Emerging Markets' Central Banks

Emerging Markets’ Central Banks: “New Normal” or Business as Usual?1

Maria Antonieta Del Tedesco Lins Institute of International Relations University of São Paulo [email protected] Giselle Datz School of Public and International Affairs Virginia Tech [email protected]

March 2016 FIRST DRAFT- comments welcome

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Paper prepared for presentation at the annual meeting of the International Studies Association, March 1619, 2016 – Atlanta, GA.

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Reflecting on central bankers’ responses to the 2008 crisis and its aftermath, then International Monetary Fund (IMF)’s chief economist, Olivier Blanchard (2013), stated unambiguously: “monetary policy will never be the same”. Indeed, no shortage of challenges have mounted for central bankers as most of the world’s economies experienced unpredicted turbulence originated from several sources: the liquidity crunch of 2008, the “unconventional monetary policy” implemented in the US and the EU after that, the 2013 “taper tantrum” (when the Federal Reserve alluded to the possibility of ending its quantitative easing program), devaluations of emerging markets’ currencies since 2015, negative interest rates in some advanced economies, and banking turmoil in China. There prevails in Washington, as well as in several of the world’s capitals, a sense that we are now living in “a new age of central banking” (Jácome 2015, Posen 2015, Lagarde 2015, Deutsche Bank Research 2013, Caruana 2013). The crisis originated in the US housing market in 2006-07 put pressure on the long-established view of monetary policy as having “one overriding objective, price stability, and one instrument, usually a short-term policy interest rate” (Bayoumi et. al. 2014: 5). Now, along with price stability, officials have been keen to stress that central bankers cannot ignore financial imbalances (Fernández-Albertos 2015, De Grauwe 2007, Carney 2009). Capital controls, long discouraged by international financial institutions, are now not only acceptable, but deemed necessary at times of destabilizing flows, particularly affecting emerging markets. In advanced economies, in turn, the mounting concern is that “central banks are running out of firepower”. With interest rates already so close to historic lows and negative in some cases, conventional monetary policy tools are being exhausted while economic recovery remains modest (Financial Times, February 19, 2016; The Economist, February 20, 2016). Overstretched central banks are hence not only fighting new battles, but also tackling old ones with a novel set of experimental tools. To be sure, there was no definitive consensus on all aspects of central banks’ operational frameworks even before the 2007-08 crisis. The label “central bank independence” has always allowed for a good deal of empirical ambiguity. For Siklos (2008: 803), “the concept of central bank independence has usually been sufficiently loosely defined to fit the particular needs of the group of countries under (usually

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quantitative) investigation”. It is common, for instance, to see both Mexico (where statutory independence has been established) and Brazil (where autonomy is at best the prevailing arrangement) sharing the same position among countries identified as having “independent central banks”. Larger-N quantitative research uses the label “central bank autonomy” as a broader category in which cases of statutory independence (de jure) and de facto “independence” are understood to fit side by side These rather confusing coding practices are symptomatic of a murky reality. As Arnone et al. (2007: 5, ft. 4) explain: “there are instances where de jure autonomy exaggerates the degree of de facto autonomy especially in countries where the rule of law is limited. However, de jure autonomy may also underestimate de facto autonomy, for example in the case of several inflation targeting central banks”. Furthermore, for Siklos (2008: 805), “central bank independence is defined not as a single index measure but rather as a multidimensional set of characteristics that, in some combination, enhances a central bank’s ability to deliver lower inflation”. Amid such conceptual blurriness and in light of current discussions about a “new age of central banking”, we ask: to what extent do different central banks’ institutional configurations impact monetary policy choices? The emphasis and often vague take on central bank independence (CBI) masks important dynamics of continuity and change in monetary authorities’ strategies and commitments in emerging markets. We have learned from the comparative institutionalist literature that institutional change need not be seen as either minor and frequent, supporting continuity; or abrupt and rare – always exogenously triggered. Rather, change is often incremental, endogenously sparked, yielding transformative results in time (Streeck and Thelen 2005, Mahoney and Thelen 2005). Taylor (2009: 510)’s analysis of the Brazilian central bank follows this approach and concludes that, “in sedimentary fashion, a succession of shifting policy challenges (…) laid down wave upon wave of minor changes driven by the policy imperatives of the moment”. More broadly, he states that “central bank independence is never a dichotomous variable” or can be conceived as the result of the simple institutionalization of a “blueprint (…) laid out a priori”. Rather, institutional innovation and change result from always-contextual policy imperatives.

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We follow Taylor’s (2009: 487, 489) take on “the policy-making process as an endogenous source of institutional change”, but consider exogenous shocks as key triggers of policy responses that may reiterate or depart from institutional conceptualizations of central banks’ objectives and reach. Given that we are interested in understanding particular institutional responses, contextualization is at the core of the analysis, as is the question of differentiation. In this sense, putting our research question in other words: Do different institutional arrangements lead to noticeably different policy responses to common exogenous pressures? In order to answer this question we develop a comparative case study analysis of three countries with markedly different institutional designs for their monetary authorities and divergent recent “track records” regarding price stability and the use of capital controls: Mexico, Brazil and India. Rather than yet another genealogy of different central banks’ institutional evolution, our comparative exercise explores the ways in which a common set of exogenous shock (the 2008 global crisis, quantitative easing pressures, the “tapering” of this program, and expectations of an imminent increase in US interest rates in 2015) affected existing commitments and ushered new courses of action pursued by the central banks of focus here. Three central arguments are advanced. First, common depictions of CBI as a dichotomous variable tend to (1) overstate institutional continuity by overlooking incremental policy changes that, albeit not culminating in statutory reform, represent significant redirections that breed their own potentially path dependent trajectories; and (2) understate convergence in initiatives embraced by central banks set up according to different institutional arrangements. Inflation targeting commitments are a clear example of such policy convergence amid institutional heterogeneity. Second, and more specifically, we argue that central bankers’ monetary policy choices in light of the exogenous pressures studied here were not limited by their institutional configurations. Rather, not unlike advanced economies’ central banks, these monetary authorities’ modus operandi changed as a function of the perceived policy imperatives of the time, as they understood them. For that no institutional reform was required or should necessarily be expected. This is particularly evident in the cases of Brazil and India, where central banks embarked in a series of crises responses that were

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not predictable given previous actions or defined institutional commitments. Mexico, the most conservative of the three central banks, comes closer to corroborating the common assumption that central bank independence entails more predictability, particularly when it comes to not straying from price stability. Yet to ascertain whether correlation in this case also means causation, one must carefully consider pressures emanating from a close connection to the US economy (a point for further investigation, beyond the present study). Third, the “new age of central banking” is not a universal one, and neither is it free from ironic twists. When inflation reemerges, distinct monetary trajectories tend to converge towards reassuring the credibility of inflation-containing commitments to the detriment of flexibility in policy approaches. This differentiates the type of strategies advanced economies can follow (more flexibility in trying to reignite economic growth under low inflation) and those afforded to developing countries (whose quest for growth is more firmly constrained by the goal of monetary stability). The irony of this variegated “new normal” for central banks becomes clear when we consider that central bank independence has been celebrated as a way to insulate monetary policy deliberations from political meddling that would lead to inefficient macroeconomic outcomes. However, in advanced economies today, when monetary policy instruments are proving themselves increasingly insufficient to keep recessions at bay, even some conservative commentators have pointed to the need to bring politics back in. The Economist’s editorial page calls for a “fiscal boost”, announcing that “the time has come for politicians to join the fight [against recession] alongside central bankers” (The Economist, February 20, 2016). In this paper, we single out emerging markets’ experience in a sequential account according to which, after flexibility is tested, the credibility imperative remerges – at least in rhetoric. The paper is organized as follows. The first section reviews the recent history of the three central banks of focus here, emphasizing their particular institutional arrangements and a convergence around inflation targeting. In the second section, we examine this differentiation in the context of the specific challenges brought about by the 2008 global crisis. Section three analyzes central banking in Brazil, Mexico and India in the post-crisis scenario, highlighting the challenges of navigating a “new normal” of

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relatively mediocre growth in most of the world, and coping with the end of the quantitative easing program in the US. In section four we engage with discussions about a “new age of central banking” focusing on our case studies and questioning what is indeed “new” in their particular experiences. Finally, a conclusion follows in section five.

