International transmission of conventional and unconventional monetary policy and financial stress shocks from the euro area to Russia

Dajčman, Silvo; Kavkler, Alenka; Merzlyakov, Sergey; Pekarskij, S. Ė.; Romih, Dejan Article International transmission of conventional and unconventional monetary policy and financial stress shocks from the euro area to Russia Journal of Central Banking Theory and Practice Provided in Cooperation with: Central Bank of Montenegro, Podgorica Suggested Citation: Dajčman, Silvo; Kavkler, Alenka; Merzlyakov, Sergey; Pekarskij, S. Ė.; Romih, Dejan (2022) : International transmission of conventional and unconventional monetary policy and financial stress shocks from the euro area to Russia, Journal of Central Banking Theory and Practice, ISSN 2336-9205, Sciendo, Warsaw, Vol. 11, Iss. 1, pp. 227-247, https://doi.org/10.2478/jcbtp-2022-0010 This Version is available at: https://hdl.handle.net/10419/299038 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by-nc-nd/4.0/ International Transmission of Conventional and Unconventional Monetary Policy and Financial Stress Shocks from the Euro Area to Russia 227 * University of Maribor, Faculty of Economics and Business, Maribor, Slovenia E-mail (corresponding author): [email protected] ** University of Maribor, Faculty of Economics and Business, Maribor, Slovenia E-mail: [email protected] *** HSE University, International Laboratory for Macroeconomic Analysis, Moscow, Russian Federation E-mail: [email protected] **** HSE University, International Laboratory for Macroeconomic Analysis, Moscow, Russian Federation E-mail: [email protected] ***** University of Maribor, Faculty of Economics and Business, Maribor, Slovenia E-mail: dejan.r[email protected] Journal of Central Banking Theory and Practice, 2022, 1, pp. 227-247 Received: 03 June 2020; accepted: 28 September 2020 UDK: 338.23:336.74 DOI: 10.2478/jcbtp-2022-0010 Silvo Dajčman *, Alenka Kavkler **, Sergey Merzlyakov ***, Sergey E. Pekarski ****, Dejan Romih ***** International Transmission of Conventional and Unconventional Monetary Policy and Financial Stress Shocks from the Euro Area to Russia1 Abstract: This paper studies the international transmission of the euro area´s monetary policy and financial stress to Russia. The results show that financial stress in the euro area damages Russian economic activity and stock prices, but not its trade balance. The contractionary euro area monetary policy shock decreases Russian GDP, leads to real appreciation of the euro against the Russian rouble, damages Russian stock prices, but does not significantly affect the trade balance between countries. We also found that the Central Bank of the Russian Federation adjusts to monetary policy shocks in the euro area. Keywords: conventional monetary policy, unconventional monetary policy, financial stress, Russia, international transmission. JEL classification: E52, F42, G15 1 Acknowledgement: This research has been supported by the Slovenian Research Agency (research core funding P5-0023 (A) and BI-RU/19-20-010). S. Merzlyakov and S. Pekarski acknowledge the support by the Basic Research Program at the HSE University, Russian Federation. Journal of Central Banking Theory and Practice 228 Introduction It has recently been documented that increasing global trade and financial flows have made economies around the world more susceptible to monetary policy actions in advanced economies (Cushman & Zha, 1997; Koray & McMillin, 1999; Takáts & Vela, 2014; Vespignani, 2015; Rey, 2016; Bluwstein & Canova, 2016) and financial stress (Dovern & van Roye, 2014; Evgenidis & Tsagkanos, 2017; Chen & Semmler, 2018). Some studies have examined in a unified framework the transmission of conventional and unconventional monetary policy and financial stress within the advanced economies of the US and the euro area (Hubrich & Tetlow, 2015; Kremer, 2016). The international transmission of both types of monetary policy and of financial stress shocks from the euro area to Russia in a unified framework has not been studied. We address this question here. The euro area and Russia are strongly connected via trade.2 Moreover, one should bear in mind a possible complexity of international monetary policy transmission of the euro area monetary policy to Russia given the new unconventional monetary policy.3 Therefore, understanding the transmission of monetary policy and financial stress from the euro area to Russia is of great importance for the design of economic policy. Prior to the introduction of unconventional measures of monetary policy in advanced economies, most studies explained international transmission of monetary policy via trade linkages (Cushman & Zha, 1997; Koray & McMillin, 1999; Kim, 2001a, b). Recently, with the onset of large-scale unconventional monetary policy operations, the focus has shifted away from international trade flows to international financial flows (Berge & Cao, 2014; Falagiarda, McQuade & Tirpák 2015; Chen, Filardo, He & Zhu, 2016; Bluwstein & Canova, 2016; Evgenidis, Philippas & Siriopoulos, 2019). Another strand of the literature has investigated international transmission of financial stress and its detrimental macroeconomic effects (Hakkio & Keeton, 2009; Gilchrist & Zakrajsek, 2012; Dovern & van Roye, 2014; Eickmeier & Ng, 2015; Dajčman, Kavkler, Mikek & Romih, 2020). 