Changing funding patterns cut both ways for emerging markets, central bankers say

Patterns of financial intermediation in emerging markets are changing, bringing some benefits for monetary policy but also new risks, according to a set of papers published by the Bank for International Settlements (BIS).

The papers, including some from the BIS and many more from emerging market central banks, were published on November 16, though they were prepared for a meeting of central bankers in February.

Although most emerging markets remain heavily reliant on bank funding, the direction of travel is towards greater intermediation by capital markets, a BIS document summarising the meeting said. The "general view" was larger and deeper capital markets would improve the transmission of monetary policy to market prices.

Deeper capital markets also have the attraction of improving financial development, participants said. They can diversify funding sources and avoid concentrating credit risk in the banking system, and may be a more reliable source of long-term funding for infrastructure investments.

Nevertheless, deeper markets and the greater global integration that tends to go with them bring a host of challenges. Throughout this year the BIS has warned emerging markets' reliance on external dollar funding could cause problems when the Federal Reserve raises its interest rate.

A paper from the Central Bank of Peru suggested the appeal of foreign funding to emerging market corporations is its lower cost and higher liquidity compared with domestic sources. This has fuelled credit growth and domestic asset prices, presenting problems for monetary policy transmission, the authors said.

Economists at the Bank of Mexico highlighted further dangers, pointing to "run-like dynamics" in emerging market bond funds, despite the funds' low leverage. They found bond flows to be highly correlated across countries, and pointed to evidence that a rise in the US policy rate could be a trigger for such runs.

The BIS noted challenges caused by greater integration vary across countries. In Malaysia, for example, higher foreign ownership of domestic markets has actually improved monetary policy pass-through by improving loan pricing, although low external corporate debt has also helped.

Some participants suggested central banks could respond to crises in bond markets by acting as market-makers of last resort. Others stressed the importance of keeping their houses in order, preventing large macroeconomic and external imbalances.

There was also widespread agreement that macro-prudential policies are "critical", although the BIS noted evidence on the effectiveness of such policies is "still rather limited".

Many participants also saw a need for global policy coordination, and most agreed countries ought to refrain from competitive devaluation. Where coordinating policies proves impractical, some saw scope for at least coordinating policy communication.