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On the Road to Greater Central Bank Discretion: Different Paths Just 30 years ago most of the world’s central banks functioned as departments of

ministries of finance, expected to use monetary policy to serve a variety of objectives from high growth and government financing to price stability. The latter was “one of several objectives in [those banks’] charter[s] and had no special status” (Cukierman 2006:2). Until the 1970s, Central banks’ operations reflected the Keynesian understanding that inflation was a means to economic growth. The 1980s marked what Jácome (2015) called the “dark period” of “the developmental phase” of Latin American central banks, when these monetary authorities were subordinated to the developmental goals of expansionary governments. The 1990s, in contrast, “marked a turning point for monetary policy” in Latin American and other emerging markets. Most Latin American countries used some form of exchange rate anchor to curb inflation, varying from crawling pegs (as in the case of Brazil) to superfixed exchange rate arrangements (like the one adopted by Argentina) [Jácome 2015: 33]. Peru and Mexico (post-1994 peso crisis) adopted flexible exchange rates. Monetary stability efforts paralleled a widespread process of granting de jure independence to central banks (so as to lock-in a particular policy path) or increasing the autonomy of institutions where no statutory reforms were put in place. Mexico remains a notable example of de jure independence and Brazil and instructive outlier within this regional reform trend. In contrast, until 1991, India had not adopted a strict monetary policy framework since administered prices and interest rates affected a vast number of goods and applied to different credit lines. Since the start of liberalization reforms in the late-1980s and early 1990s, the local currency (the rupee) was allowed to float. However, the country’s central bank constantly intervened in foreign exchange markets and imposed capital

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controls, moves characteristic of its role as an active policy player (Bhattacharya and Patnaik 2014). Despite the pursuit of monetary stability since the 1990s, emerging markets were challenged by several financial crises, which tested institutional commitments in the face of global financial contagion, mostly through “sudden stops” of capital outflows (Calvo 1998, Bordo 2007). In all these episodes of turbulence central bank independence and, in many cases, a more informal “autonomous” design would lock-in a monetary policy course that backed austerity. This was part of “the technocratic ethos of the neoliberal paradigm, with its purportedly objective, nonpartisan, disinterested, and depoliticized approach to policy making” (Pollo and Guillén 2005: 1768). In fact, central bank independence and arrangements such as inflation targeting “have become widely accepted commitment devices” (Cukierman 2006: 2, Fraga et al. 2003). Such seeming convergence should not obscure, however, significant differences in the institutional design and evolution of emerging markets’ central banks. We briefly highlight those pertaining to Mexico, Brazil and India, respectively. Mexico’s central bank independence: signaling credibility The Mexican central bank (Banco de México) opened its doors in 1925. Years later, under President Cárdenas’s tenure (1934-40), the bank became instrumental to his goal to build a new labor-and-peasant-supported party (the PRI). For that the central bank served as a “subservient financier of an expensive process of political consolidation”, absent access to international financing (Maxfield 1997: 93). Things changed in the 1950s when the search for new foreign sources of credit “imposed very strong discipline and greatly strengthened the authority of the central bank and the finance ministry to define how to make Mexico attractive to international creditors” (Maxfield 1997: 97). Yet, in the 1970s, ample foreign credit supply and political pressure from President Echeverría Alves’s (1970-76), who wanted to “buy back popular support”, led to deficit spending. The president centralized fiscal and monetary authorities, leaving little room for dissenting Banco de México directors to reverse the path of fiscal expansion.

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From 1980 to 1982, oil prices fell and Mexico’s total external debt grew substantially. By the end of the 1982, foreigners stopped financing new capital inflow. Dealing with this crisis, President López Portillo (1976-1982) changed the Banco de México’s charter at the same time that he nationalized the banking system, devalued the peso, and ultimately defaulted on the debt (Bergoeing et al 2002). Leading Mexico’s economic recovery, President de la Madrid (1982-1988) restricted central bank autonomy with a norm “empowering the Ministry of Finance to respond flexibly under inflationary pressures and restricting the central bank to acting in accordance with the decision taken by the directives on credit and monetary policy indicated by the Minister of Finance” (Banco de México 1985 art. 2, quoted in Valdés 2009: 7). Finally, in the midst of bold market reforms under President Salinas (1988-1994), Banco de México’s was granted legal independence in 1993. In Maxfield (1997)’s account the reform was motivated by the government’s need to signal a commitment to monetary stability that would improve creditworthiness and thus promote capital inflows at potentially lower costs for the sovereign borrower2. Valdes, on the other hand, states that “economically, the [central bank independence] reform’s objective was less one of establishing credibility than of legitimating the stabilization program; the autonomy of the central bank thus had to wait until the government had succeeded in attaining singledigit inflation and a budgetary surplus”, and would only be possible once fiscal reform was carried out in the late 1990s. Indeed, despite the 1993 reform, “the finance ministry retained decisive control and voting power over a wide range of policies, including exchange-rate policy. The central bank’s ability to determine interest rates independently of executive branch policy was seriously and deliberately constrained” (Valdés 2009: 12, Boylan 2001). The Mexican peso crisis that followed in late 1994 “posed a major challenge to the reputation of (…) central bank” (Valdés 2009:14). While the 1995 devaluation allowed the central bank more room to move, it was the 1997 reform that granted a new legal status and total autonomy to the monetary authority.

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Babb (2001: 175) emphasizes the determining role of not only international investors and US officials, but also multilateral institutions (notably the IMF) and, importantly, domestic technocrats. She stresses that the “most important actors in policy transformation were government officials [most of which foreign trained in liberal economics] rather than organized domestic interest groups”.

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Brazil’s central bank’s conditioned “autonomy” As Taylor (2015: 20) puts it, the Brazilian central bank “is one of the institutions that has undergone the most significant change over the course of the past generation, and indeed, since its creation” in 1964, only 8 months after the coup that installed a military dictatorship. The “changes include the elimination of rival centers of monetary policy [notably the Bank of Brazil], increased discipline over both private and public sector banks, and the [eventual] elimination of the central bank’s [explicit] role as an agent of development”. In 1986, the National Treasury Secretariat was created and monetary control by the central bank improved, even though minister of finance, Dilson Funaro, clearly called the shots. The following year, and under a new minister of finance (Bresser Pereira), the developmental function of the central bank was set aside, the administration of the public debt was transferred to the Finance Ministry, and a single and unified federal budget was set up along with the Integrated Financial Administration System (Taylor 2009). Taylor (2009: 503) explains that contrary to expectations of fundamental institutional change as part of the democratic transition, “the Constitutional Assembly [of 1987-88] devoted little time to proposals regarding the [central bank of Brazil] and public attention to the theme was low”. Nonetheless, its article number 164 forbids the central bank from financing the Treasury or any other agency that is not a financial institution, marking a normative step toward operational autonomy (Raposo and Kasahara 2010: 936). The Real Plan of 1994 that finally tamed Brazilian hyperinflation “transferred unprecedented power to the central bank of Brazil, generating the effective supremacy of monetary policy over all other economic instruments”. Yet, as de Carvalho (1995: 139) explains, the interaction between the Executive (led by president Fernando Henrique Cardoso) and the central bank was based on a “social consensus around stability”, on the specific team of experts gathered around the Plan Real. Together, they determined monetary policy. Absent these factors, a simple legal maneuver would not have served as an “effective straight jacket” constraining inflationary forces in the Brazilian economy (ibid). Indeed, contrary to general assumptions about the existence of a unidirectional

