Bandid Nijathaworn: The pursuit of monetary and financial stability in
emerging market economies1
Speech by Dr Bandid Nijathaworn, Deputy Governor of the Bank of Thailand, at a Public
Lecture at the Centre for Banking Studies of the Central Bank of Sri Lanka, Colombo,
23 July 2008.
* * *
Ladies and Gentlemen,
I am delighted to be here today in Colombo, and am honoured by the invitation that has been
extended to me by the Centre for Banking Studies of the Central Bank of Sri Lanka to give
this evening's public lecture. The Bank of Thailand and the Central Bank of Sri Lanka has a
long history of mutual friendship and cooperation. So, I am deeply touched by the invitation,
and am privileged to join the long list of eminent speakers and scholars who have previously
participated in this prestigious lecture series.
The topic of my lecture this evening is the Pursuit of Monetary and Financial Stability in
Emerging Market Economies. The lecture is drawn from the research done at the Bank of
Thailand on the same topic. The research paper was first presented last year at a seminar at
the Bank of England, and the lecture today is an updated version of that paper. What the
research attempts to do is to examine the challenge faced by emerging market economies in
the pursuit of monetary and financial stability. The key hypothesis of the research is that the
context in which monetary and financial stability is pursued in emerging market economies is
different to that of developed economies, and so the challenge and the implications for policy
are different.
My lecture this evening is organized into two parts. In the first part, I will talk about the unique
context of emerging market economies compared to developed economies in the attainment
of monetary and financial stability, and discuss the underlying cause of the difference. In the
second part, I will highlight the key implications of these differences for the pursuance of
monetary and financial stability in emerging market economies, both in the context of
shortterm stabilization challenge and the longer-term structural challenge in implementing
structural reforms. The lecture will be brief, so that we will have time for a Q and A session
afterward.
1. First, the unique context of emerging market economies.
As a general statement, one can begin with the notion that the attainment of monetary and
financial stability is something that policymakers everywhere place at the forefront of their
agendas. And, monetary and financial stability are desirable because they are prerequisites
for welfare-enhancing macroeconomic outcomes. Along this line, the context in which
monetary and financial stability is pursued in emerging market economies is quite distinct
from that in developed economies. For emerging markets, there are two stylized facts that
are unique to its policy setting. The first is the greater income and consumption volatility that
have been observed in emerging markets, both in terms of the level and in terms of growth
relative to developed economies. And the second is the fact that economic agents in
emerging markets face greater limitations in the ability to smooth consumption in response to
shocks.
The empirical evidence from two recent studies are summarized in Table 1.
As documented by Aguiar and Gopinath in 2007, consumption is around 40 percent more
volatile than income at business cycle frequencies for emerging markets, while the ratio is
less than one for developed economies. The same is true when comparing relative volatility
in growth rates of consumption and income. A study by Kose, Prasad, and Terrones in 2005
also shows greater income and consumption volatility in emerging markets relative to
developed economies. Such heightened volatility in macroeconomic outcomes undoubtedly
has adverse implications for welfare. And the fact that consumption is so volatile - in itself as
well as in relation to income - suggests the existence of serious limitations in the ability of
economic agents in emerging markets to smooth consumption in response to shocks.
A central proposition of our studies is that a large part of the explanation for higher
macroeconomic volatility in emerging markets rests with key differences in the nature of
shocks hitting emerging market economies, as well as the way in which the economic system
of emerging markets propagate the shocks.
Figure 1 captures our basic arguments, and depicts how observed macroeconomic
outcomes are the result of the interaction between the nature of shocks and the structural
features of the economic system.
Firstly, the nature of shocks that emerging market economies experience is quite different
from that of developed economies. A particularly pertinent example in this context is capital
flow shocks. By virtue of their limited access to capital relative to their growth potential,
emerging market economies are natural recipients of capital inflows from capital-rich
economies. These inflows are attracted by prospects of higher return and provide the
necessary funding of investments that facilitate economic development, especially when the
inflows are of the type that bring technological transfers and managerial expertise.
