This essay is adapted from a series of blog posts covering the Asian Monetary Policy Forum, which took place in Singapore on May 24. The forum was organized by Chicago Booth, the National University of Singapore Business School, and the Monetary Authority of Singapore.
When the global financial crisis erupted with full force in 2008, risk premia and borrowing costs surged around the world. And when then–Federal Reserve Chairman Ben Bernanke suggested in May 2013 that the Fed might taper the pace of its bond purchases sooner rather than later, bond yields jumped sharply in emerging economies. Currency values in Brazil, India, Indonesia, and Turkey, to give just a few examples, also came under intense downward pressure. These episodes illustrate the vulnerability of emerging economies to financial shocks and risks outside their control. They confront policymakers in emerging economies with difficult challenges.
Maurice Obstfeld, professor of economics at the University of California, Berkeley, addresses the challenges in a thoughtful paper presented at the inaugural Asian Monetary Policy Forum (AMPF), an event cosponsored by Chicago Booth, and held in Singapore in May. Obstfeld’s paper assesses the capacity of emerging economies to use monetary policy and macroprudential tools to moderate the domestic effects of global financial forces.
In thinking about this issue, a first order of business is to recognize the power of global financial forces to create and amplify stresses in emerging-market financial systems and to rock their economies. Even emerging economies with strong growth records, persistent current-account surpluses, and relatively sturdy financial systems are vulnerable to the potentially disruptive effects of these forces. Global financial forces affect emerging markets through multiple channels.
First, consider interest-rate linkages. Mobile financial capital transmits financial conditions internationally through term and risk premia in interest rates that, in turn, affect asset values and the cost of funds in the domestic economy. Look at the effects of the global financial crisis on borrowing costs for businesses in South Korea. As the crisis intensified after August 2008, borrowing costs rose sharply, more so for companies with lower credit ratings. These higher borrowing costs restrained investment spending and hiring activity by Korean businesses.
Recall the dramatic events of September 2008. Mounting losses on mortgages and mortgage-related securities and guarantees compelled the US government to place Fannie Mae and Freddie Mac in conservatorship on September 7. Lehman Brothers filed for bankruptcy on September 15, roiling financial markets worldwide. A day later, losses on Lehman Brothers’ debt holdings caused the Reserve Primary Money Fund to “break the buck,” triggering a widespread run on money-market funds. The Fed and the US Treasury soon responded with unprecedented policy actions to stem the panic and shore up US money-market funds. On September 17, the US government seized control of AIG, a massive insurance company, to head off what policymakers saw as a potentially catastrophic failure. A week later, the Federal Deposit Insurance Corporation closed Washington Mutual in the largest commercial-bank failure in US history.
While the US financial system was the initial epicenter of the crisis, global financial linkages quickly transmitted the shocks associated with these events to borrowing costs in South Korea and other countries. The capacity of Korean policymakers to mute or offset these developments was limited, and their economy suffered for it.
Obstfeld provides evidence that monetary policy affords emerging economies some ability to moderate the effects of external shocks on shorter-term domestic interest rates. Longer-term rates, however, are less responsive to domestic monetary policy and more subject to global financial conditions, even in emerging markets with flexible exchange-rate systems. Shocks and developments that originate elsewhere can sharply raise the cost of funds in the domestic economy, and drive down asset valuations.
While it is easy to see interest-rate linkages at work in extreme episodes, they operate in more tranquil times as well.
To appreciate some of the implications, consider US monetary policy and its spillover effects on other countries. Since the global financial crisis (and earlier by some influential accounts), the US has pursued a highly accommodative monetary policy. The Fed deployed tools to keep rates on short-term US Treasuries near zero, compress risk premiums, lower borrowing costs, and reduce bond yields—all with the aim of supporting economic recovery. In combination with sluggish growth and the absence of strong inflationary pressures, these actions have kept US nominal interest rates at extraordinarily low levels for several years.
Countries that adopt the US dollar as their main currency—such as Ecuador, Panama, and East Timor—directly inherit these US monetary and financial conditions. The same is true for jurisdictions such as Hong Kong, which operate with open capital markets and a credible exchange-rate peg to the US dollar. It’s also important to recognize that a large volume of dollar-denominated credit transactions occurs outside US borders. Obstfeld observes that US dollar–denominated bank credit extended to nonfinancial entities outside the US is now 35% as large as US domestic-bank credit. In turn, US domestic-bank lending to nonfinancial entities is nearly as large as US annual GDP. In short, Fed actions directly affect interest rates and credit conditions in much of the world.
Spillover effects from US monetary policy are more complex for countries that restrict international capital flows or let their exchange rates fluctuate against the US dollar. In principle, a country with open capital markets can conduct an independent monetary policy by allowing its currency to float freely in foreign exchange markets. In practice, most countries and currency areas operate with a managed float and, in effect, resist large and rapid exchange-rate adjustments. They do so, in part, because large exchange-rate movements have important effects on the cost of living for domestic consumers and on the ability of domestic producers to export their goods and services. Exchange-rate considerations are especially important in smaller, highly open economies.
