Publication - Volatility spillovers of Federal Reserve and ECB balance sheet expansions to emerging market economies - Working Paper by Apostolos Apostolou, John Beirne
Non-technical summary
The expansion of international trade and a more pronounced increase in cross-border capital flows over the past decade or so means that countries are more interconnected, with developing countries receiving and sending substantial amounts of capital.
The global financial crisis has reversed some of these capital flows to EMEs and has led to increased levels of financial and real volatility. The unprecedented actions by major central banks, which can affect the ‘world’ interest rate, are also likely to have had an impact on the volatility in EMEs. This paper examines volatility spillovers to EMEs from changes in the balance sheets of the Federal Reserve (FED) and the European Central Bank (ECB) over the period 2003 to 2014.
When the FED announced that it may slow its monetary stimulus in May 2013, emerging markets’ currencies and asset prices became more volatile. The recent literature concentrated on the spillovers from unconventional monetary policies in developed countries and their effects on the levels of financial variables in other countries. However, the volatility that was observed in the financial and real variables of many developing countries has largely been ignored. The discontinuation on the one hand of unconventional monetary policies in the U.S., and the decision of the ECB on the other hand to embark on quantitative easing, have renewed interest in the volatility spillovers from these policies to EMEs. This paper estimates the extent to which the volatility across 13 EMEs can be explained by the changes in the FED and ECB balance sheets. In particular, we explore the dual transmission channel of monetary policy to domestic economies and spillovers to EMEs using a two-step specification to measure volatility spillovers to EMEs. Volatility spillovers are estimated with respect to financial variables such as the bilateral exchange rate, stock and bond markets, as well as macroeconomic variables such as inflation and industrial production.
Overall, our results indicate that the volatility of the FED and ECB balance sheets can explain some of the volatility in EMEs. We find that EME bond markets are most susceptible to positive volatility spillovers from both the FED and ECB in terms of the magnitude of the effect. Positive volatility spillovers to EME currency markets are higher in the case of FED balance sheet expansions than those of the ECB by a factor of about ten. By contrast, we find that EME stock markets are subject to negative volatility spillovers from both the expansion of the FED and ECB balance sheets, whereby volatility in EME stock markets is dampened due to this. Moreover, we find only limited evidence of volatility transmission to the real economy of EMEs following the monetary policy actions of the FED and ECB.
Volatility spillovers from the ECB and the FED were generally more pronounced during the peak of the crisis in late 2008. Volatility spillovers from the FED have been diminishing since late 2008, due its exit from unconventional monetary policies but have not diminished as drastically for the ECB. Our results have policy implications for EMEs exposed to volatility spillovers from advanced economy central bank balance sheet expansions. These particularly pertain to calls for local currency bond markets, given that EME bond markets are most susceptible to negative volatility spillovers for both FED and ECB balance sheet expansions.
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