Weekend Reading / Global

Covid-19 business transformations: The subscription revolution

  • The impact of Covid-19 on the shape of business will be immense
  • The pandemic will both accelerate the shift to subscription models in developed markets and catalyse the shift in EM
  • Investors should favour firms that deepen their customer relationships and implement recurring revenue business models

There is widespread agreement among observers and commentators that Covid-19 will fundamentally change business and commerce. Some of those changes will simply mean extending the working practices, like tech-enabled remote working for the masses, that began during Covid-19. Other changes will build on trends that the Covid-19 response has accelerated, like shifting away from cash to digital money, with positive knock-on effects for the growth of e-commerce in the developing world. In other cases, changes will be focused on business by geopolitics, for example as geopolitical competition increases the risk of tariffs and other trade disruption. The impetus for economic recovery also risks rolling back positive progress in ESG and climate, as governments and investors cast a blind eye on long-term damage incurred in the course of short-term growth.

Let’s get recurring

All of these are examples of projecting current developments into the future, but changes will also result from the lessons that companies learn during the lockdown and the impact of those lessons on their business models. While these lessons are many and varied, ranging from questioning just-in-time supply chains to reassessing how to market to and engage customers, the biggest of these lessons is likely to be around the value of committed customer relationships and recurring revenue. Covid-19 will both accelerate the shift to subscription, recurring revenue, business models in developed markets and catalyse such a shift in developing markets.

Commitment issues

Markets have long recognised that not all revenue is created equal, and the 20+ EBITDA multiples on many subscription businesses prior to Covid-19 already reflected the value of beginning your financial year with committed customer relationships, client contracts and revenue already in place. Covid-19 has highlighted just how valuable recurring revenue is and will cause more consumers to prefer to engage through a subscription model. Successful businesses will use this crisis as an opportunity to make the transition to recurring-revenue business models.

Discussion of business models is easily dominated by the business’s own perspective – after all, the business model is all about how the business organises itself and goes to market, but a business model only works if it meets the needs of the market, so let’s begin with the customer’s perspective. Covid-19 has taken a tremendous toll on household incomes, especially in developed countries that failed to effectively implement policies to maintain employment, like the US, and emerging markets without the resources to do so. It is unsurprising that hire-purchase, arguably the first transformation of a traditional business into a recurring revenue business, first came into common use in Britain during the Great Depression, leading parliament to pass the Hire-Purchase Act of 1938 to protect buyers from overly aggressive tactics by sellers.

Today, businesses, like households, are stressed and uncertain – concerned about both future prospects and short-term cashflow. In such circumstances, customers, whether they are end consumers or businesses themselves, are more likely to prefer to commit to an ongoing service at a manageable cost rather than expose themselves to the potentially higher, less predictable cost of working with a traditional vendor. Importantly, they are also more likely to prefer a bundle of services that are good enough rather than pay more to get the best possible service in each category, and, as we shall see shortly, bundles are a natural extension of recurring revenue business models.

Revenue security

Covid-19 has shown just how quickly a dislocation can cause revenue to vanish, even from established customers. More worryingly, when a firm is no longer engaged with its customer, that historical relationship may count for little when that customer returns to the market, looking for a new solution to their problems. Firms with large cash balances have had resources to buffer the impact of Covid-19 and give them time to reorient, but firms with subscription business models have another powerful buffer: commitment revenue and committed customers. Indeed recent data indicates that only c30% of subscription businesses have experienced revenue contraction during Covid-19.

Deeper customer engagement

Recurring revenue relationships can encourage businesses to engage more closely with their customers and think more deeply about their customer needs. Rather than selling a product or a one-off service, a subscription creates an ongoing relationship. This encourages firms to take the time to understand how their customers’ needs are changing and what they can do to deepen relationships and increase the value that they offer customers. This means the subscription businesses are better positioned to respond to downward pricing pressure by increasing value, by offering bundles of complementary services for example, rather than discounting prices or losing customers. This will help them to respond to Covid-19 with greater agility than traditional businesses.

Deeper customer relationships also give recurring revenue businesses more options to work with customers through difficult circumstances. Recent research has found that businesses offering the flexibility to suspend and resume subscriptions are more likely to retain customers. By keeping the customer relationship intact through the period of lockdown and recession, these businesses will be able to restart existing relationships as Covid-19 abates rather than needing to rebuild from scratch.

