Zeti Akhtar Aziz: Role of central banks in emerging economies
Speech by Dr Zeti Akhtar Aziz, Governor of the Central Bank of Malaysia, at the Svein
Gjedrem Colloquium, Oslo, 18 November 2010.
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Introduction
Central banks continue to be challenged with changing demands as the environment before
us is rapidly being transformed. These fundamental and pronounced changes have
prompted calls for a review of the role of central banks in the financial system and in the
economy. Frequently, such calls have been precipitated during a financial crisis, as was the
case during the Asian financial crisis and more recently during this current global financial
crisis. However, such institutional reforms undertaken in periods of exceptional conditions
risks influencing the nature and direction of the reforms. While the reforms following a crisis
may address the immediate term demands, of equal importance is the medium and the
longer term implications of the reforms. Perhaps, an important lesson for central banks is that
such reinvention and modernisation should be undertaken during the good times so that we
will not be subjected to such changes during the worst of times. In essence, in such a
dynamic environment, central banks need to continue to adjust and evolve to remain relevant
and, thus, useful.
It is my great honour to be invited to speak at the Norges Bank Colloquium held in honour of
Governor Svein Gjedrem. Let me take this opportunity to congratulate Governor Gjedrem for
the achievements of the Bank under this leadership during his twelve year terms in office. My
remarks today will focus on the role of central banks from the perspective of emerging
economies and more specifically in the context of central banking in Asia as we confront the
challenges in this rapidly changing global economic and financial environment.
Central bank mandates
While there is no unique blueprint for the design of the institutional arrangements for a
central bank, of importance is that it needs to be relevant to our own circumstances. But of
importance is that there is clarity on the mandate, the governance framework and the areas
of accountability of the central bank. And that needs to be supported by the empowering
legislation to ensure that the central bank has at its disposal the capabilities to deliver the
mandate.
Central banks in emerging economies generally have a broader mandate beyond the
traditional mandates of monetary and financial stability. Even within these traditional
mandates, the role of central banks have varied considerably. In the mandate of monetary
stability, it has ranged from having the narrow mandate of price stability to the mandate
where price stability is the primary role of the central bank while due consideration is also
given to economic and employment objectives. While for some the mandates are clearly
hierarchical, for others, the multiple mandates involve assessments of the trade-offs.
The central bank mandate of financial stability is less clearly defined particularly in
circumstances in which the supervisory function does not reside in the central bank. The
majority of central banks in emerging economies in Asia, however, has the responsibility of
the supervisory function although for three of the region's major economies - Japan, China
and Korea, this function resides in a separate agency. Even for central banks that has the
responsibility of the supervisory function, the specific outcomes to be achieved are less
clearly defined compared to the mandate for price stability. In Malaysia, our new Central
Bank Act of 2009 has defined this mandate in terms of the risks to financial stability - that is,
the risk of the disruption to financial intermediation, the risk of disruption to the orderly
functioning of financial markets and the risk of loss of confidence in the financial system.
Common to most central banks in emerging economies is the mandate to develop the
financial system. Given the stage of development of financial systems in emerging
economies, this is an important mandate not only to enhance the financial intermediation
process in the economy but also for the purposes of facilitating the mandate of monetary and
financial stability. This mandate has involved institutional building, financial market
development and the strengthening of the financial infrastructure including that of the
payment systems and the legislative framework.
The decade of financial reforms and financial sector development that followed the Asia
financial crisis have resulted in more developed and resilient financial systems that is now
better able to intermediate the more volatile financial flows and to withstand shocks to the
system. During the recent global financial crisis, most emerging economies in Asia did not
experience any disruptions to the financial intermediation process and credit flows continued
uninterrupted providing important support to economic activity. It also allowed the financial
markets to facilitate the transmission of policies to support the economic recovery.
This developmental role is also significant in contributing towards preserving financial
stability. The development of the domestic financial markets and the development of a more
diversified financial system has reduced the risk of over concentration on the banking
system, a feature that was prevalent during the Asian financial crisis. The introduction of new
institutional arrangements has also been aimed at keeping abreast with innovation, the
advancement in technology and the intensification of globalisation. It has also allowed for the
adoption of a more balanced approach towards regulation in which it is complemented by the
newly developed mechanisms for surveillance including across borders, strengthened
supervisory oversight and institutional arrangements for resolution.
