Mervyn King, former Governor of the Bank of England, used to say that good monetary policy is boring. Indeed, during 16 months of help in the fight against Covid-19, central banks around the world have lived through a torrid period.
Central banks in advanced and emerging market economies have learned important lessons. Countries like Poland, a relatively small and open economy classified as an emerging market, have used a judicious mix of conventional and unconventional monetary policies to carve out some autonomy for themselves in a world dominated by the actions of large economies.
Central banks in emerging markets have succeeded in broadening their arsenal of monetary measures to mitigate the most severe economic effects of the crisis. One of these methods is to accumulate foreign exchange reserves in order to reduce the value of national currencies. This helps ensure that small countries do not suffer the economic setbacks of massive quantitative easing by large countries through government bond purchases.
Until early 2020, unconventional monetary policies were limited to a few rich countries. The pandemic has been a game-changer, as shown in Central and Eastern Europe as well as a dozen other emerging market economies. Central banks in Croatia, Poland and Hungary have bought significant amounts of their domestic debt securities, increasing their balance sheets by 13%, 50% and 70% respectively since the start of the pandemic.
By crossing the Rubicon in unconventional policies, emerging market central banks have, in monetary terms, joined the nuclear weapons club. It can confer prestige, but it does not solve all problems. Conventional weapons are still needed.
This becomes evident by examining the currency effects of QE in large countries. It is naive to believe that small economies in the giant’s orbit will always benefit from demand increases generated by QE and adopted by their larger neighbors. QE weakens the exchange rate of the largest executing country. By enjoying a global or regional “exorbitant privilege”, large monetary authorities can shift the burden of adjustment onto others.
Guido Mantega, Brazilian finance minister in 2010, was right to say that the exchange rate repercussions of the Federal Reserve’s QE amounted to “currency wars”. Since then, in the wake of Covid-19, the amount of liquidity pumped into the global banking system has skyrocketed – with the largest economies at the forefront by far. The Fed’s record of nearly $ 8.1 billion exceeds that of any other economy in the Western Hemisphere. The European Central Bank’s balance sheet is twice the GDP of the euro area’s largest economy, Germany. The total assets of the Swiss National Bank are almost equivalent to the combined GDP of Poland, Czechia, Hungary and Slovakia.
With the total assets of the top five central banks accounting for nearly 28% of global GDP, small countries have a right to defend themselves, to avoid being caught off guard by negative consequences. Philip Lowe, Governor of the Reserve Bank of Australia, is correct that the the actions of the biggest players mitigate the effects of his own bank’s bond purchases by lowering Australian interest rates and the Australian dollar.
Faced with this unbalanced “fight against the giants”, what should central banks in emerging markets do? Simply scaling up unconventional policies can be counterproductive. Asset purchases aimed at stabilizing national economies can end up destabilizing national financial markets. Less developed economies face higher risks of mismatch. This is one of the reasons why asset purchases in Central Europe have been rather weak. The Romanian central bank bought bonds worth less than 0.5% of gross domestic product. Hungarian and Polish purchases at around 5% and 6% of GDP respectively were much lower than those of the European Central Bank, whose bond purchases accounted for around 32% of euro area GDP.
In this context, the use of “conventional” weapons takes on its full meaning. Foreign exchange intervention has become fashionable again to prevent the rise of national currencies. Many European and surrounding countries have stepped in to ease the upward pressure on their currencies, including Switzerland, the Czech Republic, Israel and Poland. This is underlined by the increase in the foreign exchange reserves of these countries.
For many years over the past half century, Poland has been hampered by chronically low foreign exchange reserves. Today, with reserves (including gold) of nearly 163 billion dollars against 128 billion dollars in 2019 and 95 billion dollars in 2015, Poland is, fortunately, among the top 20 holders of reserve currencies. in the world. Part of this increase comes from the sale of zlotys by the central bank and the purchase of foreign currency. Some purists may complain about it. But the International Monetary Fund has given its blessing to these policies.
Along with the exchange rate, central banks must be alert to the risks of rising inflation. For the time being, that appears under controlnot least because today’s world is much more competitive than it was in the 1970s, when we last witnessed significant inflationary pressure. Once the post-Covid recovery looks sustainable, we can start thinking about tightening policies. But central banks are far from it.
For now, we need to focus on continuing the recovery – using all possible means. If it requires currency intervention to maintain an otherwise unacceptable currency appreciation, then that is a legitimate line of defense.
The nuclear option of unconventional policies is part of our arsenal. Yet, to win wars, conventional armaments are often the key weapons. So the best way forward for Poland and other emerging market economies is to use a mix of conventional and unconventional monetary policies. This is a key lesson from the crisis that will be very useful to us in the years to come.
Adam Glapiński is chairman of Narodowy Bank Polski.
To note: Hungary’s bond-to-GDP ratio was calculated using the “general government” balance sheet subheading of Magyar Nemzeti Bank, which is part of “holdings of securities other than shares issued by residents’ position “. Polish bond purchase calculations iInclude purchases of government securities and government guaranteed debt securities. The ECB ratio was calculated by adding up all purchases made under the public sector procurement and emergency pandemic procurement programs.