Category: Finance

The Washington Consensus: Steps to build an economy?

~ Finance_TAPMI

Imagine being in charge of a country which has undergone a rapid change for the worse in terms of an economic standpoint. It is definitely difficult to get the country back on track. Because of the help of the IMF and the World Bank you can now start afresh. However, it is still confusing about what has to be done to build your economy from scratch. Thankfully there are a set of rules to help you in this endeavor in setting up a self-sufficient economy known as the Washington Consensus. So let us find out what it is and how it functions.

What is the Washington Consensus?

John Williamson, an economist, first used the term “Washington Consensus” in 1989. He was discussing a set of measures that had gained acceptance among Latin American politicians in reaction to the early to mid-1980s macroeconomic unrest and debt crisis. In order to aid in the recovery from the debt crisis, these measures were also supported by specialists in Washington’s international institutions, particularly the International Monetary Fund and the World Bank as well as the US Treasury.

A note of caution, these rules are only meant to be descriptive and not prescriptive, which means that these rules do not guarantee the economy to be a success. Definitely there will have to be some considerations taken in place depending on the scenario of the country and what can actually be done depending on the ability of the government.

Maintaining fiscal restraint, reallocating public spending priorities (from subsidies to health and education spending), reforming tax law, letting the market determine interest rates, upholding a competitive exchange rate, liberalising trade, allowing inward foreign investment, privatising state enterprises, removing barriers to entry and exit, and protecting property rights are among the main Washington Consensus policies. Williamson pointed out that these policies went against what was believed to be true in developing nations, many of which adopted state-dominated systems in the 1950s.

The 10 rules of the Washington Consensus

  • Reduce national budget deficits

Large budget deficits lead to high variable tax rates. To counteract this, it was suggested to observe fiscal discipline either by raising tax revenues or by reducing domestic spending to reduce the amount of spending done by the government.

  • Redirect spending from politically popular areas toward neglected fields with high economic returns

Some aspects of public spending, such as subsidies to state-owned businesses or for the purchase of food or fuel, caused economic distortions and favored wealthier urban people over the impoverished in rural areas. Reducing subsidies for politically connected economic sectors may cost some people money, but it frees up funds for expenditure on infrastructure, education, and fundamental social services.

  • Reform the tax system

Reforms should enlarge the tax base and eliminate the exclusions that exempt some people and organizations with political ties from paying taxes. Taxation that is more inclusive and straightforward can boost productivity, increase tax revenue, and lessen tax evasion.

  • Liberalize the financial sector with the goal of market-determined interest rates

Government interest rate regulations typically penalize savers, deter investment, and stifle financial progress; restricting credit typically encourages corruption and benefits political insiders. Market-based interest rates encourage saving and ensuring that banks or the financial sector, not politicians in the government, decide how much credit is given out.

  • Adopt a competitive single exchange rate

A competitive, market-driven exchange rate can encourage export-led economic growth and alleviate balance of payments issues; avoid inflated exchange rates that deter exports and cause currency rationing.

  • Reduce trade restrictions

Trade barriers that support particular interests should be eased generally. Tariffs are better to quotas and other arbitrary trade restrictions that stifle trade since they allow for progressive reduction, local enterprises to adapt, and produce money for the government as opposed to quota rents for special interests.

  • Abolish barriers to foreign direct investment

Foreign investment that is prohibited or restricted at home gives monopolies to native companies and lessens competition. A country can increase its capital, create jobs, and develop its workforce through foreign investment, but also increasing competition for native businesses. Domestic businesses that attract FDI can encourage intellectual property breakthroughs that advance development.

  • Privatize state-owned enterprises

State-owned businesses frequently operate inefficiently and rely on subsidies from the government, which increase countries’ fiscal deficits. While some unemployment may result from privatization, these changes are more likely to boost firm productivity and profitability.

  • Abolish policies that restrict competition

Removing regulations and obstacles that prevent new firms from entering the marketplace can stimulate competition, efficiency, and economic growth.

  • Provide secure, affordable property rights

Investment and individual liberty are encouraged by a legal system that awards and preserves property rights, including the rights of those who hold land without legal documentation and work undocumented jobs in the informal sector. Owners can obtain financing thanks to private assets, which grows the economy and the revenue base of the government.

Effects of the Washington Consensus

By the middle of the 1990s, the benefits had mainly fallen short of expectations, especially in Latin America, where reforms had been pursued with particular zeal. The Washington Consensus was expanded to prescribe a longer list of adjustments in response, which is evident in the increasing number of terms and conditions associated with IMF and World Bank loans.

