3. Taper Tantrum or Tedium: How Will the Normalization of U.S. Monetary Policy Affect Latin America and the Caribbean?
Author: International Monetary Fund
Language:
English
Keywords:
REO; commodity; emerging market; bond yield; real GDP; risk premium; IMF staff calculation; net capital; federal funds rate; Emerging and frontier financial markets; Securities markets; Real interest rates; Global; Caribbean; Central America
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Abstract

A stronger U.S. recovery will impart a positive impulse primarily to Mexico, Central America, and the Caribbean, whereas the anticipated normalization of U.S. monetary policy will affect all countries in Latin America and the Caribbean (LAC). Traditional exposures to U.S. interest rates have diminished, as governments in LAC have reduced their reliance on U.S. dollar–denominated debt. However, U.S. monetary shocks also spill over into local funding and foreign exchange markets. Spillovers to domestic bond yields have typically been contained over the past decade, but the market turmoil of mid-2013 illustrates the risk of outsized responses under certain conditions. In a smooth normalization scenario, net capital inflows to LAC are unlikely to reverse, although new risk premium shocks could trigger outflow pressures. Countries cannot fully protect themselves against such external shocks, but strong balance sheets and credible policy frameworks provide resilience in the face of financial volatility.

A stronger U.S. recovery will impart a positive impulse primarily to Mexico, Central America, and the Caribbean, whereas the anticipated normalization of U.S. monetary policy will affect all countries in Latin America and the Caribbean (LAC). Traditional exposures to U.S. interest rates have diminished, as governments in LAC have reduced their reliance on U.S. dollar–denominated debt. However, U.S. monetary shocks also spill over into local funding and foreign exchange markets. Spillovers to domestic bond yields have typically been contained over the past decade, but the market turmoil of mid-2013 illustrates the risk of outsized responses under certain conditions. In a smooth normalization scenario, net capital inflows to LAC are unlikely to reverse, although new risk premium shocks could trigger outflow pressures. Countries cannot fully protect themselves against such external shocks, but strong balance sheets and credible policy frameworks provide resilience in the face of financial volatility.

Introduction

Since the beginning of 2014, the U.S. Federal Reserve has started to reduce the scale of its bond purchases. Although the Federal Reserve’s stance remains highly expansionary, this “tapering” process marks the first stage in the anticipated normalization of U.S. monetary policy. Given the novelty of the Federal Reserve’s quantitative easing (QE) program, there are many questions over how its unwinding will affect the rest of the world. Repeated bouts of financial market turmoil since May 2013 have raised concerns that sustained increases in U.S. interest rates could destabilize emerging markets that have benefited from ultra-low external financing costs and received large capital inflows in recent years.

This chapter examines how prospective changes in U.S. monetary conditions could affect the LAC region, focusing in particular on spillovers through trade flows, bond, and foreign exchange markets.

Spillover Channels

The Federal Reserve’s decision to start tapering its bond purchases points to what is a priori a big positive for global economic activity, namely the firming recovery in the U.S. economy. Higher U.S. demand for imports will support the LAC economies, although the size of this impact varies across countries. One of the greatest beneficiaries is likely to be Mexico, whose manufacturing industry has become highly integrated into the North American supply chain. Indeed, Mexico’s exports to the United States far exceed those of all other large economies in LAC, both in absolute terms and relative to GDP (Figure 3.1). A stronger U.S. recovery will also help some economies in Central America and the Caribbean with close U.S. trade links.1 Most of South America, however, would benefit only marginally.

Figure 3.1
Figure 3.1

LAC: Exports of Goods to the United States1

(Percent of GDP)

Sources: IMF, Direction of Trade Statistics database; and IMF staff calculations.1 Average ratios to GDP for 2010-12.2 See Annex 2.1 for details on Argentina’s GDP.