2 According to Eurostat data (Eurostat, 2019a), in 2018 imports to the euro area from Russia were 123.15 billion euros or 5.9% of total non-euro area imports. Exports from the euro area to Russia amounted to 66.3 billion euros or 2.9% of total exports. 3 From 2008, the ECB has adopted several unconventional tools: direct and indirect credit and quantitative easing and forward guidance (Fiedler, Jannsen, Wolters, Hanisch & Hallett Hughes, 2016). For details see Neri and Siviero (2019). International Transmission of Conventional and Unconventional Monetary Policy and Financial Stress Shocks from the Euro Area to Russia 229 Only a few studies have investigated international transmission of monetary policy to Russia, focusing mainly on international transmission of US monetary policy (Takáts & Vela, 2014; Chen, Lombardi, Ross & Zhu, 2017; Ono, 2018; Kruglova, Styrin & Ushakova, 2018), while international transmission of euro area monetary policy has attracted little attention (Chen et al., 2017). To fill this gap, we investigate the transmission of euro area (conventional and unconventional) monetary policy to Russia and the relevance of individual channels of transmission. With respect to international transmission of monetary policy, this paper extends Kremer´s (2016) one-country model to a two-country macroeconomic model. The model enables us not only to assess the effects of euro area conventional and unconventional monetary policy shocks, but also the effects of euro area financial stress shocks for a set of Russian economic variables. These variables include economic activity (GDP), price level, monetary policy rate, bilateral trade with the euro area, the bilateral exchange rate, stock prices and government bonds yield. Literature review The literature traditionally argues that international transmission of monetary policy works via the impact of exchange rates on trade flows and other macroeconomic variables (Cushman & Zha, 1997; Koray & McMillin, 1999; Kim, 2001a, b; Maćkowiak, 2007; Vespignani, 2015; Shobande & Shodipe, 2021). Mohanty (2014) notes that central bank practitioners identify the adjustment in the exchange rate and the monetary policy rate as the prime channels of monetary policy transmission from advanced to emerging economies: the former is singled out as the main channel in economies with a floating exchange rate regime, the latter with a fixed exchange rate regime. Rey (2016) and Evgenidis et al. (2019) point out that in a floating exchange rate regime, monetary policy impulses can exert influence on the trade balance of domestic and foreign economies in two opposing ways: demand-augmenting effects and expenditure-switching effects. A contractionary domestic monetary policy impulse weakens domestic demand including imports, which improves the domestic trade balance (demand-aug- menting effect) and, at the same time, an increase in domestic policy rate may induce a real appreciation of the domestic currency, which in turn worsens the domestic trade balance (expenditure-switching effect) and affects other domestic and foreign macroeconomic variables (ibidem). Takáts and Vela (2014) and Rey (2016) show that a floating exchange rate regime cannot insulate domestic economies from monetary spillovers from advanced economies, while Bluwstein and Canova (2016) contend that the exchange rate is the most potent international Journal of Central Banking Theory and Practice 230 transmission channel of conventional ECB´s monetary policy for non-euro European countries, irrespective of the exchange rate regime. Takáts and Vela (2014) reason that with fixed exchange rates, the international spillover of policy rates from advanced to emerging economies is direct. The international transmission of unconventional monetary policy may differ from the conventional monetary policy (see IMF, 2014, and references therein; Bluwstein & Canova, 2016). While the exchange rate channel is still considered as a major channel of transmission (Bluwstein & Canova, 2016; Varghese & Zhang, 2018; Inoue & Rossi, 2018), the literature has identified several other potentially important channels4 that work via financial ties between