Information about Asia and the Pacific Asia y el Pacífico

Chapter 2. Lessons for Frontier Economies from the Recent Experience of Emerging Markets

Alfred Schipke
Published Date:
April 2015
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Information about Asia and the Pacific Asia y el Pacífico

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Itai Agur, Mangal Goswami, Shinichi Nakabayashi and Sunil Sharma 

Frontier economies have grown rapidly since the turn of the century. While GDP growth rates have varied considerably among the countries in this group, their average growth and inflation rates have been generally higher compared with emerging market economies (Figure 2.1).1 But whether the current trajectories of frontier economies will eventually lead to emerging markets and then middle-income status depends on tackling a number of structural deficiencies and containing the buildup of macroeconomic and financial risks in the transition.

Figure 2.1Emerging and Frontier Markets: Average Growth and Inflation Rates

Source: IMF, World Economic Outlook, October 2013.

Note: The charts use the Morgan Stanley Capital International (MSCI) categorization of emerging and frontier markets.

Frontier economies face fundamental challenges in their economic and institutional development. They have to tackle deficiencies in governance, the rule of law, basic infrastructure, and the skills of the workforce to accelerate and maintain growth in incomes per capita.2 A necessary, but not sufficient, condition for success is having reasonably effective macroeconomic frameworks for conducting policies to facilitate and support growth and institutional change.

They will need to deal with these hurdles to development in the context of an international financial architecture that seems to be spawning more frequent crises, with contagion spreading to all parts of the globe. Achieving low inflation, sturdy exchange rates, financial stability, and sustained growth is a difficult balancing act under the best of circumstances. In a world of volatile capital flows and cross-border spillover from large regional and global economies, charting a steady growth path will be a difficult act for frontier markets unless monetary, financial, and fiscal policies are mutually consistent, sufficiently flexible, and generally pulling in the same direction. It will be important for frontier markets to avoid the “boom-bust” cycles that have derailed and set back the development and convergence process for emerging market economies in the past.

In this chapter, we examine the recent experience of emerging market economies to draw some macroeconomic and financial lessons for the frontier economies.

Monetary and Exchange Rate Policies

The international financial system has changed profoundly in the past few decades, posing new challenges for emerging market economies in the maintenance of internal and external balances. During the Bretton Woods era, severe constraints on capital mobility coupled with a globally coordinated exchange rate system shielded developing economies against sudden losses in their international reserves. While external imbalances were frequent, limited capital mobility afforded countries long adjustment periods, and devaluations and expenditure restraint were expected to provide relief from trade deficits. Over the past few decades the acceleration of international financial integration and the experiences of emerging market capital account crises have changed the nature of macroeconomic management in emerging market economies. In particular, with flexible exchange rates, a strong nominal anchor was needed to stabilize inflation expectations and promote price stability, with important implications for central banking and for the monetary policy frameworks the emerging market economies adopted.3

Evolving Exchange Rate Regimes

The “macroeconomic policy trilemma” provides a useful framework for analyzing emerging market monetary policy responses as international financial integration accelerated in the 1990s. In the context of increasing capital mobility, it highlights the trade-off between the degree of exchange rate stability and the extent to which governments can act to stabilize economic activity and domestic price levels (see Figure 2.2). Simply stated, with an open capital account and a fixed exchange rate, any deviation of a country’s interest rate from the globally prevailing interest rate would lead to arbitrage and trigger capital inflows that would force a country to either abandon its peg or readjust its interest rate. Reality, however, is more complicated as many countries operate somewhere in the middle rather than at the vertices of the trilemma.4 Emerging market economies grapple with managing exchange rate levels and variability, the degree of monetary policy independence, and the process of financial liberalization.5

Figure 2.2The Trilemma Framework

Source: Authors.

Emerging market experience during and in the aftermath of the global financial crisis has called into question whether the trilemma framework still appropriately captures the policy trade-offs faced. Extensive monetary accommodation by advanced economies, in the form of protracted low interest rates and quantitative easing policies, led to a search for yield among global investors. Capital flows in the form of portfolio flows and cross-border banking lowered the yield curves of many emerging market economies. This, in turn, greatly influenced credit creation and business cycles in those countries. It seemed that irrespective of a country’s exchange rate regime, monetary autonomy dwindled for emerging market economies with relatively open capital accounts. This has led Rey (2013) to argue that the policy trilemma has essentially become a policy dilemma, whereby the only choice is between capital account liberalization and monetary independence. Others take the view that the trilemma remains valid, but that the trade-offs have become starker, and the burden placed on monetary policy has no doubt become heavier in the aftermath of the global financial crisis (Obstfeld 2014). Large capital flows and financial stability concerns have complicated the conduct of monetary policy, but do not negate its independence per se. In any case, the trilemma provides a useful framework to discuss the historical evolution of emerging market policy regimes and the implications for frontier economies, which are still in the initial stages of international financial integration.

Even after the demise of Bretton Woods, exchange rate stability has remained important. Developing economies prefer to place bounds on exchange rate variability, including through various forms of capital account management measures. Exchange rate regimes have ranged from so-called managed floats, in which policymakers decide on an ad hoc basis when to intervene in markets, to fully fixed ones, in which policymakers commit to maintaining their country’s exchange rate at a given value against another currency or a basket of currencies. Freely floating exchange rates are a rarity among developing economies, which is sometimes referred to as a “fear of floating” (Calvo and Reinhart 2002). Figure 2.3 depicts the spectrum of exchange rate regimes based on both de jure and de facto classifications. It shows a pronounced shift away from relatively fixed exchange rate arrangements to intermediate regimes.

Figure 2.3Exchange Rate Arrangements in 2013

(Percent of IMF member countries)

Source: IMF, Annual Report on Exchange Arrangements and Exchange Restrictions (2013).

The fear of floating in emerging market economies results because a volatile currency is highly disruptive to local consumers, firms, financial intermediaries, and governments. In (small) open economies a large fraction of the consumption basket usually consists of imported goods, especially fuel and food, and hence movements in the exchange rate pass through quickly to domestic prices, affecting consumer purchasing power and welfare. Moreover, firms, financial intermediaries, and governments frequently face domestic borrowing constraints and have to rely on foreign-currency-denominated borrowing, which directly connects effective indebtedness to the exchange rate, as country examples discussed later in this chapter highlight.

The choice of an exchange rate regime hinges on economic structure (Fischer 2001). For countries with rigid labor and product markets, a more flexible exchange rate has the advantage of allowing for easier adjustment in the face of competition. On the other hand, small economies that rely heavily on trade, especially those that have one dominant trading partner, see significant benefits in pegging their exchange rate to the currency of a trading partner.

Even if a central bank set monetary policy independently of external influences, it may not be truly autonomous. In particular, many countries have experienced bouts of high inflation that had their roots in what is termed “fiscal dominance.” Fiscal dominance occurs when monetary policy is subjugated to fiscal policy since the “printing press” is required to meet budgetary needs in the face of a small tax base or collections (see the Fiscal Policies section). Using the exchange rate as a nominal anchor can be a useful disciplining device, but its viability depends ultimately on having supportive fiscal and structural policies. Calvo and Mishkin (2003) caution that exchange rate regimes cannot effectively substitute for institutional development. A regime choice can therefore at best be a signal of a government’s commitment to suitable policies and structural reform, and it is of particular relevance to frontier markets embarking on creating and improving institutions and policies.

External Imbalances, Learning to Float, and Building Buffers

Exchange rate regimes with hard pegs have often been successful at containing inflation, but without supporting policies they can lead to declining competitiveness and external imbalances.6 Even in successful disinflation episodes, it can take several years for a country’s inflation rate to converge to that of the country it is pegged to, and hence it may see a real exchange rate appreciation in the transition. Argentina’s experience with a currency board provides an example (Box 2.1).

Prior to the Asian crisis, most Asian emerging market economies had fixed exchange rates that closely shadowed the U.S. dollar. When the U.S. dollar appreciated against other currencies, such as the Japanese yen, the Asian emerging market currencies were towed along, eroding external competitiveness and widening already large current account deficits. One way to mitigate this link of a country’s competitiveness to another country’s exchange rate is by pegging to a basket of currencies that better reflects a country’s trade profile. But the use of a currency basket provides less clarity than a peg to a single currency.

The Asian financial crisis resulted from a combination of external imbalances from misaligned exchange rates and balance sheet mismatches (currency and maturity) brought about by increasing international financial integration. Higher Asian interest rates relative to the United States led to a large-scale carry trade, and for a while commitments to maintaining U.S. dollar pegs were not questioned. The financial and corporate sectors of Asian emerging market economies built up foreign-exchange-denominated external debts, usually of short maturity. When the capital flows reversed, international reserves proved inadequate, and debt burdens soared as currencies depreciated (IMF 1998; Eichengreen and Hausmann 1999; Frankel 2005). Currency depreciation to correct current account deficits and stem the loss of foreign exchange reserves became a double-edged sword because of balance sheet mismatches. Although prior to the Asian crisis the fiscal positions of Asian emerging market economies had generally seemed healthy, the bailouts of the private sectors created sizable fiscal burdens and contingent liabilities for the governments. This suggests that frontier markets should probably build up appropriate fiscal and foreign exchange reserve buffers to deal with economic and financial imbalances, the usual ups and downs of the business cycle, and unexpected adjustments that may be required due to the ongoing development and liberalization of the economy.

Box 2.1Argentina’s Currency Board

In 1991, Argentina’s congress passed a law mandating that the Argentine peso be convertible on a one-to-one basis against the U.S. dollar, and that the central bank’s sole monetary policy target be to maintain this peg by providing cover for the entire monetary base with U.S. dollar reserves. At the time Argentina implemented this currency board arrangement, it was a relatively closed economy, with exports and imports each constituting little over 10 percent of GDP. Hence, limiting the impact of exchange rate volatility on the real economy was not a key consideration in the choice for the exchange rate regime. Rather, the aim was to provide a credible anchor for monetary policy to curtail the hyperinflationary tendencies that had plagued the Argentine economy. And, in that respect, the currency board arrangement proved very successful: inflation that had been running at 2,314 percent in 1990 and 172 percent in 1991 fell to 25 percent in 1992 and reached single digits in 1994.

By 1995, Argentina’s inflation had converged with that of the United States. But unfortunately this achievement in price stability exacted a toll on the country’s external competitiveness, because along the convergence path, inflation in Argentina had remained considerably higher than that in the United States, and it experienced a sizable real exchange rate appreciation of about 25 percent. Consequently, Argentina’s export growth remained subdued, imports surged, and the current account deficit widened to over 4 percent of GDP.

