The Impact of U.S. Monetary Policy Normalization on Capital Flows to EMEs Tatjana Dahlhaus Garima Vasishtha Bank of Canada 13th Research Meeting of NIPFP-DEA Research Program March 6, 215
Introduction Many EMEs experienced a sharp withdrawal in private capital flows in the second half of 213. $ bn % 1 3.5 5 3. 2.5 2. -5 1.5-1 1..5-15. 2-Jan-13 3-Jan-13 27-Feb-13 27-Mar-13 24-Apr-13 22-May-13 19-Jun-13 17-Jul-13 14-Aug-13 11-Sep-13 9-Oct-13 6-Nov-13 4-Dec-13 1-Jan-14 29-Jan-14 26-Feb-14 Net bond inflows ($bn) Net equity inflows ($ bn) 1-yr Treasury yield (RHS)
Introduction Were markets reacting to rising long-term yields or to changing expectations of the Federal funds rate? 3. 1 yr Treasury yield spread vs. market expectations of the Federal funds rate (monthly data) 2. percent 1.. Jan 12 Feb 12 Mar 12 Apr 12 May 12 Jun 12 Jul 12 Aug 12 Sep 12 Oct 12 Nov 12 Dec 12 36 month Federal funds futures Jan 13 Feb 13 Mar 13 Apr 13 May 13 Jun 13 Jul 13 Aug 13 Sep 13 Oct 13 Nov 13 1 yr Treasury yield spread Dec 13 Jan 14 Feb 14 Source: Bloomberg, Haver and authors' calculations Last observation: February, 214 back
Introduction Markets were not expecting a quick move to raise interest rates though. percent.5.3.1.1 Jan 13 Feb 13 Mar 13 Apr 13 Market expectations of the Federal funds rate (monthly data) May 13 Jun 13 Jul 13 Aug 13 Sep 13 Oct 13 Nov 13 Dec 13 Jan 14 Feb 14 percent 2. 1.8 1.6 1.4 1.2 1..8.6.4.2. 1 month futures 6 month futures 36 month futures (right axis) Source: Bloomberg and authors' calculations
This paper Introduction Examines the potential impact of U.S monetary policy normalization on portfolio flows to EMEs using a VAR model. Accounts for market expectations of future path of short-term interest rate Policy normalization shock - increases both the long-term spread as well as monetary policy expectations while leaving the policy rate per se unchanged. Monetary policy expectations are derived from Federal funds futures contracts at a long-term horizon.
Literature Review Impact of news about Fed tapering on EM exchange rates, interest rates, and asset prices: Event study approach: Eichengreen and Gupta (214), Mishra et al. (214), etc. U.S. monetary policy expectations: FFR futures data: D Amico and Farka (211), Gurkaynak (25), Hamilton (28), Kuttner (21) Futures-based surprises in classic MP VAR: Barakchian and Crowe (213), Gertler and Karadi (215) Extant literature on determinants of capital flows to EMEs, including role of U.S monetary policy. Relation between capital flows and U.S. monetary policy expectations has not received much attention.
Ex ante it is unclear what the effects of U.S. monetary policy normalization on capital flows are: 1 Rising U.S. interest rates will likely decrease the demand for developing country assets and increase the cost of external borrowing for EMEs. 2 A stronger U.S. economy will be beneficial for EMEs as it means stronger demand for their exports.
Lessons from the Past Evidence from former Fed tightening cycles is mixed. $bn 199s cycle % $bn 2s cycle % 6 9 4 6 5 4 3 2 1 199212 19936 199312 19946 199412 19956 199512 19966 199612 19976 199712 19986 199812 Portfolio flows (annual) Fed Funds Target Rate (right scale) 1-Year Treasury yield (right scale) 8 7 6 5 4 3 2 1 3 2 1-1 -2-3 2212 235 231 243 248 251 256 2511 264 269 272 277 2712 Portfolio flows (annual) Fed Funds Rate (right scale) 1-Year Treasury yield (right scale) 5 4 3 2 1
Data Introduction Capital flows: 23 EMEs:Argentina, Brazil, Bulgaria, Chile, China, Colombia, Czech Republic, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, the Philippines, Poland, Romania, Russia, South Africa, Thailand, Turkey, Ukraine, and Venezuela. Monthly EPFR data on (net) portfolio capital flows (equity and bond flows) into EM-dedicated funds. EPFR data is being increasingly used in academic research on capital flows. Sample: January 24 to January 214.
