Central banks must break with short-term political cycles – Díaz de León

Mexican governor stresses independence and long-term objectives can help tackle populism
Alejandro Díaz de León

Central banks should decouple from short-term political cycles and harness their independence to resist the rise of populist leaders, said Alejandro Díaz de León, governor of the Bank of Mexico.

In a speech today (May 23) at Central Banking’s National Asset-Liability Management conference in Mexico City, Díaz de León analysed the role central banks in emerging countries can play to promote growth and stability.

“Idiosyncratic risks are becoming increasingly important in political as well as economic outlooks,” said the Mexican governor. “This is because societies are growing impatient, as widespread access to information increases expectations of social mobility, but governments fall behind the curve in developing the instruments to offer better opportunities.”  

Against this backdrop, short-term political narratives offering simple solutions are on the rise, added Díaz de León. However, “central bank independence and long-term horizons should be used to decouple from short-term political cycles, helping to develop the policies that deliver sustainable growth and stability.”

Global integration

The governor stressed how emerging markets became more integrated in global financial markets after the financial crisis. The process offers enhanced financial flows, but also increases their exposure to global risks.

As central banks in advanced economies implemented unconventional monetary policies such as negative rates and bond-purchase programmes, returns declined at home, boosting investors’ demand for the higher-yielding assets that emerging markets could offer.

“Total capital flows to emerging markets since 2008 up until May 2019 amount to $300 billion. And this is evenly distributed between fixed income and equity markets,” said Díaz de León.

This has contributed to a reduction in sovereign-debt spreads in Mexico, Colombia, Peru, Chile and Brazil, the governor said. But it has opened the door to greater volatility.

For instance, these flows have varied widely. While capital inflows reached very high levels from 2009–2010, volatile commodity prices and incipient US policy normalisation sharply reduced them in 2015. Additionally, this process has contributed to a sharp increase in non-resident holders of government bonds.

This increased integration has been accompanied by higher correlations between assets. Currencies, equities and sovereign bonds now move in more dramatic fashion when stress hits markets, Díaz de León said.

Latin America, and especially Mexico, are affected by the trade disputes started by the US president Donald Trump. This has negatively impacted investment and GDP growth forecasts. “Mexico was hit earlier by this process,” said the governor. “Trade tensions are challenging for open economies and, as trade conditions become blurry, it is challenging to deploy investment. This is particularly the case in manufacturing.”

Lower and more uncertain GDP growth forecasts have decreased inflation expectations in advanced economies, which in turn has triggered the adoption of more accommodative monetary policies.

“This looser policy in the US financial market has allowed emerging countries to record a favourable performance,” he said. “However, trade tensions have already caused some investors to fly to higher quality and safety assets.”

Challenges for the Mexican economy

As a result, Mexico has recorded lower external financial flows. This calls for a structural change in the external account and tighter fiscal and monetary policies, the governor said.

Another factor complicating the outlook is lower oil export revenues. For the first time, Mexico is recording lower oil production, in the context of weak international prices. This is due to the decay of major oil fields that the national oil company, Pemex, has failed to replace.

“Therefore the non-oil trade balance needed to offset that supported by a real exchange rate depreciation, which has required a tighter monetary policy to tackle inflation.”

This current account adjustment and the ongoing renewal of the North American Free Trade Agreement (Nafta), including Mexico, the US and Canada, impose tight financial conditions as growth remains subdued.

In order to improve the resilience of the Mexican economy, Díaz de León thinks it necessary to maintain solid economic fundamentals. A robust fiscal and monetary framework, a healthy financial system and a floating foreign exchange regime all contribute, he said.

The governor highlighted the importance of being an open economy, in spite of the challenges it now entails. “Benefits still outweigh risks when it comes to having an open financial market,” said the governor.

However, stronger economic growth will be needed. In order to attain that goal Mexico must be able to better deploy and attract investment, as well as increase productivity fostering competition.

Finally, an essential and still missing factor is developing a strong rule of law, Díaz de León said. Mexico must reduce insecurity, corruption and impunity if it is to reach a future marked by economic growth, price stability and a sound financial system.

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