countries, including the wealth channel (stock prices) and the portfolio rebalancing channel (sovereign bond yields)5 (see IMF, 2014; Bluwstein & Canova, 2016; Varghese & Zhang, 2018; Inoue & Rossi, 2018). Bluwstein and Canova (2016) argue that unconventional monetary policy affects the cost of capital which in turn may affect stock prices (wealth channel). Unconventional monetary policy may affect bond yields triggering investors´ portfolio changes (portfolio rebalancing channel) (Falagiarda et al. 2015; Bluwstein & Canova, 2016; Varghese and Zhang, 2018; Boermans & Keshkov, 2018). In this line of research, Tillmann (2014) and Aizenman, Binici and Hutchinson (2016) find that the Fed´s unconventional monetary policy significantly affects the exchange rates and stock prices of emerging markets. Bowman, Londono and Sapriza (2015) argue that unconventional US monetary policy affects the bond yields of emerging market economies. Falagiarda et al. (2015), who investigated international transmission of ECB´s monetary policy, note that the impact is mainly on sovereign bond yields. Bluwstein and Canova (2016) find that unconventional ECB policy measures affect nine non-euro European countries via the exchange rate, the wealth channels and the portfolio channels. Varghese and Zhang (2018) investigated the ECB´s unconventional monetary policy transmission to four non-euro area European countries. They found that the exchange rate and portfolio rebalancing channels are operational. MacDonald and Popiel (2017) note two main approaches capturing the stance of unconventional monetary policy: the shadow rate (computed e.g. by Wu & Xia, 2016) and a measure of expansion of the central bank´s balance sheet (see 4 For a thorough review of different channels of unconventional monetary policy transmission see Mohanty (2014) and Bluwstein and Canova (2016). A recent review of conventional monetary policy transmission channels is provided by Pazardjiev and Vasilev (2021). 5 These channels may also be important for the transmission of conventional monetary policy (Ioannidis & Kontonikas, 2008; Bluwstein & Canova, 2016). Ioannidis & Kontonikas (2008) argue that by increasing policy rates, monetary policy can affect stock prices either by increasing the discount rates or worsening expectations of profits on future enterprises. International Transmission of Conventional and Unconventional Monetary Policy and Financial Stress Shocks from the Euro Area to Russia 231 e.g. Boeckx, Dossche & Peersman, 2017; Kremer, 2016). MacDonald and Popiel (2017) point out that each approach has its own advantages and disadvantages. For instance, the balance sheet cannot capture the central bank´s forward guidance, while the shadow rate can (ibidem). However, its weakness stems from the fact that if this rate alone is used to represent the stance of monetary policy, we cannot separate conventional from unconventional monetary policy during the period when the central bank´s official policy rate has not yet reached the zero lower bound (ibidem). The literature on the transmission of unconventional monetary policy to Russia is sparse. Takáts and Vela (2014) have studied repercussions of US unconventional and conventional monetary policy in 24 emerging economies. They find that the Russian policy rate responds positively to shifts in the US policy rate, but not to shifts in the US shadow rate. Further, they find a significant positive relationship between the US and Russian long-term interest rates. Chen et al. (2017) have analysed and compared the impact of the Fed´s and the ECB´s unconventional monetary policies, proxied by their shadow interest rates, in 24 advanced and emerging economies, including Russia. They find that upon an expansionary Fed policy shock, Russia´s GDP growth and inflation rates increase, while upon the ECB´s monetary policy shock, only credit growth responds positively and significantly. Ono (2018) concentrates on Fed´s conventional and unconventional monetary policy shocks, proxied commonly by the shadow rate and assesses the impact on Russian stock prices, policy rate and bilateral exchange rate. The main finding of the study is that an increase in the shadow rate reduces Russian stock prices and interest rates and depreciates the Russian rouble. Kruglova et al. (2018) apply bank-level data to appraise the impact of the US unconventional monetary policy. They find that monetary tightening is associated with a reduction in bank lending in Russia. Specifically, banks that rely more heavily on international financing cut their loans more heavily. They also note that a structural change occurred in the Russian macroeconomic environment in 2014 and that economic modelling of the Russian economy should take this into account. Our