However, sluggish development, recurrent fiscal crises, and widening inequality cast doubt on the success of the entire project, severely harming the Washington Consensus’ political reputation. A new wave of leftist governments appeared in Latin America in the 2000s, many of which ran on platforms promising to reverse these regulations.

Major Criticisms

  1. Free trade is not necessarily advantageous for emerging economies, according to some economists. To ensure long-term prosperity, several strategic and young industries must first be preserved. These businesses can also need protection from imports in the form of subsidies or taxes.
  2. Government assistance has allowed Chinese businesses to make significant investments in Asia, Latin America, and Africa’s developing nations. These businesses frequently make infrastructural investments, opening doors for long-term trade and growth.
  3. Privatization can boost output and raise the standard of the good or service. Privatization, however, frequently causes businesses to disregard specific low-income segments or the social demands of a rising economy.

Conclusion

There can never be a fixed set of rules that even by theory can help to build a self-sufficient economy, the short-term impacts of these rules did not help the targeted economies, however it helped them build a strong base on which these economies can stay stable and thus helped the long-term growth of these economies. Any sets of rules can only be descriptive and not prescriptive for an economy, as each economy in itself is unique and all require different solutions for them to get through their problems. Sure, these rules could be taken as an outline, but definitely not the guidebook to build an economy.

Abishek Jeremy Lobo

Editor, TJEF

References

  1. https://www.piie.com/blogs/realtime-economic-issues-watch/what-washington-consensus
  2. https://www.piie.com/commentary/speeches-papers/washington-consensus-policy-prescription-development
  3. https://www.washingtonpost.com/politics/2021/04/16/people-have-long-predicted-collapse-washington-consensus-it-keeps-reappearing-under-new-guises/
  4. https://www.intelligenteconomist.com/washington-consensus/

Should emerging markets worry about the US monetary policy announcements?

~ Finance_TAPMI ~ 1 Comment

INTRODUCTION

Financial markets of both developed, as well as emerging countries, usually have some kind of impact due to the United States Monetary Policy. Any changes made by the United States or even ramblings about potential changes can have both positive as well as negative impacts on the Exchange rates as well as Bond rates of Emerging Market Economies (EMEs). When Foreign Banks lend to firms in EMEs they essentially do them in terms of dollars. This creates a direct relation between the United States Monetary Policy and the credit cycles of the EMEs. The impact of the United States Monetary Policy is varied depending on the nation as well as the industries that are directly affected by them. The local lenders of EMEs do not have an offsetting impact on the foreign bank capital inflows, while the United States Monetary Policy affects the credit conditions both extensively as well as intensively. It has been found by many researchers that the spillover effect of the United States Monetary Policy is stronger for EMEs which have a higher risk.

FEDERAL OPEN MARKET COMMITTEE (FOMC) AND ITS ANNOUNCEMENTS

Monetary policy decisions in the United States have a significant impact on financial markets in both developed and developing countries. This was clear in the summer of 2013 when Federal Reserve Chairman Ben Bernanke first mentioned the prospect of decreasing the Federal Reserve Board’s security purchases on May 22. In the months that followed, this “tapering talk” had a significant negative influence on financial conditions in developing countries, with currency rates depreciating, bond spreads widening, and equities prices falling. A full-fledged balance of payments crisis appeared to be looming for several of the countries.

The US Federal Reserve chose to utilize the Federal Open Market Committee to undertake monetary policy changes in response to the Global Financial Crisis caused by the Sub-Prime Crisis in 2008. (FOMC). The FOMC chose to employ an unconventional monetary policy starting in 2008, as illustrated in the chart below.

Fig: Period of Unconventional Monetary Policy

The next era was highlighted by the Large-Scale Asset Purchase Program (LSAP), a programme of direct asset purchases, as well as prior indications on monetary policy direction. The research relied on high frequency variations in longer-term Treasury rates to detect monetary policy shocks because the federal funds futures rate no longer provided a suitable basis for doing so during the unconventional monetary policy phase. The identifying assumption is the same as for the traditional monetary policy period: Treasury rate fluctuations in a brief window around policy announcements are attributable to unanticipated changes in the US monetary policy stance.

Fig: Treasury Yields on FOMC days

Two-year Treasury rates are seen in the first panel of Chart 2. The period is characterised by medium-term patterns, in which yields declined between 2008 and 2011, stayed low from 2012 to 2013, and then rebounded, as well as shorter-term variations with more regularity. The vertical lines represent FOMC days where the percentage change in yields was 2 standard deviations below or above the period average.

