The perils of monetary policy in the global periphery during the Covid-19 pandemic

For several decades, countries of the periphery have been deeply in the grip of debt. The Covid-19-induced crisis has severely accelerated indebtedness and thus increased financial vulnerability. Recent policy measures by peripheral governments and central banks have brought momentary relief, but ultimately represent a manifestation of the interests of finance capital to get the most out of peripheral economies as long as it is still possible. 

Because of the dependence of their currencies on international capital flows, political autonomy in peripheral economies is extremely limited due to the possible effects of political decisions on the movement of such flows. The enormous power of financial markets over monetary policy in the periphery is again becoming evident during the current crisis. The crisis in the global periphery is generally much more severe than in the central countries, not only because of often inadequate health systems that have been abandoned under three decades of neoliberal policy. As peripheral assets do not serve as a store of value, “investors” withdrew almost 100 billion dollars from “emerging markets” within three months, constituting a historically unprecedented capital flight. Factors such as the deflation of prices of primary resources, the fall in external demand for manufactured products, and the fall in cash flows due to decreasing remittances and tourism mean that financial pressure has increased even more. Consequently, peripheral currencies significantly depreciated with the beginning of the crisis, in some cases by as much as 20-30%, as in the cases of Brazil and Mexico.

Central banks in the periphery have been frantically trying to stop further currency devaluations and capital outflows, which could set in motion a spiral of hyperinflation and insolvencies as seen in past financial crisis of the 1980s and 1990s. Significant depreciations of their currencies against the US-Dollar would be devastating as their import dependency has sharply increased in the context of economic liberalization and deindustrialization since the 1980s. Moreover, the domestic corporate and banking sectors have accumulated massive amounts of Dollar-denominated debt, especially as a consequence of carry trade (i.e. borrowing foreign exchange and lending domestic currency, gaining from the interest rate spread). 

With the water up to their neck, peripheral countries have drawn on a series of measures. Among the conventional ones are resorting to IMF emergency credits and short-term liquidity lines. Moreover, many peripheral central banks have sold a large amount of foreign exchange reserves in March and April 2020 in order to support their currencies (they do so by buying them on the international forex market). However, in addition to these more “traditional” emergency measures, there are two more unconventional approaches that central banks have used to defend their currencies. 

First, in order to obtain US-Dollars for providing liquidity to large banks and companies, and stabilize the exchange rate without using reserves, some central banks, like those of Brazil (BCB) and Mexico (Banxico), have made use of the swap lines offered by the Federal Reserve. This means that they exchange their own currency at a fixed exchange rate against Dollars with the FED, and then auction these Dollars to the domestic private sector in the form of non-deliverable forwards. However, while the instrument is praised as one that permits stabilizing the exchange rate without draining reserves, it is not without risks. When the coverage period with the FED ends, BCB and Banxico have to return the same amount in Dollars to the latter. If the exchange rate against the Dollar depreciated, the central banks pay the domestic buyers of the forwards the difference between the exchange rate of that day and the price at which the coverage was agreed. Hence, effectively the operation works as an insurance of the exchange rate for private actors in their countries. The cost for the central bank could be offset through the increasing value of foreign exchange reserves, which are usually held in the form of US government bonds, but these also involve a substantial cost. Should the exchange rate appreciate in favour of the Brazilian Real and the Mexican Peso, the governments may have to either accept a fiscal loss due to the losses accruing to the corporations or banks that purchased the forwards, or else roll them over. Ultimately, the cost of the operation lies with the Brazilian and Mexican state.

Second, several peripheral central banks, for instance those of Chile, Colombia, Indonesia, Mexico, the Philippines and Turkey, recently began to inject liquidity in the domestic financial system through purchases of public and / or private sector bonds and also legal reductions in the monetary regulation deposit (minimum reserves that banks have to have with the central bank). This seems like a copy of the Quantitative Easing (QE) measures that central banks in the centers of the world economy have been implementing since the 2008 financial crisis. However, in the periphery the story is a different one. FED and ECB have been able to “print money” in massive quantities by purchasing treasury and corporate bonds on financial markets without their currencies losing value. To the contrary, such measures imply a considerable risk for financial stability in the periphery, whose currencies depend on the continuous demand for these by financial markets. This is reflected in threatening comments by investment banks and the financial press regarding these actions, such as “The jury is still out”, “Emerging markets to face judgement day as QE goes global”, “Should QE go on for a period of time without an FX reaction, that does not mean there will not be one”. Therefore, such liquidity injections in the periphery must be sterilized (that is, offset through the issuing of new debt bonds) if they are not to expand the monetary base. It is unclear whether all countries that have implemented “QE” have done so (it seems to be the case for Mexico and many others), or rather financed their programmes with selling international reserves (as claimed by BIS). After all, in order to (temporarily) stabilize the exchange rate through “acting as a buyer of last resort” and not achieve the opposite effect, peripheral states must either incur new debt on financial markets, or accept a drain on their international reserves.  

For the moment, these measures seem to have stabilized exchange rates, recovering capital of more than 83 billion dollars. In fact, flooded with fresh and abundant money from FED and ECB, finance capital welcomes the opportunity to further profit from lending to the periphery, as stated by an investment banker according to whom “[t]he March sell-off, coupled with radical action from global policymakers, created […] one of the best opportunities to increase EM exposure he had seen in his 30 years of experience”. 

The question is, however, for how long the financial bubble can continue to grow. The international reserves of many countries will not be enough to pay the mounting piles of debt, if (or when) abrupt capital flight causes high currency depreciations. Therefore, it is likely that financial crises will occur sooner or later. The investment bank JP Morgan still expects a potential for 11-12% returns on investment in “Emerging Markets” for the next 12 months, while financial analysts forecast a 34% “Emerging Markets” insolvency rate for 2021. At the end of the day, the ones who are going to pay the bill of investment banks are the working classes of the global periphery.

Nadine Reis is a research professor at the Center for Demographic, Urban and Environmental Studies (CEDUA) at El Colegio de México. Her current research focuses on financialization and urbanization in Latin America, especially Mexico. She tweets at @nadinreis​.

Photo: IMF. By AgnosticPreachersKid.

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