As Obstfeld explains, the demands of a fully flexible exchange-rate regime are not small. For example, to rely on its current exchange rate to fully accommodate a modest compression of risk premia induced by US monetary-policy actions, a country must be willing to tolerate a relatively large currency appreciation. Whether for this reason or others, few countries allow their currency values to float freely. As a consequence, US monetary-policy decisions influence interest rates and credit conditions throughout the world.
These international spillover effects are a source of concern for two basic reasons. First, mistakes in the conduct of US monetary policy have adverse consequences globally. Second, even if US monetary policy is optimally tailored to US macroeconomic and financial conditions, other countries typically face different—sometimes very different—conditions. The second concern is especially pertinent for policymakers in emerging economies in recent years. In many cases, they faced stronger inflation pressures than the US, more pressing concerns about threats to financial stability, and stronger growth prospects.
International capital flows bring other risks and potential disruptions that create additional challenges for policymakers in emerging economies.
Capital inflows increase the elasticity of credit supply to the domestic economy. In a closed economy, the domestic credit supply restrains borrowing binges propelled by optimism about the domestic economic outlook, whether warranted or not. As borrowing expands and bumps up against the limits of domestic supply, rising interest rates temper the credit boom. In an open economy, external credit adds an extra source of financing for emerging economies, relaxing the restraints on a domestic credit boom and possibly setting the stage for a larger bust afterward.
Portfolio-demand shifts in rich countries are another source of risk. For example, rich-country portfolio shifts in favor of emerging-market assets can cause a surge in gross capital inflows, affecting domestic financial conditions and asset prices. As Obstfeld notes:
Where these portfolio shifts are accommodated through the home central bank’s intervention, the inflows finance foreign reserve increases. Where the central bank instead allows currency appreciation, net private claims by foreigners still rise, albeit gradually over time, due to a reduced current account balance. China’s case shows how both mechanisms can operate at once. Whether the central bank intervenes or not, domestic financial conditions are affected immediately, though the expansion effect is probably bigger when intervention occurs and causes an increase in the domestic money supply and domestic bank credit.
These capital-inflow surges can cause a range of dislocations. First, and perhaps most obviously, they create vulnerabilities to capital-flow reversals down the road. Second, by driving up real-estate prices and the value of other assets that can serve as collateral for loans, they can fuel a domestic credit boom, raising concerns about financial stability. Third, unless fully neutralized by the central bank through foreign-reserve additions, capital-inflow surges place upward pressure on the exchange-rate value of the domestic currency. The resulting currency appreciation reduces the competitiveness of domestic exports. As Obstfeld notes, countries that resist currency appreciation tend to experience greater upward pressure on asset prices and domestic credit growth.
One way policymakers in emerging economies seek to manage the challenges presented by interest-rate linkages, monetary-policy spillovers, and international capital flows is through macroprudential policy tools. The objective is to manage systemic risks to the financial system and prevent those risks from damaging the economy. Looking across countries, macroprudential policy instruments include a wide variety of credit restrictions, liquidity provisions, and capital-related regulations.
The use of macroprudential tools reflects the view that sound monetary policy is not enough to ensure financial stability. Prudential regulations that focus on the safety of individual financial institutions can help in this regard. But traditional forms of prudential regulation do not adequately guard against systemic risks and threats that arise from unregulated banking activities. In addition, poorly designed or poorly implemented banking regulations can become a source of financial instability rather than a prophylactic.
Broadly speaking, the hope for macroprudential policy is that it can supplement sound monetary policy and traditional prudential regulation in securing financial stability. Unlike monetary policy, a blunt tool that “gets in all the cracks” of the financial system, macroprudential policy can “target specific cracks” where financial vulnerabilities concentrate, to borrow a metaphor that Ravi Menon, managing director of the Monetary Authority of Singapore, used in a speech at the AMPF.
Menon draws a sharp distinction between macroprudential policies applied “inside the house” and capital-flow measures applied “at the gate.” He takes a dim view of the latter, characterizing them as highly distortionary, and warranted, if at all, only to safeguard financial stability under extreme circumstances. Echoing the IMF, he remarks that, if used, capital-flow measures should be “targeted, transparent, and generally temporary.” Consistent with these remarks, Singapore maintains open capital markets but has aggressively deployed macroprudential measures from time to time, especially in real-estate markets.
Menon also stresses that no single macroprudential instrument is likely to exhibit a stable and reliable relationship to asset prices and financial stability. This pushes policymakers to deploy multiple macroprudential instruments over time, makes it harder to learn from experience, and complicates the task of conducting effective macroprudential policy. It also suggests that macroprudential policy is intrinsically less amenable to a rules-based approach than is traditional monetary policy.
Menon’s overall assessment of macroprudential policy concludes on a modest, cautiously optimistic note: “So far, the results [in Asia] have not been bad. [Policy actions] have largely tempered the credit cycle and the pace of asset price increases, while generally maintaining price and output stability.”
He also reminds us that the current global situation is highly unusual. After the dust settles and conditions normalize, Menon anticipates that the conduct and role of monetary policy will not look all that different from the period before the global financial crisis. To be sure, central bankers will devote a more watchful eye to financial-stability considerations, and they will carry and use a bigger macroprudential toolbox. These changes amount to important modifications in the practice of monetary policy and central banking, but not a major reinvention.
Steven J. Davis is William H. Abbott Professor of International Business and Economics and deputy dean for faculty.
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