The second panel shows the percentage change in yields on each of the FOMC days. Day-to-day changes in response to FOMC announcements that exceeded the two-standard deviation band around the average changes are indicated in red. The third panel compares the daily percentage change in rates on FOMC days to the daily percentage change in yields on all other days in the sample period. It shows that Treasury yields declined on FOMC days on average compared to non-FOMC days, and that the former had more tail events, such as sudden rises or drops in yields.

Finally, on the days of the FOMC announcements, we compare changes in 2-year Treasury yields to changes in 10-year Treasury yields in the last panel. On FOMC days, the fluctuations in 2-year and 10-year rates were significantly connected, as shown in the graph. There were only a few times when the yields’ near synchronisation was broken.

IMPACT OF US MONETARY POLICY ON INDIAN ECONOMY

There was a lot of research done to identify the effects of the US Monetary Policy on the Emerging Market Economies, various statistical as well as regression models were run to come to various conclusions. The most significant of which were the following.

Bhattarai et al (2018) estimated the spill-over effects of US QE on EMEs and assessed the differences in the responses in the policy of those economies, in which they found that the US quantitative easing (QE) resulted in currency appreciation for EMEs, as well as higher long-term bond rates, stock prices, and capital inflows.

Dahlhaus and Vasishtha (2014) studied the possible impact of the withdrawal of stimulus due to QE on EMEs which resulted them in finding for EMEs, the impact of QE tapering was predicted to be minor as a percentage of GDP. However, they warn that this might still create severe market volatility.

Gupta et al (2017) looked at the effects of QE and EMEs, in which they found In EMEs, QE had a considerable impact on exchange rates, stock prices, and bond yields.

Impact on India

Fig: INDM1 (Indian Money Supply), USMBASE (United States Monetary Base), EFFR (Effective Federal Funds Rate), INDBNCRE (Indian Bank Credit Rate), USD INR (Exchange Rate), and Indian Interest Rate changes

QE increased the money supply in the United States, which in turn increased capital inflows into emerging economies like India, increasing the economy’s money supply. At the same time, as the money supply shifted to growing economies such as India, the money supply in the United States shrank. As a result, there is a bi-directional causality between the money supply in India and the money supply in the United States. Indian Money Supply and Indian Bank credit rate also show a bi-directional causality due to the fact that the increase in bank credit will lead to increase in money supply.

QE increased the money supply in the United States. As a result, inflows into emerging economies like as India increased dramatically. This should have caused the Indian rupee to appreciate against the US dollar during QE and depreciate during tapering. In contrast, the rupee has been progressively losing strength versus the US dollar. This is because the Reserve Bank of India intervenes in the foreign exchange market to prevent the Indian currency from gaining too much, lowering volatility. The influence of QE on the currency rate has been negligible as a consequence of the RBI’s involvement.

CONCLUSION

According to our research, surprise US policy pronouncements have a big and significant influence on asset values in developing countries. Our estimates demonstrate that in developing nations, a surprise monetary easing, as assessed by a decline in the 2-year Treasury yield on the day of the FOMC announcement, leads to exchange rate appreciation, equities price gains, and bond yield reductions. A surprise tightening, as measured by an increase in the 2-year Treasury rate, on the other hand, has the opposite effect.

Evidence suggests that monetary policy shocks have a lesser spill-over in other advanced economies, such as the euro-zone, Japan, and the United Kingdom, owing to their weaker financial connectivity with emerging economies.

The signaling effect or portfolio rebalance effect, of US policy statements may have an impact on emerging economies. The findings highlight the impact of unexpected US monetary policy pronouncements for emerging economies and add credence to emerging market policymakers’ concerns in recent years. They emphasize the necessity for emerging economies to remain cautious in the face of US policy changes.

The Federal Reserve Bank of the United States, and to a lesser extent other advanced countries’ central banks, prepare the markets well in advance by providing unambiguous guidance, particularly when policy tightening is expected. The influence would then dissipate over a longer period until the day of the announcement, and emerging economies would be unlikely to see significant short-term financial upheaval.

REFERENCES:

  1. Jaswal, A., & Ahuja, B. R. (2021). Unconventional US Monetary Policy: Impact on the Indian Economy. The Indian Economic Journal, 0019466221998627.
  2. Bräuning, F., & Ivashina, V. (2020). US monetary policy and emerging market credit cycles. Journal of Monetary Economics, 112, 57-76.
  3. Gupta, P., Masetti, O., & Rosenblatt, D. (2017). Should emerging markets worry about US monetary policy announcements?. World Bank Policy Research Working Paper, (8100).
  4. Arora, V. B., & Cerisola, M. D. (2000). How does US monetary policy influence economic conditions in emerging markets?