World Economic Outlook, Managing Divergent Recoveries, chapter

International Monetary Fund | April 2021 81

Advanced economies are expected to recover from the

COVID-19 crisis faster than most emerging market

economies, reflecting their earlier access to vaccinations

and greater room to maintain supportive macroeconomic

policies. Divergent economic recoveries could complicate

the task of emerging market central banks should interest

rates in advanced economies begin to rise when conditions

in emerging market economies continue to warrant a

loose monetary policy stance. The findings in this chapter

confirm that monetary policy in advanced economies—

especially in the United States—still has a large impact

on financial conditions in emerging market economies.

Aggressive policy easing by advanced economy central

banks early in the pandemic thus provided much relief to

financial markets in emerging market economies. Looking

ahead to the recovery, clear guidance from advanced

economy central banks on future scenarios for policy will

be key to avoiding financial disruption to emerging mar-

kets. The analysis of the chapter suggests that, whereas a

monetary policy tightening resulting from a stronger-than-

expected US economy tends to be relatively benign for

most economies, a surprise tightening, which could reflect

a change in the US Federal Reserve’s expected reaction

function, tends to curb global investor risk appetite and

trigger capital outflows from emerging markets. The chap-

ter’s analysis also suggests that emerging market economies

with lower fiscal vulnerability are more insulated from

external financial shocks than others, and countries with

more transparent and rules-based monetary and fiscal

frameworks enjoy greater monetary policy autonomy.

Introduction

At the end of February 2020, news of the global

spread of COVID-19 hit ﬁnancial markets with dev-

astating force. One month later, global risk aversion

e authors of this chapter are Philipp Engler, Roberto Piazza

(team leader), and Galen Sher, with contributions from Chiara

Fratto, Brendan Harnoys Vannier, Borislava Mircheva, David

de Padua, and Hélène Poirson, and support from Eric Bang,

Ananta Dua, Chanpheng Fizzarotti, Ilse Peirtsegaele, and Daniela

Rojas Fernandez. e chapter beneﬁted from insightful com-

ments by Christopher Erceg and internal seminar participants.

Refet Gürkaynak was a consultant for the project.

had reached an intensity not observed since the peak

of the global ﬁnancial crisis, while capital ﬂows began

to cascade out of emerging market and developing

economies (Figure 4.1).

Emerging market economies mounted a strongly

countercyclical monetary policy response, on the

heels of central banks in advanced economies, that

cut policy rates wherever possible and introduced an

array of asset purchase programs (APPs) to support

credit markets (Figures 4.2 and 4.3).

e set of policy

tools employed by central banks in emerging markets

was notably broad—including not only conventional

policy rate cuts, but also APPs in several economies

(Figures 4.4 and 4.5).

Soon after these strong mea-

sures, sovereign default risk premiums in emerging

markets began to recede.

Since the announcement of several successful

COVID-19 vaccine trials in late 2020, the global

economic outlook has improved, but remains vastly

diﬀerentiated. Given a more backloaded access to vac-

cinations and less policy space to provide lifelines and

support economic activity, many emerging market and

developing economies are projected to have a more

protracted recovery than major advanced economies.

is scenario raises the possibility that policymakers in

emerging markets might face diﬀerent challenges than

during the recovery from the global ﬁnancial crisis,

when their countries enjoyed relatively strong growth.

During a multispeed economic recovery, many

emerging markets might struggle to provide sizable

ﬁscal policy support for a prolonged period, given

their more constrained policy space (Végh and Vuletin

2012)—and even more so following last year’s sharp

is chapter largely focuses on ﬁnancial conditions in emerging

markets, deﬁned as the World Economic Outlook (WEO) emerging

market and developing economy group, excluding countries in the

low- income and developing economy group. Only a limited number

of countries in the latter group displays signiﬁcant integration with

global ﬁnancial markets.

Fiscal expansions were also instrumental in containing the fallout

from the crisis, but they are not examined here. While focused on

monetary policy, this chapter explores various instances where ﬁscal

policy matters for a country’s sensitivity to international monetary

policy spillovers and for the domestic monetary policy response to

the pandemic.

SHIFTING GEARS: MONETARY POLICY SPILLOVERS DURING THE

RECOVERY FROM COVID19

CHAPTER

82 International Monetary Fund | April 2021

WORLD ECONOMIC OUTLOOK: MANAGING DIVERGENT RECOVERIES

Sub-Saharan Africa

Emerging market economies (right scale)

Sources: Bloomberg Finance L.P.; and EPFR Global.

Note: Cumulative EPFR fund ﬂows for sub-Saharan Africa comprise those for

Côte d’Ivoire, Ghana, Kenya, Namibia, Nigeria, Rwanda, South Africa, and Zambia.

–5

–4

–3

–2

–1

–120

–100

–80

–60

–40

–20

Feb.

2020

Apr.

Jun.

Aug.

Oct.

Dec.

Jan.

2021

Figure 4.1. Cumulative Portfolio Flows

(Billions of dollars)

United States (10-year government bond yield change)

Germany (10-year government bond yield change)

United States (CB assets change, billions of dollars, right scale)

ECB (CB assets change, billions of euros, right scale)

Figure 4.2. Monetary Policy in Advanced Economies

(Percentage points, unless noted otherwise)

Sources: Federal Reserve Bank of St. Louis; and Haver Analytics.

Note: Ten-year government bond yields are in changes from the Feb. 2020 levels.

Central bank assets are in changes from their Jan. 2020 levels. CB = central bank;

ECB = European Central Bank.

–1

–650

650

1,300

1,950

2,600

3,250

Jan.

2020

Feb. Mar. Apr. May Jun. Jul. Aug. Sep. Oct. Nov.

EMBI spread (median, percent) Fed/ECB announcements

Source: Bloomberg Finance L.P.

Note: ECB = European Central Bank; EMBI = J.P. Morgan Emerging Market Bond

Index; Fed = Federal Reserve.

Feb.

2020

Mar. Apr. May Jun. Jul.

Figure 4.3. Credit Risk Premiums in Emerging Market

Economies

(Median, percent)

Figure 4.4. Policy Rate Cuts in Emerging Market

Economies between March and August 2020

(Percent)

Source: IMF staff calculations.

Note: Data labels use International Organization for Standardization (ISO) country

codes.

–6

–5

–4

–3

–2

–1

PAK

UKR

EGY

ZAF

TUR

MEX

BRA

ARG

COL

PHL

POL

ARE

CHL

IND

ROU

IDN

THA

KAZ

CHN

83International Monetary Fund | April 2021

CHAPTER 4

SHIFTING GEARS: MONETARY POLICY SPILLOVERS DURING THE RECOVERY FROM COVID19

increase in public debt. Constrained ﬁscal policy, in

turn, would heighten the role of monetary policy.

is prompts the question of how much autonomy

policymakers in emerging markets would have in

keeping monetary policy rates low at a time when

improved economic conditions may lead central banks

in advanced economies to begin increasing interest

rates. On this point, a commonly held view is that,

even with a ﬂexible exchange rate, emerging markets

have little monetary policy autonomy against a power-

ful global ﬁnancial cycle that is strongly inﬂuenced by

monetary policy in advanced economies (Rey 2015).

Several arguments temper the concerns about

monetary policy in emerging markets during the global

economic recovery. First, ﬂexible exchange rates oﬀer

imperfect but still signiﬁcant insulation from the global

ﬁnancial cycle (Obstfeld, Ostry, and Qureshi 2019),

One consideration that can stop central banks in emerging

markets from countering the global ﬁnancial cycle is a “fear of

ﬂoating” (Calvo and Reinhart 2002). In addition, ﬁnancial frictions

in emerging markets may limit the pass-through of monetary policy

to domestic ﬁnancial conditions (Kalemli-Özcan 2019).

whose impact on capital ﬂows may not be so dramatic

after all (Cerutti, Claessens, and Rose 2019). Second,

the commitment of central banks in advanced econo-

mies to maintain ample monetary accommodation until

the recovery is well under way reduces the possibility

of an early tightening in global ﬁnancial conditions.

e commitment is exempliﬁed in the United States

by the Federal Reserve Board’s new ﬂexible inﬂation

targeting framework. ird, aggressive monetary policy

easing by emerging markets during the COVID-19

pandemic may indicate that these countries have gained

further autonomy in setting their policies in line with

domestic needs.