The flip side of an improving economic outlook for the United States is the gradual removal of the extraordinary monetary stimulus that the Federal Reserve has imparted since 2008. In the short term, the main effect should be some upward drift in longer-term U.S. interest rates, as the horizon shrinks over which policy rates are expected to stay close to zero. IMF staff projections are premised on a smooth adjustment, with 10-year yields increasing by some 120 basis points from current levels by end-2015 (consistent with the argument in Chapter 3 of the April 2014 World Economic Outlook [IMF, 2014a] that U.S. real interest rates will remain relatively low for some time). However, more abrupt changes in U.S. bond yields are possible, either because of news about the likely path of future policy rates or because of sudden shifts in the term premium (the gap between long-term bond yields and the average of expected short-term interest rates over the same horizon). Term premium shocks could arise, in particular, from remaining uncertainty over the timing and modalities of the exit from QE.

Higher long-term U.S. interest rates have a direct effect on emerging market debt denominated in U.S. dollars. As little as two decades ago, this category represented the bulk of public debt in LAC. Accordingly, tighter Federal Reserve policy ineluctably drove up the marginal funding costs of governments (and other borrowers)—typically by more than one-for-one, as higher U.S. interest rates tend to coincide with wider spreads on foreign currency emerging market debt (Table 3.1). Over the past decade, however, this vulnerability has diminished appreciably in LAC, as most countries have shifted their issuance toward local currency debt (Figure 3.2).

Table 3.1.

U.S. Monetary Policy and Emerging Market External Bond Spreads: Some Previous Studies

article image
Source: IMF staff compilation.Note: EM = emerging market; EMBI = J.P. Morgan Emerging Markets Bond Index; VAR = vector autoregression.
Figure 3.2
Figure 3.2

Selected LAC Economies: Public Debt Denominated in Foreign Currency: 2013 vs. 20031

(Percent of GDP)

Sources: National authorities; and IMF staff calculations.Note: See page 63 for a list of country name abbreviations.1 Includes debt instruments linked to foreign currency. Definition of the government sector varies somewhat across countries.

This is not to deny that sizable direct exposures persist in some cases, notably in economies with fully dollarized financial systems, such as Ecuador and Panama, or those with limited capacity to issue local currency debt. In addition, the region’s large firms have borrowed significant amounts abroad in recent years, notably through corporate bond markets. While this trend creates new vulnerabilities, many firms are initially shielded by the relatively long tenor of the bonds they issued. Near-term maturities are relatively moderate in general, delaying the direct effect of tighter U.S. financial conditions on refinancing costs and roll-over risk (Figure 3.3), although potential currency mismatches bear close monitoring (see also Box 2.1).

Figure 3.3
Figure 3.3

Latin America: Foreign Currency Bonds Outstanding by Maturity Date1

(Billions of U.S. dollars)

Sources: Bloomberg L.P.; and IMF staff calculations.1 Includes all bonds denominated in advanced economy currencies with original maturity greater than one year that were outstanding as of early January 2014. Corporate bonds identified based on issuer’s “country of risk.”

Focus on Local Bond Markets

The gradual dedollarization of public debt has boosted the resilience to exchange rate changes among the emerging markets in LAC. In principle, it has also created greater scope for domestic financing costs to differ from foreign interest rates. However, domestic monetary policy settings and broader financial conditions clearly are not immune to external developments in a world of large cross-border flows and increased foreign investment in local emerging market bond markets.2 One tentative indication is the nearly universal, albeit differentiated, rise in long-term bond yields across emerging markets since the May 2013 “taper shock” (Figure 3.4). The impact of higher bond yields on domestic demand will vary across countries but is likely to be important in many cases, given the deepening of domestic credit markets over the past decade. Lower emerging market equity prices in the wake of an interest rate shock would add to the contractionary impact, though a weaker exchange rate should generally be supportive of growth.

Figure 3.4
Figure 3.4

Selected Economies: Changes in Policy Rates and Domestic Bond Yields Since End-April 20131

(Percentage points)

Sources: Bloomberg L.P.; and IMF staff calculations.Note: See page 63 for a list of country name abbreviations.1 Change over the period April 30, 2013, to March 27, 2014.2 Bond yield data for Brazil and Chile reflect bonds with a residual maturity of nine years toward the end of the sample period.