Making it work in emerging markets: The Theory

The shift to recurring revenue business models has been underway for some time in developed markets, but it has proven more challenging in emerging markets. Covid-19 might change that. Recurring revenue relationships typically rely on both the buyer and the seller accepting one another’s creditworthiness. If the buyer pays in advance, they need to be confident that the seller will be around to provide the service when they need it. Similarly, where the buyer pays in contracted installments, the contract is an asset of the seller, the value of which depends on the buyer meeting their contractual obligations.

Furthermore, many such models require regular recurring payments, which are more complicated, especially in B2C, in many emerging markets than in developed markets, which benefit from widely distributed credit card networks and direct debit arrangements. By accelerating the adoption of digital payments and electronic money, Covid-19 is helping emerging markets to build a payments ecosystem that will enable subscription business models in the same way that cards and direct debits do in developed markets. Not only will Covid-19 accelerate the development of the infrastructure to support recurring revenue, it will also lead firms in emerging markets to welcome new business models. Necessity, in the form of financially strained, risk-averse customers, will help to overcome the inertia of existing business models.

Making it work in emerging markets: The Practice

Having helped businesses in both developed and developing countries to make this business model transformation, I appreciate the complexity it entails, including reengineering business processes, changing the approach to sales and marketing, reprofiling revenue and engaging differently with customers. At the end of that process, the impact can be greater in emerging markets than in developed ones because a recurring revenue business model allows the firm to lower barriers to entry by reducing initial cost and increasing flexibility.

In developed markets, new subscription services are often displacing existing traditional businesses, whether in enterprise software, video rental or business services. In emerging markets, however, subscription models can allow a customer, whether a business or a household, to procure a service for the first time, both by lowering the entry cost and by allowing customers, especially business customers, to experiment with a new type of solution on a small scale. This can mean, for example, implementing new services or software in a small number of sites or in a single city before rolling it out across the business. As such, the subscription transition often enables emerging market businesses to access new customer segments as well as serve existing customers differently.

Roof-top solar is one example. High upfront cost combined with the risk of breakages and obsolescence have limited the roll-out of these systems, especially to households. A subscription model would be ideal, as it would spread the cost of power as a service, incorporating maintenance and equipment upgrades into a single monthly payment. Historically such a model would have been constrained by the complexity of collecting monthly payments and difficulty assessing the credit quality of the customers. Digital payments are addressing the first problem, as well as providing data that can help to measure credit quality. New tech products are now using a range of alternative data to help to better assess credit, helping to solve the second problem. Finally the Covid-19 recession is likely to shrink the pool of customers who can afford these systems up front, forcing solar companies to find new ways to access customers. Technology is reducing the risk of moving to a subscription business model, while Covid-19 is leading firms to increase their risk appetite. This creates a new area of acceptable risk, where new subscription business models will emerge.

What it means for investors

New entrants often arise as dominant players after recessions because recessions both are caused by and cause major changes in the structure of the economy. Not only did Salesforce, Facebook, Airbnb and Google famously grow into dominant positions during recent recessions, but GE, GM, Disney and many others are children of more distant recessions. New entrants don’t need to transform their businesses to thrive in the new environment – the new environment is the only environment they’ve known. For established firms to match their agility, they need to recognise the need to transform early, rather than merely seek to wait for good times to return, and they need to be willing to abandon aspects of their historical business model to achieve a new one.

Investors should be looking at the private company universe, especially in rapidly changing areas like fintech, to try to find the new entrants that understand the new environment and will thrive. Some of these companies are young and well-placed for the future, as GM and Google were. Others will be founded during the recession itself, as Disney and Airbnb were.

When assessing established, listed firms, investors will need, as many already are, to shift their focus to emphasise the robustness and resilience of a firm’s strategy in multiple future scenarios. Business models are a key driver of robustness and resilience, and investors should watch closely for firms that implement subscription and recurring revenue business models to deepen their relationships with customers and improve the robustness of their revenues.

This is the first in a series of reports that seek to pull together many strands of Tellimer research to understand better how business, globally and especially in developing markets, could change after Covid-19.


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Macro Analysis / Global

Fibre towards a gigabit society

ING Think
22 June 2020

Executive summary

We believe that one of the effects of Covid-19 is that many companies will adopt best practices learned during the lockdown period and that these will be structurally incorporated in their business models. This includes working more from home. Therefore, we expect there will be more demand for higher network speeds. Fibre-to-the-home (FTTH) networks will become increasingly important in a Gigabit society, but there is still a large divergence in coverage among European countries and operators need to invest significantly to make their networks future-proof.