But as shown in Table 2, capital flow shocks, especially debt and equity, are more volatile in
emerging markets relative to developed economies, as well as relative to other developing
economies.
Such volatility, which sometimes manifest itself in "sudden stop", is linked to a variety of
factors including the pro-cyclical nature of the flows. For example, the pro-cyclical nature with
respect to sovereign bond ratings. On the other hand, information asymmetries in emerging
market economies may also make the flows more susceptible to contagion effect, resulting in
large swings in capital flows unrelated to changes in fundamentals. Macroeconomic
conditions in developed countries is another factor that can make emerging market
economies more susceptible to a wide array of global shocks.
And lastly, domestic political shock in the form of policy uncertainty can also be more
pronounced in emerging markets, as evidenced by more frequent regime switches, that is
from fixed to floating exchange rates, as well as reversals in policies. Such shocks can
exacerbate capital flow volatility and manifest themselves in terms of greater macroeconomic
volatility.
The second key difference between emerging market economies and developed economies
has to do with structural features of the economic system that influences how various shocks
are propagated through the economy. While there are many key differences in this regard,
two features are especially important in the context of monetary and financial stability. The
first is the financial development and the second is the institutional framework of monetary
and financial supervision policy.
On financial development, one of the most vital foundations of modern economies is the
process of channeling resources to their most productive uses. Whether an economy
functions smoothly and efficiently or not depends much on the manner in which the financial
system performs this task. A strong banking sector with highly disciplined risk management
helps to mitigate the risks of financial imbalances while the existence of a deep and liquid
financial market that offers a breadth of financial instruments helps improve the ability of the
economy to absorb shocks. More generally, the level of development of an economy's
financial sector has a fundamental bearing on social welfare insofar as it determines the
ability of agents to smooth out their consumption profile in the face of fluctuations in income.
As such, a substantial part of the observed differences in macroeconomic outcomes between
emerging market economies and developed economies can be attributable to the disparate
levels of financial sector development in these two groups of countries. Indeed, a number of
empirical studies indicate that financial development, especially greater financial access, is
associated with lower macroeconomic volatility.2
Next, the institutional framework of monetary and financial supervision policy also has an
important influence on the extent to which various shocks make their way through the
economy. Importantly, in a setting where the central bank lacks independence, its
performance is likely to be more easily influenced for short-term political ends with adverse
macroeconomic consequences. At the same time, a weak financial supervision framework
increases the risk of financial imbalances building up, especially in situations where
substantial capital flows drive up asset prices and generate favorable conditions for credit
expansion, which may ultimately lead to severe economic dislocations. In contrast, a credible
policy framework and enshrined central bank independence provide the necessary
preconditions for alleviating the impact of shocks on the economy. For example, by
anchoring the public's long run inflation expectations to the target level, a credible
inflationtargeting framework helps to mitigate the impact of temporary supply shocks on inflation and
allows the central bank more leeway to adjust its policy instrument to cushion any negative
impact on output.
Overall, our observation is that the unique combination of shocks and structural features of
the economic system in emerging market economies give rise to a macroeconomic backdrop
that is characterized by significantly higher output and consumption volatility than in
developed economies. The period leading up to and immediately following the Asian financial
crisis is a prime example of this interaction. In that case, rapid movements of capital flows
into and out of emerging markets interacted with financial system underdevelopment,
deficient bank supervision, and balance sheet weaknesses, resulting in a boom-bust cycle. In
contrast, the experience of developed economies is more generally characterized by one
where large shocks typically result in substantial asset price volatility and substantial financial
losses that are not accompanied by significant disruption to either short run or long run
economic growth. A rigorous assessment of the challenges of monetary and financial stability
in emerging market economies therefore must explicitly recognize this underlying difference
in the economic backdrop.
Let me now turn to the second part of my lecture and discuss the implications of these
differences on the pursuance of monetary policy and financial stability.