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causal connection linking greater central bank autonomy to monetary stability, in the Brazilian case, autonomy was a consequence of (rather than a precondition for) inflationary control (Sola et al. 1998). This autonomy was also conditioned by what scholars have called “fiscal dominance”, namely, the inability of the central bank to increase interest rates in order to contain inflation without also (albeit unwillingly) increasing the probability of a debt default and currency devaluation, as Brazil experienced in 2002 and 2003 (Blanchard 2004). In other words, fiscal dominance, can lead to a vicious cycle of depreciation fueling even higher inflation, despite an increase in interest rates. Hence where fiscal credibility is low, the central bank’s ability to contain inflation and hence stick to inflation targets is significantly diminished (Fraga 2003). India’s Central Bank: “Development” first and foremost The Indian central bank’s history is markedly different from those of Brazil and Mexico. One of the oldest central banks in developing countries, the Reserve Bank of India (RBI) was established in 1935 as an independent agency, free from political pressures and with the goal of assuring that regular payments to Great Britain would be made. Soon after India achieved its independence, the RBI was nationalized and incorporated into the government’s bureaucracy. As Goyal (2014: 23) explains, “the initial jockeying between the RBI and the Ministry of Finance made it clear that the RBI was to be regarded as a department of the government. Monetary policy was another instrument to achieve national goals. The RBI lost even instrument independence.” In the Preamble to the RBI Act “there is no explicit mandate for price-stability or formal inflation targeting. The twin objectives of monetary policy in India have evolved over the years as those of maintaining price stability and ensuring adequate flow of credit to facilitate the growth process” (Reddy 2007). Until the liberalization reforms of the 1990s, the RBI functioned as a multi-tasking development agent. It was an exclusive financing agency of the state through bond issuances, an operator and regulator of credit markets, and – later on – an inflation controlling authority. In this context, “monetary policy was there to support public expenditures” and the RBI’s room to maneuver was bounded not only by the Ministry of Finance and the Planning Commission but also by

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other government agencies, as well as public and a few private financial institutions (Goyal 2014: 11). Interest rates were set partly through the RBI deliberations on the costs of lending to commercial banks and partly through the federal government’s stipulations on the returns on public debt (Singh 2005). The RBI functions as both a regulator and a market player (Shah and Patnaik 2011). Differently from Brazil and Mexico, where special, separate agencies for capital markets regulation exist, India passed an amendment to the RBI Act establishing its role as the regulator of the bond and currency markets in 2006. Although the Securities and Exchange Board of India, created in 1992, is the formal authority of capital markets, the Ministry of Finance is still the agency responsible for the whole financial system as well as for the RBI. India’s monetary authority has undergone gradual but important transformations in the 2000s, leading to an increase of some the RBI’s de facto autonomy. The Fiscal Responsibility and Budget Management (FRBM) Act of 2003 prohibits the RBI from participating in primary issuances of all government securities. Moreover, the Reserve Bank of India Amendment Act of 2006 increased the bank’s flexibility in regard to cash reserve requirements, deployment of foreign reserves, and clarity in regulation over money, foreign reserves and government securities markets. While banking supervision continues to be exercised by the RBI, “it has been accorded a distinct semi-independent status”. The Board for Financial Supervision (BFS), a committee of the Central Board of the RBI, was set up in 1994. Finally, although it remains legally able to provide concessional finance to specific sectors such as agriculture, industry and export, the RBI has gradually withdrawn from such targeted credit provision. It is the bank’s understanding that “direct fiscal support to development activities” is preferred to monetary operations that “would tantamount to quasi-fiscal operations” (Reddy 2007).

All roads lead to inflation targeting Inflation targeting regimes were implemented after inflation had already declined in Brazil, Chile, Colombia, Mexico and Peru. It was, as Paulin (2006: 10) explains, a way to “lock in” their “hard-won progress” in monetary stability. With inflation targeting, the

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single price stability objective is pursued through changes in a single policy instrument: the short-term interest rate. Central banks share with the public their target for inflation, and change the policy rate that determines the cost of interbank funding through regular meetings of the monetary authority3 (Jácome 2015: 41). In Mexico, inflation targeting was adopted in 2001 when the country “was considered to have in place the main components [for the framework] (…): an independent monetary authority that has inflation as its fundamental policy objective, a flexible exchange rate regime, the absence of nominal anchors and a ‘transparent’ framework for the implementation of monetary policy” (Ros 2015: 486). Although GDP growth had been approximately 2.5% per year since 1994, inflationary control was indeed achieved and the central bank’s inflation target was met, immediately prior to the Mexican peso crisis, as shown in Table 2 (Ros 2015). With the decline in inflation rates to single digits in the late-1990s and early2000s, Brazil - an outlier in a region where most other countries instituted statutory central bank independence - joined Chile, Colombia, Mexico, and Peru in introducing its own inflation targeting regime in 1999 (see Table 2). The framework took advantage of Brazil’s then “flexible exchange rates to smooth external pressures, (…) turning reserve accumulation into a healthy precaution rather than an absolute necessity” (da Silva et al. 2012: 6). As inflation was kept within the target range, the credibility of the regime grew (Jácome 2015: 42). However, according to Barbosa-Filho (2008: 188-189), “since the [central bank of Brazil] is not independent and its penalty for not meeting the inflation target is just to explain why that happened, (…) the Brazilian inflation-targeting regime is basically a loose way for the federal government to assure society, especially financial markets, that it will not let inflation run out of control”. Despite trials and errors, inflation targeting managed to reduce inflation in Brazil after its 1999 and 2002 currency crises, and “reduced the real interest rate of the economy, which nevertheless remained well above international standards and more than three times higher” than Brazilian GDP growth from 199 to 2006. Benign external 3

From 1997 to 2002, 13 emerging markets adopted an explicit inflation-targeting regime. They were: Israel, the Czech Republic, Poland, Brazil, Chile, Colombia, South Africa, Thailand, Korea, Mexico, Hungary, Peru and the Philippines. Joining this group in 2005-06 were the Slovak Republic, Indonesia, Romania and Turkey.

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conditions allowed Brazil to “accumulate foreign reserves, repay most of its foreign debt, and reduce its dependence on foreign capital” (Barbosa-Filho 2008: 198). Unlike the Brazilian and Mexican central banks, the RBI had no formal mandate to target inflation when it was first established. Administered prices and limited financial markets until 1991 fed the notion that there was no need for a monetary policy framework. Indeed, inflation measured by a traditional measure of the Wholesale Price Index, started before independence, has been generally less than 9%. If measured by the Consumer Price Index (featuring more non-tradable foods and services), inflation has been around 10% (Singh 2014). After the 1991 liberalization reforms, prices and the exchange rate became market-determined (Bhattacharya and Patnaik 2014). Moreover, the RBI started to fix a numeraire to inflation – i.e., a “self-imposed medium-term ceiling” (Reddy 2007). The debate over the establishment of an inflation targeting regime, ongoing for twenty years, received new “impetus when Raghuram Rajan, in his first speech as RBI Governor [in 2013], again emphasized the importance of low and stable inflation for Indian monetary policy and, in January 2014, the Expert Committee of the RBI to Revise and Strengthen the Monetary Policy Framework submitted the report recommending adoption of IT”, which was done in March 2015 (Singh 2014: 7). Table 1 summarizes the particular institutional characteristics of the three central banks studied here. Table 2 depicts the significant disparities in the three case studies’ inflation trajectories. In India inflation was not stable in the 1980s, yet remained below double digits. In the same decade, along with a debt crisis, Mexico faced extremely high inflation rates and Brazil battled hyperinflation. After the 1990s stabilization policies and liberalization reforms, inflation rates at first reflected each central bank’s institutional frameworks. Mexico achieved lower and more stable rates, carrying the effort further even after the 2008 crisis. Brazil conquered hyperinflation in the 1990s, but monetary policy was loosened after the crisis. In India, combining the effects of rapid growth and the developmental needs of most of its financial institutions with profound economic transformations led to strong pressures on inflation rates in the 2000s.