Large capital inflows were required to finance the current account deficit. Foreign lenders were quite eager to provide funds based on Argentina’s perceived gains in monetary credibility, GDP growth powered by rising private consumption and investment, and persistently loose fiscal policy. The government and private sector borrowed at relatively low interest rates as foreign investors demanded only a small country risk premium. However, the external funding came in a form that has often proved to be a prelude to vulnerabilities in the developing world—namely foreign-exchange-denominated debt. Since the currency board implied that pesos and dollars were virtually identical, and currency mismatches no longer seemed to matter, both borrowers and lenders perceived little risk in the issuance of dollar-denominated loans (IMF 2003a). Argentina’s external debt grew rapidly and, compared with its meager export base, reached 530 percent of exports by 1999, placing a severe strain on the country’s repayment capacity.

Restoring Argentina’s external competitiveness proved elusive throughout the 1990s. Since the nominal exchange rate had been irrevocably fixed, the only route to improving competitiveness was through lower inflation. But the labor market was relatively rigid, and in spite of a rise in unemployment after the adoption of the currency board, wage increases did not moderate or decline to facilitate the adjustment process. Toward the end of the 1990s Argentina did begin to experience deflation of consumer prices, but by then the debt buildup had reached problematic levels, and the deflation put further strain on public finances by raising the real value of the debt. When, in addition, the country risk premium began to rise, and markets started to question the operation of the currency board itself, the pressures became unbearable and eventually led to the crisis of 2001, during which Argentina abandoned the currency board and defaulted on its public debt.

After years of high inflation, the currency board arrangement and its extreme rigidity provided a credible monetary anchor for a period of time. But this characteristic also proved to be its key weakness, because the constraints on policies needed to support the rigid exchange rate regime were not respected. Once the currency board had been in place for some time, Argentina was essentially “locked in,” and the buildup of dollar-denominated liabilities meant that an abandonment of the currency board would almost certainly undermine public and private debt sustainability.

Sources: IMF (2003a, 2003b).

While most emerging market crises have been preceded by an erosion of external competitiveness, it is important to stress that not all current account deficits are problematic or indicative of vulnerabilities. If a developing economy is building up productive industries, or investing in human and physical infrastructure to make industries internationally competitive, then a current account deficit can indicate a healthy development phase that eventually boosts its ability to meet domestic demand, export goods and services, and attract foreign capital. If instead foreign capital is financing an unsustainable rise in domestic consumption, or excessive credit growth that is channeled into real estate or relatively unproductive investments, then the effects of a future capital flow reversal can be severe. While during the Bretton Woods era international financial flows generally mirrored the borrowing needs stemming from a country’s current account, in recent decades capital inflows have frequently been a cause of current account deficits by fueling rapid growth of domestic demand.

The experiences of the capital account crises of the 1990s and the new millennium have led many emerging market economies to abandon fully fixed exchange rates. This is not to say that these economies have moved to the other extreme of freely floating exchange rates. Rather, most have opted for so-called managed floats, in which the central bank intervenes if and when it deems necessary (Rogoff and others 2003). In most managed floats the official aim of foreign exchange intervention is to mitigate excessive exchange rate volatility. However, in practice, an additional aim for many emerging markets has been to maintain their exchange rates at relatively “competitive” levels as part of an export-led growth strategy. The success of such a strategy is highly dependent on domestic supply capabilities and on economic developments in the country’s main export markets. Emerging market economies that were successful in spurring export growth managed to significantly improve their current accounts at the start of the new millennium as compared with the 1990s. Recently, however, emerging market economies’ external positions have come under strain as the advanced economies have slowed substantially in the wake of the global financial crisis (Figure 2.4).

Figure 2.4Selected Emerging Markets: Current Account

(Percent of GDP)

Source: IMF, World Economic Outlook, October 2014.

Emerging market economies are likely to have more stable outcomes with a growth strategy that favors a better balance between domestic and external demand and a more diversified output mix (Kose and Prasad 2010). The emerging market crisis experience also highlights the need for policies that shield domestic economies from external shocks. As emerging market economies pursued deeper financial integration after the Asian crisis, they proactively built up international reserves as a buffer against sudden stops (Choi, Sharma, and Strömqvist 2007; Ahmad and Zlate 2013). However, a large stock of foreign reserves can involve sizable costs, since it is invested mostly in safe and liquid paper issued by advanced economies, which has yields that are much lower than the returns on domestic investments. Moreover, a relatively depreciated currency depresses the purchasing power of domestic players and constrains the demand for foreign investment goods.

Monetary Autonomy and Institution Building

In the absence of a fixed exchange rate peg as a nominal anchor, the adoption of an alternative target for monetary policy can enhance the transparency of central bank communication with markets and the public (Bernanke and others 1999). This gives it additional clout in defending its decisions in the face of pressure from the government, industrial lobbies, or other interest groups. Such a target can also provide an internal guideline for central bank policy analysis and formulation. Following the adoption of inflation targeting by a number of advanced economies, many emerging market economies have established inflation targets as the central anchor for their monetary policy (Figure 2.5), and several others are considering doing so in the near future (Reserve Bank of India 2014).

Figure 2.5Adoption of Inflation-Targeting Frameworks

Source: IMF staff.

Note: Countries in bold have since adopted the euro and are no longer inflation targeters. Countries adopting inflation targeting since 2007 include Albania, Armenia, Georgia, Guatemala, Moldova, Peru, Serbia, and Uruguay.

Recent research also suggests that monetary policy in emerging market economies has become increasingly less procyclical, with institutional quality, financial market development, better macroeconomic fundamentals, and the adoption of inflation-targeting frameworks important drivers of this change. Since procyclical macroeconomic policies in emerging market economies have been associated with higher output volatility, success in increasing the countercyclical orientation has led to lower output fluctuations over the cycle and hence large benefits, especially for the relatively poorer segments of emerging market economies.12

Macroprudential Policies

A challenge that inflation-targeting emerging market economies have in common with advanced economies is taking account of financial stability concerns in the setting of monetary policy. The run-up to the global financial crisis saw low consumer price inflation go hand in hand with excessive asset price growth. Policy rates during those years were too low from a financial stability perspective and encouraged the credit creation and leverage that eventually led to trouble (Borio and Zhu 2012). In the crisis aftermath, policymakers facing the zero lower bound of interest rates sought unconventional ways to stimulate economies. Rather than discarding inflation targeting altogether, however, a new consensus has begun to emerge in which inflation targeting is being revised to anchor expectations while economies deal with slow growth, weak banks, and highly indebted public sectors (Reichlin and Baldwin 2013).

Of particular importance in this respect has been the development of macroprudential frameworks aimed at targeting systemic risk.13 Macroprudential instruments that directly constrain credit growth, focus on specific markets, such as real estate, or limit certain types of capital flows can supplement the traditional policy toolkit and potentially make it easier to jointly achieve inflation and financial stability objectives. Developing economies, especially in Asia, hampered by nascent markets and murkier market transmission of policies, have not hesitated to use such direct measures in the past. Generally, the application of these tools had been somewhat ad hoc, but in the aftermath of the global financial crisis, emerging market economies too have formalized their macroprudential frameworks (Kawai and Prasad 2011; Lim and others 2011; Nier and others 2011). Frontier economies are also moving in the same direction, and some of them (such as Nigeria and Vietnam) have applied macroprudential remedies to contain financial risks.

As the policymaking institutions evolve, frontier economies would do well to start putting in place a structure for designing and implementing macroprudential policy and also widening the perimeter of regulation to encompass the entire financial system, including nonbank financial intermediation. The system of oversight should prevent systemic and sectoral threats from appearing, because once a meltdown starts it is hard to control, given complex interactions, the difficulties of managing expectations under pressure, and the problems of coordinating and implementing policy through multiple agencies.

Although central banks are likely to play a vital role, whether the mandate for conducting macroprudential policy is best placed on the central bank, the treasury, or an independent committee with representation from many agencies—and how the institutional and political structures interact to influence the implementation of policies—remain key questions that only experience will answer (Agur and Sharma 2014). The availability of timely data is a particularly important constraint for frontier markets. And both in terms of data availability and operational implementation, macroprudential policies rely on the capabilities of the banking supervisor. Hence, effective bank regulation and supervision will be an essential requirement for the success of macroprudential policies.

Financial Development and Global Integration

Over the past decade as emerging market economies integrated into the international financial system, they had to deal with larger volumes of capital inflows and outflows (Figure 2.6). In this context, two intricately linked issues arise: the nature and speed of financial sector development and the pace of external financial liberalization. Agricultural imagery may help: removing constraints on capital movements affects how much water flows onto an irrigated tract of land, while financial sector reform and development determine the structure of the irrigation system, including its storage and catchment abilities; a well-constructed irrigation system can deal with greater variability of water flow, but pouring large quantities of water into a poorly built system risks flooding. The structure of the economic system determines whether capital flows have positive or negative effects on growth and financial stability (Box 2.3).

Monetary autonomy has reinforced the need for institution building in emerging market economies. In that sense, the selection of an exchange rate regime is much more than a choice between fixed and floating rates; it is choosing a path for institutional development (Batini and others 2006). A monetary policy framework consists of many facets and its evolution depends on the interaction between a country’s economic and institutional progression. Central bank independence may not only require a new law, but also essentially a cultural transformation within the government. There are various ways that the government can exercise power over the central bank, many of which remain even after central bank independence has been legislated. For example, governments retain the power to appoint the central bank’s governor and, usually, also the rest of the executive board. In addition, government officials can influence central bankers in many tacit ways, for example through control over recapitalization if and when the central bank suffers losses.

The credibility of central banks has been critical to the evolution of effective monetary frameworks (Freedman and Ötker-Robe 2010). Central bank independence requires the creation of an institutional framework that reaches well beyond the doors of the central bank and continues to evolve as a track record is established. Only when it is perceived that the central bank can formulate appropriate monetary policies and hold its own against the Treasury if needed, does central bank independence become credible (Heenan, Peter, and Roger 2006). Essential prerequisites include the building of skills to collect and analyze data, formulate and implement policies in a well-informed way, and communicate effectively with markets and the public at large. Independent policies rely to an important extent on independent thought and foresight, and therefore human capital formation in the central bank is a crucial element in the design of credible monetary policies and their shielding from the political cycle.

