Mexico bank chief calls for EM monetary policy action

Agustin Carstens, governor of Banco de Mexico.
Susana Gonzalez | Bloomberg | Getty Images
Agustin Carstens, governor of Banco de Mexico.

Central banks in emerging markets could follow counterparts in the developed world and become "market makers of last resort", using unconventional monetary policies to try and stimulate their flatlining economies, according to Mexico's central bank chief.

The comments by Agustín Carstens will add to a rising chorus of concern about the deteriorating prospects for EMs in 2016, led by an economic slowdown in China.

"Emerging markets need to be ready for a potentially severe shock," Mr Carstens told the Financial Times. "The adjustment could be violent and policymakers need to be ready for it."

Policymakers and economists have warned that heavy selling of EM stocks and bonds by international investors since the middle of last year threatens to provoke a credit crunch that would make it hard for EM companies to service their debts.

Many EM companies have filled up on cheap credit over the past decade, after a commodities boom and ultra-loose monetary policies led by the US Federal Reserve resulted in very low borrowing costs. As investors pull out, those costs are set to soar.

Mr Carstens said the required policy response from EM central bankers would stop short of outright "quantitative easing" — the large-scale buying of financial assets undertaken by the Fed and other developed market central banks.

But it would include exchanging high risk, long-dated assets held by investors for less risky, shorter-dated central bank and government liabilities.

Michael Dooley of Drobny Global Advisors, an investment research firm, wrote a paper for the Bank for International Settlements in September 2014 questioning whether EM central banks could act as market makers of last resort.

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He notes that, when a central bank buys assets in the market, it pays for them with its own or the government's bonds or other liabilities — effectively, pumping money into the financial system.

The operation would only work if market participants believed the government was solvent and that its liabilities would hold their value, as measured, for example, against a foreign currency such as the US dollar.

"As long as the government is solvent and can support the value of the assets, it is just helping people over a bad patch and can sell the assets back later at a profit," Mr Dooley says.

This might work in Mexico's case, he says, adding that such policies may well be put to the test there given the "immense" amount of low-interest debt in Mexico's private sector.

Alberto Gallo, head of macro credit research at RBS, says China is already operating such a policy through its so-called national team of big financial institutions. Analysts say this national team has been stepping in to support shares and other assets following the stock market's abrupt rise and fall last year, with funding supplied by the People's Bank of China, the central bank.

"The PBoC has been lending them the money and in a pure accounting sense the credit risk is held by the national team," he says. "But in practice the two are intertwined."

Mr Carstens said China was going further than he would recommend for other EMs.

Mr Gallo said China was a separate case, partly because of the enormous size of its foreign currency reserves and partly because it is a one-party state. Other EMs, he says, would find it impossible to support their own currencies while engaging in such large-scale asset purchases. The result would be a surge in inflation, inflicting economic pain on the poorest parts of the population.

"QE boosts wealth inequality," he says. "In countries where inequality is already high and the poverty threshold is being broken by more and more people, they are getting to a political breaking point."

He points to Brazil as one country facing "a very fragile social equilibrium".

Mr Gallo adds that RBS expects China's currency to depreciate by at least 10 per cent against the US dollar in the next 12 months, dragging other EM currencies down with it.

"There will be an EM credit crunch and central banks will have to deal with it," he says. "It will be a very hard job."

Mr Dooley goes further, predicting a credit crunch in developed markets, too, as US growth pushes interest rates up more quickly than markets expect.

For emerging markets, he says, confidence as well as solvency will be key. "In Carstens, Mexico has somebody in charge who understands what's going on," he says. "That won't be true in every country."