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Table 1: Varieties of Central Banking: Operational Principles in Mexico, Brazil and India Country

Institutional form

Mandate

Statutory independence 1994 (Law on the Bank of Mexico), amended in 1999.

Price stability as the primary objective. Promote sound development of the financial system and proper functioning of the payment system. - Lending to the executive is subject to a ceiling of 1.5% of the government’s current expenses. Price stability and economic development.

Mexico

Brazil

Statutory autonomy - Amendment of May 2000 to the 1998 Constitution.

Neither independent nor autonomous. Subordinated to the Ministry of Finance

India

- Lending to the executive branch is explicitly prohibited. "To regulate the issue of Bank notes and keeping of reserves with a view to securing monetary stability in India and generally, to operate the currency and credit system of the country to its advantage" (RBI Act, quoted in Reddy 2007). - The Fiscal Responsibility and Budget Management (FRBM) Act of 2003 prohibits the RBI from participating in primary issuances of all government securities. -The RBI is a banker to the government and a banker to banks.

Mechanism for removal of central bank director Strictly on legal grounds - Removal proposed by the Legislative branch.

“Independence” in the use of monetary policy instruments Restrictions on the conduct of monetary and exchange rate policy. The government is authorized but is not required to capitalize the central bank.

The stability-confidence nexus Confidence in the monetary authority was a goal pursued simultaneously with monetary stability.

On non-legal grounds or for economic policy reasons. - Removal proposed by the Executive branch alone.

Full independence in monetary and exchange rate policy. The government is required to maintain central bank’s capital.

Confidence in the monetary authority was achieved after monetary stability.

The Governor is appointed by the Central Government and may be removed from office without specifying any reason.

Monetary and exchange rate policies are subject to the Finance Ministry’s approval.

Monetary authority is seen as part of the government. Shift occurs after Sept. 2013.

Sources: Carstens and Jácome 2005, Reddy 2007, and authors’ notes.

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Table 2: Inflation in Brazil, India and Mexico: 1981-2014 (average annual rates)

1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Brazil

India

Mexico

101,7 100,5 135,0 192,1 226,0 147,1 228,3 629,1 1430,7 2947,7 432,8 951,6 1928,0 2075,9 66,0 15,8 6,9 3,2 4,9 7,0 6,8 8,5 14,7 6,6 6,9 4,2 3,6 5,7 4,9 5,0 6,6 5,4 6,2 6,3

13,1 7,9 11,9 8,3 5,6 8,7 8,8 9,4 3,3 9,0 13,9 11,8 6,4 10,2 10,2 9,0 7,2 13,2 4,7 4,0 3,7 4,4 3,8 3,8 4,2 6,1 6,4 8,4 10,9 12,0 8,9 9,3 10,9 6,4

27,9 58,9 101,8 65,5 57,7 86,2 131,8 114,2 20,0 26,7 22,7 15,5 9,8 7,0 35,0 34,4 20,6 15,9 16,6 9,5 6,4 5,0 4,5 4,7 4,0 3,6 4,0 5,1 5,3 4,2 3,4 4,1 3,8 4,0

Source: World Bank Database.

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II.

Weathering the 2008 Global Financial Crisis

The relative resilience of emerging markets to the global crisis of 2008 was widely commented and attributed to the macroeconomic and financial reforms that had been carried out a decade before, particularly as lessons learned from the 1997 Asian and 1998 Russian crises (Jácome 2015, Kapur and Mohan 2014, Didier et al. 2012). The transition from pegged and semi-pegged exchange rate regimes to one of floating rates combined with inflationary control and relatively open capital accounts allowed for more sustained macroeconomic stability in several of these economies. The institutional strengthening of monetary authorities was a requisite and a result of this process. During the crisis, particularly in its early moments when uncertainty and a liquidity drought predominated, central banks’ rapid responses were fundamental to contain contagion effects in both financial and productive sectors of local economies. In 2007, Brazil was enjoying a favorable period in its recent economic history. After the speculative attacks that accompanied President Lula’s first campaign for office in 2002, both prices and exchange rates had realigned with macroeconomic policy objectives. China’s growth and the boom in commodity prices fed even more positive expectations about the country’s performance. Those were backed up by credit rating upgrades by the three main agencies (S&P, Fitch and Moody’s), ultimately granting Brazil investment grade status in April 2008. Moreover, GDP grew 6% in 2007, the highest rate in the decade. FDI inflows increased 85% in the same year. The inflow of portfolio investment was also substantial between 2006 and 2007. With about US$ 180 billion in international reserves (13% of GDP), double the amount accumulated the year before, the Brazilian central bank had enough ammunition to defend the real against excessive capital outflows should the need arise. At the same time, the very characteristics of the local banking industry (high concentration among strong institutions under rigorous regulation and low levels of foreign indebtedness) allowed it to cope well with the crisis (Wise and Lins 2015). This limited the need for the central bank to increase liquidity or enforce stronger regulatory rules on local banks.

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A similar set of developments were observed in the case of India’s banks. They remained relatively isolated from the crisis given the strong presence of public institutions and the limited liberalization that had been carried out in their recent past. Constrained international liquidity impacted Indian financial markets through local companies that had acquired foreign debts. Restrictions against foreign presence in local capital markets boosted firms’ financing abroad. When it became harder to renew these loans, these firms turned to domestic financial institutions, converting rupees into dollars in order to pay for their foreign obligations. This process was at the heart of the capital outflows that followed the crisis outset, pushing the RBI to intervene in the foreign exchange market (Echeverri-Gent 2015). Like in the Brazilian case, when the crisis begun, the Indian economy was on track; average growth was 9% between 2003 and early 2008 (Kapur and Mohan 2014). The decrease in trade with the West was compensated by increasing exports within Asia, thanks to the liberalization policies that had been pursued in the previous decade (Echeverri-Gent 2015). Indeed, since the end of the 1990s, changes in India’s exchange rate policy allowed the RBI to increase its stock of international reserves, just as the Brazilian central bank had done (see Chart 1).