Controlling Inflation

To control inflation, emerging market economies have embraced a variety of frameworks, most of which can be characterized as variations on explicit or implicit inflation-targeting frameworks of the earlier advanced economy adopters.7 And in implementing these frameworks, emerging market economies have had to deal with a number of challenges.8 First, to achieve the established inflation target, the central banks need tools that are able to influence inflation and a reasonably good understanding of how and to what extent these tools can affect domestic prices, the real economy, and the financial sector. Second, indirect monetary instruments such as open market operations require well-functioning and liquid financial markets and some form of collateral that is trusted, tradable, and in plentiful supply. While there has been some deepening of emerging financial markets, this is a recent phenomenon, and money and bond markets remain underdeveloped compared with those of the advanced economies. Since public debt is commonly the collateral underlying open market operations, limited trading in these instruments complicates the implementation of monetary operations. Treasury paper is often held to maturity by commercial banks, pension funds, and official agencies that are required to hold it either by law or through suasion. In some cases, the limited supply of public debt rather than its tradability has prevented its use as collateral.

The policy transmission channels and their effectiveness have been important considerations in the reform of monetary frameworks (Mohanty and Turner 2008). Understanding the impact of instruments on the real economy and the transmission mechanisms—interest rates, credit spreads, asset prices, and exchange rates—has been critical. For example, the U.S. Federal Reserve and the European Central Bank gauge the effectiveness of their monetary operations in normal times by monitoring changes in interbank rates as they transmit policy changes through the financial sector to the rest of the economy. But many emerging market economies have underdeveloped interbank markets and hence the transmission of policy-rate changes may be sluggish or impaired (Coulibaly 2012; Mishra and Montiel 2012). As a result, the impact of monetary operations is often measured through other means, such as the effect on bank deposit and loan rates. These tend to move much more slowly; besides, policy rates also depend on a multitude of other factors—regulations, bank competition, creditworthiness of clients—complicating the analysis of monetary transmission.

Implementing inflation-targeting frameworks in emerging market economies has been significantly more demanding compared to advanced economies and will be particularly difficult in frontier markets. First, determining the level of inflation commensurate with monetary and financial stability is more problematic for countries that are undergoing rapid structural transformations. This occasionally necessitates changes to the inflation target, which can lead to volatility in market expectations and could be detrimental to anchoring inflation expectations. Second, not only the level but also the type of inflation that the central bank chooses to target is an essential choice in the establishment of an inflation-targeting regime. Central banks are faced with a choice between targeting core or headline inflation (which excludes food and energy prices). Monetary policy tools tend to have a stronger linkage with core rather than headline inflation, as food and energy prices are largely determined on global markets. However, food and energy prices tend to constitute a sizable portion of the consumption basket in emerging market economies, and hence core inflation may have a looser connection to the cost of living for a significant proportion of the public. Box 2.2 discusses how the Republic of Korea grappled with the choice between targeting core and headline inflation and has alternated between different inflation measures.

Emerging market economies using a variety of inflation-targeting frameworks have faced a fundamental tension between pursuing a relatively pure inflationtargeting regime and managing the exchange rate.9 While monitoring exchange rate movements is an integral part of inflation targeting for a small, open economy, exchange rate management and large-scale foreign exchange intervention are generally considered inconsistent with a pure inflation-targeting regime (Svensson 2010). In practice, however, emerging market economies with relatively open capital accounts that have an inflation-targeting regime actively manage their exchange rates.10 In a sense, the extensive buildup of foreign exchange reserves by various inflation-targeting emerging market economies is itself suggestive of managed exchange rates.

Inflation targeting and active exchange rate management need not be at odds with each other.11 The use of the exchange rate instrument makes an inflationtargeting emerging market central bank more rather than less credible. When an emerging market’s exchange rate becomes too detached from underlying economic fundamentals, using the interest rate as the sole policy tool places a heavy burden on just one instrument and risks confusing the public. For instance, sharply reducing the policy interest rate in response to an excessive exchange rate appreciation risks pushing inflation above the target, but ignoring such an appreciation is not feasible either, given the central role of the exchange rate in emerging market economies. Given that both inflation and the exchange rate are, in practice, key targets for policymakers, both instruments—interest rate changes and exchange market intervention—have been used.

Box 2.2Inflation Targeting in the Republic of Korea

In 1998, in the wake of the Asian Crisis, the Republic of Korea became one of the first emerging markets to implement an inflation-targeting framework (see Figure 2.4). Although the revised Bank of Korea Act in April 1998 identified price stability as the primary objective of monetary policy, the Bank of Korea did not make the leap to “full-fledged” inflation targeting at once. Rather, it initially specified dual targets—that is, for both inflation and broad money (M3) growth. The reason for keeping the M3 target for a transition period from the earlier monetary targeting framework was to give markets and the public time to adjust to the new regime (Kim and Park 2006).

Initially, the Bank of Korea set an inflation target that was adjustable annually, rather than specifying a fixed medium-term inflation objective (Hoffmaister 1999). The idea of a constant target to facilitate the formation and anchoring of inflation expectations has been central to the inflation-targeting frameworks of advanced economies. However, the adjustability of the annual target provided the Bank of Korea with flexibility that was desirable in the aftermath of the Asian crisis. This flexibility was enhanced by a 1 percent band around the inflation target that provided policymakers with additional room to maneuver in a period of uncertainty. In 1998, the inflation target was set at 9 percent, and in the following year it was lowered to 3 percent. Korean policymakers were willing to sacrifice a bit of the clarity of a single, stable target to ensure a smooth transition to a new regime. The transition was completed by 2001, the monetary target was relinquished, and the authorities specified a medium-term inflation target accompanied by a narrow band.

In 2001, the Bank of Korea also switched from targeting headline inflation to aiming at core inflation, a decision it reversed in 2007. The change back to headline inflation was due to the difficulties of implementing a core inflation target, which, while more directly affected by domestic monetary policy than headline inflation, is harder to communicate to the public (Inoue, Toyoshima, and Hamori 2012).

Korea’s experience with inflation targeting is generally regarded as quite successful in that it has achieved low and stable inflation (Eichengreen 2004). The Bank of Korea has, however, faced challenges in trying to manage both inflation and financial stability. While Korean consumer prices have remained quite stable over the past decade, asset prices, and in particular real estate prices, have risen sharply. The Korean bank’s provision of credit, having exhausted the domestic deposit base, has increased its reliance on international wholesale funding markets, and the recourse to short-term, dollar-denominated borrowing has raised concern about currency and maturity mismatches (Ree, Yoon, and Park 2012).

It has been argued that since real estate prices are not included in consumer price indices, focusing only on headline inflation may bring with it the risk of ignoring budding financial imbalances (Reichlin and Baldwin 2013). But adjusting interest rate policy in response to real estate prices, credit growth metrics, or the composition of bank liabilities would be difficult to square with an inflation-targeting framework. The approach taken by the Korean authorities has been to formulate and implement macroprudential measures specifically aimed at preventing the buildup of risks to the financial system. These policies include a levy and a cap on the short-term foreign-denominated liabilities of banks. Bruno and Shin (2014) in analyzing the timing and implementation of such policies conclude that they have been quite successful at limiting the exposure of the Korean banking sector to global liquidity conditions.

Financial Liberalization

An overarching question in the context of financial liberalization is the extent to which financial integration promotes growth. In theory, financial integration enhances growth by augmenting domestic savings, lowering the cost of finance, better allocating risk, and facilitating the transfer of technology. However, empirically it has been difficult to establish a robust relationship between financial integration and growth (Bhagwati 1998; Ishii and others 2002; Edison, Levine, and Sløk 2002). This is particularly true in the short to medium term, although there tends to be some consensus on positive long-term effects (Fischer 1998; Summers 2000). Threshold effects matter, and the benefits of financial integration are positive only when economies have reached a minimum level of development—capital inflows may be more conducive to economic growth in countries that have good governance, the rule of law, and property rights. International financial integration can also generate “collateral benefits” by imposing discipline on macroeconomic policies, allocating resources better, and making domestic firms more efficient through increased competition (Dell’Ariccia and others 2008; Prasad and Rajan 2008; Kose and others 2009a, 2009b; Kose, Prasad, and Taylor 2011).

Figure 2.6Financial Integration: Total Stock of International Assets and Liabilities of Emerging Market Economies and Frontier Economies

Source: Lane and Milesi–Ferretti (2007 and updates).

Box 2.3Financial Globalization

Source: Kose and others (2009a).

Note: TFP = total factor productivity.

Financial globalization can also have drawbacks, since it increases a country’s exposure to external shocks and policy spillovers from the rest of the world. During the global financial crisis, large two-way movements of capital took place in countries that had more open and developed financial markets. Greater openness to trade and a higher degree of international financial integration were important determinants of the swings in economic activity and capital flows to emerging markets during the global financial crisis (Kose and Prasad 2010; Bunda, Lall, and Sharma 2011). More recently, emerging market economies with relatively large, liquid, and internationally integrated markets were more affected by the U.S. Federal Reserve’s “tapering talk” (Eichengreen and Gupta 2014).

Liberalizing too rapidly when the prerequisites are not yet in place risks heightened macroeconomic volatility (Kawai and Prasad 2011). Capital inflows tend to incubate bubbles, which when they burst impair financial stability—they cause asset prices to decline sharply, private credit growth to slow, risk premiums to rise considerably, and exchange rates to depreciate. While in principle access to international capital markets should allow countries to better insure themselves against shocks, experience suggests that premature liberalization may lead to vulnerabilities, especially if currency and maturity mismatches are widespread, risk management is deficient, and financial regulation and supervision are inadequate.

Caution in Liberalizing Capital Flows

The prevailing wisdom on capital flow liberalization calls for a gradual, pragmatic, and cautious approach. There is no longer a presumption that full liberalization is an appropriate goal for all countries.14 Rather, the appropriate degree of liberalization for a country depends on its specific circumstances and on the level of financial development. IMF (2012b) puts forward some basic principles to guide liberalization (see Box 2.4).

A phased process is preferred whereby capital flows that are considered relatively safe and stable are liberalized first. This sequence is often loosely summarized as “long term before short term, non-debt creating (foreign direct investment and equity) before debt, and inflows before outflows.” Foreign direct investment (FDI) tends to be much more stable than other types of capital flows, which was underscored by its relative stability during the global financial crisis. Such flows, depending on local conditions, can lead to higher total factor productivity through knowledge spillover, transfers of technology and new management techniques, and linkages with domestic firms.15 The Chinese experience stands out in this respect: joint-venture FDI has often been cited as one of the main sources of successful technology adoption by Chinese companies. However, in recent years the Chinese experience with FDI suggests a note of caution, because a sizable share of it went to the real estate sector, where the potential for technology transfer is small and the likelihood of a bubble is large (Liu 2011).