To provide a framework for thinking about the

monetary policy challenges confronting emerging

markets during the recovery, this chapter addresses

the following questions:

• How do monetary policy surprises in advanced econo-

mies shape financial conditions in emerging markets?

How has this influence changed over time, and how

does it vary across countries?

• How does economic news in advanced economies

affect financial conditions in emerging markets?

• Which characteristics of emerging markets are

associated with greater ability to ease monetary

policy at the onset of the pandemic? Are APPs

effective in easing financial conditions in emerging

markets?

e chapter includes two key streams of analysis.

e ﬁrst is a set of event studies that examines

how monetary policy shifts in advanced economies

aﬀect ﬁnancial conditions in emerging market and

developing economies, leveraging two types of situa-

tions: (1) when a monetary policy announcement in

advanced economies surprises markets because it does

not appear directly attributed to observed changes in

economic conditions—these surprises include a change

in how central banks interpret data or react to it; and

(2) when new information on the state of advanced

economies changes market expectations of future

monetary policy. e second stream of analysis looks

at factors that could predict which emerging markets

were able to provide greater monetary policy easing

during the pandemic, focusing on both conventional

e main measures of ﬁnancial conditions in emerging

markets presented in the chapter include yields on sovereign bonds

denominated in local currency, spreads on dollar-denominated

sovereign bonds, nominal exchange rates vis-à-vis the dollar, and

investment fund inﬂows.

VIX

HRV, HUN, JAM, POL, CHL, IND, ROU, EGY, THA, COL

ZAF, CPV, BOL, TUR, PHL, AGO, CRI

Figure 4.5. Asset Purchase Program Announcement Dates

in Emerging Market Economies and the VIX

(Index)

Sources: Haver Analytics; and IMF staff calculations.

Note: VIX = Chicago Board Options Exchange Volatility Index. Data labels use

International Organization for Standardization (ISO) country codes.

IDN

MUS

CHN

BRA

Jan.

2020

Feb. Mar. Apr. May Jun. Jul. Aug. Sep.

84 International Monetary Fund | April 2021

WORLD ECONOMIC OUTLOOK: MANAGING DIVERGENT RECOVERIES

policy rate cuts and APPs. e main ﬁndings of the

chapter are as follows:

• Monetary policy actions by the Federal Reserve

have a significant influence on financial condi-

tions in emerging markets, whereas spillovers from

policies of the European Central Bank (ECB) are

smaller and regional. As observed in the 2013

“taper tantrum” episode, signals of unexpected policy

tightening in the United States raise emerging

market yields, cause portfolio outflows, and depre-

ciate emerging market currencies. The intensity of

these effects is heterogenous over time and across

countries: it seems to be stronger now than before

the global financial crisis, and stronger for countries

that are seen as riskier investments. This suggests

that perceptions of risk (risk channel) are important

in the transmission of the spillover. Notably, the

change in domestic yields comes almost entirely

from a change in the term premium, with an only

marginal contribution from revised expectations of

policy rates in emerging markets. Monetary eas-

ing by the Federal Reserve helped reduce yields in

emerging markets by more than 100 basis points

during the pandemic, and the announcement of

central bank US dollar swap lines was effective in

calming markets.

• The release of good news about the US economy,

even as it is accompanied by expectations of tighter

US monetary policy, is relatively benign for financial

conditions in emerging markets. Following posi-

tive news about US employment, capital appears

to flow into emerging markets, the Chicago Board

Options Exchange Volatility Index (VIX) and risk

premiums on emerging market dollar-denominated

bonds fall, while yields on emerging market domes-

tic bonds tend to rise. This could be attributed in

part to a positive risk channel (greater global risk

appetite) and in part to a positive trade channel,

where positive growth news in the United States

is also associated with improved growth prospects

in emerging markets, leading to higher expected

monetary policy rates in emerging markets. Surprise

increases in US inflation also lead to an increase

in US nominal yields, but do not seem to impact

financial conditions in emerging markets. Finally,

positive news about the development of vaccines

against COVID-19 in advanced economies has

been particularly beneficial for emerging markets as

their domestic yields did not increase, nor did their

currencies depreciate.

• Domestic monetary and fiscal frameworks help

predict the extent to which emerging markets were

able to provide more monetary policy accommo-

dation during the pandemic. Countries with more

flexible exchange rates, more transparent central

banks, and rules-based fiscal and monetary policy

frameworks cut their policy rates by more and were

also more likely to announce an APP— controlling

for the state of the economy. Countries with the

most constrained fiscal position had instead a

smaller likelihood of an APP. In general, APPs

appear to have been effective in calming domestic

financial conditions.

Given the uniqueness of the current episode, any

attempt to use past experience to extrapolate lessons

for the future must be made with caution. With this

warning in mind, the ﬁndings of the chapter suggest

that a multispeed global recovery, with growth picking

up earlier in advanced economies, may not on its own

lead to a premature tightening of global ﬁnancial con-

ditions in emerging markets. Assuming that inﬂation

does not rise above target in a sustained manner, a

quicker-than-expected resolution of the pandemic in

advanced economies may drive strong capital inﬂows

to emerging markets and frontier economies, especially

if interest rates in advanced economies remain low. In

this event, emerging markets could employ a variety of

policy tools to curb the buildup of domestic ﬁnancial

risks (IMF 2020).

If, with the recovery taking hold, central banks in

advanced economies were instead to suddenly signal

greater concern for inﬂation risks, then a surprise

tightening of global ﬁnancial conditions similar to the

2013 taper tantrum might occur. To reduce this risk,

central banks in advanced economies need to continue

providing markets with clear communication and

guidance about their policies, including on new policy

frameworks. In emerging markets, actions to improve

conﬁdence about the sustainability of medium-term

debt can help reduce the sensitivity of domestic ﬁnan-

cial conditions to spillovers. Strengthening ﬁscal and

monetary frameworks would also help create room for

a more forceful countercyclical monetary policy.

Spillovers on Emerging Market Financial Conditions

is section uses event studies to answer two

questions: How do ﬁnancial conditions in emerging

markets change following a surprise monetary policy

85International Monetary Fund | April 2021

CHAPTER 4

SHIFTING GEARS: MONETARY POLICY SPILLOVERS DURING THE RECOVERY FROM COVID19

announcement in advanced economies? How do ﬁnan-

cial conditions in emerging markets change following

surprises about the state of the economy in advanced

economies?

e two questions are complementary.

e ﬁrst considers changes in ﬁnancial conditions that

can be entirely traced to the spillover eﬀect of an unex-

pected monetary policy announcement by central banks

in advanced economies. e second considers changes

in ﬁnancial conditions that instead can be entirely

attributed to news about economic conditions in

advanced economies and to the attending implications

for, among others, the expected reaction of monetary

policy in advanced economies. is would be the case,

for instance, of positive news about payrolls or the

development of COVID-19 vaccines.

Regardless of the type of shock considered, spillovers

from advanced economies on ﬁnancial conditions

in emerging markets operate through a variety of

channels. e chapter gives prominence to two. e

ﬁrst is a “risk channel,” where surprise monetary policy

changes in advanced economies aﬀect perceptions of

risk and thus ﬁnancial conditions in emerging markets.

e second is a “trade channel,” where economic news

in advanced economies changes economic conditions

and investment opportunities in emerging markets.

Monetary policy in emerging markets reacts to both

types of changes, as discussed in the next section.

Spillovers from Monetary Policy Surprises in

Advanced Economies

Analytical Framework

Monetary policy surprises in the United States and

the euro area are deﬁned as changes in the respective

two-year government bond yields in a window of

time around each monetary policy announcement.

e choice of the two-year maturity follows Gertler

and Karadi (2015) and Hanson and Stein (2015) and

allows to capture the eﬀects of forward guidance and

asset purchases.

For the euro area, the two-year yield

is constructed as a weighted average of the correspond-

In both exercises, the sample covers 60 emerging market

economies, but country coverage is smaller for some indicators. For

example, only 21 emerging market economies have data on gov-

ernment bond yields. e sample of low-income countries contains

exchange rate data for 23 economies, but government bond yields

for only ﬁve of them.