In this report, we look at the large divergence in FTTH coverage across Europe. Coverage in rural areas is particularly poor.

We examine the next generation access networks that are becoming increasingly available.

We also look at the fibre rollout plans by existing players. And while Spain is leading FTTH coverage across the continent, we examine why Germany, the UK and the Netherlands perhaps need to do more.


 
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Macro Analysis / Global

Digital solutions to fight financial crime

Refinitiv Perspectives
29 June 2020

The digital revolution has enhanced many aspects of our lives, and yet this technology also enables financial criminals to defraud individuals, countries and societies. A Refinitiv expert talk analyzed different aspects of the revolution, and explains how digital onboarding and digital identity solutions offer banks and financial institutions a chance to fight back against criminals.


  1. A Refinitiv expert talk looked at how financial criminals are exploiting the capabilities of emerging technology to further their illegal activities.
  2. During the COVID-19 crisis the situation has been exacerbated. Financial criminals have been able to exploit increased opportunities caused by the fear, uncertainty and desperation in society during the pandemic.
  3. Qual-ID offers a unique combination of elements to deliver a holistic digital identity and screening solution that boosts compliance team efficiency, controls costs, and promotes a positive client experience.

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As digital evolution continues to grow in a number of industries, tech-savvy consumers increasingly expect the same 24/7/365 digital experience they receive in digital retail to be present in other areas of their lives, such as retail banking and wealth management.

Connectivity, convenience and increased consumer engagement rank among the most appealing benefits of digitization. However, there is a pressing need for banks and financial institutions (FIs) to protect their customers from highly sophisticated financial criminals who can harness digital capabilities to defraud both companies and individuals.

Read the expert talk: Digital solutions to fight against financial crime

1% of criminal proceeds generated in the EU are confiscated bv aurhorities

COVID-19 and financial crime

The FBI provides various examples relating to how criminals are using COVID-19 to defraud individuals, including posing as government employees in order to extract personal information for illegal purposes.

And work-from-home fraud, in which victims are asked to send or move money, effectively becoming money mules and enabling criminals.

Refinitiv’s own research confirms that financial crime remains pervasive. Our 2019 report, ‘Innovation and the fight against financial crime’, found that over two-thirds (72 percent) of respondents were aware of financial crime taking place in their global operations during the 12 months preceding the survey.

Refinitiv white paper statistic. Digital solutions to fight against financial crime

Digital evolution will continue to gather momentum. In fact, digital commerce is expected to grow globally at more than a 20 percent CAGR by 2022, reaching nearly US$5.8 trillion in value.

Alongside this growth, sophisticated criminals will continue to exploit emerging technology to further their illicit activity.

It is therefore imperative that banks and FIs harness the power of the best available technology and solutions to prevent financial crime and protect their customers.

Digital identity solutions offer an immediate opportunity for success in this critical area.

James Mirfin quote. Digital solutions to fight against financial crime

The growth of digital solutions

Many banks and FIs are juggling fierce competition, tightening margins, and the over-arching need to ensure a positive client experience, while also mitigating security threats such as large scale data breaches, phishing and social engineering attacks. All of which have made it easier for fraudsters to assume the identities of legitimate account owners via account takeover fraud.

The COVID-19 crisis has only compounded this scenario, serving to increase opportunities for financial criminals to exploit raised levels of fear, uncertainty and desperation.

Forward-thinking banks and FIs are therefore accelerating their digital transformation programs to mitigate the higher levels of risk anticipated during and after the pandemic.

In particular, we expect a significant uptick in the use of digital onboarding and digital identity solutions, which deliver diverse benefits including: Faster turnaround times; improved accuracy; better security; enhanced operational efficiency; cost savings; and a more favorable customer experience.

Watch: Refinitiv Qual-ID is a unique digital identity solution

A holistic digital identity and screening solution

Refinitiv’s digital identification and verification solution, Qual-ID has been built specifically to address many of the challenges faced by FIs.

Qual-ID offers a unique combination of elements to deliver a holistic digital identity and screening solution that boosts compliance team efficiency, controls costs, and promotes a positive client experience.

The solution leverages our market-leading World-Check Risk Intelligence Database of accurate and reliable information from reputable sources, including watch lists, government records, and media searches.