Two channels, in particular, account for the synchronized rise in bond yields apparent from Figure 3.4. First, rising U.S. bond yields lower the attractiveness of investments in other currencies, putting pressure on emerging market exchange rates. These pressures may lead central banks to raise policy rates to avert excessive pass-through to domestic inflation (or other destabilizing effects related to capital outflows and currency depreciation). A higher path for short-term policy rates, in turn, affects longer-term bond yields. Second, term premiums are likely to be positively correlated across countries, reflecting common trends in uncertainty and risk aversion.3 Both effects appear to have been present in emerging markets over the past year.

A third potential explanation for the synchronized rise in interest rates is that it reflects a generalized improvement in the growth outlook. However, the evidence seems to rule out this possibility. Countries facing the largest rise in interest rates have tended to experience the sharpest downward revisions in growth forecasts (Figure 3.5). Put differently, domestic financial conditions have tightened the most not in countries featuring the brightest near-term growth prospects, but in those facing a combination of inflation and exchange rate pressures (Figure 3.6). On further inspection, these attributes also correlate closely with elevated current account deficits and significant earlier appreciation of the real exchange rate. The underlying problem, therefore, may be a recent history of strong capital inflow pressures that pushed up real exchange rates—fueling wider external deficits—and led central banks to keep monetary policy looser than they otherwise would have.4

Figure 3.5
Figure 3.5

Selected Economies: Changes in Policy Rates, Domestic Bond Yields, and Growth Forecasts Since End-April 2013

(Percentage points)

Sources: Bloomberg L.P.; and IMF staff calculations.Note: See page 63 for a list of country name abbreviations.1 Change in average growth forecast among analysts surveyed by Bloomberg L.P. between April 30, 2013, and March 27, 2014.2 Change over the period April 30, 2013, to March 27, 2014.3 Change in 10-year domestic bond yield between April 30, 2013, and March 27, 2014. Changes for Chile and Israel were negative. Yield data for Brazil and Chile reflect bonds with a residual maturity of nine years toward the end of the sample period.
Figure 3.6
Figure 3.6

Selected Economies: Changes in Exchange Rates and Domestic Bond Yields Since End-April 2013 vs. Initial CPI Inflation

(Percent)

Sources: Bloomberg L.P.; Haver Analytics; and IMF staff calculations.Note: CPI = consumer price index. See page 63 for a list of country name abbreviations.1 Percent change in the U.S. dollar per local currency exchange rate between April 30, 2013, and March 27, 2014.2 Percent change in inflation over the year through April 2013.3 Change in 10-year domestic bond yield between April 30, 2013, and March 27, 2014. Changes for Chile and Israel were negative. Yield data for Brazil and Chile reflect bonds with a residual maturity of nine years toward the end of the sample period.

Sensitivity of Bond Yields to U.S. Monetary Shocks

Turning to a more formal investigation, we trace the response of 10-year local currency government bond yields to U.S. monetary shocks. The latter are identified in a U.S.-specific vector autoregression model with sign restrictions. Positive monetary shocks are identified as innovations that drive up 10-year U.S. Treasury bond yields, while depressing the price of equities. As such, they are distinguished from positive news shocks, which raise both bond yields and equity prices.5 In essence, monetary shocks capture unanticipated changes in the perceived outlook for monetary policy that are unrelated to changes in growth expectations or investor risk sentiment. The analysis focuses on shocks affecting long-term U.S. bond yields, as these capture perceived changes in the monetary policy outlook even under unconventional policies, such as QE or “forward guidance.”

Bond Market Turmoil in 2013: Structural Break or Anomaly?