In light of the unique agglomeration of factors in emerging market economies outlined above,
the pursuit of monetary and financial stability in emerging markets has two key facets. The
first is to address the immediate short run concerns emanating from the various shocks; and
the second is to implement structural reforms to ensure that financial stability becomes
embedded in the underlying economic structure of emerging markets in the long run. The
former essentially concerns the challenge of maintaining economic stability through
appropriate policy settings and actions to offset the various shocks hitting the economy at
any given point in time. The latter, on the other hand, focuses on strengthening the
institutional framework for monetary policy and financial supervision as well as fostering
financial sector development that improves the ability of the system to absorb shocks by
itself, in a way that minimizes the impact on the real economy without the need for policy
intervention. Given the significant gap that emerging market economies have in this respect
relative to developed economies, it becomes more crucial that the pursuit of monetary and
financial stability in emerging markets be accompanied by a vigilant focus on making
progress on structural reforms. In what follows, I will discuss some specific challenges to
monetary and financial stability in emerging markets from both the short and the longer run
perspectives.
Let's begin first with the short run stabilization challenge.
As we have seen in past years, the search for yield among international investors has
resulted in a resurgence of capital inflow into emerging markets, leading to a pick-up in asset
price volatility.3 Given the high degree of dependence on foreign trade, and the inadequate
experience with modern financial risk-management tools particularly at the firm level, these
asset price fluctuations have become an important policy issue in emerging markets.
Typically, when large capital flows into financially shallow markets, it puts pressure on
emerging market central banks to lower interest rates or to increase sterilized intervention in
the foreign exchange market. Both of these actions are accommodative from a monetary
policy sense and tend to sow the seeds for inflation down the road. And in the case where
capital inflows are persistent, the flows may even induce authorities to make use of
prudential measures, which can range from credit policy to capital account restriction on
short-term inflows. The core issue facing emerging market central banks in the short run,
therefore, is how best to contain financial vulnerabilities that accompany the volatility of
short-term capital.
On this issue, when the challenge is on the side of managing capital inflows, there are three
key decisions that emerging market policymakers must face in the short term. The first is
how to deal with the cost and the constraint of coping with capital inflows. The second is the
challenge in finding a set of tools that can help assess the potential build-up of financial
vulnerabilities. And the third is how best to complement monetary policy with prudential
measures to help prevent potential financial instability.
On the first decision, for those under a managed float regime, lowering interest rates to
reduce the relative attractiveness of the country to capital inflows may be an appropriate way
to ensure price stability. But concerns of fast appreciation may not subside as exchange
rates tend to behave more like asset prices than relative goods prices in practice. That
means the nominal effective exchange rate can appreciate for a while in the short run, even
after central banks repeatedly cut interest rates. This is an element of the well-known
exchange rate disconnect puzzle. The risk is that a central bank may cut interest rate by too
much, and at the same time sowing the seeds for inflation and an asset price boom down the
road. An obvious important technical challenge to emerging market central banks, then, is to
improve its ability to forecast inflation and output and be more precise about the range of
possible natural rates of interest, which vary through time.
Resisting the appreciating momentum of the exchange rate through interest rates alone may
not be sufficient. A widely adopted practice that is assumed to be effective in the short run is
through sterilized intervention. Sterilized intervention, however, entails quasi-fiscal costs from
swaps or bond issuance, which adds to the liability side of the consolidated public sector
balance sheet. Since the debt is in local currency, there is an inflation risk attached to it
should there be future fiscal stress. There is also a potential for the market to raise doubts
about monetary policy independence and therefore increase the risk of policy uncertainty. In
the same vein, accumulating international reserves can also lead to a possible damage to
central bank credibility in some countries, as they incur balance sheet losses when assets
and liabilities are marked to market in local currencies.
In sum, the challenge of containing the effects of capital inflows on asset prices may pose
risks to future inflation and financial stability in emerging markets. This challenge seems to
suggest a potential for complementing monetary policy with prudential measures. The extent
of the challenge here depends crucially on the ability of the economy to cope with asset price
fluctuations. Also, it depends critically on the ability of the real sector to adjust to the pace of
the appreciation as capital inflows continue.