Box 2.4The Integrated Approach to Capital Flow Liberalization

  • Lifting controls on international capital flows (and financial liberalization more generally) is best undertaken against a backdrop of sound and sustainable macroeconomic policies.

  • Financial sector reforms that support and reinforce macroeconomic stabilization should be given priority.

  • Financial sector reforms that are operationally linked and mutually reinforcing should be implemented together.

  • Prudential regulation and supervision and financial restructuring policies should be implemented to complement other financial reforms aimed at enhancing competitive efficiency and market development.

  • The liberalization of capital flows by instruments or sectors should be sequenced to take into account the concomitant risks.

  • The pace of reforms should take into account the conditions relating to the financial structure of nonfinancial corporations and other entities (for example, debt-equity ratios and foreign currency exposure) and their effects on the quality of the loan portfolios and capital base of financial institutions.

  • Reforms that require substantial lead time for technical preparations and capacity building should be started early.

  • Reforms need to take account of the effectiveness of existing capital controls.

  • The pace, timing, and sequencing of liberalization need to take account of political and regional considerations.

  • The operational and institutional arrangements for policy transparency and data disclosure—including monetary and financial policy transparency—need to be adapted to support capital account opening.

Source: IMF (2012b).

The IMF’s integrated approach identifies three stages for capital flow deregulation (Figure 2.7). During the first, FDI inflows are liberalized while the groundwork is laid for further opening by introducing international accounting standards, improving national statistics, and strengthening the monetary and financial frameworks. The second stage allows for FDI outflows and long-term portfolio flows. Some short-term flows can also be approved at this stage. The last stage eliminates all remaining controls after financial markets are reasonably developed, there is confidence in the management of risks by institutions and market players, and suitable supervision and prudential regulations are in place. Each phase requires a broad set of supporting legal, accounting, financial, and corporate frameworks. For example, India’s comparatively strict regulation of short-term debt flows and a preference for flows that do not create debt has reflected financial stability concerns (Mohanty and Turner 2010). South Africa removed controls on inflows before outflows and gradually lifted restrictions on investments by residents to safeguard reserves and banking stability. Korea is another example of largely successful capital account liberalization over the past few decades (Box 2.5).

Figure 2.7Stages of Capital Flow Liberalization

Source: IMF (2012b).

Note: FDI = foreign direct investment.

In analyzing the recent history of capital flows to emerging market economies and discussing the policy issues raised, Montiel (2013) concludes that a country’s resilience in dealing with capital flows depends on a number of factors: (1) the single most important component of resilience is a safe fiscal margin of solvency, underpinned by well-functioning and sound fiscal institutions, government borrowing that is largely long term and in domestic currency, and strong automatic fiscal stabilizers; (2) a well-functioning and regulated financial system that can properly intermediate the capital flows while keeping financial risks in check; (3) a competent central bank that understands the policy transmission mechanisms and can flexibly implement monetary policy free from fiscal dominance and reputational concerns; (4) an exchange rate regime that allows for sufficient exchange rate flexibility to serve as a stabilizing mechanism in the short run and is supported by a large stock of foreign exchange reserves; (5) an institutional and policy environment (including capital account restrictions) that facilitates and encourages relatively stable and safer capital flows, such as FDI and equity flows over short-term debt flows.

Financial Sector Development and Reforms

Economic growth and financial sector development go hand in hand, and they also help forge a more robust integration with the world economy. The level of financial development can also influence a country’s choice of macroeconomic policy regime (such as exchange rate and monetary frameworks) and the efficacy of policy implementation. Countries with deeper markets are more likely to have flexible exchange rates and use indirect instruments of monetary policy and more effective countercyclical fiscal policies (although the causation can run both ways). And even after controlling for financial crises, exchange rate flexibility in the presence of reasonably developed financial markets and a well-regulated banking system is often associated with lower aggregate macroeconomic volatility (IMF 2013a).

Box 2.5Case Study: Financial Liberalization in Korea

Over the past two decades or so, the Korean authorities have significantly and successfully liberalized capital flows. Important lessons, however, were learned from the early stages of capital account liberalization, when external sector vulnerabilities built up and led to a financial crisis in 1997–98. During 1988–96, a range of reforms were implemented to develop financial markets, and this was accompanied by a loosening of capital account restrictions. Capital flows financed an investment boom, and short-term external debt rose from $40 billion in 1993 to about $100 billion at the end of September 1997. The sharp decline in reserve coverage due to the growth of short-term debt contributed to the liquidity crisis in 1997–98. In the aftermath of the Asian financial crisis, Korean policymakers followed the “integrated approach” to capital account liberalization in several respects, with specific attention to financial market regulation, adequate safeguards, and corporate governance.

Since the early 1990s, Korea has gradually eliminated capital controls with the objective of achieving a degree of openness associated with Organisation for Economic Co-operation and Development countries.

  • Liberalization proceeded generally against a backdrop of broadly sound, sustainable, and consistent macroeconomic policies anchored around prudent fiscal policies, a flexible exchange rate regime, and monetary policy under inflation targeting.

  • Financial sector reforms were given priority with the development of a local currency bond market and a framework for securitization.

  • Financial sector development was reinforced by enhancing the transparency of the foreign exchange market through strengthening disclosure requirements and accounting standards.

  • Financial sector regulation was strengthened in preparation for, and during, capital flow liberalization. For example, the authorities put in place strict liquidity requirements in the context of implementing Basel II rules.

  • Less risky flows were liberalized before more risky ones. For example, restrictions on longer-term flows such as foreign direct investment (except for certain sectors) were removed first along with those on certain portfolio investments.

The gradual transition to a more open financial system by and large served Korea well, despite occasional surges in capital inflows and outflows. Despite the cautious approach, the banking system accumulated substantial forward foreign exchange positions and short-term external debt in the wholesale funding market and became highly leveraged. During the global financial crisis, Korea experienced a “sudden stop” as access to short-term external financing dried up abruptly and banks had difficulty rolling over their debt. The Korean authorities subsequently introduced measures (including macroprudential regulations) to prevent a renewed buildup of financial sector vulnerabilities and limit the associated potential for macroeconomic volatility. A key lesson from the Korean financial liberalization experience is that regulation and supervision of the banking system and of capital and derivatives markets must be continuously recalibrated to keep up with liberalization and the introduction of new financial instruments.

Source: IMF (2012d).

Recent experience of emerging market economies suggests that the development of frontier economies will need to be managed carefully because information and regulatory gaps will undoubtedly emerge. Simpler financial instruments will need to be introduced first, and reform may require parallel changes in interrelated markets and policies to foster development of the system as a whole.16 Institutional mechanisms will have to be created to lower and contain the frictions associated with information, monitoring, and enforcement costs. In the initial stages, governments will have to put in place the basic infrastructure (such as payment and settlement systems, trading platforms, and custodians for securities) to support financial markets, strengthen the rules that foster development, and rewrite or remove those that hinder it. Policies will have to evolve with technological progress and the changing needs of growing economies, with the objective of creating a competitive system that allows for innovation but is properly regulated and supervised.

There should be sufficient recognition of the inherent market failures associated with financial markets and the identification of specific frictions to alleviate in different economies. The management and control of risks will have to rely on a diversity of instruments that complement each other, rather than on a single instrument. The regulatory strategy should have two prongs: alter incentives so that private and social returns are better aligned and, when necessary, impose direct constraints that limit inappropriate risk taking by managers and owners of financial institutions (Stiglitz 2001). For example, despite the “risk adjustments” in capital adequacy calculations, sometimes ceilings on bank deposit rates may be required to prevent banks from taking on additional risk while touting the safety provided by deposit insurance or other government guarantees. It is important to recognize that supervising risk-management systems is difficult even in developed economies, let alone in emerging market and frontier economies. Traditional constraints on banks, such as rules on capital and loan-loss reserves, may be difficult to monitor and enforce, especially if the financial system is in transition and regulatory institutions are weak. Hence, regulators in frontier economies may have to rely on direct constraints on collateral requirements and valuation, restrictions on loan categories (such as residential and commercial real estate loans), interest rates, and even entry into markets (such as eligibility rules for owning and running banks and capital market intermediaries).

An important lesson of the Asian crisis was that liberalizing the financial sector before an appropriate regulatory system is in place is a recipe for trouble. Regulatory agencies will have to be given the legal authority and independence to do their job while being held accountable for outcomes. However, during transition and development, frontier economies will have to live with the fact that it takes time to build regulatory institutions and capacity and strengthen financial sector oversight. They will have to face the scarcity of human capital and trained personnel in both the private and public sectors. Managers of financial institutions may not be well versed in comprehending and managing the risks of new financial instruments or even those of traditional instruments in more liberal and competitive markets. Regulatory cadres are difficult to cultivate when access to good schooling is limited and universities do not provide the quality of education needed to function in the new domestic and international environments. With limits on remuneration in the public sector, official agencies also have to contend with competing with the private sector for scarce talent.

Recent crises also highlight the importance of maintaining public confidence in the banking system. After the Asian crisis, most countries in the region adopted explicit deposit insurance schemes to provide a basic level of protection for small depositors (Lindgren and others 1999). And better resolution regimes for dealing with bank failures supplemented the lender-of-last-resort function of central banks. Frontier economies will have to manage the incentives created for banks’ risk taking with appropriate oversight and constraints and appropriate pricing of government guarantees.17 With financial markets still at a nascent stage, cross-border flows will be channeled through global and regional banks, and experience suggests that such flows are likely to be highly procyclical. To assess threats to financial stability, focusing on net flows is not enough, and it is important that frontier economies build systems to keep track of gross cross-border flows and gross external assets and liabilities.18

In the past decade, Asian emerging market economies have focused considerable attention on developing domestic debt markets, and more generally diversifying the financial system, to reduce foreign exchange mismatches in their financial systems and to decrease the concentration of risks in banks. Domestic debt markets are seen as providing funds for government and private sector needs and large infrastructure requirements and as another important channel for financial intermediation should the banks get into a mess. For now, the equity culture coupled with the comfortable liquidity positions of banks and corporations are hurdles for the expansion of local bond markets. However, in some countries (such as China and India), economic growth has begun to catalyze a shift toward broader capital market development as the demand for corporate and household credit rises.