work is also related to studies of the transmission of financial stress in otherwise standard monetary Vector Autoregressive (VAR) models (Hubrich & Tetlow, 2015; Kremer, 2016). To analyse euro area stress and monetary policy transmission to Russia, we extended the model of Kremer (2016) who studied the macroeconomic effects of conventional and unconventional ECB´s monetary policy and financial stress (proxied by the Composite Indicator of Systemic Stress) and found that financial stress significantly affects output and inflation. Journal of Central Banking Theory and Practice 232 Methodology The impact of euro area conventional and unconventional monetary policy and financial stress shocks on the Russian economy is assessed by fitting a two-coun- try VAR model and computing impulse responses. The estimated VAR can be written as (see e.g. Christiano, Eichenbaum & Evans, 1996, 1999; Luetkepohl, 2011; Kremer, 2016)6: (1) where is vector of endogenous variables partitioned into 3 blocks is matrix of regression coefficients, l denotes the lag (1,…,p), is vector of regression constants and is a vector of errors. The first block of endogenous variables consists of euro area variables , the Russian variables are contained in the vector , and the variables related to foreign trade in the vector . is the real GDP for the euro area (Russia, respectively), is consumer price index, is the Composite Indicator of Systemic Stress in the euro area, is monetary policy rate, capturing the stance of conventional monetary policy in the euro area and in Russia respectively, is the Eurosystem´s balance sheet capturing the stance of unconventional monetary policy in the euro area, is stock prices index for Russia, is the yield on long-term Russian government bonds, is the real exchange rate between the rouble (RUB) and the euro (EUR), i.e., the price of one euro in roubles, and is the bilateral trade balance of the euro area with Russia in real terms. and are included in the Russian block variables to identify whether ECB´s monetary policy is transmitted to the Russian economy via the wealth and the portfolio rebalancing channels. The block of variables related to foreign trade helps to identify whether the international transmission of ECB´s monetary policy via trade linkages between the economies is operational. To control for a possible structural change in the Russian economy after 20147, an 6 Compare also to Cushman and Zha´s (1997) model. 7 In 2014, at least three important factors may have contributed to this change (Kruglova et al., 2018; Central Bank of the Russian Federation, 2014): i) new monetary policy regime (managed exchange rate regime was substituted by formal inflation targeting), ii) a large fall in the price of oil, the main Russian export commodity and iii) the imposition of economic sanctions amongst others by the euro area countries. International Transmission of Conventional and Unconventional Monetary Policy and Financial Stress Shocks from the Euro Area to Russia 233 exogenous dummy variable was added8 in model (1) VAR equations for the and blocks of variables. In addition, the world oil price ( ) was added as an exogenous variable9, entering all equations in VAR model (1). All variables, except , , and enter equation (1) in natural logarithm of levels10. The lag, , is determined by information criteria. In equation (1), unconventional monetary policy of ECB is proxied by the volume of the Eurosystem’s balance sheet ( ). By taking this proxy instead of the shadow rate, we can disentangle unconventional from conventional monetary policy of ECB at a time when its policy rate has not yet reached the zero lower bound (see MacDonald & Popiel, 2017)11. The total consolidated balance sheet of the Eurosystem is considered (Kremer, 2016; Boeckx et al., 2017). Identification of shocks is achieved by (Cholesky decomposition) assuming that variables in block are not contemporaneously affected by shocks in variables in blocks and , while variables in block are not contemporaneously affected by shocks in variables in block . All computations are made with standard Stata VAR and impulse responses (estimation and drawing) procedures. Following the standard VARs of monetary policy transmission (Christiano et al., 1996; Christiano et al., 1999) and VARs which study transmission of conventional and unconventional monetary policy (Kremer, 2016; Boeckx et al., 2017; Dajcman & Tica, 2017) the specific order of the euro area variables implies that the shock in conventional ECB´s monetary policy is identified by assuming that the ECB sets its policy rate by considering contemporaneously information on economic activity, price dynamics and financial stability in the euro area, whereas all other determinants considered in the model affect policy rate decisions with a lag. 8 We follow Kruglova et al. (2018) and determine that a regime change could have happened in 2014. We set March 2014 as the regime-shift date, since after that time factors outlined in footnote 6 started to realize (see also e.g. Gurvich and Prilepskiy (2015) for analysis on the impact of sanctions). The dummy variable thus takes value 1 (and 0 otherwise) for the period from March 2014 until the end of the sample. We allow the regime change in the Russian economy to impact only and blocks of variables. 