For robustness to using yields of diﬀerent maturity during zero

lower bound periods, see Online Annex 4.1. All annexes are available

at www .imf .org/ en/ Publications/ WEO.

ing yields for Germany, France, Italy, and Spain. In

the case of the Federal Reserve, the window covers the

full announcement day, while for the ECB, it covers

two hours around the ECB Governing Council’s press

releases and press conferences.

Spillovers from Federal

Reserve or ECB monetary policy announcements on

emerging markets are measured as changes in various

emerging market asset prices and ﬁnancial indica-

tors during the two-day windows around monetary

policy announcements, which allows for diﬀerences

in time zones.

Impact on Emerging Markets

US monetary policy spills over strongly to domes-

tic government bond yields in emerging markets, at

all maturities (Figure 4.6). A surprise tightening of

100 basis points by the Federal Reserve translates

into a 47-basis-point increase in two-year government

bond yields in emerging markets.

Euro area monetary

policy surprises have smaller eﬀects, which are statisti-

cally signiﬁcant only at intermediate maturities or for

emerging markets more economically integrated with

the euro area.

US monetary policy surprises also have signiﬁcant

eﬀects on exchange rates and capital ﬂows to emerg-

ing markets, but the evidence does not show sys-

tematic eﬀects on emerging market stock prices or

benchmark Emerging Market Bond Index spreads

(Figure 4.7). Every 100-basis-point tightening of US

monetary policy leads to an immediate 1 percentage

point depreciation of emerging market currencies

vis-à-vis the US dollar and portfolio outﬂows from

For the United States, dates of oﬃcial monetary policy state-

ments were provided directly by the Federal Reserve Board. For the

ECB, the intraday monetary policy surprises were taken from the

online data set of Altavilla and others (2019) until April 2020, and

merged with daily changes in yields for the remaining announce-

ments in 2020. is produces 176 and 217 monetary policy

surprises by the Federal Reserve and ECB, respectively, between

2000 and 2020. For more details on the econometric speciﬁcation,

see Online Annex 4.1.

ese estimates are consistent with those of Bowman, Londono,

and Sapriza (2015); Curcuru and others (2018); Albagli and

others (2019); Caballero and Kamber (2019); and Hoek, Kamin,

and Yoldas (2020). A separate analysis indicates that US surprise

monetary policy easings and tightenings have symmetric eﬀects

on emerging markets.

For example, emerging markets with deeper trade links to the

euro area experience stronger responses of three-month, six-month,

and 10-year yields than other emerging markets. is suggests that

ﬁnancial conditions in central and eastern European economies

are more aﬀected by ECB monetary policy.

86 International Monetary Fund | April 2021

WORLD ECONOMIC OUTLOOK: MANAGING DIVERGENT RECOVERIES

emerging markets of 7 basis points of annual GDP.

While (trade-weighted) emerging market currencies

do depreciate after tightening in the euro area, ECB

monetary policy surprises do not seem to aﬀect term

premiums, expected future short-term interest rates,

stock prices, portfolio ﬂows, or bond spreads in the

average emerging market. Given the relatively small

spillovers from the ECB, the rest of the chapter focuses

on spillovers from US monetary policy.

Looking over time, monetary policy spillovers from

the United States were especially strong during the

period that included the global ﬁnancial crisis, the euro

area crisis, and the 2013 taper tantrum (Figure 4.8).

Although the sensitivity of emerging market yields

e chapter focuses on the response of emerging market

exchange rates vis-à-vis the US dollar. A large literature highlights

the outsized role played by the dollar exchange rate in causing ﬁnan-

cial shocks in emerging markets (for example, because of liability

dollarization) and demand shocks (because of dollar invoicing in

international trade). See, for instance, Calvo and Reinhart (2002)

and Gopinath and others (2020).

fell from 2014 onward, it seems to have remained

higher than it was before the global ﬁnancial crisis.

The “Risk Channel”

It is important to bear in mind that, beyond the

average eﬀects discussed above, there is signiﬁcant

heterogeneity in the way ﬁnancial conditions in

emerging markets react to monetary policy changes in

advanced economies. Focusing on some features of this

heterogeneity can provide a partial glimpse into speciﬁc

Although the sensitivity is higher, the diﬀerence is not statisti-

cally signiﬁcant. A further exploration based on shocks on 10-year

US Treasury securities suggests that this increased sensitivity does

not seem to be driven by the adoption of unconventional monetary

policy tools by advanced economies.

Federal Reserve European Central Bank

Source: IMF staff calculations.

Note: The ﬁgure shows the two-day changes in emerging market local currency

government bond yield curves in response to a 100-basis-point surprise tightening

of the United States or euro area monetary policy. Solid bars show maturities that

are statistically signiﬁcant; hollow bars show those that are not.

3 6 12 24 60 120

Months to maturity

Figure 4.6. Change in Emerging Market Government Bond

Yield Curves in Response to Monetary Policy Surprises

(Basis points)

Figure 4.7. Effects of US Monetary Policy Surprises on

Selected Variables

(Basis points; * = percentage points; ** = basis points of annual GDP)

Source: IMF staff calculations.

Note: The squares show the response of each variable to a 100-basis-point

surprise monetary policy tightening in the United States. The whiskers show

90 percent conﬁdence intervals. An increase in the nominal effective exchange

rate (NEER) for the United States, or in the nominal exchange rate vis-à-vis the

United States for the emerging market economies, denotes appreciation.

EMBI = J.P. Morgan Emerging Bond Index; VIX = Chicago Board Options Exchange

Volatility Index.

–90

–60

–30

120

United States/global Emerging market economies

–300

–200

–100

100

200

300

400

Stocks*

VIX*

Expected policy rate

Term premium

EMBI

Stocks*

Portfolio inﬂows**

ortfolio bond inﬂows**

NEER (right scale)

Exchange rate (right scale)

87International Monetary Fund | April 2021

CHAPTER 4

SHIFTING GEARS: MONETARY POLICY SPILLOVERS DURING THE RECOVERY FROM COVID19

channels of transmission of international monetary pol-

icy spillovers. As shown in Figure 4.9, economies with

a speculative sovereign debt credit rating experience

an extra 27-basis-point increase in their 10-year bond

yield following a surprise 100-basis-point US mone-

tary policy tightening. Spillovers are also stronger for

countries with a higher proportion of debt held exter-

nally or with higher currency volatility. For instance,

moving from the 25th percentile in the cross-country

distribution of external debt (for example, Armenia)

to the 75th percentile (Brazil) raises the sensitivity of

10-year yields by 17 basis points. Similarly, going from

a currency volatility at the 25th percentile of economies

(for example, Romania) to the 75th percentile (Russia)

increases the response of yields by 20 basis points.

e sensitivities of yields to these three indicators

can be used to construct a “vulnerability index,” which

is used in the next part of the chapter that looks at the

determinants of monetary policy reactions in emerging

markets during the pandemic. Moreover, all these indi-

cators can be considered proxies for some form of risk.

Sovereign default risk, in particular, is inﬂuenced by the

level and expected path of public debt and therefore

provides a mechanism by which ﬁscal policy directly

inﬂuences ﬁnancial conditions in emerging markets and

thus, indirectly, the conduct of monetary policy.

at countries with higher perceived sovereign

risk experience stronger spillovers suggests that US

monetary policy is transmitted to emerging markets

through a “risk channel,” whereby monetary policy in

the United States can change the objective riskiness

of emerging market assets (for example, by increasing

perceived default probabilities) or aﬀect investors’

risk aversion (Chen, Griﬀoli, and Sahay 2014; IMF

2014; Bowman, Londono, and Sapriza 2015; Ahmed,

Coulibaly, and Zlate 2017; Kalemli-Özcan 2019).

e conclusion on the possible presence of a risk channel is

based here only on the observed heterogenous response of bond

yields for diﬀerent classes of sovereign borrowers (Figure 4.9). No

evidence of a risk channel is instead found based on the behavior of

the VIX (Figure 4.7), which is a measure of global risk aversion that

many studies (for example, Bekaert, Hoerova, and Lo Duca 2013)

but not all (for example, Bekaert, Hoerova, and Xu 2020) ﬁnd to

respond signiﬁcantly to surprise changes in US monetary policy.