Next, the second challenge in the near term concerns the ability of emerging market central
banks or financial supervision authorities to identify and quantify risks of potential financial
instability in advance. In this context, stress-testing is one of the most powerful tools to
assess financial stability ex-ante. If implemented effectively across the financial industry,
stress-testing can help curb destabilizing activities and help prepare financial institutions to
deal with macroeconomic or financial shocks. Unfortunately, financial institutions and
regulators in emerging economies have lagged behind their counterparts in advanced
economies on this issue, especially on the credit and liquidity risk stress-testing.
A priority for regulators in emerging economies, therefore, is to move faster on stress-testing.
To accomplish this, they should push financial institutions to invest in human resource and
technology, with the aim of conducting macro stress-testing at least on an annual basis. As
regard implementation, regulators and monetary policy makers must increase coordination
so that macroeconomic and financial stability assessment can be done in an integrated
fashion, so as to arrive at a more relevant and convincing macro stress-testing scenario.
Finally, the third challenge or decision is the use of prudential measures. While it is unclear
how effective domestic monetary policy can be in checking excessive asset price volatility,
the threat of financial instability has given rise to a more prominent role for macro-prudential
measures to reduce the procyclicality of the credit market. As we see it, the primary
challenge in this respect is how best to move forward. Combining the use of prudential
measures with monetary policy is a useful policy option, but it is still an unsettling issue
because of the concern for efficiency. In practice, discretionary prudential measures pose
difficulty in the form of potential regulatory forbearance, market distortion, timing
effectiveness, and the difficulty in modeling early warning system. Rule-based prudential
measures, on the other hand, pose difficulty in policy calibration. That is to say, calibrating
this type of policy tools has so far proven difficult for emerging markets where data
availability is limited and large structural breaks are usually present.
Let us now turn to the longer-term challenge in the pursuance of monetary and
financial stability in emerging markets, that is, the issue of structural reform and its
implementation.
From a longer-term perspective, the attainment of monetary and financial stability is
determined predominantly by the embedded structural features of the economy. These
matter not only with regard to how shocks are propagated through the system but they also
influence the effectiveness that policy stabilization efforts can cushion the economy from
such shocks. In what follows, I will discuss two key aspects of the structural features that are
important for the pursuance of monetary and financial stability. These are the financial
development and the policy institutions and framework.
First, financial development.
One important requirement to ensure that the risk management capacity of the economy
evolves with the changing nature of risk is to enhance the risk management ability of
economic agents. The key to this would be to strengthen the efficiency and the robustness of
the financial system. To achieve this, the strategy to enhance economic and financial
resiliency must pay attention to the following considerations:
The first is to recognize the benefit of having a well-balanced financial structure.
Efficient and well-balanced financial system will allow the system to better manage and
absorb shocks as the market would be less prone to one-way market conditions and would
posses greater liquidity. A well-balanced financial structure contributes positively to
information processing, price discovery, and risk management. The experience of the Asian
crisis, for example, points to the critical importance of the development of a long-term local
currency debt market, to increase the depth and the breadth of the financial market. In
relation to this, the Bank for International Settlements, in their studies, have identified that the
lack of diversified structure and market may lead to increased risk from concentration of
credit and maturity risks in the banking system as the lack of markets may lead to the
mispricing of risk, excessive delay in correcting large exposures, as well as increased
vulnerabilities from capital inflows.
The second important consideration is the importance of strong financial market
infrastructure.
One of the key issues for emerging markets is the structural weaknesses which can create
disincentive and moral hazard. The presence of such distortions contribute to a build-up of
financial vulnerability, hinder growth of market solution for tackling risk, and complicate policy
actions in events of crisis management. Progress in correcting these weaknesses in
emerging markets, however, may have been somewhat slowed.
Market-driven financial market developments need the support of critical infrastructure,
namely: (1) Information that allows efficient decision making and pricing on various asset
markets, financial as well as related markets such as real estate market, which are still very
lacking in many emerging markets, and may be an area of public support. (2) Legal reforms
to ensure an enabling environment for innovation in products and business models for the
financial system. Human resource with proper competency in modern financial and
And (3)
risk management are scarce and is becoming a bottleneck for development. The authority
may need to step in to facilitate training and accredition of professional standards, if it has
external benefits.