Using a simple regression approach for daily data going back to 2004, we find that the response of 10-year U.S. bond yields to the monetary shocks described above is very steady, with yields rising by about 3 basis points in response to a standardized positive shock. The response of local currency emerging market bond yields is more variable, but typically hovers in a range of 1 to 2 basis points, implying that they co-move less than one for one with U.S. bond yields, including in Latin America (Figure 3.7).6 However, the estimated sensitivity surged markedly in 2013, with most emerging market bond yields exhibiting betas (that is, responses relative to the change in the U.S. yield itself) well in excess of one.7 For the most intense period of last year’s emerging market turmoil, that is, May 21 to September 5, these high betas explain between 30 percent and 80 percent of the observed increase in bond yields for most emerging markets (Figure 3.8).

Figure 3.7
Figure 3.7

Normalized Response (“Beta”) of Domestic Bond Yields to U.S. Monetary Shocks, 2004–141

Sources: Bloomberg L.P.; and IMF staff calculations.1 Based on country-specific, six-month rolling regressions of daily changes in 10-year domestic government bond yields on the contemporaneous and one-day-lagged U.S. monetary and news shocks. The betas shown above are computed by adding the two coefficients on the U.S. monetary shock from the country-specific regression, and dividing by the sum of the corresponding two coefficients from the U.S. bond yield regression.2 Economies with data availability for January 2004-February 2014: China, Hong Kong SAR, Hungary, India, Indonesia, Korea, Mexico, Philippines, Poland, Singapore, South Africa, and Thailand.3 Panel varies, due to data availability, but in all periods shown includes at least four of the following countries: Brazil, Chile, Colombia, Mexico, and Peru. Yield data for Brazil and Chile combine bonds with 9 and 10 years’ residual maturity.
Figure 3.8
Figure 3.8

Selected Economies: Factors Explaining Changes in Bond Yields following the “Taper Shock”1

(Basis points)

Sources: Bloomberg L.P.; and IMF staff calculations.1 Refers to the period May 21, 2013, to September 5, 2013, based on a regression of daily changes in 10-year government bond yields on identified U.S. shocks. Yield data for Brazil and Chile combine bonds with 9 and 10 years’ residual maturity.2 Includes impact of other external or domestic factors captured by the regression constant and residuals.

Does this striking rise in the impact of U.S. monetary shocks on emerging market bond yields signal a lasting change, coinciding with an inflection point in Federal Reserve policy? It is difficult to be sure, but there are a few indications to the contrary. First, the sensitivity of emerging market bond yields has started to ease again in recent months. Second, we find no evidence of a structural break in 2008–09, when QE was first launched, casting doubt on the notion that the impact of U.S. monetary policy changed fundamentally with the shift to unconventional policy. Third, there also is no evidence in our sample that upward moves in U.S. bond yields have systematically larger effects on emerging market yields than downward moves. Despite these considerations, it would not seem prudent to dismiss the taper shock as a total anomaly either.

One factor that may explain the outsized changes in emerging market bond yields in mid-2013 is the extreme market situation prior to the taper shock—interest rates in most emerging markets had hit record-low levels, both in nominal and real terms, as many investors were positioned for persistently loose monetary conditions and low volatility. This situation made markets particularly vulnerable to news about a monetary turning point or a rise in uncertainty—as generated by the May 22 testimony by then Federal Reserve Chairman Bernanke, which triggered the sell-off in global bond markets. Since then, long-term interest rates—both nominal and real—in emerging markets have normalized to some extent, although they remain below longer-term averages in most countries (Figure 3.9).

Figure 3.9
Figure 3.9

Selected Economies: Real Interest Rates, January 2006–March 20141

(Percent)

Sources: Bloomberg L.P.; Consensus Forecasts; and IMF staff calculations.1 Computed as the difference between five-year interest rate swap rates and the consensus forecast for consumer price index inflation one year ahead. Data for Malaysia only start in November 2006; those for Romania and Russia start in August 2006.

Panel Regression Results

The results from the daily yield regressions are broadly confirmed by a panel regression that uses monthly data and several control variables to explain changes in emerging market bond yields. As before, there is robust evidence for a positive response to U.S. monetary shocks and for a marked increase in that response in 2013. Also, as before, the results do not point to any systematic difference in the response to positive versus negative U.S. monetary shocks. Perhaps more surprisingly, there is no evidence for yield sensitivities to be systematically related to typical indicators of economic fundamentals over the whole sample period, although some of these variables are found to have a direct influence on emerging market yields (Table 3.2).8

Table 3.2.

