Policy Responses to Economic Downturns

Developing countries do not only experience recessions more frequently, they also have a lesser tendency to implement countercyclical monetary policy. Vegh and Vuletin (2012) argues that emerging market economies do not implement countercyclical monetary policy during economic downturns because monetary expansion during a recession could lead to currency depreciation and consequently, capital outflows to the extent that developing countries have opened up their financial markets. Table 12 reports the number of recessions which industrialized countries, emerging market and non-emerging market developing countries did not respond to with a countercyclical monetary policy response or responded to in a “fast” or “slow” manner. According to Table 12, industrialized countries are found to implement “fast” monetary policy in 69 of 115 recession episodes (60.00%). This is higher compared to emerging market economies and other developing countries with 74 of 158 (46.84%) and 36 of 117 (30.77%), respectively. Conversely, developing countries have a higher likelihood of failing to implement a countercyclical monetary policy. Emerging market and non-emerging market developing countries did not implement a countercyclical monetary policy in 53 of 158 (33.54%) and 56 of 117 (47.86%) of recession episodes detected, respectively. In contrast, industrialized countries and emerging market economies did not implement a countercyclical monetary policy in 27 of 115 (23.48%) and recession episodes, respectively. The results presented in the table shows that that industrialized countries conduct countercyclical policy in more than three fourths of their recessions, while non-market developing countries could barely implement countercyclical monetary policy responses half of the time.

Table 12. Monetary Policy Responses, by level of their economic and institutional development

No CCMP Response

(# of recessions)

Slow CCMP Response

(# of recessions)

Fast CCMP Response

(# of recessions)

Total Recessions

(# of recessions)

All 136 75 179 390

IDCs 27 19 69 115

EMEs 53 31 74 158

ODCs 56 25 36 117

Source: Author’s Calculation Notes:

(1) Industrialized countries (IDCs), Emerging market economies (EMEs), Non-emerging market developing country or other developing country (ODCs)

(2) Countercyclical monetary policy (CCMP)

The inability of developing countries to implement a countercyclical monetary policy is highlighted in cases when policymakers in developing countries could plausibly foresee an economic downturn coming—such as in cases when the downturn is caused by a contraction in demand in industrial countries—but still could not implement a countercyclical monetary policy. Table 13 reports four episodes of major economic downturns in industrialized countries as well as the monetary policy responses of countries. The last column of the table shows the number of countries which fell into recession during each global recession episode. Since industrial countries comprise most of the share in global output, their recession can cause a decline in trade with and capital inflows to developing countries which can also cause an economic downturn in developing countries (Kose, Ortok and Prasad 2012). These major economic downturns in industrialized countries, which caused a decline in PPP-weighted world real GDP per capita, are thus deemed as global downturn episodes (IMF 2009). A notable example of an industrial country-developing country spill-over is during the 1980-1983 global recession when an economic downturn in the United States eventually led to the Latin American Crisis. As shown in Table 13, many developing countries also fall into recession during the global downturns, which originated in industrialized countries.

Table 13. Summary of Global Downturns and Monetary Policy Responses No CCMP

Response (# of recessions)

Slow CCMP Response

(# of recessions)

Fast CCMP Response

(# of recessions)

Total Recessions

(# of recessions) 1974-1975: Stagflation in industrialized countries

All 10 4 8 22

IDCs 2 3 7 12

EMEs 5 0 1 6

ODCs 3 1 0 4

1980-1983: Contractionary monetary policy of the Fed to mitigate high inflation led to an economic downturn in the US

All 17 4 17 38

IDCs 2 0 10 12

EMEs 7 3 6 16

ODCs 8 1 1 10

1990-1993: Fall in profits, fall in investments and thus fall in employment in industrialized countries / ERM crisis

All 11 8 23 42

IDCs 1 4 9 14

EMEs 5 3 10 18

ODCs 5 1 4 10

2008-2010: Global Financial Crisis

All 5 9 22 36

IDCs 0 2 4 6

EMEs 4 4 10 18

ODCs 1 3 8 12

Notes:

(1) Industrialized countries (IDCs), Emerging market economies (EMEs), Non-emerging market developing country or other developing country (ODCs)

(2) Countercyclical monetary policy (CCMP)