World-Check Risk Intelligence. Digital solutions to fight against financial crime

The incorporation of World-Check capabilities into Qual-ID means that customers can verify identity against trusted sources, proof legal documents, and screen for regulatory and financial risk — all in one transaction, via one API.

As digital evolution continues along its exponential path, banks and FIs have a real and tangible opportunity to embrace digital transformation, and to harness the power of the latest tools and solutions to optimize their efforts in the ongoing fight against financial crime.

Read the expert talk: Digital solutions to fight against financial crime

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Macro Analysis / Global

New alliance helps close sustainable data gap

Refinitiv Perspectives
18 May 2020

Gaps in ESG data are among the factors influencing the adoption of sustainable behavior and financing. How will the recently launched Future of Sustainable Data Alliance (FoSDA) help to understand what data investors and governments need to meet the requirements of regulators, citizens and market demand for sustainable investments and portfolios to 2030?


  1. Reliable ESG data is a critical requirement for effective sustainable investment and for achieving the UN’s 17 Sustainable Development Goals.
  2. At January’s World Economic Forum in Davos, Refinitiv was one of the founding partners behind the launch of FoSDA.
  3. FoSDA aims to foster co-operation between regulators and the industry, empowering all organizations to help to understand what data investors and governments need to meet the requirements of regulators, citizens and market demand for sustainable investments and portfolios to 2030.

As the COVID-19 impact is felt around the world, we cannot lose focus on the urgent need to protect our planet and address the many social and environmental challenges faced by all.

What we invest in and how we invest needs to change, and we urgently need to plot the path to get there by understanding the data needs of the future and urgently making progress to make it available.

FoSDA is driving sustainable finance for a better future. New alliance helps close sustainable data gap

Significant growth in sustainable investment is evident towards our 2030 goals, but our efforts, nonetheless, remain in the starting blocks.

Become a supporter of FoSDA

Despite many governments and regulatory bodies developing policies focused on sustainable investment as part of their strategies to meet the SDGs, no country is as yet on track to meet the 2030 deadline, and the COVID-19 crisis has moved us even more off track.

Therefore, reliable ESG data – which can help guide the allocation of trillions of dollars of investment capital – is now a critical requirement for effective sustainable investment.

Watch: Future of Sustainable Data Alliance: David Marsh

ESG data: evolution in action

The need for standardized, accessible data to guide the financial industry — as well as governments, central banks and regulators — on how best to incorporate ESG risk into decision-making processes has grown in recent years.

There has been much progress in disclosure standards, driven in particular by the Task Force on Climate-Related Financial Disclosures. Despite this, the available data still needs more depth, breadth and connectivity.

Significant work is also needed to address fundamental data requirements in climate risk assessment, water, waste, and biodiversity for environmental risk assessments.

To successfully ensure that the world shifts towards a sustainable future, ESG data — the bedrock of sustainable financial markets — needs to continue its evolution. To become truly valuable, data needs to be complete, coherent, and comparable.

There is an urgent need for the industry to identify gaps in existing data sets, plan for future data needs and pinpoint what it is that the investment community needs in order to make better and more impactful investment decisions at scale.

Future of Sustainable Data Alliance

Against this backdrop, Refinitiv spearheaded the formation of a new multi-member alliance. In January 2020, we launched the Future of Sustainable Data Alliance with the World Economic Forum in Davos.

Fostering ecosystem collaboration. New alliance helps close sustainable data gap

The other founding partners are the World Economic Forum, United Nations, IIF, ASIFMA, Tsinghua University, OMFIF, GFMA, Climate Bonds Initiative, FinTech4good, Everledger, Oxford University, The Spatial Finance Initiative, Catapult, Finance for Biodiversity, and GoImpact.

This newly formed collaborative body of global influencers will focus on the fact that investors actually need to confidently invest more in sustainable economic activities.It will also aim to accurately inform and increase capital raising and allocation at the scale needed to tackle global societies’ environmental and social challenges.

FoSDA has the following key goals:

  • To articulate the future data requirements that investors and governments need to accurately integrate ESG data into decision-making processes.
  • To highlight new technology and data sets, in a post-COVID-19 world, there is even more need to channel stimulus that can support a just transition to sustainable development.
  • To determine data needs and how to satisfy them for investors who want to take greater account of SDG-related risks and impacts.