Five-year bond Ten-year bond

Figure 4.8. Time Variation in the Sensitivity of Emerging

Market Yields to US Monetary Policy Surprises

(Basis points)

Source: IMF staff calculations.

Note: The bars show the effects of a 100-basis-point surprise US monetary policy

tightening on ﬁve- and 10-year emerging market government bond yields during

various periods. The 2014–20 bars are not statistically signiﬁcantly higher than

the pre-November 2008 bars.

100

120

Before Nov. 2008

Nov. 08–13

14–20

Figure 4.9. Spillover Ampliﬁers from US Monetary Policy

Surprises

(Basis points)

Source: IMF staff calculations.

Note: The ﬁgure shows how the sensitivity of emerging market 10-year yields to

each 100-basis-point US monetary policy surprise depends on economy

characteristics. “High” refers to the 75th percentile of the distribution of the

economy characteristic in the latest available year. Not shown i

n the ﬁgure, the

values for investment-grade credit rating, low external debt share, low currency

volatility, low bond substitutability, and low ﬁnancial openness are 0, 0, 14, –2,

and 3, respectively. Solid bars show economic characteristics that are statistically

signiﬁcant; hollow bars show those that are not.

Speculative-

grade

credit

High external

debt share

High currency

volatility

High bond

substitutability

High ﬁnancial

openness

–10

88 International Monetary Fund | April 2021

WORLD ECONOMIC OUTLOOK: MANAGING DIVERGENT RECOVERIES

By contrast, the chapter ﬁnds no direct evidence that

ﬁnancial openness or greater correlation between the

total return of emerging market sovereign bonds and

US Treasury securities (a proxy for bond substitutabil-

ity from the point of view of investors) are associated

with a stronger response of domestic yields in emerging

markets to US monetary policy shocks (Figure 4.9).

Almost all the change in emerging market domes-

tic yields can be accounted for by the change in term

premiums, suggesting that the perceived riskiness of

holding emerging market bonds rises after a surprise

tightening in US monetary policy, consistent with

the ﬁnding that countries with higher sovereign risk

are more sensitive to spillovers. Markets do expect

central banks in emerging market economies to follow

a surprise Federal Reserve tightening with tightenings

of their own, but only slightly. ese conclusions are

obtained by relying on dynamic factor models (Adrian,

Crump, and Moench 2013) to split the changes in

yields on ﬁve-year sovereign bonds in emerging mar-

kets into one component attributed to changes in the

expected monetary policy rate in emerging markets and

another residual term premium. e term premium

represents the extra return required by investors to

shoulder the greater risk (such as inﬂation, liquidity,

and credit risks) associated with a ﬁxed long-term rate

of return (Figure 4.7).

Of course, the yield decomposition into expected

monetary policy rates and term premiums must be

treated carefully, given that it is sensitive to speciﬁc

model assumptions. Moreover, market expectations

of future monetary policy rates may be an imper-

fect indicator of actual future policy rates, especially

over long time periods. Still, the results presented

here suggest that, whereas overall ﬁnancial conditions

in emerging markets react strongly to changes in

US monetary policy, monetary policy in emerging

markets does not.

Higher values for these two measures for an emerging market

could imply that foreign investors in that emerging market are

more inclined to change their portfolio composition after a US

monetary policy announcement, which would indicate the presence

of a “portfolio balance channel.” e fact that the two regressors

are not signiﬁcant may then suggest the “portfolio balance channel”

has a limited role in transmitting monetary policy spillovers from

advanced economies. e degree of substitutability of an economy’s

government bonds with US Treasury securities is measured as the

correlation between the total returns on its 10-year local currency

government bonds, converted to US dollars at market exchange

rates, and the total returns on 10-year US Treasury securities. Online

Annex 4.1 provides more detail.

is ﬁnding implies a certain degree of monetary

policy autonomy in emerging markets, consistent

with the ﬁndings in Chapter 3 of the April 2017

Global Financial Stability Report. At the same time, the

tightening— via risk premiums—of overall ﬁnancial

conditions following a surprise tightening in US policy

can be expected to reduce growth in emerging markets.

If central banks in emerging markets had full autonomy

to adjust their own interest rate policy, then it could

be reasonably argued that future monetary policy rates

might be expected to fall to oﬀset the rise in domestic

yields. e fact that this does not happen (future policy

rates are actually expected to go up slightly) may indi-

cate the presence of only partial autonomy.

Spillovers from US Monetary Policy during the Pandemic

As Figure 4.10 shows, the GDP-weighted average

of emerging market yields ﬁrst increased in February

2020, then fell quickly until the end of April, then

slowly crawled back toward 4 percent in late 2020.

Although, as already noted, monetary policy spillovers

are heterogenous across emerging markets, estimates in

this chapter can be used to perform some back-of-the-

envelope calculations to suggest that, had the Federal

Reserve not eased monetary policy in March, average

yields in emerging markets would have been more than

1 percentage point higher. Most of this eﬀect would

have come from higher term premiums. Of course, had

the Federal Reserve not eased at a time of deep global

crisis, the fallout in ﬁnancial markets would have been

severe; as such, the estimate in Figure 4.10 for the

spillover eﬀects of the March 2020 actions likely puts a

lower bound on the true eﬀect.

Some monetary policy actions taken by central banks

in advanced economies during the pandemic were

aimed at aﬀecting ﬁnancial conditions in foreign mar-

kets, including in emerging markets. One such example

is the Federal Reserve’s announcement on March 19,

2020, of the establishment of temporary US dollar swap

line facilities with nine other central banks.

Brazil

and Mexico were the only emerging markets included,

and thus provide an interesting event study to assess the

eﬀectiveness of the tool in limiting US dollar fund-

ing pressures. Figure 4.11 shows that, following the

Swap lines can be useful temporary sources of US dollars for the

counterparty central banks, which may draw on them to lend US

dollars to ﬁnancial intermediaries while preserving their interna-

tional reserves. Swap lines may also support investor conﬁdence in

liquidity conditions.

89International Monetary Fund | April 2021

CHAPTER 4

SHIFTING GEARS: MONETARY POLICY SPILLOVERS DURING THE RECOVERY FROM COVID19

announcement, spreads on Brazilian and Mexican sov-

ereign debt denominated in US dollars narrowed, while

spreads continued to widen in other emerging markets.

Similarly, the Brazilian real and Mexican peso appre-

ciated, while the currencies of other emerging markets

continued to depreciate. erefore, it appears that the

swap lines announcement was eﬀective in stabilizing

ﬁnancial conditions in these two countries.

Spillovers from Economic News in

Advanced Economies

Analytical Framework

e methodology here closely follows that used for

examining spillovers from monetary policy surprises, but

the shocks in advanced economies that are now con-

sidered include news about (1) economic activity in the

United States, (2) inﬂation in the United States, and

(3) the development of vaccines in advanced economies.

News about economic activity and inﬂation in the

United States is proxied by surprises about nonfarm

payroll employment and core consumer-price inﬂa-

tion released from 2000 to 2020.

News about the

development of vaccines in advanced economies is

proxied by whether the stock returns of Moderna

and Pﬁzer- BioNTech are within the top or bottom

10th percentiles of their historical distribution, con-

trolling for their usual comovement with a portfolio

of health care stocks.

In this case, the analysis covers

April 1 through December 15, 2020, which saw

positive news about the development of COVID-19

vaccines, though mostly ones that have stringent

cold-chain requirements that make it diﬃcult for

them to be delivered in many emerging market and

developing economies.

Data were provided by Gürkaynak, Kisacikoğlu, and Wright

(2020).

Moderna and BioNTech are companies involved in the devel-

opment of two vaccines that, during 2021, are expected to provide

advanced economies with a relatively wide vaccination coverage,

well beyond that of emerging markets.

Actual ﬁve-year yield

Higher ﬁve-year emerging market term premium

Higher ﬁve-year expected policy rate

Figure 4.10. Counterfactual: Emerging Market Financial

Conditions Absent Federal Reserve Easing

(Weighted average, percent a year)

Source: IMF staff calculations.

