Interview with Guillermo Ortiz

Member of the Group of Thirty; former Governor of the Bank of Mexico; former Chairman of the Board of the Bank for International Settlements; former Secretary of Finance and Public Credit of the Mexican Federal Government. 

Has the experience of the crisis changed your view of the central bank policy tool kit?

Governor Ortiz: I think that we have to make a distinction between the central bankers in the developed world whose banking systems were affected and those in the emerging market world where banking systems were not affected.

It is quite remarkable that no country in the emerging markets world that had a financial crisis in the 1990s (starting with Mexico in 1994 and then continuing with the Asian crisis, Russia, Brazil, Argentina, Turkey, and so on) had a severe or even a significant financial dislocation as a consequence of the Great Crisis. In these countries, I think that we learned from our mistakes. This whole concept of financial stability and the issues of currency mismatches, maturity mismatches, excessive leverage, and so on, were incorporated in the policy tool kit of these central banks (before the concept of financial stability became mainstream) after the earlier crises. So, there was no need to display additional policy tools during the recent crisis. In addition, these economies had accumulated enough buffers in terms of international reserves before the crisis. The proportion of international reserves of emerging markets to total reserves doubled from 2002 to 2009. Also, in 2009, the IMF established the FCL (Flexible Credit Line) to which Mexico, Colombia, and Poland were given access. This helped emerging markets navigate through the very turbulent times after the Lehman moment. In the aftermath of the crisis, several emerging market central banks have adopted macroprudential measures.

The swap lines that the Fed opened during the crisis were also very helpful. For the first time, these swap lines also included some emerging markets. In the case of Mexico, for example, we requested and received a swap line from the Fed of US$30 billion. So did three or four other non-G10 countries. It also was the first time that the Fed actually provided an unsecured swap line to emerging markets, so that was very important. The influence of the swap line did not reside in the amount required – the Bank of Mexico used only a small quantity (US$3 billion) – but in the positive signal it provided to the financial markets.

In the case of the developed countries, I think that quantitative easing (QE) was the right policy to address the 2008 financial crisis and to insure that the lack of liquidity did not push solvent economic agents into bankruptcy, inducing downward production spirals. Maintaining an active monetary policy once the zero lower bound of nominal interest rates had been reached meant entering uncharted waters. Fed purchases in long-term bond markets ended up being much bigger than expected – amid private sector deleveraging, restrictive fiscal policies, and liquidity leaking into emerging financial markets.

So, for liquidity provision to be sufficient, it had to be excessive. I think it worked. It had an effect on term premiums, as predicted by the Fed. And, to enable an escape from a depression in the developed economies, it was almost inevitable to form bubbles, particularly in the emerging markets. For example, according to the Institute of International Finance, since 2009, emerging market non-bank corporates have raised US$1.6 trillion in domestic and international debt markets.

Now, with respect to forward guidance, I think the effectiveness of this instrument has been overstated as a tool to manage the exit from QE. No matter how gradual the tapering of QE, adjustments are likely to occur: it is in the nature of financial markets to overreact and overshoot. The measures used to bring about an escape from a potential depression built in the elements of a bumpy road to normalization, particularly in this environment of divergent monetary policies. As always, central bank communication strategies are important and may mitigate volatility, but I think that it should not be confused as a crucial policy tool. The Fed has repeatedly stated that its policy actions would be data dependent, but there’s a lot of second guessing here. What does the Fed’s statement mean? The Fed is watching the markets, the markets are watching the Fed, and everybody’s watching each other. I think there is a very confused and difficult debate here on the question of forward guidance.

Where should we be looking now for financial stability risks given this experience?

Governor Ortiz: I think that I already touched upon this subject a little bit in discussing the unintended consequences of QE. Take, for example, the taper tantrum when the Fed signaled the forthcoming end of QE in mid-2013. Emerging markets became the focus of financial distress, and emerging market policy makers had to go beyond temporary measures to defend currencies and to stem capital outflows. As you know, the exposed countries – the famous “vulnerable five” (Brazil, India, Indonesia, South Africa, and Turkey) – moved to reduce external vulnerabilities. They are now in a better position to start this second round.

Now, I would like to say something regarding the taper tantrum. I think that there has been a shift in the Fed’s awareness of its impact in the international sphere. It is widely acknowledged that the mandate of the Fed is domestic, even though the spillover effects of its actions are global. That has always been the case, and no matter how undesirable this situation may be, it is a fact of life deriving from the fact that the dollar is the reserve currency of the world. No matter how beneficial the international role of the dollar may be for the U.S. economy, the reserve status of the dollar is not a decision of the U.S. government, but one of the international financial markets. Obviously, the Fed does care about international financial stability, not only out of benevolent concerns, but because it affects the dynamics of the U.S. economy in obvious ways. In the short term, for example, slow global growth acts as a headwind, reducing demand for U.S. products and, to some extent, foreign earnings of U.S. corporations.

There has been an apparent attitude shift at the Fed. Something that really caught my attention is that the January communique of the FOMC for the first time explicitly mentions conditions in the international financial markets. I think this is important.

Now, getting away from the emerging markets sphere, I think that a number of financial stability problems emerged from the different applications of financial regulation in the different parts of the developed world – Europe, the United States, the United Kingdom, and so on. There has been quite a bit of progress addressing these issues, and in making the banking systems more resilient. However, the implementation of regulation differs significantly across countries and regions. And still, in my view, there remains a lot of leverage in the financial system. In addition, regulation has been directed mostly to the banking system. However, there also is the whole question of shadow banking. In countries like China, where the extension of shadow banking has been very, very fast, there have been serious doubts as to whether it can be contained and handled in a way that avoids financial turmoil.

What do we need to do to preserve the benefits of global finance?

Governor Ortiz: It depends on how you define “global finance.” If you define it as global banks with global reach into all kinds of business and the ability (according to them) to service clients all over the world with different products, then I think that the benefits have been vastly exaggerated. I think that there has been a retrenchment in the reach of this kind of global banking that I don’t see as something that is particularly dangerous for global finance.

Where I am much more focused is on the increasing barriers that we are seeing in the payments systems. With the implementation of “know your client” rules, anti-money laundering efforts, and so on, it has become increasingly difficult to have an efficient payment system. Many banks have retired from the business, for example, of handling remittances, which are a very important source of income for many emerging markets. So, this is something that is of great concern. And it’s mostly a political decision that has to be addressed at the global level. It’s affecting not only countries in Latin America or Mexico with regard to remittances from the United States, but also countries in Asia – the Philippines, India, and so on. Many of the banks that were very active in these kinds of transactions have pulled back because of the huge regulatory costs that are being imposed on them. So that is one aspect that is worrying.

Finally, in the case of emerging markets, countries have to be ready for a more volatile environment. They need to have a sufficiently strong framework of monetary and fiscal policy cushions, with healthy banking systems and so on, to navigate through the unsettled waters that we are now experiencing, and that may become more turbulent once the Fed starts tightening.