Responses of Monetary Authorities in Emerging Economies to International Financial Crises: What Do We Really know?

Abstract

1. Introduction The empirical literature on business cycles and crises in emerging markets (see, for instance, Kose and Prasad, 2010; Claessens et al., 2011) exhibits two main features. First, the volatility of macroeconomic variables tends to be higher in developing and emerging economies relative to advanced countries (2). Interestingly, the effects of globalization have accentuated this volatility gap, mainly between advanced economies and emerging countries. Second, if, over the period 1978-2007 Kose and Prasad (2010) find no noticeable difference between emerging and advanced countries in terms of recessions duration, they show that their amplitude is three times larger in emerging markets relative to advanced economies. In addition, emerging economies suffer from larger cumulative output losses while recessions associated with financial crises exert stronger negative influences on macroeconomic variables. Such stylized facts must be joined with the fact that severe financial crises exert long-lasting negative effects on growth (Cerra and Saxena, 2008; Balakrishnan et al., 2011). From this perspective, an important question is to determine what are the policy options available for emerging economies to cope with the financial crises. In other words, how do emerging markets respond to financial crises? A seminal paper on this question has been published by Kaminsky et al. (2005). Considering a large sample of 104 advanced and developing countries for the period 1960-2003, they show that if net capital inflows are pro-cyclical in the two groups of countries, their economic policy differ. Developing countries exhibit pro-cyclical fiscal and monetary policies, amplifying the destabilizing effects of capital inflows. At the opposite, in OECD countries, authorities conduct counter-cyclical policies that mitigate the negative effects on output of capital flows. Kaminsky et al. (2005) identify several factors that can explain the adoption of pro-cyclical policies in emerging countries: political distortions, weak institutions, and capital markets imperfections. The global financial crisis of 2008-09 had led to a renewed interest of the analysis concerning economic policies responses in emerging countries to financial crises (See, for instance, Ghosh et al., 2009; IMF, 2010a). It is important to keep in mind that two main features distinguish the current episode from the crises of the late 1990s and early 2000s. On the one hand, the main trigger of the crisis is a shock originated in the financial sector of advanced countries. After an initial period of resilience, the financial turmoil in advanced economies hit emerging markets in late 2008. On the other hand, this crisis is characterized by an exceptional synchronization at a worldwide level. Interestingly, a growing number of studies have provided new empirical evidences according to which emerging economies tend to adopt more frequently counter-cyclical policies to face crises (3). Vegh and Vuletin (2012) study the cyclical components of short-term interest rates and real GDP for 68 countries over the period 1960-2009 (4). They find that from 1960 to 1999, 51 percent of developing countries pursued pro-cyclical monetary policy (i.e., a negative correlation between the short-term interest and the GDP cyclical components) while over the period 2000-2009, around 77 percent of these countries conducted counter-cyclical monetary policy (i.e., a positive correlation between the short-term interest and the GDP cyclical components). Coulibaly (2012) analyzes the behavior of monetary policy during financial and economic crises over a sample of 188 countries from 1970 to 2009. Monetary policy stance is measured with short-term interest rates. A decline in the interest rate in the year of the crisis relative to the previous year signals a counter-cyclical monetary policy. While in the 1990s, around 55 percent of emerging economies lowered their interest rate during crises episodes, this share increased to 70 percent during 2000s, and reached 80 percent in 2008-2009. …