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Chart 1. Foreign Reserves, USD billion

400

350 300 250 200 150 100 50 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Brasil

India

México

Source:World Bank Database

In Mexico, macroeconomic and institutional stability along with the high prices of oil allowed the country to also accumulate a substantial stock of foreign reserves prior to 2008 (Chart 1). However, in contrast to Brazil and India, Mexico was one of the emerging market countries most affected by the 2008 at its outset. Given its economic ties with the US (80% of Mexican exports are bought by American importers), the country suffered the impact of the crisis in its trade flows, FDI, credit availability and, as a result, economic activity. Nevertheless, the economic and financial reforms implemented a decade before allowed policymakers and especially the central bank to enjoy some room of maneuver when it was needed. In sum, all three countries had accumulated enough foreign reserves to face an exogenous shock with some “fiscal space” for targeted intervention to smooth a downturn. They had also experienced growth and relative monetary stability. Yet how central banks’ would choose to act was not solely a result of their institutional configurations. They maneuvered with flexibility, in some instances (as in the case of Brazil) sacrificing

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credibility in the process. In order to better understand these dynamics in detail, we take a closer look at three key areas of central bank intervention in each case: (1) interest rates and domestic liquidity, (2) foreign exchange markets, and (3) capital controls. Interest rates and domestic liquidity

Since October 2008, the Brazilian central bank, started to reduce reserve requirements in some types of financial operations in order to inject liquidity back into the economy. Almost simultaneously, the government also began to encourage the giant public banks (the Bank of Brazil, the National Savings Bank, and the National Development Bank) to expand their supply of credit to private financial institutions, and reduced the reference rate in March 2009 (see Chart 2). Although arguably following an inflation-targeting regime, Brazil took the countercyclical route in order to smooth the exogenous shock. Far from a purely reactionary move, this was also part of a “policy shift towards as more state-centered approach to economic development”, marked by the “almost exclusive emphasis on the consumption side of demand management” (Sola and Vale 2015: 32) and the pursuit of “industrial policy” through subsidized credit channels. Hence monetary policy not only responded to global pressures, but also reflected political tensions emanating from economic stagnation since 2011. Despite public credit expansion, productive activity did not return to pre crisis levels. Incrementally, the economic policies of president Rousseff’s first mandate (2010-2014) broke with some of the pillars of macroeconomic stability, most notably the Brazilian central bank’s de facto autonomy. In spite of Rousseff’s rhetorical endorsement of the stabilization model adopted by previous governments, economic actors saw her administration’s monetary policy choices distancing the government from its commitment to the inflation target4. Hence, in spite of ten years of relative autonomy, the

4

Although some analysts read the conundrum faced by the Brazilian central bank as one marked by seemingly perpetual fiscal dominance (as explained above), unlike in the early 2000s, in Rousseff’s Brazil interest rates are comparatively lower and only a small portion of the public debt is dollar-denominated (Taylor 2015; The Economist, October 31; 2015; Reuters, October 22, 2015; Financial Times, January 18, 2016). Beyond fiscal dominance, hence, the Brazilian currency’s vertiginous fall in 2015 and 2016 can be explained by a general lack of credibility in the government’s ability to reverse negative growth estimates in the short term, based also on a lingering political crisis that makes the necessary reforms less feasible.

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Brazilian monetary authority found itself captured by the Executive, taking a backseat in a policy approach that was not compatible with monetary stability. As mentioned above, in India, liquidity problems became evident when local firms that could no longer roll over their foreign debts started to request credit from local financial institutions, converting rupees into dollars and sending them abroad. The boom in commodity prices led to higher food prices, contributing to a new inflationary trend. Yet as a countercyclical measure to deal with the crisis’ aftermath, the RBI – like the Brazilian central bank - reduced interest rates (Echeverri-Gent 2015) [see Chart 2]. This scenario would only change in the 2010-2011 fiscal year when fast economic recovery was achieved: GDP growth stood at 8.5% and 10% in 2009 and 2010, respectively (Kapur and Mohan 2014). However, rising inflation imposed a serious political challenge to the Singh government. Because in India institutional and political reforms are carried out as a product of long bureaucratic and legislative processes, the significant political changes that resulted from Prime Minister Modi’s victory in May 2014 have yet to impact macroeconomic policy in substantive ways.

Chart 2: Policy Rates, percent annual 16 14 12 10 8 6 4 2

Brazil

India

2015-04

2015-01

2014-10

2014-07

2014-04

2014-01

2013-10

2013-07

2013-04

2013-01

2012-10

2012-07

2012-04

2012-01

2011-10

2011-07

2011-04

2011-01

2010-10

2010-07

2010-04

2010-01

2009-10

2009-07

2009-04

2009-01

2008-10

2008-07

2008-04

2008-01

0

Mexico

Sources: Banco Central do Brasil, Reserve Bank of India and Banco de México

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In contrast to most developed and developing countries who were loosening monetary policy, Mexico was tightening it in the beginning of the crisis. Indeed, the Mexican central bank remained committed to inflation targeting. With higher food prices, and despite a reduction in economic growth (standing at 1.4% of GDP), Banco de México increased interest rates in the summer of 2008, embracing a clearly procyclical policy – as can be seen in Chart 2. According to Esquivel (2015), this was due to the orthodox background of Mexican central bank officials. For Ros (2015: 496), the explanation is more substantive. Banco de México struggled with its “fear of depreciation”, which would pressure inflation upward and increase the cost of debt in foreign currency. This fear then “tends to make monetary policy procyclical in the face of external shocks”. An interest rate reduction in the aftermath of the 2008 crisis only came in January 2009 (Chart 2), going from 8.25% in December 2008 to 4.5% in August 2009, when the crisis’ negative effects on the Mexican economy were already evident. Intervention in foreign exchange markets The impressive amount of reserves accumulated by emerging markets in the early 2000s introduced new interventionist dynamics in foreign exchange markets. In India, capital outflows resulting from the 2008 crisis let the RBI to intervene to prevent the substantial depreciation of the local currency. Among the tools utilized in November of that year were rupee-dollar swaps, increases “in the rate ceiling on foreign currency deposits to encourage foreign exchange inflows from nonresident Indians, [liberalization of] restrictions on external commercial borrowing”, and permission for nonbank financial companies to access foreign credit (Echeverri-Gent 2015: 82). Beyond direct intervention, derivatives regulation (2010-2011), new rules for foreign currency accounts (2011), and restrictions on banks’ gold imports (2013) also impacted the rupee (Goyal 2014:59). In October 2008, the Banco de México conducted extraordinary auction sales of dollars to improve liquidity in the foreign exchange market. In February 2009, discretionary sales (decreed by the Foreign Exchange Commission) of US dollars were

21

carried out to attenuate the pressure on the peso (Ros 2015: 501). In its commitment to inflation targeting and an open capital account, the Mexican central bank was left with room for only small interventions in the foreign exchange market in order to adjust peso fluctuations and accumulate reserves with the goal of maintaining the resilience of the monetary system. The Brazilian central bank’s response to the same external pressures was much more forceful. Indeed, given their intensity, and to some extent originality, the interventions of the Brazilian central bank in foreign exchange markets between 2008 and 2014 became a reference in the recent literature on foreign exchange policies and capital flows (Chamon et al. 2015, Garcia and Volpon 2014). They entailed the direct involvement of the monetary authority in the foreign exchange market, negotiating in dollars or through swaps (paper with a repurchase commitment) via measures traditionally used to control foreign capital flows. It is thus hard to isolate policies related to exchange rate markets from those related to capital control in this period. When it comes to the real’s excessive appreciation until July 2011 (see Chart 3), different tools were used to limit this phenomenon, despite its benign effect on inflationary pressures.

22

Chart 3: Nominal Exchange Rates, Index: Aug 2007=100 170

150

130

110

90

jan/07 abr/07 jul/07 out/07 jan/08 abr/08 jul/08 out/08 jan/09 abr/09 jul/09 out/09 jan/10 abr/10 jul/10 out/10 jan/11 abr/11 jul/11 out/11 jan/12 abr/12 jul/12 out/12 jan/13 abr/13 jul/13 out/13 jan/14 abr/14 jul/14 out/14 jan/15 abr/15 jul/15

70

Brazilian Real

Mexican Peso

Indian Rupee

Sources: Banco Central do Brasil, Reserve Bank of India and Banco de México.