Note: Five-year denotes government bonds with a ﬁve-year maturity.

Jan.

2020

Feb.

Mar.

Apr.

May

Jun.

Jul.

Aug.

Sep.

Oct.

Nov.

BRA and MEX: EMBI

Other emerging market economies: EMBI

BRA and MEX: exchange rate (right scale)

Other emerging market economies: exchange rate (right scale)

Figure 4.11. Effects of Swap Line Announcements for Brazil

and Mexico

(Percent; changes after March 19, 2020)

Sources: Bloomberg Finance L.P.; Haver Analytics; and IMF staff calculations.

Note: BRA and MEX denote Brazil and Mexico, respectively. EMBI spreads are in

percentage point deviations from those of March 19; exchange rates are in

percent changes from those of that date. Increases denote depreciation.

EMBI = J.P. Morgan Emerging Market Bond Index.

–0.4

–0.2

0.0

0.2

0.4

0.6

0.8

–4

–2

Mar. 18 Mar. 19 Mar. 20

90 International Monetary Fund | April 2021

WORLD ECONOMIC OUTLOOK: MANAGING DIVERGENT RECOVERIES

Impact on Advanced and Emerging Market Economies

Good news about US economic activity lifts longer-

term US interest rates (Figure 4.12). e eﬀect is clear

at all maturities and, on average, over the 20 years

considered, is almost entirely down to expectations of

higher monetary policy rates (with almost no change

in US term premiums). Good news about the US

economy lowers global uncertainty, measured by the

VIX, and leads to a nominal eﬀective appreciation of

the dollar. Stock prices are not impacted signiﬁcantly,

likely because expectations of higher monetary policy

rates counterbalance the eﬀect on stock prices of better

economic prospects for ﬁrms.

e eﬀect of good news about US economic activity

on ﬁnancial conditions in the average emerging market

tends to be benign, in contrast to the impact of sur-

prise monetary policy changes.

Good US economic

news still depreciates emerging market currencies, on

average. However, in parallel with a reduction in the

VIX, emerging market default premiums on dollar-

denominated debt (Emerging Market Bond Index)

now fall and portfolio capital ows into emerging mar-

kets (the eﬀect on capital inﬂows has a moderate level

of statistical conﬁdence with a p-value of 13 percent).

ese ﬁndings are consistent with a positive risk chan-

nel, where good economic news in the United States

reduces the risk aversion of international investors. In

addition, domestic bond yields still appear to rise in

the average emerging market (although with limited

statistical signiﬁcance), but the increase seems now to

entirely reﬂect expectations of higher monetary policy

rates, possibly driven by improved growth expecta-

tions. is, for instance, would be consistent with a

positive “trade channel,” whose strength should be

expected to be heterogeneous across countries, where

higher aggregate demand in the advanced economies

leads to more demand for tradable goods produced in

emerging markets.

e eﬀect of positive news about COVID-19

vaccines in advanced economies has been positive,

thanks in part to the muted response of US interest

For an explanation of the lack of a clear eﬀect on US stock

prices, see Gürkaynak, Kisacikoğlu, and Wright (2020).

is is consistent with previous studies, for example, IMF

(2014) and Hoek, Kamin, and Yoldas (2020).

Additional tests reveal that, after an increase in US employ-

ment, spreads on dollar-denominated bonds fall more and

exchange rates depreciate less in those emerging markets that have

stronger trade links with the United States. Online Annex 4.1

provides the details.

rates (Figure 4.13). Longer-term US yields have risen

on the news, but two-year yields have not reacted,

reﬂecting the Federal Reserve’s explicit commitment to

maintaining an expansionary monetary policy stance

until a ﬁrm recovery is under way.

Positive vaccine

news has lifted corporate earnings expectations and the

US stock market, in the context of a muted expected

response of monetary policy, and the US dollar has

not appreciated.

Domestic bond yields in the average emerging

market have not reacted to vaccine news, and there

have even been indications of an expected easing in

Even at the 10-year maturity, all the increase in US yields is

attributed to rising term premiums and not to increases in conven-

tional short-term policy rates.

Figure 4.12. Effects of Positive News about US Economic

Activity

(Basis points; * = percentage points; ** = basis points of annual GDP)

Source: IMF staff calculations.

Note: The squares show estimates of the effect of a two-standard-deviation

surprise in US nonfarm payrolls. The whiskers show 90 percent conﬁdence

intervals. Average expected policy rates are calculated at the 10-year maturity for

the United States and at the ﬁve-year maturity for emerging market economies. An

increase in the nominal effective exchange rate (NEER) for the United States, or in

the nominal exchange rate vis-à-vis the United States for emerging market

economies, denotes appreciation. Portfolio inﬂows denote bond inﬂows.

EMBI = J.P. Morgan Emerging Market Bond Index; VIX = Chicago Board Options

Exchange Volatility Index.

–20

–10

Two-

year yield

Five-

year yield

Ten-

year yield

Expected policy rate

Stocks*

VIX*

NEER

One-

year yield

Five-

year yield

Ten-

year yield

Expected policy rate

Term premium

EMBI

Stocks*

Exchange rate

Portfolio inﬂows**

United States Emerging market economies

91International Monetary Fund | April 2021

CHAPTER 4

SHIFTING GEARS: MONETARY POLICY SPILLOVERS DURING THE RECOVERY FROM COVID19

domestic monetary policy. Domestic stock markets

have risen, on average. As seen when economic

news is positive, the VIX has fallen and, in parallel,

benchmark emerging market bond spreads have

shrunk, while capital has ﬂowed into emerging

markets (and the eﬀect is now statistically signiﬁ-

cant). e beneﬁcial eﬀects of positive vaccine news

on emerging market ﬁnancial conditions are likely

driven by a combination of the aforementioned risk

and trade channels, together with the “low-for-long”

expectation for US interest rates and, possibly, with

improved prospects for vaccinations globally.

Finally, the chapter ﬁnds that longer-term nominal

US yields also rise when US inﬂation comes in higher

than expected, but such surprises do not seem to impact

the US dollar, aggregate US stock prices, or the VIX.

e spillovers from surprise US inﬂation to interest rates

in the average emerging market are minimal,

and there

is no evidence of eﬀects on the average emerging mar-

ket’s exchange rates, aggregate stock prices, or spreads

on dollar-denominated debt. e lack of spillovers from

US inﬂation could be consistent with a mixture of US

demand and cost-push shocks, which would have oppo-

site implications for growth in other countries. Future

research could explore whether the speciﬁc source of the

US inﬂation shock matters for spillovers.

Spillovers to Low-Income Countries

Financial conditions in low-income countries

generally do not respond as much as conditions in

emerging markets do to monetary policy surprises

by the Federal Reserve or ECB, or to news about US

economic activity or COVID-19 vaccines. ere are,

however, some exceptions. First, positive vaccine news

in 2020 lifted 10-year government bond yields, on

average, in the ﬁve low-income countries with data

series (Ghana, Kenya, Nigeria, Uganda, Vietnam).

Second, positive ECB monetary policy surprises tend

to lift six-month government bond yields, on average,

in the three low-income countries with data (Nigeria,

Rwanda, Zambia). ird, the currencies of low-income

countries depreciate by about 1.2 percent, on average,

vis-à-vis the US dollar for each 100 basis points of

surprise tightening by the Federal Reserve, similar to

the response of emerging markets. at said, while the

impact of monetary policy on ﬁnancial conditions of

low-income countries appears to be smaller than on

emerging markets, its eﬀect on commodity prices can

still be signiﬁcant, with overall important repercussions

for commodity exporters.

Determinants of Emerging Market Monetary

Policy Reactions

APPs and conventional policy rate cuts were emerg-

ing markets’ two major monetary policy instruments

used to counter ﬁnancial market turmoil and lessen

the depth of the recession during the early months

of the pandemic.

is section uncovers the factors

that drove the frequency and intensity of their use.

Spillovers from US inﬂation to emerging market interest rates

vary slightly by method, as explained in Online Annex 4.1.

An investigation of the role of macroprudential measures

during COVID-19 is beyond the scope of this chapter. For a

comprehensive analysis of the eﬀectiveness of macroprudential

measures, see Chapter 3 of the April 2020 WEO.

