The unprecedented conditions created by the spread of the coronavirus call for exceptional policy responses from the regional monetary authorities. Besides traditional tools such as interest rate reductions, central banks have been pursuing unconventional measures to avoid permanent consequences from a transitory, but potentially severe, negative shock. Since the 2008 global financial crisis, central banks have developed new tools that they can deploy to help firms and households weather the storm. Not only do central banks find themselves in a different situation than before the previous financial crisis, the shock they are facing is also of a different nature. This article lays out several policies that some central banks may already be implementing and others may want to consider, and explains some of the limitations of other policies.
As we show in the recently launched 2020 Latin American and Caribbean Macroeconomic Report, in the last decade, central banks in the region have gained credibility maintaining low levels of inflation. Largely due to anchored inflation expectations, policy interest rates are lower relative to the period 2003-2008. Furthermore, and as a response to the global financial crisis, central banks’ balance sheets have grown. Many countries in the region also have some degree of exchange rate flexibility, which can help absorb part of the negative shock. International reserve positions are generally stronger today compared to prior to the global financial crisis, but lower than their “optimal” level (as explained in the 2019 Latin American and Caribbean Macroeconomic Report). During 2003-2008, international reserves represented 13% of GDP, while for the 2014-2019 period, international reserves were 16.25% of GDP.
Given that this shock is as much a shock to supply as to demand, the traditional notion of countercyclical demand management through monetary policy is less relevant. But firms and households will likely come under serious financial stress. Lowering the policy interest rate may then still be a useful tool in countries where such actions may translate to a lower cost of financing for firms and lower loan repayments for households. Central banks are in different positions concerning the space they have to reduce rates and the likely benefits of such policies. The space depends not only on the level of the policy rate but also on the degree to which inflation expectations are anchored. As of April 15, 2020, at least 14 central banks in the region have already reacted by reducing rates; and some did more than once. Given that the coronavirus outbreak is lowering both supply and demand, the impact on prices is not clear.
Households with breadwinners in the informal market may be the most affected, not only because they could lose their source of income, but also because they would not receive unemployment benefits and likely lack health insurance. Small and medium-sized businesses (SMEs) that depend on the day-to-day sales and have little to no cash reserves may also be placed under severe financial stress and may have to shed workers. Such firms are connected to others of the same size, as well as to larger firms through supply chains. While many SMEs may not obtain credit directly, lower interest rates may help the larger firms they are connected to through supply chains, keeping firms in business that otherwise may have to close.
Similar to the global financial crisis, unconventional monetary policy (or direct monetary policy actions) may also help to counter the negative shock, especially where the transmission of interest rate policy (a more indirect mechanism) is weak. Central banks have different instruments and legal mandates, and they may face hurdles in extending liquidity to different types of agents or in purchasing different types of assets. Central banks may need to consider carefully how such tools can be used and whether it is appropriate to make adjustments to legal frameworks to gain greater flexibility.
Many monetary authorities in the region maintain systems of reserve or liquidity requirements, and these can be lowered to give banks greater liquidity. We discuss these measures in greater detail in our 2020 Latin American and Macroeconomic Report. Some central banks may also be able to extend liquidity directly to non-financial firms. In some circumstances it may even make sense to consider a stay on certain debt payments although the impact on banks’ balance sheets should be carefully assessed.
Many countries will face extraordinary budget pressures and may face funding problems both for the public and the private sector, which can rapidly translate to problems in financing current account deficits and balance-of-payments problems. For cases where the macroeconomic starting conditions were not very strong, serious consideration should be given to a stand-by or other type of lending agreement with the IMF. An IMF agreement may also open up greater access to financing from other multilaterals and possibly even bilateral sources.
On March 19, the Federal Reserve Board established U.S. dollar liquidity arrangements with several central banks, including with those in Brazil and in Mexico for up to US$60 billion for at least six months. These lines, which were deployed successfully during the global financial crisis, aim to mitigate the effects on the international supply of credit to banks and to firms that participate in international markets and have knock-on effects to credit more generally.
Since the end of February, countries with flexible exchange rates in the region have faced sharp domestic currency depreciation. This might bring some pressure on inflation in the short term for countries in which the passthrough is still high, but, more importantly, it might put pressure on those corporates with large U.S. dollar debts. Not only because these firms are now facing an increase in their debt, but also because they are facing losses in dollar and domestic currency incomes. Central banks should monitor the corporate sector to understand the potential problems that might arise.
Given the extraordinary nature of the current situation, central banks may also wish to work with fiscal authorities to evaluate the possibility of providing liquidity to the health system. In the end, this is surely a fiscal issue, but central banks might be able to supply liquidity quickly in exchange for a government bond for some portion of the rapid liquidity injection that may be required.
Lastly, and as shown in previous uncertainty periods, central banks should have a clear communication strategy with the general public, not only with the experts, regarding their measures and objectives. This will help to reduce uncertainty at every level of society. Additionally, it will help to explain the temporary nature of the measures taken and the strategy to phase out many of these actions.
As discussed in our new report, the coronavirus will certainly have a large impact on the economies of the region. Central banks can assist in reducing the size of that shock by reducing interest rates and supplying liquidity to keep supply chains open and minimize the loss of employment and bankruptcies. These may be very difficult times that may call for extraordinary temporary measures.
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