Data Introduction Monetary policy expectations: Proxy based on Federal funds future contracts at the 36-month horizon. Each observation is the expected Federal funds rate 36 months later. Using a long-term horizon avoids problems with the ZLB, i.e., expectations are flat at short-term horizons. Data availability: FFR futures: January 211 onwards Eurodollar futures: before 211
Empirical Framework 1 Extract a common factor from portfolio flows to EMEs. Literature has documented co-movement of capital flows, e.g., Forster et al. (212), Fratzscher (212), and Puy (213). 2 Estimate a VAR model containing U.S. variables and the estimated capital flow factor. Identify a policy normalization" shock and assess its effects on portfolio flows to EMEs.
Factor Estimation Factor model representation: W t = χ t + ξ t (1) = λ F t + ξ t, χ t is the common component of W t ξ t is the idiosyncratic component F t is a r 1 vector of "common" or "static" factors λ is an r N matrix of factor loadings Estimated by method of principal components
VAR Model Introduction VAR model: y t = α + A(L)y t 1 + u t (2) y t contains 7 variables: 1 Federal funds rate 2 Spread between the US 1-year Treasury yield and Federal funds rate 3 36-month Federal funds futures contracts 4 U.S. IP growth 5 U.S. inflation 6 Implied U.S. stock market volatility (VIX) 7 Common factor of capital flows
VAR Model Introduction Including the common factor of capital flows in the VAR model allows us to calculate the effects of Fed policy normalization: On capital flows to individual countries On aggregate flows VAR includes 1 lag (chosen by AIC and BIC) Estimated using standard Bayesian methods (i.e., Gibbs sampler)
Policy normalization shock: Identification We use a mixture of zero and sign restrictions. A policy normalization shock has no effect on the FFR on impact (ZLB). Increases the 1-year Treasury yield spread and expectations of the future FFR. Expectations theory of the term structure After the Bernanke testimony in May 213 both variables moved in tandem Graph Market participants likely reacted to both changes in long-term yields and in expectations of the Federal funds rate
Policy normalization shock: Identification Decreases economic activity and prices Evidence for a negative relationship between the term spread and economic activity, e.g., Eickmeier and Hofmann (212); Gilchrist et al. (29); Rudebusch et al. (27). Restrictions similar to Baumeister and Benati (213) used to identify a spread" (QE) shock Responses of common factor of capital flows and VIX left unrestricted
Co-movement of Capital Flows $ bn 4 4 3 3 2 2 1 1 1 1 2 3 2 4 3 5 4 24 25 26 27 28 29 21 211 212 213 214 First common factor Total portfolio flows (right axis)
Policy normalization shock: Impulse responses Federal Funds Rate Spread 1 2 percentage 1 2 percentage 1 3 5 1 15 2 25 3 35 1 5 1 15 2 25 3 35 3 Federal Funds Futures 1 Inflation percentage 2 1 percentage 1 2 1 5 1 15 2 25 3 35 3 5 1 15 2 25 3 35 2 Industrial production (growth rate) 4 VIX percentage 2 4 2 6 5 1 15 2 25 3 35 2 5 1 15 2 25 3 35 2 Factor of Capital Flows 2 4 6 5 1 15 2 25 3 35
Common factor of bond flows 1-1 -2-3 -4-5 -6-7 -8 5 1 15 2 25 3 35 4 Months
Common factor of equity flows 2 1-1 -2-3 -4-5 5 1 15 2 25 3 35 4 Months
The countries identified as being the most affected are the ones that received greater financial inflows prior to 213. South Africa Hungary Malaysia Thailand Korea Peru Poland Mexico Philippines Brazil Turkey Indonesia Russia Chile Ukraine Colombia Czech Rep. India Argentina China Venezuela Romania Bulgaria 4 3 2 1 Estimated 3 month cumulative effect on capital flows/gdp of a 12 bps "policy normalization" shock 25 2 15 1 5 Financial flows from 21 212 as a share of GDP
Strong association between countries identified as being the most affected and the ones that saw greater outflows over May-Sept 213. 4.5 4 3.5 3 2.5 2 1.5 1.5 Bulgaria. Argentina Venezuela Czech Republic China India.5 Hungary Estimated 3 month cumulative effect on capital flows/gdp of a 12 bps "policy normalization " shock (%) South Africa Malaysia Peru Thailand Korea Mexico Brazil Poland Turkey Philippines Russia Indonesia Chile Colombia Ukraine Romania 1. 1.5 2. 2.5 Cumulative outflows over May Sept 213 as percentage of GDP (%)
Conclusion Introduction This paper studies the effect of Fed policy normalization on portfolio capital flows to EMEs. Contributes to the literature by accounting for the role of monetary policy expectations in driving capital flows using a structural model.
Conclusion Introduction show: Effects of U.S monetary policy normalization on capital flows are rather muted. Size of inflows received prior to 213 matters. Effects are in line with the response of capital flows seen from May to September 213. Bond flows respond slightly more than equity flows.
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