
access to US dollar liquidity. Under the facility the central banks of
Mexico and Brazil could request up to US$60 billion from the Federal
Reserve in exchange for an equivalent amount of their domestic currencies.
The US dollars could then be distributed to help cover current account
deficits, repay external borrowing and provide liquidity to the banking system.
Only the central bank of Mexico used the facility.

Asset purchases in the secondary market

Many EME central banks launched asset purchase programs for the first time,
purchasing mainly local currency government
bonds. The main purpose of these programs has been to support
local market functioning although, in a few cases, central banks have used
these programs to help their governments finance substantial fiscal support
packages. EME asset purchase programs have differed from those in advanced
economies, both because they have been conducted with policy rates mostly
well above zero and, for the most part, they have not been used to provide
a broader easing of financial conditions by lowering longer-term risk-free
interest rates. Government bond purchases by EME central banks have generally
been small (in most cases between 0.5−1.5 per cent of GDP;
Graph 6) relative to advanced economy central bank purchases (in most
cases between 2−15 per cent of
GDP).

Event studies suggest that EME central bank announcements of government bond
purchase programs have reduced longer-term government bond yields but have
not been associated with exchange rate depreciations. Longer-term local currency
yields were found to be 20─60 basis points lower over the week
following a program’s announcement (Arslan, Drehmann and Hofmann 2020;
IMF 2020d; Hartley and Rebucci
2020). The lack of impact on the exchange rate perhaps reflects the
small size of the programs and the sterilisation of purchases in many cases
(Hartley and Rebucci 2020).

If EMEs were to reach the lower bound of policy rates and pursue monetary easing
via large scale asset purchases, they would likely face greater obstacles
relative to advanced economies.

• Some EME central banks face restrictions in purchasing government bonds because
  of clauses in legislation or constitutions. In Brazil and Indonesia, however,
  legislation was temporarily changed in 2020 to relax restrictions on their
  respective central banks.
• Bond markets in EMEs are generally smaller and less liquid than those in advanced
  economies. This could potentially make bond yields more sensitive to increased
  participation of EME central banks in government bond markets, particularly
  for EME central banks that already own a large share of bonds outstanding.
• The channels through which a reduction in government bond yields passes through
  to broader financial conditions and economic activity are often weaker in
  EMEs. In part, this is because, in EMEs government bond yields are not used
  as often as a pricing benchmark for other domestic interest rates and the
  use of financial services is lower which can reduce pass-through from funding
  costs to lending rates.
• Central bank asset purchases could place significant downward pressure on
  the exchange rate if foreign investors shift from EME government bonds to
  foreign assets as a result, which could cause financial conditions to tighten.
• Prolonged use of asset purchases associated with worsening fiscal positions
  in EMEs could erode perceptions of central bank independence and credibility,
  which may de-anchor inflation expectations and cause bond yields to rise
  (World Bank 2021a). This is particularly the case for central banks purchasing
  government bonds in the primary market.

Purchases of government debt at issuance

Some EME central banks have purchased government bonds in the primary market
with the explicit intention of assisting their governments to finance large
fiscal deficits. The scale of the fiscal response to the
COVID-19-induced economic crisis has been larger than any previous
crises and this response has generally been funded by EMEs issuing local currency
debt. In 2 cases, central banks began purchasing government debt at issuance
or providing funds directly to the government, despite the deepening of their
local currency debt markets in recent years.

In July 2020 Bank Indonesia announced a deficit burden-sharing arrangement
with the Indonesian Ministry of Finance in which it would purchase government
bonds in the primary market to assist in financing the government’s fiscal
response to the
COVID-19 crisis. The central bank’s purchases have been split
into 3 parts and directly linked to components of the government’s
fiscal response to the
COVID-19 crisis including health and social security spending, and
support for businesses. 2 of the 3 parts concluded in 2020, with
1 part still ongoing and scheduled to run until the end of 2021. The
value of bonds purchased under the arrangement was around 4 per cent
of GDP by December 2020.

In the Philippines, the central bank directly purchased government bonds through
a pre-existing ‘provisional advance’ facility with the Philippine
fiscal authority. In September the limit on the size of this facility was
increased to 30 per cent of average government revenues over the
previous 3 years (from 20 per cent), and will remain at the
higher level for 2 years. Direct purchases in 2020 were equivalent to
3 per cent of GDP.