Central banks and financial markets
A more recently much discussed mandate is the role of the central bank in ensuring the
orderly functioning of financial markets. Orderly functioning financial markets are vital not
only for the efficient allocation of financial resources in the economy but it is also essential for
the transmission of the monetary policy and for preserving financial stability. While
competitive forces are expected to result in efficient and optimal outcomes, central banks in
emerging economies have had the important role of balancing between the market forces
and intervention with the objective of ensuring the orderly functioning of the financial
markets. It needs to be recognised that several important preconditions need to be in place
to generate equilibrium prices that reflect the underlying fundamentals. This includes the
institutional and market infrastructure, the incentive structure, the rules of the game and the
level of financial literacy that recognise and understand the market signals. When these
elements are still yet to be fully developed in many emerging economies, it increases the risk
to instability. Thus, as a result of the stage of development of such markets, or its size or
prevailing market imperfections, emerging economies have tended to be more vulnerable to
greater volatility and circumstances in which markets do not self-equilibrate. The recent
global financial crisis has shown that such dislocations have occurred even in developed
financial systems. Institutional structures and rules that become deficient and less relevant
heighten the risk for such unstable market conditions. Experience has also shown that such
market dislocations have severe and far reaching adverse implications on the overall
economy.
For the effectiveness of such interventions, however, there needs to be clarity in the
objectives to be achieved by such central bank presence and the results that are expected to
be delivered. Of importance, there needs to be the recognition of the temporary nature of
such interventions and the challenge of efficiently unwinding such presence when the
objectives are achieved. There is also the need to manage the risks of unintended
consequences of such direct central bank interventions. Such risks could include the
potential for circumvention, or the gravitation to other markets not protected by such
intervention. There could also be potential costs associated with such interventions, not only
the current costs, but also the cost to future generations.
While the pace of deregulation and liberalisation may differ across emerging economies,
there is a discernable distinct shift to greater market orientation in this recent decade. These
reform efforts have been reinforced by efforts to develop the financial markets and financial
infrastructure. Within this framework, the nature of intervention has been in the form of direct
presence in the financial markets, the setting of rules and regulation, and in the resolution of
problem financial institutions. Such interventions were evident during the Asian financial
crisis in the late 1990s to restore stability in the financial markets. This in turn created
conditions for the resumption of the financial intermediation process. While the efficient
functioning of the financial system was vital for the economic recovery in Asia, more
important was the comprehensive set of policies that produced the recovery. Within a year of
the introduction of the pro-growth measures, most of the crisis affected economies
experienced a strong recovery.
More recently, the global financial crisis has seen several rounds of wide ranging direct
market interventions to restore the smooth functioning of these markets. Described as
actions taken in the most extraordinary and exceptional circumstances, it demonstrates that
this phenomenon of severe market dislocations has the potential to occur even in the most
developed of the financial systems. As these massive interventions continue, primarily in the
public and private securities markets, the concern is on its potential consequences on other
parts of the world, in particular, to the emerging world. In the now more interconnected and
interdependent world, these actions are already creating significant shifts in capital flows.
Important for the emerging world is the ability to intermediate such surges in capital flows
and to manage the risks associated with such liquidity inflows and its potential to undermine
the current recovery.
A further element that has frequently been underestimated is the role of behaviour which has
had a major influence on the dynamics of the financial markets. Extreme forms of such
behaviour are evident in asset and foreign exchange markets. While the former is prone to
boom and bust, the latter is prone to overshooting. While several emerging economies have
successfully relied on macro prudential measures to contain the formation of such asset
bubbles, the foreign exchange market is not like any other market. With a daily transaction
amounting to USD4 trillion, it is the most liquid and dynamic market in the world. The role of
sentiment and expectations has resulted in a market that is frequently prone to excessive
movements and overshooting. As highly open economies, disruptions and disequilibrium in
the foreign exchange market have far reaching consequences in the real economy.