9 Although oil is an important Russian export commodity (according to the Central Bank of the Russian Federation (2014), more than 50% of Russian exports is attributed to oil export) we assume that the world price of this commodity is exogenous to the modelled variables (for such treatment of this variable see e.g. Ono, 2018). 10 This is also common practice in the referenced literature (Cushman & Zha, 1997; Koray & Mc- Millin, 1999; Vespignani, 2015; MacDonald & Popiel, 2017; Boeckx et al., 2017). 11 ECB´s key policy rate (the rate used in its ordinary main refinancing operations) reached zero level in 2016, whereas an expansion of the Eurosystem´s (consolidated) balance sheet due to its unconventional measures started sooner (see e.g. Fiedler et al., 2016; Boeckx et al., 2017). Journal of Central Banking Theory and Practice 234 An ECB´s unconventional monetary policy shock is identified by assuming that, in a particular month, the central bank evaluates that months´ indicators of the euro area economic activity, price dynamics, financial stability and the current level of its policy rate before taking any action that will have an impact on the size of Eurosystem´s balance sheet, , while other variables impact Eurosystem´s balance sheet with a lag. We identify the Central Bank of the Russian Federation monetary policy shock by assuming that it considers contemporaneously all euro area economic and financial sector variables included in the model (1). This reasoning is standard in the previous studies on the international transmission of monetary policy from large, advanced, to small, open or emerging economies (Cushman & Zha, 1997; MacDonald & Popiel, 2017). The ordering implies that the balance of bilateral trade and the RUB/EUR exchange rate dynamics are contemporaneously affected by all euro area and Russian variables shocks. Data and empirical results Model (1) is estimated on monthly data. Although for some variables data availability started in 1999M1, the availability of data for some others was shorter and given the estimated model characteristics the actual period of VAR model (1) estimation was 2000M10-2018M6. A detailed specification of variables is presented in Table 1. Table 1: Description of the variables Variable notation Description Monthly index of seasonally adjusted real GDP for euro area and Russia. Monthly time series was estimated from monthly seasonally adjusted industrial production index for euro area and Russia (total industry, excluding construction; OECD (2019a) data was used) and quarterly (seasonally adjusted) GDP index series for Russia (OECD (2019b) data) and euro area (seasonally and calendar adjusted) (Eurostat (2019b) data) by temporal disaggregation method of Chow-Lin (1971)a. Computation is based on the sum method (index for each month was obtained by summing the estimates obtained by the method for the current and past two months) and as a robustness test the time series was estimated with the average method (see Quilis, 2019). The natural logarithm of the time series enters model (1). Consumer price index for the euro area and Russia. For euro area the seasonally and working day harmonized index of consumer prices (HICP) is used (European Central Bank – ECB (2019a) data), while for Russia the consumer price index (OECD (2019a) data). In robustness test we also seasonally adjusted the series for Russia by using the X-13ARIMA-SEATS methodb. The natural logarithm of the time series enters model (1). International Transmission of Conventional and Unconventional Monetary Policy and Financial Stress Shocks from the Euro Area to Russia 241 Conclusion The scope of international trade and financial links between Russia and the euro area countries implies a potential importance of international transmission of monetary policy and financial stress to Russia. This paper fills the gap in quantitative analysis of these issues. Some of our results are in line with the reviewed literature. The reaction of Russian GDP and CPI to a euro area financial stress and conventional and unconventional monetary policy shocks qualitatively corresponds to the evidence in other countries. 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