Notwithstanding these challenges, however, notable progress has been made by emerging
markets in the past decade, much of which is catalysed by comprehensive economic reform
in which market-oriented economic and financial liberalization have been the main features.
For East Asia, despite the progress made, significant gap still exists in diversification,
efficiency and robustness when compared to the role played by financial markets in
developed economies. Looking ahead, in addition to the pressure from globalization, the shift
in demographic structure will also be an additional pressure. This is to say some smaller
emerging markets will face an aging population and the increase in demand for wealth
management, while the supply of local products are limited for diversification. This will pose
challenges for inter-temporal allocation of resource and risk. Thus, it is imperative that
emerging markets devise a proper strategy and process to expedite reforms and develop the
financial system.
The second longer-term reform I want to bring up is policy institution and framework. On this,
two policy institutions are of utmost important for attaining monetary and financial stability.
The first is a credible monetary framework that effectively anchors the public's expectation of
inflation. The key issue here is the importance of independence and transparency of the
monetary policy process. The usual case is that the lack of independence can come at a
great cost in terms of lower central bank credibility and a less favorable trade-off between
inflation and output volatility. Likewise, weaknesses in monetary policy transparency can
contribute to policy uncertainty and exacerbate the impact of shocks on macroeconomic
volatility.
The second important policy institution is an effective supervisory policy and domestic
financial institution's capacity for sound risk management. The logic for this is clear. With less
effective supervision and limited capacity to manage risk, the ability of the economic system
to absorb volatility from global markets is significantly compromised.
Reflecting this, emerging markets have put enormous emphasis on building up the
necessary institutions with regard to effective supervision. But the challenges are many. For
example, at this time, many emerging markets are facing the challenges in implementing
Basel II.
The objective of Basel II is to strengthen the soundness and stability of the banking system
through more risk-sensitive capital requirements and rigorous internal risk assessment
process. This has a direct bearing on ensuring financial stability. But because Basel II is
developed from the current practice among banks in developed countries, some banks in
emerging markets may have a large gap to fill. For example, in moving away from
collateralbased to credit-based loan approval, banks must focus more on the ability to pay of
customers and to make loan decisions in a forward looking manner. This requires a different
set of expertise that focuses on risk assessment in the environment of changing economic
cycle and asset quality.
Next is the information system which is the most important foundation for achieving financial
stability through capital adequacy. Whereas developed countries generally already have in
place the necessary infrastructure in this regard, financial institutions in emerging countries
have to build the system from the ground up, involving areas such as data collection,
storage, analysis, and ways to effectively embed the information in the decision-making
process. This step may take more time and effort because it involves building a knowledge
base for quantitative analytical skills and ability to apply international best practices to the
unique local settings of emerging markets.
Another difficulty in Basel II implementation is that other players in the wider financial
industry will be playing more active roles in the banking sector's risk assessment. For
instance, the simple approach of Basel II ties the amount of required capital to ratings by
External Credit Assessment Institutions (ECAIs) because they have the strength in both the
wealth of data and expertise in credit risk assessment. Unfortunately, only a few large
companies in emerging countries are rated. Therefore, the challenge for regulators lies in the
process of ECAI recognitions and risk-weight mapping processes as they must ensure the
stability of the banking system while at the same time, foster the development of local ECAIs
and the bond market. These efforts will undoubtedly take considerable time and patience, but
it is a road that has to be taken.
Financial development and the strengthening of policy institutions and framework, therefore,
are the two most important structural features of emerging markets that need to be
promoted, developed, and strengthened in the pursuance of monetary and financial stability.
In my view, this is the most important reform issue that need to be effectively carried out.
For the remaining part of my lecture, let me now turn to my last topic, that is the
challenge of implementing structural reforms.