Dependent Variable: Monthly Change in Domestic Government Bond Yield

(Percentage points)

article image
Source: IMF staff calculations.Note: The regressions are estimated using monthly data for a sample of 18 emerging markets, including Brazil, Chile, Colombia, Mexico, and Peru, from January 2006 to December 2013. Robust standard errors are in parentheses. All variables in percent or percent of GDP and differenced, except for the U.S. monetary and news shocks. Unreported robustness checks included additional control variables (for instance, current account balances and a capital account openness indicator) and interaction terms, but generally did not yield significant estimates. *** p-value < 0.01, ** p-value < 0.05, * p-value < 0.1. Inflation and growth forecasts are obtained from Consensus Economics.

Limited Spillovers from Gradual Normalization, but Volatility Risks Remain

Overall, the results presented so far suggest that a gradual and orderly normalization of U.S. monetary conditions should affect emerging market bond markets in a relatively moderate fashion. Local yields have historically tended to respond to U.S. monetary shocks, but less than one for one. Other news shocks, which include positive U.S. growth surprises, appear to have even more limited (and possibly benign) effects on emerging market bond yields.9

Nonetheless, important risks remain. Renewed volatility in U.S. bond yields could trigger large, sudden moves in emerging market bond markets, especially if it were to coincide with other negative shocks to investor sentiment, such as adverse political or economic developments in emerging markets. Based on the evidence of the mid-2013 market turmoil, the impact would tend to be larger in economies with weak external positions and limited capacity to maintain an accommodative policy stance. Market fluctuations could be heightened by the apparent decline in trading liquidity in recent years, as some banks have reduced their market-making activities.

A Capital Flow Perspective

Further light on the possible impact of U.S. monetary policy normalization can be shed by focusing on capital flows rather than bond yields. As has been amply documented, the record-low real interest rates observed across emerging markets in early 2013 were partly the reflection of strong portfolio capital inflows observed up to that point (Figure 3.10). This heightens the concern that rising U.S. interest rates could slow or reverse the flow of capital to emerging markets.

Figure 3.10
Figure 3.10

LA5: Aggregated Portfolio Inflows, 1988–20131

(Percent of aggregated GDP)

Sources: National authorities; and IMF staff calculations.1 LA5 includes Brazil, Chile, Colombia, Mexico, and Peru. Gross inflows refer to the change in portfolio liabilities and net inflows to the change in portfolio liabilities minus the change in portfolio assets. For 2013, data are annualized based on quarterly data through the third quarter (through the second quarter only for Peru).

To analyze the response of capital flows to shocks to long-term U.S. real interest rates, we estimate a panel vector autoregression with quarterly data since 1990 for a group of 38 emerging markets. Two alternative specifications are considered, one using net and the other gross capital flows.10 Besides the capital flow variables, the model includes country-specific fixed effects and a set of global variables, that is, U.S. real output growth, global uncertainty (proxied by the VIX), changes in the real U.S. federal funds rate, changes in the 10-year real U.S. interest rate, and the log difference of a commodity price index.11

Investor Reactions to Changes in U.S. Interest Rates

The results from the regressions suggest that shocks to the real U.S. Treasury bond rate have a significant impact on capital flows to emerging markets (Figure 3.11). Gross inflows decline markedly, falling by almost 2 percent of GDP over six quarters in response to a 100-basis-point increase in the real Treasury rate. The impact on net capital inflows, while also negative, is more muted, reflecting the stabilizing role played by domestic investors. Indeed, the latter tend to react by repatriating external assets, partly offsetting the retrenchment of foreign investors.12

Figure 3.11
Figure 3.11

Response of Capital Flows to Emerging Markets to a U.S. Long-Term Interest Rate Shock1

(Percentage points of domestic GDP)

Source: IMF staff calculations.1 Response to a one standard-deviation shock (that is, 23 basis points) to the real 10-year Treasury bond yield. Confidence intervals (5th and 95th percentiles) computed with Monte Carlo simulations. Gross inflows denote the change in international labilities; gross outflows denote the change in international assets.