Despite the expansion of local debt markets, progress needs to be made on several fronts (Goswami and Sharma 2011). These include improvements in market access and infrastructure, transparency, risk assessment and management by financial institutions, the legal and regulatory framework, and market liquidity. The major barriers to debt market development include the following:

  • Bank dominance

  • Lack of critical size in issuance

  • Lack of a diverse investor base and preponderance of buy-and-hold investors

  • An embryonic legal and regulatory framework for nonbank financial institutions

  • Tax and capital controls on foreign investors

  • Weak corporate governance

  • Inadequate information provision, including pricing transparency, and infrastructure issues

  • High issuance and transaction costs

  • Lack of pricing benchmarks and hedging instruments

  • Lack of a robust framework for asset-backed securitization

Bank dependence can be reduced in emerging market and frontier economies by improving confidence in the regulatory, supervisory, and enforcement frameworks for capital markets and nonbank financial institutions. For capital markets to function effectively, sufficient information to assess credit risks adequately is critical. Credible rating systems, appropriate reporting requirements, and adoption of international accounting standards are helping to foster market discipline. Emerging market economies are rationalizing and consolidating the supervision of nonbank financial institutions to increase effectiveness and reduce the scope for regulatory arbitrage. In 2009, for example, Korea implemented a new framework for the financial investment industry (Financial Investment Services and Capital Market Act) that consolidates the oversight of all capital-market-related institutions. The new framework adopts a functional approach to regulation in which financial functions are similarly regulated irrespective of the institution in which they are performed.

Given the part played by shadow banking in the global financial crisis—facilitating credit provision, leverage, and financial layering in the system—the Financial Stability Board is encouraging country authorities to define and assess the role of nonbank financial intermediaries in their financial systems (Financial Stability Board 2011, 2012, 2013). Countries are being asked to improve the granularity and quality of information available on the balance sheets, operations, and risk management processes of nonbank financial intermediaries, with a view to understanding the functions they are performing and their links to banks and money and capital markets. The objective is to prevent regulatory arbitrage and examine to what extent nonbank financial intermediaries could contribute to the production and propagation of systemic risks. In recent years, the rapid expansion of the shadow banking sector in China has raised concern about financial stability, due to the variable quality of nonbank financial intermediaries’ loans, and their packaging into wealth-management products offered by banks and trusts to institutional and retail customers.

Asset-backed securitization in Asian emerging market economies is eventually likely to be driven by the desire to enhance liquidity in the banking system as disin-termediation gathers pace, and to meet the funding needs of the real economy rather than balance sheet arbitrage (Lejot, Arner, and Schou-Zibell 2008). Illiquid assets like mortgage and consumer loans could be securitized as capital markets develop and securitization frameworks, including for covered bonds, are established. This should increase the size of private bond markets and provide institutional investors with a more diverse set of instruments as assets are created from infrastructure investments, commercial real estate, housing, and household borrowing.

A well-diversified domestic and foreign institutional investor base (pension, insurance, mutual funds) is required to support capital market development by increasing the demand for long-term financial assets. A broad base of domestic investors, besides increasing the liquidity and depth of local bond markets, may increase an economy’s ability to handle capital flows triggered by external events. Banks holding large portfolios of government bonds are exposed to interest rate volatility and sovereign risk, and longer-term infrastructure lending aggravates maturity mismatches. To maintain their franchise value, greater diversification of revenue sources for banks is required, coupled with more prudent credit risk assessments.

Financial depth and inclusion are related but distinct dimensions of financial development, and financial systems can become deep without delivering access for all (Demirgüç-Kunt and Klapper 2013). While financial sectors in emerging market and frontier economies have expanded over the past few decades, low-income households and small firms continue to find it difficult to access financial services. Lack of access to finance is a major impediment in many parts of Asia, where more than half the population and a significant proportion of small and medium-sized enterprises have no connection to the formal financial system (Balakrishnan, Steinberg, and Syed 2013). Financial development that broadens access to finance can benefit the poor disproportionately because market imperfections—asymmetric information and the costs associated with transactions and contract enforcement—hit poor and small-scale entrepreneurs hardest as they typically lack collateral, credit histories, and connections. Through recourse to financial services, individuals can build their assets, invest in human capital, and improve their standard of living (Allen and others 2013).

Fiscal Policies

The concept of sustainability is central to any framework for designing and implementing fiscal policy. High and unsustainable debt levels tend to dampen economic growth by raising interest rates and crowding out private sector investments. Sustainability implies that the government can continue to service its debt without an expectation that a large correction will be necessary to balance revenues and expenditures in the future. In emerging market economies, the fiscal challenges are defined by a small tax base, a tax administration system that is unable to fully collect taxes and other levies, and a greater vulnerability to external shocks, especially for governments with sizable foreign-currency-denominated debt. High public debt and persistent deficits also accentuate the links between fiscal and monetary policy, leading to fiscal dominance that undermines the credibility of monetary policy.

Fiscal policy in frontier economies should be supportive of growth, employment, and equity.19 Historical experience suggests that without robust economic growth it is difficult to provide public goods while keeping debt ratios down. With steady growth, productive investments in education, infrastructure, health care, legal and judicial services, and regulatory systems can be made without imposing onerous burdens on firms and households. In addition, equity considerations require the government to have an efficient and effective social safety net that targets the benefits to low-income households.

The Role of Fiscal Institutions

The purpose of fiscal institutions is to establish incentives and constraints that induce policymakers to promote long-term solvency and create fiscal space for short-term stabilization needs. In the fiscal domain (revenue collection, government spending, debt management), developing economies (and some postcrisis developed economies) have been striving to create well-functioning fiscal institutions that mitigate discretionary spending biases arising from the “common pool problem” as competing groups vie for government expenditures financed through broad-based tax revenues. Because benefits are concentrated—whereas costs are widely dispersed—this tends to lead to overspending.

Such biases can also result from conflict between the long- and short-term objectives of fiscal policy. The long-term objective is to maintain socially useful expenditure programs in a manner consistent with debt sustainability. In the short run, however, governments often aim to stabilize output while simultaneously facing pressures arising from electoral cycles. An excessive focus on short-term considerations can result in procyclical spending patterns as well as structural budget deficits over time. If the degree of fiscal discretion in the budget process is the main problem, then discretion can be constrained by fiscal rules or alternatively delegated to independent fiscal agencies.20

Box 2.6Chile’s Fiscal Rules

An important macro-fiscal challenge for some frontier economies is the effective management of natural resource revenues over commodity cycles. Chile offers an interesting example of a resource-rich economy (as the world’s prime producer and exporter of copper) that has prudently managed its natural resource revenues while achieving a reasonable degree of economic diversification. During 1986–98, Chile had GDP growth rates averaging 7.3 percent, similar to those of the so-called Asian tigers. While harnessing its copper wealth judiciously, Chile managed to diversify its economy and develop industries that reduced its reliance on copper, with the share of mining declining from about 90 percent of Chilean exports in the early 1970s to about 40 percent by 2001.

The central pillar of macroeconomic policy prudence in Chile has been the successful implementation of fiscal rules to manage copper revenues through the business cycle. Since the mid-1980s, successive governments have maintained a cyclically adjusted budget surplus. This was first implemented through an implicit fiscal rule, and, beginning in 2001, with an explicit fiscal surplus target (structural revenues minus expenditures) of 1 percent of GDP. Two panels of independent economic experts are asked to produce projections from which the potential output and the copper reference price are calculated by simple averaging (excluding outliers). In May 2007, when central government debt had declined to only 4 percent from 45 percent in 1990, the surplus target was lowered to 0.5 percent, releasing funds for increased spending on education.

In 2006, the Fiscal Responsibility Law further strengthened the fiscal structure. The budget surplus target was authorized by law and the surplus earnings apportioned to the Economic and Social Stabilization Fund, the Pensions Reserve Fund, and the Contingency Unemployment Program. The two funds, managed by the central bank on behalf of the government, make both domestic and foreign investments, and the authorities are fully aware of the virtues of automatic sterilization if the funds are invested abroad.

Source: Havro and Santiso (2008).

Given that some frontier economies are commodity dependent, managing commodity price volatility is an important challenge for fiscal policy. Chile appears to be at one end of a spectrum of countries that have successfully avoided procyclical policies, whereas Argentina and Venezuela are at the other end, with fiscal policies accentuating business and commodity cycles. To avoid overspending during booms and periods of buoyant commodity prices, Chile has implemented a fiscal rule that targets a constant structural balance after adjusting for commodity price volatility and cyclical fluctuations in GDP (see Box 2.6).

Fiscal rules cannot substitute for political will, but they have gained prominence as tools to correct or limit distortions stemming from political shortsightedness and the common-pool problem. Fiscal rules have spread worldwide and have been increasingly adopted by emerging market economies. A recent IMF survey showed that 76 countries, many of which are emerging market economies, had fiscal rules, up from 5 in 1990 (Schaechter and others 2012).21 For example, the Fiscal Responsibility Law introduced in Brazil in 2000 established policy rules consisting of limits and targets for selected fiscal indicators for all levels of government, including debt ceilings and transparency requirements.

One lesson from the global financial crisis is that fiscal rules should be made more binding in good economic times, while allowing room to maneuver when the economy is weak. Such rules tend to explicitly combine the sustainability objective with more flexibility to accommodate economic shocks by targeting structural balances and accounting for the cycle. National rules that provide some flexibility, either by accounting for the cycle (such as in Australia or Switzerland) or by including explicit escape clauses (Brazil), generally fared better. Empirical studies suggest that fiscal rules have played a supportive role in several cases of large fiscal adjustments (Debrun and others 2008). But rules may often come with weak political commitment, and quite often countries may not have the prerequisites to implement them, which can undermine credibility. Simple fiscal rules that rely on nominal variables are often procyclical and lack the flexibility to accommodate major shocks, which makes it more difficult to enforce them. Rules may also encourage creative accounting, including the setting up of off-budget entities (Irwin 2012).

Enforcement mechanisms and other arrangements supporting the implementation of fiscal rules are not easy to put in place. Fiscal councils can be important tools to enforce fiscal rules. They are publicly funded independent bodies with a mandate from elected officials to provide nonpartisan oversight, analysis, or advice on fiscal policy and performance. The apparent success of central bank independence has raised the idea of delegating some aspects of fiscal policy to independent fiscal agencies. No country has as yet established a truly independent fiscal authority. However, some countries (such as Chile, Korea, the United Kingdom, and the United States) have established fiscal councils that, while leaving decision-making authority in the hands of the government, provide independent budget projections, as well as assessments of policy consistency with long-term objectives and proposals for adjustment, if required. The National Assembly Budget Office in Korea examines all aspects of fiscal policy of interest to the Parliament and reviews fiscal plans, prepares alternative macro-fiscal projections, and appraises major projects (Cangiano, Curristine, and Lazare 2013). That said, the success of a fiscal council depends on a reputation for political neutrality. Political interference, or a perception of it, can quickly undermine its credibility and usefulness.

