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Monetary policy challenges in the five major emerging countries of BRICS

Is there an existing economic theory that provides teachings that are relevant for the designing of effective monetary policy frameworks in emerging markets? What are the lessons learned from cross-country studies as well as from the experiences of specific countries that have adopted divergent approaches? Whereas country-specific conditions and initial conditions are of importance in the formulation of appropriate frameworks, are there clear general principles that can be used as a guide in this process? These are among the issues to be addressed in the discourse between academics and policy-makers.

BRICS represents the five major emerging economies: Brazil, Russia, India, China, and South Africa. A summary of the main issues, connecting them to broader debates in the academic literature as well as an evaluation of how individual countries have chosen to respond to specific policy challenges and what the results have been are provided. A further discussion is provided of the many controversies where there exist stark differences in views between and amongst theorists and practitioners. There are also definitions of a few key analytical issues with vast gaps between theory and practice. A broad agenda for further research in this area is further set out.

In the case of India, the monetary policy committees of the BRICS central banks shocked the market by keeping policy rates unchanged. Many financial market analysts anticipated that the rate-setting committee would increase policy rates by twenty-five basis points. However, the committees altered the policy stance from neutral to “calibrated tightening". The change in the policy position is in the correct direction, nevertheless, the decision to not raise rates remains perplexing.

It demonstrates that there is a significant difference in the way the monetary policy committee and financial markets are reading the evolving economic situation, which was also echoed in the post-policy press conference. The decision may be explained by the fact that inflation forecasts have been reviewed lower and the monetary policy committee thinks that the last two hikes are sufficient to keep inflation close to the target. However, many analysts thought that rising crude and the falling rupee merited a rate response. The tightening of global financial circumstances and rising interest rates in the US will make the bankrolling of the current account deficit difficult. This will put downward pressure on the rupee and raise inflation risks. Although the government is trying to reduce the current account deficit, the steps taken thus far are unlikely to have a significant impact. The policies of the BRICS central banks are to manage undue volatility in currency and not target any specific level. However, policy tightening would have assisted in the present situation when volatility is expected to remain raised.

It would have signaled to the market that the central bank is eager to compress aggregate demand to deal with the current account deficit and inflationary risks originating from the weakening of the currency, ultimately reducing the need to use foreign exchange reserves to contain volatility. The move would have been congruent with the legislated mandate of inflation targeting and the wider aim of safeguarding financial stability. However, by not increasing rates, the monetary policy committee has left it in the hands of the currency market to make the macro adjustment. This may be unsafe as it is likely that the pressure on the rupee will increase. Even though there is a case for gradual depreciation, the risk posed is that the currency might overshoot considerably on the downside and affect economic activity, along with raising inflationary prospects and financial stability risks. Such an outcome might affect the reliability of the central bank. It could also have a bearing on the central bank’s ability to anchor inflationary expectations.

In light of the situation, a more conservative approach would have been more appropriate and aided in anchoring inflationary expectations. The BRICS central banks might have undervalued inflationary risks. A new analytical chapter from the October edition of the World Economic Outlook, released by the International Monetary Fund, is focused on monetary policy challenges in emerging market economies. It states that “improvements in the extent of anchoring of inflation expectations can significantly improve economic resilience to adverse external shocks in emerging markets. Anchoring reduces inflation persistence and limits the pass-through of currency depreciations to domestic prices, allowing monetary policy to focus more on smoothing fluctuations in output.”


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