The Future of Sustainable Data Alliance will lead the way in delivering decision-ready data to the investment community, and in so doing, empower all stakeholders to make better, more sustainable decisions.

FoSDA members will strive to foster an evolving mindset; co-operate with regulators and the industry; and work to empower all organizations to meet our shared goals of economic stability and inclusive growth.

As we step into a new decade, it is this form of deep collaboration that will ensure that we have the right mix of data, tools and human expertise necessary for all stakeholders to make a positive and informed contribution to the fulfillment of the UN’s SDGs.

Tell us about your company and how you can help FoSDA achieve its sustainable data goals this year.Webinar: Biodiversity loss: Why your portfolio is already at risk

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Macro Analysis / Global

Compliance risk in a changing world

Refinitiv Perspectives
22 June 2020

COVID-19 has caused huge disruption to working practices in financial services across the globe, with many people now remotely communicating with colleagues rather than face to face. And while this may have accelerated a paradigm shift in the way we operate, close attention must be paid to the potential rise in compliance risk caused by working from home.


  1. The impact of COVID-19 has caused upheaval in financial services working practices. E-communications have evolved rapidly to become the ‘new normal’ for colleagues to interact while they are working from home.
  2. The financial services sector has shown great operational resilience. People working from home have largely been able to continue with their daily workflows uninterrupted.
  3. However, the move to the ‘virtual office’ has exposed companies to a new range of compliance risk, in areas such as confidential information sharing and intellectual property protection.

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The market disruption caused by COVID-19 has accelerated the path of some key trends and behaviors in our societies, reshaping the way we interact, socialize, learn and work.

Crises pose challenges and force us to re-think, re-strategize and look for better solutions. Similar to conflicts and other global shocks, the current scenario is acting as a reset and driving innovation, but also polarizing wealth and creating greater inequality in society.

While COVID-19 can be perceived as an important moment to reset our lives to the right sequence of priorities, it has undoubtedly changed the way we work.

Refinitiv Compliance Archive provides a unified archiving portal for you to reconstruct, supervise and analyze your message and trade activity in an efficient and compliant way

Adapting to working from home

Some industries have been severely hit by the crisis. Others, meanwhile, have found new opportunities or have had to quickly adapt. For those adjusting to this new scenario, access to internet, hardware and collaboration tools has played a crucial role in enabling daily activities to continue.

Financial markets have seen little difference. Almost all employees are able to leverage home connectivity, VPNs, authentication systems and a wide range of collaboration tools to continue their daily workflows.

Initially, accessibility and security were the first deliverables that helped to guarantee the continuity of operations. Some would say it was a great opportunity to test those emergency plans and protocols, but also those IT infrastructures that were not designed, in the first instance, to deal with a scenario only Hollywood could dream up.

The ability to employ operational resilience is crucial.

Before the pandemic hit, we could already detect growth in the amount, size and variety of social media and collaboration tools permeating our professional and private lives, with undesired overlaps between the two.

At the start of the year, nobody could have anticipated the increase in the use of collaboration tools. This change has revealed how interconnected we are, how much we depend on social relationships, and how easily our access to the internet could help facilitate or harm our daily private and business activities.

As the chart shows, our real-time message rates, that typically see 80 billion messages a day on our core network, have leapt to double that volume, reaching a peak of 176 billion messages on 28 February.

Number of messages carried in each daily region. Compliance risk in a changing world
* The messages axis is in billions

Financial trading activity moved to the home, leveraging company hardware (in most cases), secure connectivity and collaboration tools.

Microsoft Teams experienced a huge increase in users and usage, as did several other collaboration platforms, including some brand new ones. Team drinks became virtual as well, with colleagues connected from their homes.

Most financial market players reported no big issues, and the transition was smooth, sometimes even faster than anticipated. Business continuity was achieved, and there were no market crashes caused by operational and infrastructure failovers.

To avoid overloading operations, regulators helped by easing elements of their regulations, and slowed down the need for the industry to adopt incoming rules.

Some companies have observed increased productivity in their workforces because of reduced commuting times and increased interconnectivity time, and workers displaying resolve in circumstances that have pushed many to do more while dealing with family responsibilities. But what are the challenges this new normal is hiding or introducing?

What’s changed in e-comms?

Over the past five years, the growth in electronic communications has been driven by the evolution of collaboration tools and better connectivity, while the velocity with which we are able to interact has more than doubled.