Fiscal Risks

Underestimation of fiscal risks from macroeconomic shocks and contingent liabilities continue to be an important policy issue (IMF 2013d). The experience of Ireland and Spain recently made it clear that the materialization of contingent liabilities can add significantly to public debt and quickly raise questions about sustainability. The recapitalization of banking systems, in particular, has proved costly, and government guarantees on private sector projects are a further source of risk. Indonesia’s bank recapitalization in response to the Asian crisis of 1997–98 proved very costly. Total net cost was about 52 percent of GDP, with recoveries from asset sales and workouts totaling less than 5 percent of GDP. In contrast, for Malaysia, where banking supervision was tighter and which experienced smaller exchange rate depreciation during 1998–99, the cost of back-stopping the banking system was much lower at about 5 percent of GDP (Greene 2012).

Assessing the size and likelihood of bearing contingent liabilities is therefore an important step in improving fiscal transparency. This contributes to a better understanding of an underlying fiscal position and related risks. The decade before the global financial crisis saw a concerted effort to develop a set of internationally accepted standards for fiscal transparency. The comprehensiveness, quality, and timeliness of public financial reporting in countries across the income scale also steadily improved. Despite precrisis advances, shortcomings in fiscal disclosure resulted in an inadequate understanding of underlying fiscal positions and fiscal risks. Several countries experienced large unexpected increases in deficits and debt as a result.

Fiscal risks from shortcomings in fiscal disclosure are mainly due to the narrow scope of fiscal reporting or weak compliance with fiscal transparency standards. Most countries report fiscal variables for the general government. However, this excludes a range of entities outside the general government perimeter whose activities can have fiscal implications. Lack of timely and accurate in-year fiscal data can lead to substantial revisions of initial estimates for general government debt and deficits, and large revisions can render a fiscal adjustment plan out of date shortly after approval.

The IMF’s Fiscal Transparency Code, Manual, and Assessment have been updated to reflect the lessons from the crisis. The following reforms are going to be critical: (1) broadening the institutional coverage of fiscal reports, (2) providing balance sheet information, (3) increasing the frequency of fiscal reporting, (4) requiring greater disclosure and management of contingent liabilities, and (5) increasing the consistency between forecast, in-year, and year-end fiscal data.

There is some evidence that the disclosure of fiscal risks can strengthen confidence, lead to better sovereign bond ratings, and facilitate greater access to international capital markets (Cebotari and others 2009). The Fiscal Policy Office within the Indonesian Ministry of Finance prepares a fiscal risk statement that is included in the annual budget documents—making Indonesia one of the pioneers in fiscal risk analysis among emerging market economies (IMF 2010). The fiscal risk statement covers (1) sensitivity analysis of the state budget and the budgetary impact of state-owned enterprises to variations in key macroeconomic assumptions; (2) public debt risk of the central government; (3) contingent liabilities of the central government related to infrastructure development projects, civil service pensions, the financial sector, legal claims on the government, membership in international financial organizations and agencies, and natural disasters; (4) risks related to fiscal decentralization; and (5) other risks.

Public Debt

Potential risks associated with high public debt have long been a concern of emerging market policymakers, as these can force painful adjustments that hamper economic performance. The rise in emerging market public debt can be attributed to a number of features in their fiscal and public debt structures that have important implications for debt sustainability. First, revenue ratios in emerging markets are low, because effective tax rates are generally much lower than in advanced economies. This low effective tax rate is the result of inefficient tax systems, significant tax exemptions, and a large informal sector. For example, in Asian emerging market economies and low-income countries, the average ratio of revenues to GDP in 2011 was 19 percent, compared with 30 percent in Latin America and 37 percent in emerging Europe and Commonwealth of Independent States countries (Figure 2.8). Second, revenues in emerging market economies tend to be volatile, partly due to the greater underlying volatility of the economy, income, consumption, and the terms of trade. Third, interest costs account for a high proportion of government expenditure in emerging market economies and are more variable because a large proportion of debt is denominated in foreign currency while revenues are in domestic currency with high exchange rate volatility. For small, open emerging market economies, this can result in large spikes in interest (and principal) payments relative to government income when the domestic currency depreciates. Furthermore, domestic debt often has shorter maturity, making the interest costs more sensitive to changes in domestic credit conditions.

Figure 2.8General Government Revenue and GDP per Capita, 2011

Source: IMF (2013a).

Note: AUS = Australia; KHM = Cambodia; CHN = China; HKG = Hong Kong SAR; IND = India; IDN = Indonesia; JPN = Japan; KOR = Korea; LAO = LAO P.D.R.; MYS = Malaysia; NPL = Nepal; NZL = New Zealand; PHL = the Philippines; SGP = Singapore; TWN = Taiwan Province of China; THA = Thailand; VNM = Vietnam. EME/CIS = Emerging Europe and Commonwealth of Independent States.

Public debt in emerging market economies has risen quite sharply since the mid-1990s, and averaged about 70 percent of GDP in 2002. It was concentrated in Latin America and emerging Asia, with the latter seeing a notable rise due to the impact of the Asian crisis—debt-to-GDP ratios rose significantly within a year or so of a crisis (by about 20 percent of GDP in Mexico and Thailand and about 15 percent in the Republic of Korea—Hemming, Kell, and Schimmelpfennig 2003). Interest and exchange rate movements combined with the realization of off-balance-sheet and contingent liabilities drove the rise in emerging market public debt. In a number of countries (Indonesia, Korea, Thailand), the cost of recapitalizing banking systems was particularly high (IMF 2003b).

Emerging market economies with high public debt have a mixed track record on sovereign debt default. The countries that have defaulted do have, on average, a higher ratio of public debt to GDP, but they also have a higher proportion of external debt in total public debt and a lower ratio of broad money to GDP than countries that did not default. Indeed, in a number of cases overvalued exchange rates held down the debt ratios prior to a crisis, given the share of foreign-currency-denominated public debt. Most of the cases of sovereign debt default occurred during the 1980s and early 1990s, when several of these economies had experienced a significant loss of international competitiveness but did not necessarily have high public debt levels. In contrast, emerging market economies, such as India, have managed to maintain relatively high public debt for a long period without a default.

Arriving at an optimal composition of the public debt, depends on a country’s circumstances, but generally involves a trade-off between maintaining a government’s anti-inflationary credibility and decreasing the vulnerability of the budget to macroeconomic and financial shocks. Sovereigns that have anti-inflationary credibility favor long-term nominal securities, while those that do not may have to settle for indexed debt of varying maturities. Further, to retain market access for a spectrum of needs and catalyze domestic financial market development governments should try to fund themselves with a wide variety of securities (Montiel 2005).

Fiscal Reforms

A sustainable debt level implies that the government’s intertemporal budget constraint is satisfied without an expectation that an unrealistically large future correction in the primary balance will be necessary (IMF 2002). Solvency must therefore be viewed in relation to a fiscal (adjustment) path that is both economically and politically feasible. In addition, liquidity conditions are also important—that is, even if a government satisfies its present-value budget constraint, it may not have sufficient assets and financing available to meet its maturing liabilities.

  • Tax reforms and expenditure control: Reforms to strengthen and broaden the tax base are needed so that governments have access to higher and less variable revenues. Better control of expenditures during economic upswings is also essential to ensure that periods of strong revenue growth result in higher primary surpluses rather than increased spending.22 Since the early 1990s, developing economies (Mozambique, Peru, Rwanda, Tanzania, and Vietnam, for instance) have implemented wide-ranging tax administration reforms (IMF 2011). In Indonesia, tax administration reform was important for fiscal adjustment, and about half the tax revenue increase of 1.1 percent of GDP over the reform period 2002–06. Effective tax rates in emerging markets are still generally low, suggesting that tax avoidance—through either legal or illegal means—and weak tax administration are serious issues that need to be addressed. For example, the value-added tax (VAT) gap, defined as VAT revenue with full compliance minus actual VAT collection has been estimated at 51 percent in Indonesia compared with 13 percent in the United Kingdom (Brondolo and others 2008). The continued reliance on taxes and transfers related to commodity exports is a weakness of many current tax systems, and efforts are needed to broaden the tax base to reduce its variability.

  • Structural and expenditure reforms to boost growth: Historical experience suggests that it is difficult to bring public debt ratios down without robust economic growth. And appropriately formulated revenue and expenditure policies can deliver growth-enhancing public services while minimizing growth-retarding distortions in the economy. For example, expenditures on education, research and development, and productive investment have shown the greatest potential growth dividends. Energy subsidy reform and better targeting of social benefits can free up resources to finance the required spending. Reforming fuel subsidies has been a persistent policy challenge in many emerging market economies, including Indonesia and Malaysia (Figure 2.9). The IMF, in “Energy Subsidy Reform: Lessons and Implications” distills six key ingredients of a successful energy subsidy reform from country case studies: (1) The plan should be comprehensive. (2) Reform should be accompanied by a far-reaching communications strategy, aided by improvements in transparency. (3) Energy price increases can be appropriately phased and sequenced differently across energy products. (4) producer subsidies can be reduced by improving the efficiency of state-owned enterprises. (5) The poor should be protected by targeted mitigating measures. (6) Energy pricing should be depoliticized to prevent the recurrence of subsidies. An important lesson learned is that the targeting of cash transfers and effectively communicating the objectives and planned mitigating measures to the public can promote the acceptance of reforms (IMF 2013b, 2013c). Recently, governments in Argentina, Brazil, Chile, and Mexico made an effort to better focus public transfers. To improve outcomes, cash transfers for facilitating the development of human capital among the poor were made conditional on school attendance and vaccinations (Tanzi 2011).

  • Reducing exposure to exchange rate and interest rate movements: emerging market economies used to be highly exposed to interest rate and foreign exchange rate risk, because much of the foreign borrowing came in the form of short-term foreign-denominated debt. The growth of local currency debt markets over the past decade has lessened these currency mismatches and has also raised the duration of the public debt. However, some emerging market economies (Argentina, Turkey) still have high short-term external debt in comparison with their international reserves. Further development of local currency bond markets, possibly in conjunction with macroprudential measures to discourage excessive reliance on short-term external debt, can help extend the gains of the past decade.