Countercyclical monetary policies are more important during global downturns because in most cases, developing countries cannot rely on industrialized countries as sources of export market to rebound from the economic downturn. If industrialized countries themselves are experiencing a recession, monetary authorities in developing countries need to implement an accommodative monetary policy to at least ease domestic credit condition that can help stabilize output. However, developing countries were not able to make use of expansionary monetary policy to respond to the global economic downturns. According to Table 13, most emerging market and non-emerging market developing countries did not employ monetary policy to respond to the downturns. During the 1974-1975 stagflation episode in particular, out of the 6 recession episodes detected in emerging market economies, only one country implemented a rapid monetary policy response. In addition, out of 4 recessions detected in non-emerging market developing countries, only one country implemented a countercyclical monetary policy, albeit a slow one. The results show that many developing countries were not able to implement countercyclical monetary policy even if they could have plausibly foresee the need for it when their major trading partners from industrialized countries fell into crisis.

Nevertheless, in recent years, policymakers in developing countries are catching up with industrialized countries and have developed their ability to implement countercyclical monetary policy. Table 14 reports the percentage of different policy responses to recessions in per decade. The results show that the trend towards more responsive monetary policy is increasing regardless of the level of economic and institutional development of the country.

This finding that policymakers in developing countries are beginning to adopt countercyclical monetary policy is consistent with the finding of Vegh and Vuletin (2012), who show that many developing countries have graduated from a procyclical monetary policy stance.

Table 14. Percentage of Policy Response to Recessions, by decade Pre-1980s

(in %) 1980s

(in %) 1990s

(in %) Post-2000s

(in %) Total

(in %) All

No CCMP 53.01 47.44 30.63 17.8 34.87

Slow CCMP 13.25 8.97 18.02 31.36 19.23

Fast CCMP 33.73 43.59 51.35 50.85 45.9

IDCs

No CCMP 28.95 18.18 30.00 12.00 23.48

Slow CCMP 15.79 9.09 13.33 28.00 16.52

Fast CCMP 55.26 72.73 56.67 60.00 60

EMEs

No CCMP 73.08 47.06 22.92 14.00 33.54

Slow CCMP 3.85 8.82 20.83 34.00 19.62

Fast CCMP 23.08 44.12 56.26 52.00 46.84

ODCs

No CCMP 73.68 77.27 42.42 25.58 47.86

Slow CCMP 21.05 9.09 18.18 30.23 21.37

Fast CCMP 5.26 13.64 39.39 44.19 30.77

Source: Author’s Calculation Notes:

(1) Industrialized countries (IDCs), Emerging market economies (EMEs), Non-emerging market developing country or other developing country (ODCs)

(2) Countercyclical monetary policy (CCMP)

In the past, emerging market economies could not implement countercyclical monetary policies because the policy combination of relatively open financial markets and fixed exchange rate regime had made it difficult for monetary policymakers to retain monetary autonomy. Vegh and Vuletin (2012) point out that developing countries fear currency depreciation which can trigger capital outflows and bloating their external debt. These risks prevent monetary policymakers in developing countries from implementing countercyclical monetary policy. Before the 1980s, non-emerging market developing and emerging market

1990s—prompted reforms in the financial sector which lessened the constraints monetary authorities face in implementing countercyclical monetary policy.

In order to increase the level of monetary independence, countries could choose to impose capital controls or make its exchange rate movements more flexible. In the face of the global trend in financial integration, emerging market economies have decreased the extent they pursue exchange rate stability in the 2000s (Aizenman, Chinn and Ito 2008), thereby enabling them to pursue domestic objectives through monetary policy. Consequently, from the 2000s and onwards, the percentage fast monetary policy responses during recession episodes has increased to 44.19 percent in non-emerging market developing countries, 52 percent in emerging market economies and 60 percent in industrialized countries. On the other hand, the lack of countercyclical policy responses declined from 73.68 percent in the pre-1980s period to 25.58 percent in the post-2000s period in non-emerging market developing countries, from 73.08 percent to 14.00 percent in emerging market economies and 28.95 percent to 12 percent in industrialized countries. The results reveal that not only do policymakers have increased their tendency to conduct countercyclical monetary policy, but they also increased their tendency to implement a countercyclical monetary policy response in a rapid manner.