Capital controls (i)

India

Emblematic of India’s gradualism in reform implementation, capital account and financial liberalization were planned as discrete steps within a broader program of reforms. First, a floating exchange rate regime was set up, followed by the deregulation of domestic interest rates, and only later financial openness was allowed. Shah e Patnaik (2007:609-610) explain that “Indian capital controls consist of an intricate web of a very large number of quantitative restrictions, operated by a substantial bureaucratic apparatus.” Capital controls were thus not just a product of the crisis; some had existed before it and were maintained. Examples are: limits according to which individuals and firms (FDI) could invest abroad, restrictions to the entry of foreign banks in the country, limits over the value of loans taken by Indian firms abroad and over the maximum foreign portfolio investment by foreigners allowed into the country. Restrictions on FDI in some sectors of the domestic economy were also kept (Patnaik and Shah 2012).

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(ii)

Mexico

NAFTA membership made it difficult to implement radical financial policies in Mexico. Moreover, the economic policy framework in which central bank independence and macroeconomic discipline are praised could hardly accommodate strong state intervention in financial markets. Yet we cannot say that Mexico did not intervene at all in capital flows. In 2010, the country implemented a set of foreign-exchange and capital controls measures that were primarily aimed at fighting illicit business related to drug trafficking. Limits on foreign exchange cash transactions to $1,500 per person per month were established. Two years after, in October 2012, the Ministry of Finance passed a law (the Federal Law on the Prevention and Identification of Operations from Illicit Sources) requiring that certain transactions involving cash be reported to the tax department of the Ministry of Finance, and prohibiting a number of other transactions, such as real estate transactions with a high value, to be conducted in cash. Apart from this initiative, few steps were taken to close other financial flows to and from Mexico.

(iii)

Brazil

Brazil, again, took a more interventionist direction. In October 2009, Brazilian monetary authorities implemented a 2% financial transaction tax (IOF) on nonresident equity and fixed-income portfolio inflows by the Ministry of Finance. This tax increase was doubled a year later; from 2 to 4% for fixed-income portfolio investments and equity funds. IOF was also increased to 6% for fixed-income investments in October 2010 (Chamon et al. 2014). All in all, from October 2009 to March 2012, around fifteen tax and non-taxes measures were taken in order to tighten capital flows to Brazil and prevent currency appreciation. We discuss further measures adopted by the Brazilian central bank below, where we explain the challenges faced by the country when trying to contain a massive inflow of international capital that produced currency appreciations.

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III.

Navigating the “New Normal”: “Currency Wars” and Other Battles

As is well known, in the aftermath of the 2008 global financial crisis, central banks of advanced economies took unprecedented actions to support financial and economic activity. They sharply cut policy interest rates down to or near zero. In the United States, United Kingdom, Japan, and the euro area, central banks implemented “unconventional monetary policy measures” to restore the functioning of financial markets and provide further stimulus at the zero (interest) lower bound. One of the largest programs of this kind was quantitative easing (QE) practiced by the Federal Reserve (Fed), which resulted in an approximate 750% increase in the size of its balance sheet. A consequence of these actions was the increase in global liquidity, which, along with very low returns on investment in advanced economies, spurred a surge of capital inflows to emerging markets (EMs). Indeed, between 2009 and 2012, gross capital inflows to these countries totaled US$ 4.5 trillion, half of global capital flows during the period. Yet the composition of these flows changed over time. While before the crisis they were in their majority foreign direct investment, after the crisis “portfolio flows grew to one in every four dollars entering EMs” (excluding China, where FDI continued to predominate). This led to higher bonds and equity prices along with the strengthening of local currencies in these economies (Sahay et al. 2014). In addition, as Sahay et al. (2014: 10) explain, “the relative importance of external and domestic factors in explaining capital inflows changed”. From 2011 to 2012, domestic factors became increasingly more important. Mexico, Brazil and India were in a group of only 8 countries, which together received 90% of net capital inflows to emerging markets. This “reflects the large size of these countries, their higher growth rates vis-à-vis advanced economies, financial sector reforms leading to growing financial depth, and increasing accessibility to international institutional investors (…) [However], the total inflows into these EMs were larger than their fundamentals would suggest (Sahay et al. 2014: 10) and also “larger than [the inflows prompted] by conventional policies in the past” (Lagarde 2015). For both the Brazilian and Mexican central banks such large inflows of capital meant that the challenge now was not to counter local currency depreciation (as had been the

25

case in the aftermath of the crisis), but appreciation, which jeopardizes the competitiveness of these economies. In 2010, Brazilian finance minister, Guido Mantega, accused advanced economies of engaging in an “international currency war” in which governments were competing to lower their exchange rates to boost competitiveness and lift their economies at the expense of countries who were battling appreciation. Indeed, given the fall of 25% of the dollar relative to the real, the Brazilian currency became “one of the strongest performing currencies in the world” at the time (Financial Times, September 27, 2010). To tackle this issue, apart from the measures related to capital flows implemented in 2010 (mentioned above), derivatives markets were subject to stricter regulation in 2011. New rules relating to prudential regulation were also put in place at that time. Table A in the Appendix summarizes several of these initiatives. For now, suffice it to say that, after the implementation of these policies, Brazil gained a reputation as one of the countries that most intensively made use of capital controls. In May and June 2013, stronger US recovery prospects, led the Fed to change its narrative on QE and signal a gradually unwinding of the program. At the moment, this “taper talk” by the Fed surprised investors who reviewed their expectations about US rates and pulled large amounts of capital out of emerging markets, leading to sharp currency devaluations, increases in the interest rate premiums expected of emerging borrowers, and declines in equity prices. An IMF study on such market overreaction saw it as “unusual both in terms of the size and breadth of outflows” (Sahay et al. 2014: 4). The impact on emerging markets was differentiated. Unsurprisingly, countries with “good macroeconomic fundamentals” experienced more mild market reactions (such as in the case of Mexico), while those where current account deficits and inflation were relatively high (like in Brazil and India) were particularly hit. Indeed, in Mexico, a large depreciation of the peso followed the May 22 “taper talk”, but “its deep capital markets [relative to liquidity measures] facilitated the needed adjustment in capital flows and portfolio rebalancing” (Sahay et al. 2014: 20). In contrast, as had been the case in other interventions, the Brazilian central bank was bolder. It announced the sale of US$ 2 billion in exchange rate swaps every week starting in August 2013. This was accompanied by a weekly auction of US$ 1 billion in short-term dollar credit lines to banks. Chart 3 shows that the announcement of intervention was

26

accompanied by a strong appreciation of the exchange rate (that is, a sharp fall in the rate of R$ per US$). In December of that year, the central bank then announced that it was extending the program to 2014, but reducing in half the weekly sales of swaps to US$ 1 billion. Although the first (2013) announcement led to a strong appreciation of the real, the second (2014) did not have the same effect. Nevertheless, the program was again extended; this time until the end of 2014 (Chamon et al. 2015). August 2013 was also a busy time for the Indian central bank. It announced measures to restrict capital outflows from Indian firms and individuals. Like Brazilian central bankers, Indian policymakers’ main concern at that point was the effects of capital flights on the rupee. To contain it, the RBI implemented several measures from reducing Overseas Direct Investment to limiting remittances by residents and restricting Indian companies’ deals abroad (see Table B in the Appendix). Table 3 summarizes and compares the three monetary policy interventions discussed here for the three case studies. Interventionism was a clear trend. Yet the Mexican central bank was much more determined not to skew from inflation targeting and did not implement explicit post-2008 crisis capital controls, even in light of the 2013 taper tantrum. In India, intervention in foreign exchange markets and capital controls were both pre and post-crises developments. In Brazil, the nominally autonomous central bank was creative and bold in foreign exchange markets interventions and systematic measures for capital controls, but also succumbed to political pressures, straying far from its inflation-targeting rate. The latter move has cost the country its investment grade status in a context of high public indebtedness and wide corruption scandals involving public institutions, private firms, and prominent politicians in the government’s party and its allies.