Closer inspection reveals that these dynamics are dominated by non–foreign direct investment flows. Moreover, the fall in net capital inflows following a shock to the U.S. 10-year real interest rate is found to be larger in Latin America than in other emerging market regions.

The results shown in Figure 3.11 appear broadly in line with the experience during the taper shock of 2013. In most LAC countries, the retrenchment of foreign investors was partially offset by asset repatriation by residents, mitigating the negative impact on net flows.

By controlling for U.S. output growth in the panel vector autoregression, we ensure that the estimated effects reflect those of “pure” U.S. interest rate shocks, and not the endogenous response of interest rates to U.S. output shocks. In the context of the Federal Reserve’s exit from QE, however, rising interest rates may be predominantly the result of stronger economic prospects. For this scenario, we find that net capital flows to emerging markets respond positively to an increase in U.S. GDP growth (Figure 3.12), despite the associated rise in U.S. interest rates. Although there is no clear-cut mapping from capital flows to asset prices, this finding broadly conforms with the main results from the yield regressions reported above—emerging markets would not have to be particularly concerned about an orderly normalization of U.S. monetary policy that mirrors an improving U.S. growth outlook.

Figure 3.12
Figure 3.12

Response of Net Capital Inflows to Emerging Markets to a U.S. Real Output Shock1

(Percentage points of domestic GDP)

Source: IMF staff calculations.1 Response to a one standard-deviation shock (that is, 0.6 percentage points) to U.S. real GDP growth. Confidence intervals (5th and 95th percentiles) computed with Monte Carlo simulations.

In contrast, markets are likely to suffer fresh bouts of volatility in the case of an independent shock to global risk sentiment. Indeed, such shocks (proxied by changes in the VIX) appear to have a particularly large impact on net inflows to the LAC region. Specifically, there is a considerable decline of gross inflows (twice as large as in the average emerging market) which is only partially compensated for by residents’ asset repatriation.

Illustrative Results from a Full-Fledged Macro Model

To sum up, the scenario of a strengthening U.S. recovery provides positive real-sector impulses to Mexico and several Central American and Caribbean economies, but is less important for South America. A rise in U.S. bond yields, meanwhile, tightens financial conditions more broadly, but should have only moderate effects if it is gradual and driven by positive output developments in the U.S. economy. Of greater concern would be a pure U.S. interest rate shock, whose impact would be felt most acutely in the more vulnerable economies across the region. Exchange rate flexibility, in turn, should help to buffer adverse shocks to the extent that it facilitates an orderly rebalancing toward stronger net exports.

To illustrate the interplay of these different channels, we run simulations of the IMF’s Flexible Suite of Global Models, which allows a general equilibrium analysis of the global economy with significant regional specificity. The first shock we consider is a stronger-than-expected U.S. recovery that entails a faster normalization of U.S. monetary policy. To this, we add, as a second shock, a simultaneous rise in emerging market risk premiums, as could result from a renewed surge in U.S. term premiums.

The results confirm that, among the larger economies in LAC, Mexico fares reasonably well even in the scenario of the combined shocks, reflecting the positive U.S. spillovers through the trade channel (Figure 3.13). In comparison, output growth in Brazil and a few of the other South American economies would be adversely affected as the rise in risk premiums dominates any positive output spillovers.

Figure 3.13
Figure 3.13

Selected Latin American Economies: Cumulative Effect on Real GDP from Shocks to U.S. Output and Risk Premiums, 2014–151

(Percent; relative to baseline)

Sources: National authorities; and IMF staff calculations.1 A positive U.S. growth surprise entails a 1.1 percent rise in U.S. real GDP relative to the baseline through 2015, triggering an earlier-than-expected tightening of U.S. Federal Reserve policy. Under the emerging market risk premium shock, market interest rates rise by one standard deviation in each country (computed from the country-specific distribution of Emerging Markets Bond Index Global bond spread changes since end-2011, annualized). On average, this shock amounts to 100 basis points across the sample. It is assumed to persist during 2014-15.