Figure 4.13. Effect of Positive News about COVID-19 Vaccines

(Basis points; * = percentage points; ** = basis points of annual GDP)

Source: IMF staff calculations.

Note: The squares show estimates of the effect of positive vaccine news. The

whiskers show 90 percent conﬁdence intervals. Average expected policy rates are

calculated at the 10-year maturity for the United States and at the ﬁve-year

maturity for emerging market economies. An increase in the nominal effective

exchange rate (NEER) for the United States, or in the nominal exchange rate

vis-à-vis the United States for emerging market economies, denotes

appreciations. Conﬁdence bands on the NEER are wide; they are not shown due to

space constraints. EMBI = J.P. Morgan Emerging Market Bond Index;

VIX = Chicago Board Options Exchange Volatility Index.

Two-year yield

Five-y

ear yield

Ten-year yield

Expected policy rate

Stocks*

VIX*

NEER

One-year yield

Two-year yield

Five-year yield

Expected policy rate

Term premium

EMBI

Stocks*

Exchange rate

Portfolio inﬂows**

United States/global Emerging market economies

–6

–4

–2

92 International Monetary Fund | April 2021

WORLD ECONOMIC OUTLOOK: MANAGING DIVERGENT RECOVERIES

e econometric method seeks to ensure that the driv-

ers explored are not endogenous to the repercussion

of the pandemic shock and that appropriate controls

are added to the speciﬁcations. Still, the identiﬁca-

tion of causal eﬀects is challenging and the results are

indicative of associations. A separate analysis of the

eﬀectiveness of APPs is also presented.

Asset Purchase Programs

Overview and Eﬀectiveness

e COVID-19 crisis saw an unprecedented use

of unconventional monetary policy instruments

among emerging market and developing economies.

Twenty-seven emerging market and developing econo-

mies launched APPs, with most announcing them for

the ﬁrst time—starting with Indonesia on March 2,

2020. Most emerging market and developing economy

central banks justiﬁed APPs as a means to counter mar-

ket dysfunction, with only a handful (Ghana, Indonesia,

Mauritius) also stating the support of government

ﬁnancing as a motivation for the program.

e vast

majority of countries announced that their purchases

were conﬁned to government bonds; only a few also

announced purchases of corporate or bank bonds

(Brazil, Chile, Hungary, Mauritius) or equities (Egypt).

e eﬀectiveness of APPs can be assessed by looking

at whether yields on government bonds fell with the

launch of the programs. is is an important indicator

of success, especially for those APPs whose aim was to

reduce interest rate spikes caused by rising liquidity

premiums in funding markets. Based on this yardstick,

Box 4.1 concludes that APPs by emerging market and

developing economies during the pandemic appear to

have been eﬀective.

Drivers of APPs

Countries with greater exchange rate ﬂexibility, an

inﬂation targeting framework, greater central bank

transparency, a history of a more rules-based ﬁscal

e data on APPs used in this chapter are from Fratto and

others (2021), which also includes a detailed description of APPs

during the COVID-19 crisis through 2020. e data cover all

central bank purchases and sales of private and public securities on

primary and secondary markets. ey also include twist operations

(purchase of long-term and sale of short-term government securi-

ties), the establishment of special purpose vehicles or investment

funds to purchase equities and other private securities, direct

monetary ﬁnancing of the government, and purchases of loans

made to small and medium enterprises. See also Arslan, Drehmann,

and Hofmann (2020) and Chapter 2 of the October 2020 Global

Financial Stability Report.

policy framework, and lower sovereign risk were more

likely to announce an APP between March and August

2020. e ﬁndings are based on logit regressions

relating an indicator of whether a country announced

an APP to groups of drivers that are each considered

separately.

Depending on data availability for the

diﬀerent drivers, the sample size varies between 39

and 97 emerging market and developing economies

(Online Annex 4.2 provides details).

Policy frameworks. Overall, the results indicate that

the choice of announcing an APP is highly depen-

dent on the country’s monetary and ﬁscal policy

frameworks. Countries with ﬂoating or freely ﬂoat-

ing exchange rate regimes had a 61 percentage point

higher probability of launching an APP than countries

with other exchange rate regimes (Figure 4.14),

reﬂecting little scope for expanding the money supply

when a ﬁnancially open economy has an exchange rate

target. e presence of a numerical inﬂation target

raises the probability by 35 percentage points, while a

one-standard-deviation increase in an index of central

bank transparency (Dinçer, Eichengreen, and Geraats

2019) raises the probability by 19 percentage points.

One extra rule in the ﬁscal policy framework is associ-

ated with a 10 percentage point higher probability.

Fiscal position. Countries with higher sovereign credit

ratings (those that were perceived to have less sover-

eign default risk) were more likely to announce APPs

(Figure 4.15). An investment grade rating increases

the probability of an APP by 19 percentage points.

e amount of “ﬁscal space” that the government has

seems to matter as well. Intermediate levels of ﬁscal

space (“some” or “at risk”) increased the probability

of an APP by 58 percentage points compared with

having, at the two extremes, “substantial” or “no ﬁscal

space.”

On one hand, it is possible that countries

with “substantial” ﬁscal space were unlikely to launch

an APP because their sovereign bond markets were

not disrupted. On the other hand, countries with “no”

ﬁscal space may have resisted activating an APP, fearing

that markets could interpret it negatively as an attempt

at debt monetization (ﬁscal dominance). e unlikely

For the list of APPs in emerging market and developing econo-

mies during the pandemic, see Fratto and others (2021).

A separate analysis looks at whether the probability that a

country announced an APP was associated with the strength of the

country’s trade links with other emerging market and developing

economies that announced APPs during the pandemic. No evidence

of such an eﬀect was found.

e ﬁscal space variable is constructed by IMF staﬀ for about

70 countries and published regularly in countries’ Article IV Reports.

93International Monetary Fund | April 2021

CHAPTER 4

SHIFTING GEARS: MONETARY POLICY SPILLOVERS DURING THE RECOVERY FROM COVID19

use of APPs as an indirect means of debt ﬁnancing is

corroborated by the lack of a statistically signiﬁcant

relationship between the activation of an APP and the

deterioration in the projected 2020 ﬁscal balance.

Exposure to nancial spillovers. ree proxies are used

to measure the exposure. e ﬁrst is a country-speciﬁc

“vulnerability index” to monetary policy spillovers

from Federal Reserve decisions, as derived in the

preceding section of the chapter that deals with the

spillover ampliﬁers from US monetary policy shocks.

e second is a measure of ﬁnancial openness man-

dated in law, and the third is an indicator of foreign

reserves adequacy.

None of these proxies is signiﬁcant

in predicting an APP.

Other instruments. APPs are part of a larger set of

policy instruments, which include conventional interest

cuts (analyzed in detail in the next section) and foreign

exchange interventions. A larger policy rate cut increases

Financial openness is proxied by the Chinn-Ito index for the

year 2018 (see Chinn and Ito 2006 for a description of the index).

e reserve adequacy measure is computed by IMF staﬀ and

describes reserve holdings relative to the reserve adequacy measure,

updated to 2019 (see IMF 2015 for a description).

by 10 percentage points the probability that an APP

will be announced, while use of a foreign exchange

intervention raises that probability by 18 percentage

points. e results (Figure 4.16) suggest that emerging

market and developing economies use policy rate cuts,

APPs, and foreign exchange interventions comple-

mentarily. ey also use them for diﬀerent objectives:

lowering the domestic risk-free rate, tackling disruptions

in the domestic bond market, and resolving disorderly

conditions in the market for foreign exchange.

e size of the policy rate cut and the foreign exchange inter-

vention indicator are added simultaneously to the regression. e

foreign exchange intervention dummy is based on a collection of

such interventions during the COVID-19 crisis by the IMF staﬀ.

It is highly correlated with the indicator for ﬂoating or free-ﬂoating

exchange rates, which is added as a control to each regression. is

may appear surprising as one would expect that countries with

more ﬂexible exchange rates do not rely much on foreign exchange

interventions. However, this correlation reﬂects only the partic-

ular construction of the foreign exchange intervention indicator,

which captures those interventions aimed speciﬁcally at addressing

disorderly market conditions (and, so, have a goal similar to that of

APPs). erefore, the indicator does not include all foreign exchange

interventions conducted as part of regular operations to maintain

a managed exchange rate regime. For this reason, the regression in

Figure 4.16 does not include controls for the exchange rate regime.