Intervention operations to maintain orderly market conditions reinforced by sterilisation
operations have aimed at ensuring liquidity in the market and at ensuring that the market
conditions reflect the underlying economic fundamentals. Similar to the presence in other
financial markets, this is to ensure the sustainability of the efficient functioning of the market.
Central banks and crisis containment and management
The world going forward is likely to continue to be affected by financial crisis. History has
shown that there have been more than a hundred distinct banking crises in this recent two
decades. The prospect of surviving such a crisis is not only about building resilience but also
having the capacity to manage it. Central banks have a critical role in crisis containment and
management, in particular, to provide liquidity, to restore the efficient functioning of financial
markets, to lead resolution programmes and to restore confidence to the financial system.
Given that the central bank is the lender of the last resort, the central bank is in the front line
of actions to restore stability. Regardless of the institutional arrangements for the supervision
function, - of whether it is based on an integrated model or a model that is organised along
sectoral lines, effective coordination is vital to effectively safeguard financial stability.
Established arrangement for coordination avoids a piecemeal approach by any individual
agency in the system and ensures a comprehensive response to the crisis. Greater
coordination across agencies also allows for prompt actions to be taken.
Elements for crisis management have largely been put in place in several of the emerging
economies in Asia. This has included a framework for rigorous surveillance for the early
detection of risks and vulnerabilities, the range of policy instruments to address the build-up
of risks, the governance and accountability framework as well as the coordination framework.
Regardless of whether the supervisory responsibility resides at the central bank, the role of
the central bank in surveillance for macro-economic management, and its direct contact with
the financial markets in its money market and reserve management operations can be
leveraged upon to support the financial stability mandate. This allows for a more
comprehensive response in containing and managing the crisis.
In Asia, as regional financial integration intensifies, there has been greater regional
cooperation and collaboration. During the Asian financial crisis, the management of the crisis
was by the individual economies. As the challenges become more complex, standalone
actions may not achieve the desired outcomes. Moreover, the perceived best solution for one
country may have unintended consequences for collective stability. Asia has, thus, come
together collectively to conduct regional surveillance with concrete steps to establish financial
support networks, to develop regional financial markets and payment systems. Such
collaboration also provides a collective voice and representation and the potential to be
heard in the sphere of global policy formulation.
Modernisation of the central bank
As central banks advance forward into the future of great uncertainty, the challenge of the
new environment demands new institutional capability for the central banks to remain
effective in delivering our mandates. Central banks also need to undertake its own
transformation and modernization. Such institutional capability enhancement may involve
changes in the institutional arrangements, organizational and governance structures and
practices, the empowering legislation and the talent required. Such organisational
development would thus require continual reinvention to adjust to the new realities of the
changing environment.
In most emerging economies, the largest concentration of talent resides in the central bank.
In this new environment, this talent needs to have new capabilities to deal with complex
issues from different perspectives that are no longer based on functional boundaries. While
this involves horizontal collaboration across the organization, it also requires management of
relationships including with the government while retaining the independence of the
organization. This would require institutionalizing the channels for information flows,
governance structures and clarity of accountabilities as well as the mechanisms for dealing
with disputes. Cumulatively, this would provide for a constructive relationship while
preserving the independence of the central bank.
An essential element in central banking that is paramount in an environment of great
uncertainty is having a well-developed communication strategy. Unlike the mature evolution
of communication strategy in the conduct of monetary policy, central banks' communication
with respect to financial stability is still very much in its early stage of development. Indeed,
the recent crisis has clearly surfaced the need for central banks and policy makers to design
communication strategy that balances the objective of providing information to the market
and the public, while achieving an optimal outcome of enhanced financial stability.
Conclusion
Allow me to conclude. The rapidly changing global economic and financial environment will
continue to exert much demands on the central banks. While extensive modernization and
transformation of central banks can be implemented at the national level, the increasingly
interconnected and interdependent world demands a greater emphasis on global
perspectives and considerations. The greater interface at the international level has involved
enhanced engagement to concrete collaborative actions. The common objective is surely for
an inclusive participation in the international financial system that will facilitate the common
agenda for a self-sustaining global growth and development. Thank you for your attention.