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Table 3: Monetary Policy Tools: Mexico, Brazil and India

Country

Intervention in foreign exchange markets Yes

Mexico

Brazil

Yes

India

Yes

Monetary policy tools Inflation targeting

- Yes. Since 2001. - Target: 3% plus or minus 1 percentage point (medium term) - Inflation contained within the target. - Yes. Since 1999. - Target: 4.5% plus or minus 2 percentage points (annual target) - Inflation has exceeded the target. - Yes. Since March 2015. - Target: 4% plus or minus 2 percentage points from the financial year ending in May 2017. - Inflation currently exceeds the target set for Jan. 2016 when the inflation targeting regime was put in practice.

Capital controls

No

Yes

Yes

Sources: Singh 2014, authors’ notes.

IV.

A “New Age of Central Banking” for Emerging Markets?

As mentioned above, following the 2008, crisis financial stability has entered into the mix of responsibilities of central banks. Debates about a “new age for central banking” currently underway are also recasting the credibility-flexibility trade off in monetary policy making. We argue that although all central banks have to design, enact, and constantly test macroprudential regulation, there are clear distinctions between the challenges faced by central banks in the advanced economies and the central banks of countries like the ones we study here when it comes to how they maneuver the credibility-flexibility conundrum in monetary policy making.

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Adding financial stability to the monetary mix Christine Lagarde, IMF’s managing director, asked: “should monetary policy go beyond its traditional focus on price stability” and also be responsible for financial stability? She responded in the negative, but in a contradictory fashion. On the one hand, she argues that it falls on macro and micro prudential policies the task to preserve financial stability. On the other, she admits that “prudential policies are not a panacea”; they may have negative effects and “their effectiveness may be limited because of an incomplete policy toolkit or institutional shortcomings”. Hence she adds: “this is why monetary policy may sometimes need to ‘lean against the wind’ of rising financial imbalances – even as its primary focus remains on price stability” (Lagarde 2015). In the same vein, discussing the challenge of coping with volatile capital flows, (particularly in the case of excessive capital inflows), Olivier Blanchard, former chief economist of the IMF, explained that emerging markets’ central bankers have not moved to a fully floating exchange rate system, but to a “managed float”. This entails “the joint use of the policy rate, foreign exchange intervention, macroprudential measures, and capital controls”, allowing central bankers to deal with the “old dilemma that arises when the only instrument used is the policy rate”. Even though increasing the policy (interest) rate helps contain the overheating of economies, such a move can, at the same time, attract even more foreign portfolio investment, leading to currency appreciations that reduce countries’ competitiveness. For Blanchard, combined “foreign exchange intervention, capital controls, and macro prudential tools can, at least in principle, limit movements in exchange rates, and disruptions in the financial system without recourse to the policy rate”. While some countries have relied more on capital controls, others have focused on exchange rate intervention. From the point of the view of the IMF, “these tools have worked, if not perfectly. Looking forward, the clear (and quite formidable) challenge is to understand how best to combine them”. Indeed, most of the challenges confronting central bankers speak to a large epistemological crisis ignited by the 2008 crisis (Datz 2013). As Mark Carney put it (while at the realm of the Bank of Canada, before moving to the Bank of England): “central banks are recognizing that they need a deeper understanding of financial system

29

dynamics in order to better understand the relationship between price and financial stability and, ultimately, the contribution of both to the stability of economic activity”. What is becoming clearer is that “leaning into the wind for financial stability purposes could (…) result in temporary deviations from the inflation target. To avoid threatening the monetary policy objective, these deviations could be recovered over time in order to keep the economy on a predetermined path for the price level”. Key is for central banks then to maneuver within the “discipline of a transparent and accountable price stability objective” that “could maintain central bank credibility” (Carney 2009). Ultimately, part of the “new normal” in central banking is the acknowledgement that, as Carney put it, “price stability is a necessary, but not sufficient, condition for the stabilization of economic activity, and it must be supplemented by a robust macroprudential regulatory framework. This, in turn, will have consequences for the implementation of monetary policy”. Crucially, when macroprudential tools “prove insufficient to achieve financial stability, monetary policy faces a difficult trade-off between flexibility and credibility” (Carney 2009).

The credibility-flexibility trade off

Yet, how much room central bankers really have to choose to play the flexibility card (however temporarily) and risk deteriorating credible commitments is unclear. What has become more evident is that flexibility entails a costly (and, at times, unfeasible) political compromise that may not prove enough to reverse economic slowdown or stagnation, such as we are now witnessing in the United States and particularly in the EU, despite large quantitative easing exercises. Moreover, since – to use Bank of England’s Ian McCafferty (2013)’s words - “credibility is the prerequisite for flexibility”, not all central bankers can equally afford to stray from prioritizing fiscal discipline without the costs of jeopardizing their hard-fought international reputations for their commitment to fighting inflation (Barro and Gordon 1983). Put differently, again as Carney (2009: 6) elucidates, the key question is “whether the price stability benefit of greater flexibility is worth the price stability risk of forfeited credibility”. This question is, however, one more

30

likely to be entertained by countries who have already achieved “enough” credibility that they can opt for broader discretion at lower (reputational) costs5. Beyond instrumental, mostly local, monetary calculations, as Sola and Vega suggest (2015: 14), since 2010, we have seen a heightened “politicization of monetary policy around the world”. For these authors, the Fed and ECB’s quantitative easing programs were “exercises in a (…) variety of monetary sovereignty: one where core central banks have been empowered with more discretionary powers than warranted by their admitted condition of lenders of last resort”. Crucially, they see this as a “departure from patterns of [policy] diffusion exported (and often forced) to the South in the pre-crisis context and from the economic orthodoxies that prescribed a de-politicized, independent central bank”. Yet, we argue, that even if advanced economies’ central banks have indeed engaged in a vexing new “age of central banking”, a departure from orthodoxy – as we argued above – is not universally feasible. On this point we find more consensus than divergence among the cases studied. Despite Brazil’s recent experience with inflation increases, the country’s leading monetary official, Alexandre Tombini (2015), reflecting on important lessons learned, stated that “inflation targeting emerged even stronger from the crisis”. Speaking more theoretically than as a result of his country’s recent record, Tombini added that “changing the regime, or even just raising the inflation target, in the middle of a crisis risked damaging the credibility that central banks have gained under” inflation targeting. More empirically, Brazil’s inflationary expansion during Rousseff’s first term in office made evident that countercyclicality can backfire when it is a part of a political project, which jeopardized central bank autonomy and contributed to a current environment of negative expectations about economic performance. Tombini’s rhetoric of praising inflation targeting regimes is a product of its time; it was only in 2015 that the Brazilian central bank regained its authority and hence its ability to pursue its price stability goal. Furthermore, Tombini (2015) stated that “a laissez-faire approach to capital flows is off the table” despite lingering disagreement “on how to deal with flows, on who bears the burden of adjustment, and on the scope for global policy cooperation”. Indeed, on this point Brazil set an unequivocal precedent. As we explained above, the country adopted 5

These costs are most likely to be directly measured by bond spreads and interest rate premiums.