Policy Implications

These illustrative simulations confirm the broad findings of this chapter and underscore the importance for countries across LAC to further reduce their vulnerability to large increases in external interest rates. The key to achieving greater resilience, as argued in Chapter 2, lies in continuing to strengthen policy frameworks and in securing robust balance sheets that enable countries to enact countercyclical policies when faced with adverse shocks.13

Indeed, a sharp tightening of external financial conditions may require that individual countries use some of the buffers that have been built up in recent years, notably their large holdings of international reserves. Several countries have also taken advantage of strong recent investor appetite for long-maturity assets by increasing average debt duration. Should yield curves steepen markedly going forward, these countries may have some room to reduce duration to accommodate this shock, without compromising a prudent overall strategy for debt management.

1

Beyond the impact of positive spillovers through merchandise trade, many countries in Central America and the Caribbean will also benefit from higher tourism and workers’ remittance flows from the United States.

2

Chapter 2 of the April 2014 Global Financial Stability Report (IMF, 2014b) analyzes in detail the impact of foreign portfolio investors on local bond market dynamics. Rey (2013) and Klein and Shambaugh (2013) discuss the related policy challenges.

3

For a deeper analysis of common trends in long-term real interest rates, see Chapter 3 of the April 2014 World Economic Outlook (IMF, 2014a) and Turner (2014).

5

News shocks capture other sources of news that could affect bond yields, notably growth surprises or variation in risk sentiment. For more details on the empirical approach, see the forthcoming IMF Spillover Report.

6

The regression relates emerging market bond yield changes to the contemporaneous and one-day-lagged value of the U.S. monetary and news shocks to allow for delayed effects on markets in the Asian and European time zones.

7

By contrast, the response to news shocks fluctuates around zero for the average emerging market over the whole sample period, suggesting that the positive co-movement induced by growth surprises (higher U.S. growth reduces slack in emerging markets, leading to tighter monetary conditions) is broadly offset by the negative co-movement owing to risk appetite shocks (higher risk appetite raises U.S. bond yields but lowers emerging market yields). We also find no significant response of emerging market yields to U.S. growth shocks in regressions that include the Goldman Sachs daily U.S. growth surprise index as an additional regressor.

8

See also related work by Jaramillo and Weber (2013), Kamil and others (forthcoming), and Perrelli and Goes (forthcoming). Our own regressions use monthly data in first differences. Compared to some other studies, this may make it harder to gauge the full impact of economic fundamentals, which tend to display limited high-frequency variation within the same country.

9

This is consistent with prima facie evidence from the previous U.S. monetary tightening cycle of 2004–06, when short- and longer-term interest rates in Brazil, Chile, Colombia, Mexico, and Peru rose less than in the United States, or even declined.

10

See Adler, Djigbenou, and Sosa (2014) for further details on the methodology and results as well as an overview of the related empirical literature.

11

Capital flows are expressed in percent of trend GDP. Real interest rates are computed using forward-looking inflation expectations at 1-year and 10-year horizons. To avoid endogeneity problems related to country-specific fixed effects, forward mean-differencing is used; see Love and Zicchino (2006) and Arellano and Bover (1995).

12

The asymmetric responses of domestic vs. foreign investors may reflect factors such as home bias or heterogeneity in investors’ assessment of asset valuations. Indeed, the dynamics depicted in Figure 3.11 are consistent with foreign investors reacting promptly to a change in interest rate differentials, triggering a drop in local asset prices and the currency, which may subsequently induce local investors to “take a profit” on their overseas asset holdings and switch into “cheaper” domestic assets.

13

See also the policy recommendations in Arvanitis and others (forthcoming). Separately, Chapter 2 of the April 2014 Global Financial Stability Report (IMF, 2014b) advises specific steps toward financial deepening, including the promotion of larger local investor bases, to enhance resilience to external shocks.