Figure 4.14. Determinants of Asset Purchase Program Choice

during COVID-19: Policy Frameworks

(Change in probability, percentage points)

Sources: Dinçer, Eichengreen, and Geraats 2019; IMF 2020; and IMF staff

calculations.

Note: Flexible exchange rates and inﬂation targeting represent, respectively,

ﬂoating and free ﬂoating exchange rate regimes and inﬂation-targeting central

banks. CB transparency reports the effect of a one-standard-deviation increase in

the transparency index. Coefﬁcients are signiﬁcant at the 5 percent level.

CB = central bank.

Flexible

exchange rates

Inﬂation

targeting

transparency

One additional

ﬁscal rule

Figure 4.15. Determinants of Asset Purchase Program Choice

during COVID-19: Fiscal Position

(Change in probability, percentage points)

Sources: Standard & Poor’s; and IMF staff calculations.

Note: The ﬁscal space indicator is calculated by the IMF. Investment-grade ratings

are from Standard & Poor’s. Fiscal balance deterioration is the change in the 2020

projected ﬁscal balance between the January 2020 World Economic Outlook (WEO)

Update and the April 2020 WEO, relative to 2019 GDP. Bars are signiﬁcant at the

5 percent level; the ﬁscal balance deterioration bar is not signiﬁcant.

Intermediate

ﬁscal space

Investment

grade

Fiscal balance

deterioration

94 International Monetary Fund | April 2021

WORLD ECONOMIC OUTLOOK: MANAGING DIVERGENT RECOVERIES

Policy Rate Cuts

Analysis of the “risk channel” suggests that changes

in the expected path of monetary policy rates in

emerging markets are only marginally inﬂuenced by

surprise changes in monetary policy rates in advanced

economies. is section seeks to explain the diﬀerences

between countries in how much the policy rate was

reduced from March through August 2020.

Central

banks in countries with greater exchange rate ﬂexibil-

ity, an inﬂation targeting framework, greater central

bank transparency, and a more rules-based ﬁscal policy

framework are found to have delivered deeper inter-

est rate reductions. Unlike for APPs, sovereign credit

ratings are not correlated with the extent of interest

rate cuts.

e econometric speciﬁcation relates the change in

monetary policy rates, expressed as a ratio to the policy

rate before the crisis, to four groups of drivers. e ﬁrst

three are the same as those just explored. e fourth

intends to capture how the policy rate cut depended

For a related analysis on determinants of the policy rate cuts, see

Gelos, Rawat, and Ye (2020).

on domestic economic conditions, the standard driver of

policy interest rates.

Policy frameworks. e same characteristics of policy

frameworks that determine the use of APPs also

explain the size of policy rate cuts (Figure 4.17). In

countries with ﬂexible exchange rates and inﬂation-

targeting central banks, the policy rate cut was about

20 percent larger. A one-standard-deviation increase in

the central bank transparency index raises the policy

rate cut by 6 percent and the use of one additional

ﬁscal rule makes it 5 percent larger.

Fiscal position. Neither the sovereign debt rating nor

the ﬁscal space indicator are signiﬁcant predictors of

interest rate cuts. e change in the ﬁscal balance is

also insigniﬁcant.

Exposure to nancial spillovers. Similar to the chap-

ter ﬁndings about the exposure to monetary policy

spillovers, the indicator of ﬁnancial openness and

the reserve adequacy ratio are not signiﬁcant drivers

e same domestic economic conditions did not determine

decisions to use APPs.

Figure 4.16. Determinants of Asset Purchase Program Choice

during COVID-19: Other Instruments

(Change in probability, percentage points)

Sources: National authorities; and IMF staff calculations based on national central

bank information.

Note: FXI is a dummy for countries that have used foreign exchange interventions

to address disorderly market conditions during the COVID-19 crisis. Policy rate cut

is based on a one-standard-deviation increase in the policy rate, as a percentage

of its pre-pandemic level. Coefﬁcients are signiﬁcant at the 5 percent level.

FXI Policy rate cut

Figure 4.17. Determinants of Policy Rate Cuts during

COVID-19: Policy Frameworks

(Changes, percentage points)

Sources: Dinçer, Eichengreen, and Geraats 2019; IMF 2020; and IMF staff

calculations.

Note: Flexible exchange rates and inﬂation targeting represent, respectively,

ﬂoating and free ﬂoating exchange rate regimes and inﬂation-targeting central

banks. CB transparency reports the effect of a one-standard-deviation increase in

the transparency index. Coefﬁcients are signiﬁcant at the 5 percent level.

CB = central bank.

Inﬂation

targeting

One additional

ﬁscal rule

Flexible

exchange rates

Increased

CB transparency

95International Monetary Fund | April 2021

CHAPTER 4

SHIFTING GEARS: MONETARY POLICY SPILLOVERS DURING THE RECOVERY FROM COVID19

of conventional monetary policy cuts. is result is

well aligned with the ﬁndings about spillovers from

monetary policy surprises and appears to conﬁrm that

external monetary and ﬁnancial conditions are not

important drivers of domestic monetary policy rates.

Domestic economic conditions. Interest rate cuts were

proportionally larger where pre-pandemic inﬂation was

lower and where the domestic and foreign demand

shocks were more negative (Figure 4.18). e policy

rate cut was deeper in countries with a higher number

of COVID-19 cases by September 1, 2020 (which

proxies for the size of negative domestic demand and

supply shocks, especially in the service sector). e

country’s manufacturing share in GDP captures the

eﬀect of falling foreign demand on GDP and is also

associated with more conventional easing.

Conclusions

Prospects for a multispeed recovery, with advanced

economies recovering more quickly than most other

economies, raise concerns about the eﬀects from

an asynchronous withdrawal of monetary policy

support that tightens ﬁnancial conditions for emerging

market and developing economies. ese concerns have

been ampliﬁed by the ﬁscal packages in the United

States, which could lead the Federal Reserve’s asset

purchases to be scaled back and US interest rates to rise

at an earlier-than-expected date.

is chapter ﬁnds that changes to interest rates in

the United States tend to have important ramiﬁca-

tions for ﬁnancial conditions in emerging market and

developing economies. Yet, these eﬀects depend on the

circumstances behind the change and the evolution of

global risk premiums:

• An unexpected signal of higher future US policy

rates that is not driven by changes in economic

conditions in the United States unambiguously leads

to a tightening of financial conditions in emerg-

ing markets. The trigger could arise from markets

revising their expectations of how soon or how

much the Federal Reserve will react to the evolving

information on the economy. This would potentially

lead to a shift in global risk appetite, a reversal of

capital flows to emerging markets, deleveraging by

global banks, and a depreciation in emerging market

currencies that exposes foreign exchange-related

vulnerabilities.

• By contrast, positive news on US economic activity

tends to have a relatively benign impact on financial

conditions in emerging markets. The VIX and risk

premiums on emerging market bonds fall, while

capital tends to flow into emerging markets. Positive

news from COVID-19 vaccine trials triggered strong

effects in the same direction. These findings can be

attributed in part to a positive risk channel, where

favorable economic developments in advanced

economies reduce the risk aversion of international

investors, and in part to a trade channel, which

reflects the tendency of better economic news in the

United States to imply better growth prospects for

emerging markets as well.

• Upside surprises on US inflation also lift expected

US rates, but do not appear to systematically

impact financial conditions in emerging markets.

Although the source of inflation may matter, on

average, the repercussions for emerging markets

seem to be limited.

e analysis suggests that a gradual and well-

telegraphed normalization of US interest rates driven

by a recovering US economy would likely be man-

ageable for most emerging market economies, though

Figure 4.18. Determinants of Policy Rate Cuts during

COVID-19: Domestic Conditions

(Changes, percentage points)

Sources: Johns Hopkins University; IMF, World Economic Outlook

; and World

Bank, World Development Indicators.

Note: Manufacturing contribution to GDP and cumulative COVID-19 cases per

1,000 inhabitants report the effects of a one-standard-deviation increase in the

indicator. Coefﬁcients are signiﬁcant at the 10 percent level or less.