The picture is the same when it comes to volumes. Attachments, pictures and files have become bigger and are easier to share and store. And the amount of data that needs to be stored for compliance purposes has rocketed.

At the same time, the amount and variety of collaboration tools has improved and expanded to include not only enterprise offerings — Microsoft Teams or Skype —  but also pure social media tools — LinkedIn, WhatsApp, Telegram, WeChat.

There is now much more choice, although not every tool will be approved by every company. And when client interactions start going ‘offline’ on a chat or a public social media channel, how vulnerable are we? For instance, in January JP Morgan took action against a trader for using WhatsApp at work.

What impact does regular working from home have on our conduct, and consequently, compliance risk?

Moving the workplace to the so-called ‘virtual office’ can expose us to greater compliance risk when it comes to confidential information sharing and intellectual property protection, along with exposure to a wider set of cyber risks and potential misconduct scenarios.

For trading teams, mobile devices and the potential lack of control on social media and collaboration tools means that compliance teams need to be more vigilant.

Although we keep a positive outlook on our future, some companies are adopting a longer period of working from home — some are even adopting it on a permanent basis — raising multiple challenges for compliance and audit teams to track every channel of communication.

For trading teams working from home, mobile devices and the potential lack of control on social media and collaboration tools means that compliance and audit teams need to be more vigilant because a substantial set of new challenges will need to be addressed.

Archiving per se alone will not be enough, but it will be a key requirement to start extracting value from this data, in order to analyse patterns, recognize behaviors and adhere to policies to avoid potential employee misconduct.

Ultimately, it all goes back to individuals, ethics and conduct.

Conduct and compliance risk

Stricter guidance and updates to company e-learning sessions are required to better handle this new nuance of compliance risk. Indeed, a review of the current design is necessary in the following areas: Internal policies; learning paths; governance and crisis management frameworks; business continuity plans; company ethical codes; electronic communications archiving and monitoring tools; and adherence to local laws and industry codes of conduct.

Electronic communications and unstructured data — growing through all areas of velocity, volumes, variety, virtual, vulnerability and value — require special care in the current environment. In an already fragile economic environment, damage to reputation can compromise the future of any organization.

Surveillance and value creation

When it comes to conversations and electronic communications related to transactions, it‘s not just about telephone and email. MiFID II Record Keeping clearly defines what is required. Additionally, storage needs to be secure, to enable proper search functionality and to ensure integrity. In the current working-from-home environment, this is very relevant.

But is it just about archiving and searching? Much of the new paradigm of e-comms surveillance relies on the ability to extract value from those datasets.

The aim is to recognize patterns, avoid misconduct cases, and to learn and adapt policies. A proactive approach to surveillance and monitoring should take into consideration comparing, filtering, deleting when requested; and leveraging analytics to recognize and shape behavior. And again, when it comes to efficient and safe markets, it is all about transparency.

Refinitiv Compliance Archive

Refinitiv Compliance Archive, powered by Global Relay, is a unifying cloud-based compliance archive for unstructured message and trade data from over 50 sources. It is designed to help compliance and audit teams reconstruct, oversee and efficiently analyze activity.

Its full suite of surveillance and trade reconstruction capabilities ensures that firms maintain complete visibility into their trade and communication activities while meeting their regulatory mandates.

Refinitiv Compliance Archive provides a unified archiving portal for you to reconstruct, supervise and analyze your message and trade activity in an efficient and compliant way

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Macro Analysis / Global

Toward an Integrated Policy Framework for Open Economies

International Monetary Fund
13 July 2020

By Tobias Adrian and Gita Gopinath

While capital mobility provides many benefits, capital flows to emerging market and developing economies are often volatile and depend critically on global financial conditions. The risks posed by volatile capital flows to macroeconomic and financial stability are often difficult to address with conventional monetary policy tools. Hence, policymakers have complemented interest rate policy with additional tools—including foreign exchange intervention, capital flow measures, and macroprudential actions—to achieve their objectives.

A significant shortcoming of this more eclectic approach is the lack of clear frameworks to guide how these tools should be used in concert to achieve central bank objectives. Accordingly, IMF staff have been engaged in a major push to use conceptual and quantitative models to guide how these tools should be used in an integrated way.