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Contributor Notes

Note: Prepared by Alexander Klemm, Andre Meier, and Sebastián Sosa. Anayo Osueke, Carlos Rondon, and Ben Sutton provided excellent research assistance.
Cover Regional Economic Outlook, May 2014, Western Hemisphere
Regional Economic Outlook, May 2014, Western Hemisphere
Author: International Monetary Fund
ISBN:
9781484360118
ISSN:
2071-4165
Publication Date:
24 Apr 2014
Publisher:
International Monetary Fund
DOI:
https://doi.org/10.5089/9781484360118.086
Pages:
82
  • View in gallery

    LAC: Exports of Goods to the United States1

    (Percent of GDP)

  • View in gallery

    Selected LAC Economies: Public Debt Denominated in Foreign Currency: 2013 vs. 20031

    (Percent of GDP)

  • View in gallery

    Latin America: Foreign Currency Bonds Outstanding by Maturity Date1

    (Billions of U.S. dollars)

  • View in gallery

    Selected Economies: Changes in Policy Rates and Domestic Bond Yields Since End-April 20131

    (Percentage points)

  • View in gallery

    Selected Economies: Changes in Policy Rates, Domestic Bond Yields, and Growth Forecasts Since End-April 2013

    (Percentage points)

  • View in gallery

    Selected Economies: Changes in Exchange Rates and Domestic Bond Yields Since End-April 2013 vs. Initial CPI Inflation

    (Percent)

  • View in gallery

    Normalized Response (“Beta”) of Domestic Bond Yields to U.S. Monetary Shocks, 2004–141

  • View in gallery

    Selected Economies: Factors Explaining Changes in Bond Yields following the “Taper Shock”1

    (Basis points)

  • View in gallery

    Selected Economies: Real Interest Rates, January 2006–March 20141

    (Percent)

  • View in gallery

    LA5: Aggregated Portfolio Inflows, 1988–20131

    (Percent of aggregated GDP)

  • View in gallery

    Response of Capital Flows to Emerging Markets to a U.S. Long-Term Interest Rate Shock1

    (Percentage points of domestic GDP)

  • View in gallery

    Response of Net Capital Inflows to Emerging Markets to a U.S. Real Output Shock1

    (Percentage points of domestic GDP)

  • View in gallery

    Selected Latin American Economies: Cumulative Effect on Real GDP from Shocks to U.S. Output and Risk Premiums, 2014–151

    (Percent; relative to baseline)

LAC: Exports of Goods to the United States1

(Percent of GDP)

Selected LAC Economies: Public Debt Denominated in Foreign Currency: 2013 vs. 20031

(Percent of GDP)

Latin America: Foreign Currency Bonds Outstanding by Maturity Date1

(Billions of U.S. dollars)

Selected Economies: Changes in Policy Rates and Domestic Bond Yields Since End-April 20131

(Percentage points)

Selected Economies: Changes in Policy Rates, Domestic Bond Yields, and Growth Forecasts Since End-April 2013

(Percentage points)

Selected Economies: Changes in Exchange Rates and Domestic Bond Yields Since End-April 2013 vs. Initial CPI Inflation

(Percent)

Normalized Response (“Beta”) of Domestic Bond Yields to U.S. Monetary Shocks, 2004–141

Selected Economies: Factors Explaining Changes in Bond Yields following the “Taper Shock”1

(Basis points)

Selected Economies: Real Interest Rates, January 2006–March 20141

(Percent)

LA5: Aggregated Portfolio Inflows, 1988–20131

(Percent of aggregated GDP)

Response of Capital Flows to Emerging Markets to a U.S. Long-Term Interest Rate Shock1

(Percentage points of domestic GDP)

Response of Net Capital Inflows to Emerging Markets to a U.S. Real Output Shock1

(Percentage points of domestic GDP)

Selected Latin American Economies: Cumulative Effect on Real GDP from Shocks to U.S. Output and Risk Premiums, 2014–151

(Percent; relative to baseline)

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