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very bold measures to counter capital inflows and intervened in foreign exchange markets with tools usually associated with capital controls. For its part, Indian central bankers have followed a à la carte monetary policy approach since 2008. Interventions have not been surprising, given the RBI’s track record. Yet, Raghuram Rajan’s appointment as RBI governor in September 2013 marked a turning point in Indian monetary policy. His background as a celebrated academic and former IMF chief-economist injected the RBI with credibility (along with the expectation of reform). Since taking office, Rajan has been vocal about the negative effects of advanced economies’ unconventional monetary policy to emerging markets’ economies. At a speech delivered in May 2015, Rajan (2015) argued that central banks’ “international responsibilities should not be ignored” and that the IMF “should analyze each new unconventional monetary policy (including sustained unidirectional exchange rate intervention), and based on their effects and the agreed rules of the game, declare them in- or out-of-bounds.” More recently, India has opted for a rather conventional, if also contradictory path. On the one hand, the country has finally embraced inflation targeting, a controversial step, mentioned and dismissed for years prior to Rajan’s appointment. This grants the RBI much greater autonomy. However, a draft for the New Financial Code proposes to remove the control on interest rates from the central bank. That means that the RBI’s governor would lose “veto power over the existing advisory committee of RBI members and outside appointees that sets rates” (Mallet 2015). Yet Rajan has been keen on alerting government officials to the dangers - as he sees them – of straying from price stability Indeed, at the time of writing, a battle is unfolding among top Indian officials deliberating on economic policy. Promised reductions in the fiscal deficit have already been postponed by a year. Modi government’s chief economic adviser, Arvind Subramanian, believes these reductions should be postponed further so the government can increase much-needed public investment in infrastructure and help capitalize ailing banks (Financial Times, January 31, 2016). The minister of finance, Arun Jaitley, has to weight in Rajan (2016)’s opposing view: Let me reiterate that macroeconomic stability relies immensely on policy credibility, which is the public belief that policy will depart from the charted course only under

32

extreme necessity, and not because of convenience. If every time there is any minor difficulty, we change the goal posts, we signal to the markets that we have no staying power. Let me therefore reiterate that we have absolutely no intent of departing from the inflation framework that has been agreed with the Government. We look forward to the Government amending the RBI Act to usher in the monetary policy committee, further strengthening the framework. Interestingly, Rajan (2016) explained his position by alluding to “a lesson from Brazil”. He argued that “as Brazil’s experience suggests, the enormous costs of becoming an unstable country far outweigh any small growth benefits that can be obtained through aggressive policies”. Indians should then “be very careful about jeopardizing our single most important strength during this period of global turmoil, macroeconomic stability”. Finally, after leaving interest rates practically unchanged for the past three years (the longest any G-20 nation has gone without modifying its playbook), the Mexican central bank has recently surprised markets by increasing its reference rate by half a percentage point during an unscheduled board meeting. This was in response to currency depreciations that were perceived as threatening price stability. Showing that both the central bank and the ministry of finance are singing the same tune, a US$ 7.3 billion cut in government spending was also part of the coordinated announcement involving Augustín Carstens and financial minister Luis Videgaray (Bloomberg, February 23, 2016, El Financiero, February 17, 2016).

V.

Conclusion

In the context of ongoing and still unsettled discussions about “a new age of central banking” in advanced economies, emerging markets’ central bankers are to situate their own perplexities. In the post-crisis, these monetary authorities participated in efforts to defend the value of their currencies hit by the global credit drought and generalized uncertainty. Their commitments to price stability were put to the test. Mexico’s independent central bank earned its reputation for conservative stewardship in upholding inflation targets. Indian and Brazilian central banks responded to the 2008

33

shock with countercyclical monetary policies. In both instances, rising inflation became an ever pressing problem. Although the Indian central bank has a long history of interventionism and remains subjected to the Ministry of Finance’s (political) deliberations, Brazil’s supposedly autonomous central bank failed the test of maneuvering at once flexibility and credibility. It made too much of the first, motivated by the political program of Rousseff’s first term, and sacrificed hence too much of the latter. Moreover, central banks’ interventions in foreign exchange markets were common in India, Brazil and Mexico. However, while Mexico steered clear from persistent capital controls, India and Brazil pursued them with determination and even some creativity. In India, controls already in existence were maintained. In Brazil a series of systematic measures were taken to control first the rapid appreciation of the real in 2010, then the depreciation from the taper tantrum of 2013, and more recently the record currency slide in the imminence of a normalization of US monetary policy. Central bankers in the countries we have studied understand that new dilemmas have emerged. Vast foreign reserves and monetary stability allowed for their relative resilience in face of the 2008 global crisis, but navigating the “new normal” is far from a predictable ride. Inflationary pressures have emerged from both domestic and foreign sources (notably US monetary policy). Financial instability has tested the extent to which micro and macro prudential regulation alone can deal with the domestic impact of global market turmoil without monetary policy changes, which in turn can have detrimental effects on the real economy (output and inflation). Coordinating different policies is hence the name of the game. Domestically, it is clear that regulation, fiscal (structural) and monetary policies must converge towards the same objectives. Easier said than done, as central bankers acknowledge that they are still experimenting with different initiatives and monetary policy tools. Despite calls for international monetary coordination (such as those from India’s RBI governor, Rajan), that is unlikely to result in more predictability for emerging markets’ central bankers. In this environment, central bank independence may seem to be still the most credible option, not only in normative terms, but as validated by the experience of countries like Mexico. However, between Mexico and its opposite (one could think of China), there lies

34

a whole hosts of central banks which can be labeled more or less autonomous at discrete moments in time, but not as an overarching conclusion. Such is the case of the Brazilian central bank, whose autonomy did not resist post-crises political pressures that took advantage of a global consensus in favor of fiscal and monetary countercyclical policies. Since early 2015, efforts are been made to reestablish the credibility of the Brazilian monetary authority through a re-commitment to inflation targets for which structural (political) reforms, fiscal contraction and monetary policy are been called to task. More instructive than their institutional arrangements, which at times restrain their room to move, is to understand where central banks lie in the flexibility-credibility nexus. Although the debate in advanced economies emphasizes the need to balance both, in emerging markets choosing one means foregoing the other. Ultimately, despite the diversity of challenges and responses of developing countries’ central banks, old policy concerns like growing inflation, for the most part, still reign supreme.

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APPENDIX Table A: Regulatory Measures Implemented by the Brazilian Central Bank, 2011. Regulation of Derivatives Markets

Prudential Financial Regulation

July 2011: - Increase in the financial tax (IOF) on margin requirements for FX derivatives transactions from 0.38 to 6%. - Closing of loopholes for IOF on margin requirements: foreign investors in the futures markets were no longer allowed to meet their margin requirements via locally borrowed securities or guarantees from local banks, which had allowed them to avoid the tax. - Appointment of the Monetary Council of the Brazilian Central Bank (CMN) as the agency responsible for regulating the derivatives market. - Requirement that all FX be priced according to the same method.

January 2011: - Introduction of a non interest reserve requirement equivalent to 60% of bank’s short dollar positions in the FX spot market that exceed US$3 billion or their capital base, whichever is smaller (to be implemented over 90 days). - Further introduction of an unremunerated reserve requirement of 60% of banks’ gross FX positions beyond US$ 1 billion. April 2011: - Capital controls: Extension of 6% IOF to the renewal of foreign loans with maturities of up to a year. - Extension of 6% IOF to both new and renewed foreign loans with maturities of up to 2 years. July 2011: - Institution of mandatory noninterest reserve requirement for amounts over US$1 billion or their capital base (whichever is smaller).

Source: Fritz and Prates 2014

Table B: Capital Controls in India, 2013 (i)

(ii) (iii)

Reduction of the limit for Overseas Direct Investment (ODI) under automatic route for all fresh ODI transactions, from 400% of the net worth of an Indian Party to 100% of its net worth. Reduction of the limit for remittances made by residents, under the Liberalized Remittance Scheme (LRS Scheme), from USD 200,000 to USD 75,000 per financial year. Indian companies would need special permission for deals overseas, which would constrain them from speculating on the rupee by investing abroad in companies without “real” business plans. The goal was to prevent the growth of corporate indebtedness in foreign currency. Source: Reserve Bank of India 2013.

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