On 17th December 2015, MDAE hosted Dr. Mangal Goswami, Deputy Director at IMF’s Singapore Regional Training Institute, to give a talk on “Detecting Financial Fragility.” Dr. Goswami began the talk by explaining how the monetary policy stance has changed over the years, especially after the 2008 Global Financial Crisis, when central bankers all over the world realised the importance of adding financial stability as one of the goals of monetary policy.
In the early 2000s, the central bankers in the developed economies were content with the economic scenario then, which was characterised by low inflation, high growth and low volatility. Naturally, central banks did not change their monetary policy stance; however, the low interest rates initiated increased borrowing, thereby building up high leverage. This eventually had huge repercussions in the form of the recent crises, and it just goes to show that when macroeconomics and finance integrate, the amplifications can be huge.
This can be understood by looking at data on the 10-year bond interest rates and current account balance of the Euro area. It is observed that the after the euro was adopted, the standard deviation of the interest rates collapsed, but the current account deficit widened to a great extent. This was because before the euro was introduced, the Greeks borrowed at a high interest rates whereas the Germans borrowed at a low rates. The market expected the adoption of euro to cause the interest rates to converge to the lower German interest rates. However, instead of paying back its old loans, the Greek borrowed even more at the cheaper rate, which meant an increase in government investment, causing the current account deficit to increase to unsustainable levels.
This takes us to two questions. Firstly, what should be to done to tackle the huge current account deficit? The central bank can either use its reserves to the finance the deficit that the capital inflows could not or it can increase net exports by depreciating the domestic currency. Secondly, and more importantly, how does one determine if a current account deficit is sustainable or not? This can be done is a few ways:
- By checking if there is a continuous depreciation in Real Effective Exchange Rate.
- By creating a macroeconomic model to determine the equilibrium level of current account deficit, using that as a threshold to compare the actual deficit and figuring out how much currency depreciation is required to reach the said equilibrium level
- By looking at the long-term average of current account balance, and using that as a benchmark to determine policy response
- By checking if the level of external debt is sustainable or not. If the rate of interest is more than the rate of growth, then debt is explosive. If it is the opposite, the debt is more sustainable.
Another scenario which can cause current account deficit to reach high levels is when there is high credit growth in the economy. This happens when local banks in need of capital borrow externally at cheaper rates from global banks, which lend to local banks in US$. The global banks, to meet their lending requirements, borrow from the international capital markets. This is how the global intermediation of cross-border flows work. Therefore, any shock which affects the international market, affects the global banks which in turn has an impact on the local banks. This is why after the 2008 Global Financial Crisis, analysts also focus on the liabilities side of the balance sheets of banks. For instance, between 2000 and 2010, emerging economies built large current account imbalances due to high borrowing from the private sector. Now, global banks are withdrawing funds and local banks are deleveraging. This will cause the current account balance to readjust, and increase aggregate demand.
A consequence of a huge surge of capital inflow is the presence of high liquidity because every increase in foreign assets (on the assets side) is matched by an increase in deposits of commercial banks with the central bank (on the liabilities side). If the currency regime of an economy is flexible, then the exchange rate adjusts to tackle the positive shock. The increase in capital flow is also addressed by a central bank intervention through sterilisation. In this case, the central bank issues domestic liabilities to soak up liquidity. However, this comes at a cost – the interest rate at which the central bank issues these liabilities is much higher than the rate at which local bank borrow funds, which leads to a valuation loss. Therefore, capital inflows can have an adverse impact on the central bank’s balance sheet.
India experienced a “mini crisis” in 2013 for the same reason. The corporate sector in India saw massive external borrowing, not only is US$ but also in euros and yen, at highly subsidized rates. The current account deficit reached 5.6%, which caused the Indian rupee to depreciate by 28% against US$. The central bank responded by imposing controls on gold imports, but the currency depreciation ensured that the liabilities of the central bank did not have to be repriced.
Dr. Goswami concluded the lecture by talking about why macro-prudential measures are important. Every inflow of capital will eventually be followed by a decline, and the central bank needs to have a strong response for such cyclical changes. These responses should follow a financial cycle (credit boom and busts). For example, in South Korea, the real estate prices of Gangnam area increased significantly, while the prices in the other areas remained stable. Now, increasing the rate of interest would be a very general solution, and a rather blunt response as it could have a negative consequence on other areas of the market that were not facing the price rise. Therefore, the central bank in Korea asked banks to attach a higher risk weight to loans that were being lent in the Gangnam district for real estate purchases. This is an example of a macro-prudential measure which is more targeted and directly mitigates amplifications. The general idea with a macro-prudential measure is to build buffers on the way up so that it can be drawn down on the way down. In other words, the buffers need to lean against the cycle.
Finally, Dr. Goswami remarked that the central banks before the crisis only focused on price stability and did not care about financial stability, even though financial cycles tend to be prolonged and more severe. It was only after the crisis that economists around the world understood in the interlinkages between macroeconomics and finance and importance of maintaining financial stability through macro-prudential measures. Whether macro-prudential measures work the way we expect them to is something we will see in the future.
Date(s) - 17/12/2015