  • Acknowledging contingent liabilities: Recent crises have shown that the realization of contingent liabilities can significantly add to public debt and quickly raise questions about sustainability. Indonesia’s bank recapitalization in response to the Asian crisis of 1997–98 was very expensive for the public exchequer. More recently, the recapitalization of banking systems in some euro area countries has proved to be costly, and government guarantees on private sector projects have been a further source of risk. Assessing the size and likelihood of bearing contingent liabilities is therefore an important step in improving fiscal transparency. Strengthening financial sector supervision is crucial to achieving this goal.

  • Steps to improve the credibility of fiscal policy: Building credibility requires not only the implementation of effective fiscal reforms, but also a record of adhering to new arrangements through upturns and downturns. The strengthening of fiscal institutions has a very important role to play in this regard. Fiscal rules—broadly defined as permanent constraints on fiscal performance—in some cases may play a useful role in strengthening fiscal policy credibility if appropriately designed and obeyed. For example, the Fiscal Responsibility Law introduced in Brazil in 2000—which established policy rules consisting of limits and targets for selected fiscal indicators for all levels of government, including debt ceilings and transparency requirements—appears to have helped strengthen the government’s credibility in financial markets.

Figure 2.9Food and Energy Subsidies, 2012

(Percent of GDP)

Source: IMF (2013a).

Fiscal Problems and Financial Crises

As recent experience has shown, financial crises can have a dramatic effect on a country’s fiscal situation. Cross-country empirical studies show that fiscal variables are indeed correlated with crises. A review of the theoretical literature suggests that there are three main channels by which fiscal policy can precipitate a financial crisis (Hemming, Kell, and Schimmelpfennig 2003): (1) an overly expansionary fiscal stance, leading to a lending and/or consumption boom; (2) concerns about sustainability that may be sparked by revelations of contingent liabilities or by doubts about a government’s commitment to fiscal adjustment; and (3) the debt maturity and currency structure, which can be critical to the perception of government liquidity and vulnerability to self-fulfilling crises.

The collapse of a fixed exchange rate regime can often be attributed to unsustainable fiscal policy (Krugman 1979). When the government runs a persistent primary fiscal deficit in the absence of fiscal reforms, the central bank must eventually finance this deficit with credit. This precipitates a continuous reduction in international reserves, until at some point a speculative attack happens, and the fixed exchange rate regime collapses. The importance of the structure of public debt as a source of vulnerability to crises is quite evident from emerging market experience. Hemming, Kell, and Schimmelpfennig (2003) present robust evidence that a few fiscal variables in emerging market economies are correlated with crises and with pressure in the foreign exchange market. When external public debt is high relative to tax revenue and exports, the public finances are vulnerable to a fall in the exchange rate, which increases debt-service costs without having a large positive effect on growth.

Policymakers today are faced with the challenge to reduce deficits and debt levels in a way that ensures stability but is sufficiently supportive of short-term economic growth, employment, and equity. In this regard, the choice of the appropriate speed of fiscal adjustment has to weigh the costs (that is, adverse short-term effects on growth) against the benefits of a faster adjustment (a reduction in sovereign risk). Countries that have lost access to financial markets often have little choice but to front-load fiscal consolidation. For economies with access to markets, however, a number of country-specific factors are likely to shape the choice of the speed of adjustment. A large and protracted fiscal consolidation is likely to exacerbate income inequality. Adjustments should be carefully designed to limit their negative social effects and improve their durability (Bastagli, Coady, and Gupta 2012).

Emerging market economies are developing their local debt markets to lower currency and maturity mismatches and hence reduce exposure to exchange rate and world interest rate movements. They used to be highly exposed to interest rate and foreign exchange risk, because much of the foreign borrowing came in the form of short-term foreign-denominated debt. The growth of local currency debt markets over the past decade has lessened these currency mismatches and has also raised the duration of public debt. Further development of local currency bond markets, possibly in conjunction with macroprudential measures to discourage excessive reliance on short-term external debt, can help extend the gains of the past decade.

Sovereign–Bank Nexus

The interlinkages between the financial system and the public sector can arise from exposures of domestic financial institutions to public debt. Large holdings of government bonds (encouraged by prudential regulations that treat sovereign bonds as effectively zero-risk assets) make banks vulnerable to sovereign default, because adverse developments in the government’s balance sheet can jeopardize the solvency of the banking system. Systemic banking sector problems that do not result from exposures to the sovereign but that could potentially impose large fiscal costs can also give rise to concerns about government solvency and precipitate a fiscal crisis. Also, the undermining of trust in the financial system is likely to occur at a time when the government’s ability to backstop a deposit guarantee system is questioned, increasing the probability of a bank run.

Recently, the euro area debt crisis was a powerful reminder that the sustainability of public debt and the solvency of the financial sector are intertwined.23 Commercial banks tend to be among the largest purchasers of domestic public debt in many countries, and hence any write-downs on that debt immediately affect banks’ solvency. Even in the absence of such explicit write-downs, a sudden spike in yields on public debt can lead to a recalibration of sovereign risk, impairing the capital position of banks. For instance, Greek banks have faced large losses on their asset side because of the haircuts on Greek public debt that they have had to incur. Such effects can also reach across borders, as highlighted for example by the Cypriot banking crisis, which partly originated in the exposure of Cypriot banks to Greek debt, amounting to more than a quarter of Cypriot GDP (IMF 2011).

Many emerging market economies are highly dependent on the domestic banking sector for both corporate and sovereign funding. Such bank-centric systems are particularly prone to amplification effects between public debt sustainability and financial sector vulnerability. Capital losses from sovereign exposures can often lead banks to scale back their lending activities in order to keep their capital from falling below minimum prudential levels. In countries where firms are almost entirely dependent on bank loans for their financing needs, financial sector stress can quickly translate into a credit crunch and thereby lead to an economic slowdown. This in turn lowers tax revenues, further eroding the sustainability of public debt (IMF 2012a).

At times of sovereign and financial sector strain, the interlinkages between governments and banks often deepen (Mody and Sandri 2012). As governments find it difficult to tap foreign capital markets, they may pressure domestic banks into holding more sovereign debt. Banks, in turn, may willingly comply, as this increased dependence of the sovereign on their loans can imply a greater inclination to provide bailouts if and when needed (Acharya and Rajan 2013). The deepening nexus between the sovereign and the domestic financial sector can provide temporary relief and lower public debt yields during times of stress. But it also makes for a potentially hazardous combination as the solvency of the government and the financial sector become inextricably linked (IMF 2012b).

Fiscal Dominance and Coordination of Fiscal and Monetary Policy

Fiscal dominance implies that monetary policy becomes subservient to fiscal considerations. Indeed, high fiscal deficits and public debt can accentuate the links between monetary policy, fiscal policy, and debt management, raising the specter of fiscal dominance (Bank for International Settlements 2012). In such circumstances, the credibility of monetary policy’s ability to keep inflation under control can be compromised.24 This can happen when the central bank is explicitly a part of the government or when the central bank is independent on paper but continues to be tacitly controlled by the Ministry of Finance. When coupled with large and persistent fiscal deficits, fiscal dominance can force the government to “print money” to close its financing gap, essentially implementing through inflation, a tax on the public’s holding of money. Once high inflation expectations are formed, and the monetary authority loses the trust of the public, inflation cycles can prove difficult to break. India provides an example (Box 2.7). Therefore, achieving monetary policy objectives requires financial prudence and the availability of fiscal room that can be used during economic emergencies. Frontier economies would do well to have reasonable fiscal and foreign exchange buffers and maintain strict control on direct central bank lending to the government (Jácome and others 2012).

Monetary and fiscal policy coordination is important for achieving macroeconomic stability, which in turn promotes economic growth and financial sector development. The central bank needs a credible commitment to maintaining price stability. Therefore, monetary policy reacts to fiscal policy because of its impact on demand and inflation. The government needs a credible commitment to achieving fiscal objectives that are sustainable in the long term. However, in preparing its budget, the government takes into account the implications of fiscal measures on overall demand and, therefore, on monetary policy. The global financial crisis experience revealed the limits of monetary policy, especially when constrained by the zero-interest-rate bound, and showed the importance of monetary and fiscal policy working in tandem rather than placing the burden of shoring up demand to maintain economic growth on one policy or the other (Blanchard, Dell’Ariccia, and Mauro 2010; Akerlof and others 2014).


The recent history of emerging market economies provides a number of lessons for frontier economies. On the search for an appropriate nominal anchor, perhaps the central message is that the choice of one has implications far beyond just the conduct of monetary policy. A monetary policy framework cannot be seen in isolation, but needs to be considered as part of a broader strategy for development and reform.

Over the last three decades of the 20th century, most emerging market economies chose various forms of fixed and pegged exchange rates. Such pegs provided a clear anchor that was easy to communicate and generally helped reduce inflation. But emerging market experience shows that exchange rate “fixity” also allowed imbalances to build up if the pegs were not properly designed and/or supported by appropriate fiscal and structural policies. Persistent inflation differentials relative to partner countries eroded competitiveness, and short-term capital inflows led to currency and maturity mismatches in the financial system. Countries that use pegs need to be vigilant and take appropriate measures to limit the buildup of macroeconomic and financial imbalances.

Box 2.7Fiscal Dominance in India

Although the degree of monetization has decreased considerably as a result of institutional reforms over the past two decades, high fiscal deficits still severely constrain the efficacy of monetary policy in India.

In the 1980s, the central and state governments had average deficits of about 6.7 and 2.8 percent of GDP, respectively. The fiscal deterioration placed a heavy burden on monetary policy as treasury bills issued to finance the fiscal deficits were automatically monetized. As a result, the Reserve Bank’s net credit to the government expanded rapidly in the 1980s, and led to a sharp increase in the central bank’s net domestic assets. Monetary pressures were felt as a result, despite a sharp decline in net foreign assets. After the two oil price shocks, inflation moderated until 1985–86, but returned as large fiscal expansions could not be countered by monetary contractions. The Reserve Bank raised the cash reserve ratio and the statutory liquidity ratio and used selective credit controls to maintain orderly conditions in the debt market. Credit budgeting in India was not very successful in the face of heavy fiscal dominance. It ended up generating financial repression that kept real interest rates low and discouraged savings. As a result, investments and supply capacity were constrained while inflation shot up.