Our research on an Integrated Policy Framework considers policy tradeoffs associated with using these tools in an open economy macroeconomic setting that explicitly takes account of key frictions—such as, dominant currency pricing, currency mismatch on balance sheets, foreign investors limited appetite for emerging markets’ local currency debt, poorly anchored inflation expectations—as well as both domestic and external shocks (as managing director Kristalina Georgieva pointed out recently). In this blog, we provide a brief overview of two recently released working papers that provide frameworks for an integrated use of the tools.

The paper “Conceptual Model for the Integrated Policy Framework” analytically derives optimal policies as a function of country specific frictions and shocks. Some of the insights are as follows: First, if an additional policy instrument becomes available, it should not necessarily be deployed because it may not be the right tool to address the imperfection at hand. For example, while pricing in dominant currencies, most often the dollar, in international goods markets reduces the benefits of exchange rate flexibility and can give rise to more volatile exchange rates, in the absence of other frictions, flexible exchange rates are still optimal. In this case, deploying unconventional tools such as foreign exchange intervention and capital flow measures can worsen outcomes because they do not address the specific pricing friction.

However, and this is a second insight, if there are additional frictions such as imperfections in capital markets, often associated with over-borrowing, then dominant currency pricing can enhance the need for tools such as exchange interventions and capital flows and macroprudential measures. Private agents in an open economy have a tendency to overborrow in foreign currency because they do not internalize the impact of their decisions on future market stress that can arise when foreign lending conditions tighten, currencies depreciate, and balance sheets weaken. To prevent excessive volatility over time, prudential capital inflow controls can mitigate overborrowing in good times and excessive deleveraging in bad times. There is a greater need for such prudential inflow controls in countries with dominant currency pricing because the exchange rate is less effective in stabilizing demand in those countries.

Third, unlike the classic trilemma in international economics, flexible exchange rates do not necessarily preserve monetary policy independence. Episodes such as the taper tantrum in 2013 can sharply raise premia demanded by foreign investors to hold local currency debt. To counter the adverse impact of this external shock, monetary policy comes under pressure to raise policy rates at the expense of tightening domestic financial conditions. In such circumstances, the analysis suggests that it can be beneficial to use exchange intervention and prudential policies to address the external shock freeing the domestic policy rate to focus on domestic price pressures.

A second working paper, “A Quantitative Model for the Integrated Policy Framework” proposes a more empirically-oriented approach to the integrated use of policies. The starting point is an open economy New Keynesian model as is commonly used in central banks. The model embeds complex, nonlinear balance sheet channels and a range of frictions that help capture key empirical features of financial stress episodes, including that domestic credit conditions tend to tighten when the exchange rate depreciates.

The model highlights another form of loss of monetary policy independence that arises when inflation expectations are poorly anchored, as is the case in some emerging and developing economies. In this case, their central banks often face a difficult tradeoff in responding to external shocks that cause sharp exchange rate depreciations and capital outflow pressures. If inflation expectations are poorly anchored, and tend to drift away from target, the central bank is forced to choose between sharp raising interest rates to keep inflation stable—at the cost of a steep output decline—and pursuing a more passive policy that risks allowing inflation to become unmoored.

In this case, the model suggests that foreign exchange intervention and capital controls can improve policy tradeoffs considerably under certain conditions, especially for economies with less well-anchored inflation expectations, a high sensitivity of domestic borrowing conditions to the exchange rate, and that are more vulnerable to shocks that cause capital outflow and exchange rate pressures. Notably, the use of integrated policies may reduce downside risks to output associated with shocks that resemble a sudden stop.

In sum, research on the Integrated Policy Framework is in full swing at the IMF. The COVID-19 crisis has made stark the volatile nature of capital flows and limits to conventional monetary policies. Our newly released working papers shed light on the macroeconomic policy tradeoffs that many emerging markets and small open economies face. Our contributions provide both conceptual and quantitative approaches that aim at a fully integrated macroeconomic framework to assess policy tradeoffs.

The work on model frameworks is also being complemented by extensive empirical work and country case studies at the IMF. These other streams test empirically the impact of various tools and their trade-offs, explores the unintentional consequences of deploying unconventional tools on foreign currency exposure and financial market developments, the communication challenges when multiple instruments are used, among others. The combined work, which will be discussed by the IMF’s Executive Board in the fall, should provide useful insights to policy makers on how to deploy multiple tools with special attention to the form of the shock, the specific frictions, the pre-existing conditions, alongside practical considerations.


 
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