Direct central bank financing generally raises concerns about central bank
independence and the long-run ability of the central bank to meet its legislated
objectives (IMF 2020c). Some previous episodes of large scale financing of
government spending by EME central banks in the 1980s and 1990s led to periods
of persistently high inflation, prolonged output contractions and macroeconomic
instability (World Bank 2021b). However, many circumstances are different
for the countries that have engaged in direct financing since the
COVID-19 crisis. In particular, they have developed stronger monetary
and fiscal policy frameworks and have lower external debt on average (World
Bank 2021b; Cantú, Goel and Schanz 2020).

Nevertheless, concerns remain about the programs implemented in 2020 and there
has been increasing discussion among academics and policymakers about how
direct financing episodes can be best managed. The consensus view is that
direct financing programs should include safeguards that reduce concerns regarding
central bank independence and persistent periods of high inflation. Risks
will be lower when the central bank can clearly communicate that it has control
over the direct financing and that the objective of the program is consistent
with its objectives (IMF 2020d). Direct financing could be consistent with
central bank objectives during periods of market dysfunction where it may
be difficult for the government to access sufficient funding via financial
markets, or where other monetary policy tools are exhausted and inflation
is forecast to fall short of target over the policy horizon (Bartsch et al 2019). Ideally, fiscal and monetary authorities must clearly
define and communicate whether the direct financing arrangement is to be a
permanent or temporary policy tool.

Term funding schemes

A typical response of financial institutions during periods of elevated risk
is to tighten lending standards and reduce the supply of credit to households
and businesses. This response can inhibit economic activity and slow economic
recovery. This is particularly the case for EME financial institutions which
have had a larger share of loans become impaired relative to advanced economies
during previous banking crises (BIS 2020). The lockdown measures imposed by
governments to contain the spread of
COVID-19 have made financing difficult for many firms, particularly
small and medium-sized enterprises (SMEs) (IMF 2020c). As a result, many firms
have been unable to access credit to meet their financial commitments and
working capital requirements, or to invest in projects that support economic
activity.

In response to these concerns, a number of EME central banks launched term
funding schemes in 2020 to address constraints on non-financial firms’
access to bank credit, and to improve the transmission of monetary policy.
Typically, these have been funding-for-lending arrangements, where the central
bank provides low-cost funding to participating banks on the condition that
credit is extended to firms most affected by the crisis, often SMEs. In some
cases, the credit provided is guaranteed by the central bank or government.
This is particularly important for EMEs, which generally have weaker banking
systems and a larger informal sector, placing additional constraints on SMEs’
ability to access banking credit (IMF 2020c). The size and scope of the schemes
implemented by EMEs vary but are much smaller relative to GDP than schemes
launched by advanced economy central banks. Like in advanced economies, some
EME schemes have also been complemented by additional government support programs
for SMEs as well as a loosening of some regulatory measures that help to promote
the supply of credit more broadly, however the scale and breadth of the programs
have been much smaller than those launched by advanced economies (OECD 2020).

Conclusion

EME central banks responded decisively to the
COVID-19 pandemic in order to restore orderly market functioning, ease
financial conditions and support both financial stability and the economic
recovery. An array of policy tools have been used by EME central banks in
this pursuit, including purchases of local currency government debt which
appear to have successfully contributed to a normalisation of EME financial
conditions. Nevertheless, policy rate reductions remain the primary tool for
easing broad monetary conditions in EMEs (in contrast to many advanced economies
where policy rates have been close to effective lower bounds for some time).
The scale of the policy rate response to the
COVID-19 crisis was larger, and the pace faster, in EMEs than in some
past crisis periods. This was influenced by the sudden and synchronised nature
of the
COVID-19 induced economic shock and the large scale policy response
in advanced economies that occurred alongside the EME response, without which
capital outflows and exchange rate depreciations in EMEs would have been more
severe. It also reflects the significant improvements emerging market central
banks have made to their institutional frameworks over recent decades, which
has improved the stability of inflation, and the development of foreign exchange
hedging and local currency capital markets in EMEs over the same period.

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