India gradually reduced financial repression during 1992–2003. Several steps were taken to advance market-based financing of government deficits, including the development of money market instruments, the auctioning of Treasury bills, a reduction in statutory preemption through the cash reserve ratio and statutory liquidity ratio, and partial deregulation of interest rates. The period was marked by a distinct lowering of fiscal deficits until 1996–97. The credit compression of 1995–96 led to a sharper economic slowdown than envisaged. Monetary policy was able to ensure a substantial decline in inflation, but at a hefty cost to the real economy.

From 2003–04 to 2007–08, India introduced significant reforms to foster fiscal and monetary prudence. In the financial sector, the Reserve Bank moved from direct instruments to indirect instruments of monetary control. Simultaneously, fiscal reforms were undertaken at an unprecedented pace with the enactment of the Fiscal Responsibility and Budget Management Act of 2003. It unleashed a regime of fiscal rules to restrain discretionary spending. Under the law, annual targets were set for the phased reduction in key deficit indicators.

Fiscal and monetary policies were coordinated in responding to the global financial crisis (especially after the Lehman failure), but the exit from these policy responses was less harmonious. The unprecedented fiscal slippage amounted to 2.5 percent of GDP in fiscal year 2008–09 and the sudden large extra market borrowing in the last quarter resulted in the 10-year benchmark yield shooting up to 7 percent from 5 percent between December 2008 and March 2009. This happened despite the Reserve Bank’s huge open market purchases to contain the increase in interest rates. The exit from stimulus turned out to be far more difficult than its provision, and the widening of the fiscal deficit increased the pressure to monetize the debt.

Source: Reserve Bank of India (2013).

In recent years, emerging market economies have increasingly moved away from fixed exchange rate regimes toward a variety of inflation-targeting frameworks that allow for greater variation in exchange rates. Frontier markets that plan to adopt such monetary frameworks will require some institutional preparation, including central bank independence from the Ministry of Finance. In addition, information, knowledge, and analytical capacity will be required to understand the monetary policy transmission mechanism and effectively implement such a framework. Also, most emerging market economies that adopted inflation targeting have done so in a “flexible” manner. They often continue to manage exchange rate variability within certain bounds and have fashioned a number of macroprudential instruments to supplement the monetary policy toolkit for dealing with capital flows and financial stability concerns.

Financial and institutional development has promoted domestic saving and investment, increased public access to financial services, made it easier to implement monetary and fiscal policies, and contributed to increasing resilience to external shocks. But recent crises in emerging markets have shown that the path of financial liberalization can be hazardous. And as discussed, a gradual, phased, and pragmatic approach in which first relatively simple instruments and relatively safe and stable cross-border capital flows are allowed should be favored. Policymakers need to be aware of the market failures, the information and regulatory gaps, the divergence between private and social returns, and the limits of regulatory and enforcement systems in their countries. The benefits of international financial integration seem to show up only in countries that have crossed some minimum thresholds of good governance and financial development.

The recent experience of developed and developing economies alike has shown that a solvent state and a reasonably sound fiscal position are crucial to supplying basic public goods, providing a safety net for the poor, managing aggregate demand over the business cycle, backstopping the financial system, and dealing with economic and financial emergencies. The importance of fiscal policies and their long-term sustainability are hard to overemphasize. Even the independence of the central bank is predicated on a lack of fiscal dominance, since governments that cannot fund their operations through revenues and market borrowing are forced to use financial repression and the printing press, compromising the ability of policymakers to control inflation and develop the financial system. Fiscal challenges stem from small and narrow tax bases, weak tax administration systems, and vulnerabilities associated with sovereign debt denominated in foreign currencies. Frontier economies will have to chip away at these hurdles so that fiscal policy supports growth, employment, and equity.

The lessons of recent experience are clear: robust and steady economic growth is the key to keeping public debt ratios in a comfortable range; fiscal and political institutions play an important role in promoting fiscal sustainability and in creating the room required for stabilization needs; fiscal rules can be useful for maintaining discipline, but they are not a substitute for political will and sensible implementation in extreme circumstances; raising domestic savings and developing domestic bond markets can help reduce foreign currency mismatch in private and sovereign balance sheets; fiscal risks are often underestimated, compounded by the nexus between the government and the banks; and the realization of contingent liabilities can rapidly lead to unsustainable public debt dynamics.

Governance and supply-side factors in frontier economies, especially basic infrastructure and an increasingly educated workforce, will be crucial to exploiting growth opportunities as they arise and improving productivity and income per capita. The path of structural change and accompanying policy reform will have to be managed prudently. As institutions and markets evolve, the complex interactions between economic and financial policies and the real economy can be difficult to decipher and predict, especially with countries becoming more open to trade and capital flows. Frontier economies will have to tread this path carefully, and the macro-financial frameworks they adopt will need to contain the risks and vulnerabilities on the way.


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This comparison uses the Morgan Stanley Capital International (MSCI) categories as of March 2014. The MSCI-Emerging Market group consists of Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Russia, South Africa, Taiwan Province of China, Thailand, and Turkey. The MSCI frontier markets cluster contains Argentina, Bahrain, Bangladesh, Bulgaria, Croatia, Estonia, Jordan, Kazakhstan, Kenya, Kuwait, Lebanon, Lithuania, Mauritius, Morocco, Nigeria, Oman, Pakistan, Qatar, Romania, Serbia, Slovenia, Sri Lanka, Tunisia, Ukraine, United Arab Emirates, and Vietnam. A broader categorization of frontier economies would include the following Asian countries: Bhutan, Cambodia, Lao P.D.R., Maldives, Mongolia, Myanmar, Nepal, Papua New Guinea, and Timor-Leste.

See, for example, Acemoglu, Johnson, and Robinson (2005); Gill and Kharas (2007); Acemoglu and Robinson (2012); Rodrik (2013); Im and Rosenblatt (2013); and Nunn and Trefler (2014). In the context of India, see the discussion in Bhagwati and Panagariya (2013) on what they call Track I and Track II reforms. Basu (2011) shows that a market system needs cooperation, trust, and appropriate norms to deliver growth that is reasonably efficient and fair. Fukuyama (2004) discusses the causes of “state weakness” in developing economies and the difficulties faced in creating new government institutions and strengthening existing ones.

For recent discussions of emerging market monetary policy frameworks see Hammond, Kanbur, and Prasad (2009); Filardo and Genberg (2010); and Filardo (2012).

For a perspective from Asia-Pacific policymakers on the conduct of monetary and financial policies in a world of increasing cross-border flows see Grenville (2008); Mohan and Kapur (2009); Nijathaworn and Disyatat (2009); Singh (2009, 2011); Mohan (2012); Gokarn (2013); Kim (2013); Zeti (2013); Rajan (2013, 2014); and Menon (2014).

For example, see Bernanke and others (1999); Blejer and others (2000); and Bernanke and Woodford (2005). There is some evidence suggesting that countries with a suitable inflation-targeting framework were better at dealing with some of the disruptions caused by the global financial crisis (de Carvalho Filho 2011).

Since the exchange rate is the single most important asset price for a small, open economy, it is unlikely that emerging markets or frontier markets moving toward greater exchange rate flexibility would accept benign neglect of the exchange rate (Eichengreen and others 1999; Mussa and others 2000; Stone and others 2009).

Eichengreen (2004) takes a critical look at the Korean experience.

See Lane (2003); and Kaminsky, Reinhart and Végh (2005) on the procyclicality of emerging market macroeconomic policies. Coulibaly (2012); Végh and Vuletin (2012); and McGettigan, Moriyama, and Steinberg (2013) analyze the cyclical nature of emerging market monetary policies.

See Jeanne, Subramanian, and Williamson (2012), who argue that the use of a diverse set of policies to deal with capital flows is appropriate since there is a lack of strong evidence for or against the benefits of capital account liberalization. They also push for establishing an international regime for capital controls to lessen the stigma attached to such measures and to encourage the use of suitable interventions and discourage those that are inappropriate.

For a more extended discussion see Chami, Fullenkamp, and Sharma (2010).

Acharya (2013) in assessing the U.S. Dodd-Frank Act and drawing lessons for emerging market economies highlights the risk-taking incentives created by explicit and implicit government guarantees and the need to contain and manage the competitive distortions and moral hazard they create.

The impact of redistributive fiscal instruments on economic efficiency depends on their design, and fiscal redistribution need not have any direct effect on growth (IMF 2014; Ostry, Berg, and Tsangarides 2014). See also Dreze and Sen (2013), who argue that in India the underdevelopment of social and physical infrastructure and the neglect of human capabilities threaten the sustainability of high economic growth. Stiglitz (2012) draws out the implications of increasing inequality for monetary and fiscal policies, democracy, and globalization.

The legal foundations of rules take various forms. In Germany, Poland, and Switzerland, rules are embedded in constitutional law, which confers a special weight since it is difficult to change the constitution. Some emerging markets have followed this approach, and the rules are based on statutory norms (acts of Parliament). For example, Sri Lanka introduced a Fiscal Management Responsibility Act in 2003, and Pakistan enacted a Fiscal Responsibility and Debt Limitation Act in 2005, both of which covered the general government and stipulated rules for budget balances and debt. But in other cases, rules have been established by political commitment—for example, in an agreement among partners in a governing coalition (Indonesia and the Netherlands are examples).

Broadly speaking, there are four types of rules. First, budget balance rules can be applied to the overall balance, the primary balance or the cyclically adjusted (structural) balance. Second, debt rules set explicit limits or targets for the debt-to-GDP ratio. Third, expenditure rules set limits on spending in absolute terms, in growth rates, or as a percent of GDP, often over a multiyear horizon. Fourth, revenue rules set floors or ceilings aimed at boosting revenues or constraining the tax burden.

Frankel, Végh and Vuletin (2013); and IMF (2013a, Chapter 2) show that strong institutions are a key determinant of a developing economy’s ability to conduct countercyclical fiscal policy. Fatás and Mihov (2013) provide evidence that the volatility of fiscal policy can exert a negative effect on long-term economic growth.

For a historical analysis see Reinhart and Rogoff (2011).

Examining Brazil during 2002–03, Blanchard (2004) argues the standard proposition that “a central-bank-engineered increase in real interest rates makes domestic government debt more attractive and leads to a real appreciation” may not hold if the country is highly indebted and rising real interest rates increase the probability of default. This is more likely the higher the initial debt level, the higher proportion of debt denominated in foreign currencies, and the higher the price of risk. Inflation targeting in such a situation can have perverse consequences: raising real interest rates in response to an expected increase in inflation could lead to a real depreciation.

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