While the two facets of monetary and financial stability discussed above are present in all
economies, the interaction between them and the tensions that arise in terms of where the
policy emphasis is placed are arguably more varied and more complex with greater welfare
implications in the emerging market context, not least because the gains to be had from
structural reforms are much higher in these countries. It is therefore important to focus on the
process of implementing structural reforms and how to ensure that they remain on track. In
what follows, I will discuss some of the complexities that arise on this issue and highlight
some of the lessons learned from many previous reform efforts.
The most prominent conclusion obtained from the literature on structural reforms is that they
are difficult to implement. The first problem is that the gains from reform are hard to quantify
because they are often indirect and thus rarely fully appreciated by the wider public. The
enshrinement of central bank independence, for example, helps to insulate monetary policy
from short-term political consideration and paves the way for monetary stability in the long
run, but making a case for this in a non-technical manner to a wide audience, with conflicting
interest, often proves a communication challenge for central banks.
Next, the fact that many structural reforms entail short-run costs compounds the problem.
The opening up of the domestic banking sector to foreign competition, for example, brings
long-run benefits in terms of improved banking services but may adversely impact domestic
banks' profitability in the short-run. This time mismatch between the costs and benefits of
reforms is a prime reason why they are hard to sell. And where the costs and benefits accrue
to different segments of the economy, as in this example, the difficulty of instilling reforms is
exacerbated since it is hard to create satisfactory compensation schemes while those who
lose out tend to be concentrated and thus more effective in organizing political opposition to
the reforms.
There are, however, general empirical regularities on the conditions that make reforms more
likely.4 First, is the period of economic downturn or crisis that focuses the public's mind on
the need for reform. Second, there must be sufficient fiscal room to compensate the losers.
Third, the success of previous reforms that may help create competitive pressure for reforms
in other areas. Fourth, the longer the length of time remaining in office for the Government,
the more likely that reforms will be undertaken. And fifth, external pressure either in the form
of foreign reform efforts that increase competitive pressure domestically or membership in an
international economic organization that requires reform as part of the admission criteria.
Next, even if the obstacles to the reforms have been overcome, the practical aspects of
implementing them pose further challenge. One of the most important issue in this respect
concerns the proper pace and sequencing of structural reforms. In the context of financial
sector reforms, for example, the underlying challenge is the proper mitigation of the
additional risks that are injected into the financial system as markets develop and become
more sophisticated. These risks consist of both financial risks borne by market participants
as well as macroeconomic risks that may be associated with greater financial market
volatility. Indeed, the inappropriate setting of priorities among the reform measures or an
overly rapid pace of change can result in financial instability in the short run. More generally,
initiatives in the areas of financial sector development, monetary policy regime, and capital
account liberalization are all closely related and designing appropriate reforms in one area
requires a careful consideration of how to proceed with the others.
On this issue, suffice it to say that the consensus on the importance of structural reform
efforts does not carry over with the same strength to the issue of the appropriate pace and
sequencing of policy changes. Nonetheless, it should be stressed that a frequent outcome of
the debate on this issue is excessive inertia in reaching an agreement and actually starting
the process of change. The more protracted the transition period, the greater the eventual
costs to the economy in terms of deferred benefits of stronger fundamentals.
Finally, a recurrent theme that has been underlying much of the discussion in this lecture this
evening is the intricacy of achieving monetary and financial stability while at the same time
maintaining the delicate balance of short-run stabilization efforts and long-run structural
reforms. This is perhaps the toughest challenge for emerging markets in this regard. In
particular, a heavy focus on maintaining immediate financial and economic stability can often
hinder efforts to deliver these very same goals in the long run. Thus, ensuring that the
outcome of such trade-offs turn out favorable to the attainment of monetary and financial
stability in the long term is perhaps the toughest challenge for emerging markets in the
present context.
Ladies and Gentlemen,
To conclude, despite the challenges presented above, the overall direction of change in
emerging market countries in the past decade is fundamentally reassuring. Much has been
achieved in terms of strengthening the monetary framework and financial system
development, reducing vulnerability to external shocks through the establishment of sizable
foreign reserves cushion as well as significant restructuring of external