CPI = consumer price index.

–6

–4

–2

CPI

inﬂation

Manufacturing

contribution to GDP

Cumulative COVID-19 cases

per 1,000 inhabitants

96 International Monetary Fund | April 2021

WORLD ECONOMIC OUTLOOK: MANAGING DIVERGENT RECOVERIES

some would be at risk. In fact, many emerging markets

(especially those with substantial exports to advanced

economies) could see a period of strong capital

inﬂows as economic conditions in advanced econ-

omies improve, monetary policy accommodation is

withdrawn gradually, and global risk appetite remains

favorable. A stronger-than-expected inﬂation recovery

in advanced economies could temper global ﬁnancial

risk appetite somewhat, but with likely limited reper-

cussions if inﬂation expectations remain well anchored.

is is particularly true, given that the Federal Reserve

has clearly communicated that it is targeting a tempo-

rary overshooting of its medium-term inﬂation goal

and would not raise interest rates until inﬂation has

risen to 2 percent and is on track to moderately exceed

2 percent for some time. However, some emerging

market economies with ﬁscal and external vulnerabil-

ities and a lack of trade ties to advanced economies

may ﬁnd that global ﬁnancial tightening outweighs the

beneﬁts of stronger external demand. Moreover, the

current health and economic crises are diﬀerent from

anything seen in recent decades, making evidence from

the past an imperfect guide to the future. Today’s high

debt levels may accentuate any ﬁnancial spillovers, and

eﬀorts to contain the virus may limit the beneﬁts of

trade links.

It is not assured that the economic recovery and

interest rate normalization in advanced economies

will be smooth, and central bank communications

will be a critical factor as the recovery progresses.

e chapter’s ﬁndings suggest that a rapid upward

revision in expected US monetary policy rates—for

example, if markets were suddenly to revise down their

expectations for the inﬂation level that the Federal

Reserve would tolerate before it tightened monetary

policy under its ﬂexible average inﬂation targeting

framework—could lead to rising risk premiums and

signiﬁcant capital outﬂows from emerging market and

developing economies. As such, it will be important

for the Federal Reserve to continue to emphasize its

policy approach and how it will implement its new

monetary policy strategy to anchor expectations about

its policy reaction. In general, it will be important for

advanced economy central banks to signal early if they

judge that economic conditions are evolving in a way

that will warrant scaling back of asset purchases and,

eventually, raising policy rates.

See Sahay and others (2014) for a stocktaking of lessons from

the taper tantrum episode.

Even if global ﬁnancial risk appetite remains

buoyant for some time, emerging market policymak-

ers need to keep in mind that advanced economy

central banks will eventually reduce monetary policy

accommodation. Even with central banks providing a

high degree of transparency and early communication

of changes in their policy stance, markets may still mis-

interpret intentions, and ﬁnancial conditions can shift

for reasons that are beyond the control of policymak-

ers. Moreover, as the recovery picks up, risk appetite

and term premiums may increase, as happened on

the back of expected US ﬁscal stimulus in the second

half of February. Combined with a faster expected

normalization of US monetary policy, the decompres-

sion of term premiums has steepened the US yield

curve and has spilled over into higher emerging market

bond yields as well, triggering a slowdown in capital

ﬂows. is episode foreshadows the bumps that may

lie ahead for emerging markets as the global economic

recovery progresses and extraordinary policy support

is withdrawn.

How can emerging market economies insulate

themselves from external ﬁnancial spillovers? e

correlations documented in the chapter suggest that

monetary policy in emerging markets could probably

react countercyclically in downside scenarios. How-

ever, the strength of the policy easing could be limited

and heterogenous across countries. For instance,

higher public debt might discourage some countries

from using APPs with the same intensity as in the

earlier phases of the pandemic. Moreover, if public

debt and other ﬁscal concerns were to start weighing

on the perceived independence of monetary policy and

on its rules-based frameworks, the ability of central

banks to deploy large conventional rate cuts without

raising long-term inﬂation expectations could also

be called into question. Maintaining credible ﬁscal

and monetary frameworks is therefore essential for

emerging market and developing economies to be able

to support domestic activity amid unexpected negative

shocks. In addition, taking steps to lengthen maturities

on debt and smooth out concentrations in debt service

obligations, manage leverage through macro prudential

measures and strong ﬁnancial supervision, reduce

currency mismatches, and ensure an adequate level of

international reserves can also help limit the buildup

of vulnerabilities (see Chapter 3 of the April 2020

WEO). A strong international ﬁnancial architecture,

including robust mechanisms for liquidity support for

countries, would have a key role to play too.

97International Monetary Fund | April 2021

CHAPTER 4

SHIFTING GEARS: MONETARY POLICY SPILLOVERS DURING THE RECOVERY FROM COVID19

Most Countries Deployed Asset Purchase Programs

while Short-Term Policy Rates Were Still Positive

is partly reﬂected the reported aim to smooth

volatility and provide liquidity to the domestic market.

In only 9 percent of cases were asset purchase programs

(APPs) reported to be aimed at providing monetary

stimulus. For 62 percent, market dysfunction and the

need to boost conﬁdence was the main concern. Sup-

porting ﬁscal needs was stated as the main objective in

10 percent of cases, with the rest citing the need to alle-

viate costs of the COVID-19 pandemic on the popula-

tion. e exchange rate was one of the objectives in only

one case. Purchases of long-dated government bonds (or

private sector securities) were sometimes used in com-

bination with policy rate cuts (11 out of 27 cases). e

size of APPs, both announced and implemented, was

comparable to that in small advanced economies.

Overall, Such Unconventional Monetary Policy

Measures Lowered Local Bond Yields but Had

No Salient Eﬀect on Exchange Rates or External

Borrowing Costs

e results of a multiday event study, using a

sample of (only 15, given data limitations) emerging

market and developing economies, point to het-

erogeneous eﬀects. On average, the estimated eﬀect

on domestic bond yields is negative and statistically

signiﬁcant (Figure 4.1.1), slightly stronger than that of

conventional monetary policy transmission, and higher

in emerging market and developing economies than in

advanced economies. e results are broadly consistent

with the literature (Arslan, Drehmann, and Hofmann

2020; Hartley and Rebucci 2020; Sever and others

2020).

e estimated eﬀects on the exchange rate are

instead inconclusive. Looking at the second-round

eﬀects, the announcements have predominantly an

insigniﬁcant eﬀect on emerging market benchmark

bonds. Panel regressions, controlling for policy and

global factors, conﬁrm the results.

e authors of this box are Chiara Fratto, Brendan Harnoys

Vannier, Borislava Mircheva, David de Padua, and Hélène Poirson.

is box draws on the analysis in Fratto and others (2021)

and is based on a data set of APP announcements and imple-

mentation during March through August 2020.

Results shown exclude the announcements coinciding with

policy rate cuts to avoid capturing spillover eﬀects from conven-

tional monetary policy.

Diﬀerences in Implementation and Country

Characteristics Can Explain Some of the

Heterogeneity in the Eﬀectiveness of APPs

Some country-speciﬁc factors (central bank

credibility, larger monetary policy space, low share

of nonresident holdings of government bonds) and

implementation modalities (quantity-based pro-

grams, smaller announced size, single as opposed

to repeated announcements) seemed to increase the

impact of APPs on yields. No statistically signiﬁcant

diﬀerences were found between purchasing assets on

the primary and the secondary market, nor between

single announcement and announcements made

in coordination with other national authorities.

Overall, the results suggest that APPs can be use-

fully deployed by emerging market and developing

economies in response to domestic market stress,

but may not work in dampening external market

pressures more broadly.

Interquartile range Median

Figure 4.1.1. Asset Purchase Program

Announcement: Effect on Bond Yields

(Percentage point change)

Source: Fratto and others (2021).

–0.2

–0.1

0.0

0.1

0.2

Six-month Two-year Five-year Ten-year

Box 4.1. Emerging Market Asset Purchase Programs: Rationale and Eectiveness

98 International Monetary Fund | April 2021

WORLD ECONOMIC OUTLOOK: MANAGING DIVERGENT RECOVERIES

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