IMF: Beware Unwinding of C-Bank Stimulus

Tighter monetary policy in advanced economies could create a bumpy ride for financial markets around the world that central banks may be unable to control, the International Monetary Fund said on Monday.

The Washington-based IMF, which is charged with preserving global financial stability, said unconventional monetary policies such as the U.S. Federal Reserve's massive bond-buying programs helped restore order and lift global growth in the wake of the financial crisis in 2007-2009.

They also benefited emerging market countries despite some complaints capital inflows would destabilize those economies as investors sought higher returns.

But unwinding these policies may have much more profound negative impacts, especially for countries that received the largest capital inflows.

"As is typical in stretched markets, the bust appears much more abrupt than the boom during which the seeds of financial instability are sown," the IMF said, referring to the risk of sharp reversals of capital flows.

Those risks were evident in an emerging market sell-off that was sparked earlier this year when the Fed starting discussing the possibility of scaling back its bond purchases. The Indian rupee and Turkish lira sunk to record lows against the dollar. Indonesia, Mexico and Brazil also faced pressure.

The Fund declined to specify which countries faced the biggest risks from scaled-back asset purchases, though it said Canada, Korea and Australia would likely fare the best.

Countries that may suffer include those that are particularly exposed to capital outflows or higher U.S. interest rates, and countries that have less money or currency flexibility to weather shocks, the IMF said.

India and Indonesia in particular have more limited policies to deal with the fallout, the Fund warned. And higher interest rates could also squeeze South Africa's economy, although domestic investors may step in if foreign investors withdraw, the IMF said.

UNPREDICTABLE IMPACT

The challenge of exiting unconventional policies is compounded by a less predictable relationship between central bank actions and market-set interest rates, given the incredible liquidity pumped into the financial system.

For example, the Fed has just about quadrupled its balance sheet to about $3.7 trillion through a series of three large-scale bond purchase programs.

"The vast excess (bank) reserves created by asset purchases in some countries, as well as the complications from selling such assets, make the exit from unconventional monetary policy more challenging" than a typical tightening of monetary policy, the IMF said.

Market reactions are also difficult to predict due to uncertainty about future policy rates and how asset sales will impact prices, the IMF said.

The IMF said it was also hard to measure when easy money policies would outlast their utility and start creating more problems than they solve. As in previous papers, it warned that an overly long period of bond purchases could encourage more risk-taking, reduce the incentive to implement structural reforms, and undermine central banks' independence if they are seen as financing government debts.

Communication about central banks' plans is key to tamp down market volatility, the Fund said. The Fed and the Bank of England have done a good job of communicating incremental adjustments as the economies in the United States and the United Kingdom recover.

But the Fund said there was room for clearer communication on the Fed's principles for asset sales as well as the risks from exiting too early or too late.