Central Bank of Chile's Twenty-first Annual Conference
"Monetary Policy and Financial Stability:
Transmission Mechanisms and
Policy Implications"
Opening remarks by Governor Mario Marcel
Good morning and welcome to the Twenty-first Annual Conference of the Central Bank of
Chile. It is a pleasure to host this event that every year gives us an opportunity to reflect and
discuss about issues that have direct implications on our work as central bankers from a
broader perspective. I am looking forward to active discussions through the rest of the week
on this year's conference theme: monetary policy and
financial stability.
Ten years have passed since the onset of the Global Financial Crisis and we are still dealing
with its economic consequences. But we have learnt a lot, and a decade of hindsight about
the causes and long-lasting effects has led us to rethink the way we conduct monetary policy,
how to ensure financial stability, and how these two elements are, or should be,
interconnected.
One of the most important policy lessons from the crisis concerns the relevance of actively
seeking financial stability in a context of ever-increasing financial complexity. And central
banks worldwide have been increasingly involved in assuring this, since it has become clear
that financial stability is a pre-condition for price stability. Although financial stability has
long been a key concern for policymakers, particularly in emerging countries where financial
vulnerabilities are, or were, more evident and where risks to stability often come from abroad,
nowadays the key concern is how to act in a preemptive way with actions that are costly, to
ensure financial stability into the future. How should macroeconomic policy pursue the goal
of financial stability in normal times, when the benefits are uncertain but the costs are
noticeable?
As many of you well know, this concern came with the observation that the buildup of risks
in the United States before the crisis occurred during a period of stable prices and output, the
so called "Great Moderation" period, where low nominal interest rates that were consistent
with the Central Bank's commitment with CPI inflation stability may have led to excessive
risk-taking by financial intermediaries, and to a rise in asset prices, while good economic
conditions masked the developing of financial imbalances.
In the aftermath of the crisis, policy rates were drastically reduced and diverse policy
measures were implemented as the zero-lower bound became an active constraint. But the
increasing concern about financial conditions and the consequent reassessment of the
macroeconomic policy framework was most evident with the adoption of macroprudential
policies. But the question remains about the role of monetary policy. Should monetary policy
frameworks explicitly incorporate risks to financial stability? This, the so-called Leaning
Against the Wind debate, has become one of the most hotly debated issues in
macroeconomics, in policy as well as academic circles, and will be one of the main topics
we will be discussing and learning about during these couple of days.
Let me contribute to this debate with the perspective of a policymaker in a small-open
economy like Chile. In our case, financial vulnerabilities have been often related to large and
volatile capital flows, with their consequent effects on asset prices and credit spreads. In this
context, raising the interest rate in normal times due to financial stability concerns as the
LAW strategy would prescribe, may be counterproductive as it would attract more capital
flows, would tend to appreciate the domestic currency and would encourage foreign-currency
borrowing. These mechanisms, of course, have been at the core of monetary policy in
developing countries for many years. In the case of Chile, they were more evident during the
90s when capital controls were in place to try to give more autonomy to monetary policy in
a context of persistent and large capital inflows. However, these mechanisms are relevant as
well when debating about the role of monetary policy in actively pursuing an objective of
financial stability.
A second issue I would like to point out is related to the credibility of the Central Bank, which
is also a very important concern for emerging economies like Chile, where credibility was
gained over several decades of responsible policymaking, and losing it would mean a costly
institutional setback. A strong advantage of having monetary policy focusing exclusively on
price stability is that it simplifies communication and enhances accountability, with the
resulting positive effects on credibility. Adding a different objective would hinder
transparency, endangering the anchoring of inflation expectations.
However, independently of the convenience of following a LAW strategy or keeping the
precrisis consensus with monetary policy focusing primarily on price stability, I am convinced
that the main lesson from the Crisis is that regulatory frameworks aimed at specific sectors
and markets are a key element of a defense against financial disruptions. Macroprudential
policies, and in particular monetary policy, are not substitutes for an efficient regulatory
framework. Microeconomic policies can be targeted much closer to the source of market
imperfections, mitigating their effects while at the same time avoiding the economy-wide
costs of contractionary macroeconomic
policies.
We cannot forget that inefficiencies in the regulatory framework were at the heart of the
buildup of risks in the run-up to the crisis. The fact that fragilities in the financial system,
namely inadequate levels of capitalization and liquidity, were not properly and timely
identified, may primarily reflect inadequacies in regulation and supervision.
Our best response is to continue strengthening regulation and supervision regimes aimed at
avoiding future crises. And central banks have a crucial role to play because there are clear
complementarities between financial and monetary stability, which, as is the case of Chile,
central banks'
are often formally recognized in official mandates. Before referring to what
we have done on this matter in Chile, let me briefly describe our experience with the Global
Financial Crisis and our macroeconomic policy response to it.
While we were still enjoying the commodity boom of the 2000s, we were hit by the spillover
effects of the crisis and its aftermath, namely the tightening of domestic lending conditions,
capital outflows, a reduction of the external demand for our exports and a decrease in the
price of copper, which is still the main source of external income for the Chilean economy,
and in particular an important source of revenues for the Treasury. The price of this critical
commodity fell more than 60 percent in just five months. Exports fell almost 20 percent in
two years, a strong shock for an economy where exports accounted for more than 40 percent
of GDP. A similar drop experienced public revenues, with those coming from copper
production falling 23 percent in 2008 and 50 percent the following year.
Despite the severity of the shocks, economic performance and the resilience of the financial
system have been better than in comparable situations in the past. Behind this favorable
response of the Chilean economy lies a macroeconomic policy framework able to pursue an
effective reaction, and a regulatory scheme supporting the high resilience of the domestic
financial system.
In Chile the monetary policy framework consists of a flexible inflation-targeting regime with
a floating exchange rate. This framework has allowed us to respond efficiently to external
shocks keeping inflation expectations anchored. Before the Asian Crisis of 1998, we had a
managed exchange rate and we had capital controls in place to allow monetary policy
independence to manage inflation in a context of abundant capital inflows. Indeed, we
experienced a costly adjustment to that episode, and this was fueled in part by financial
stability concerns that called against an exchange rate adjustment. But once the harder times
had passed, the exchange rate was allowed to float freely, facilitating not only the external
adjustment against shocks but also improving the incentives for private agents to properly
hedge their foreign currency operations.
The deep-rooted credibility of our Central Bank has also facilitated the conduct of monetary
policy with a floating exchange rate system. The fact that the market understands that the
Central Bank pursues a goal for inflation at a 24-month horizon means that the exchange rate
pass-through to inflation is relatively low, indeed the lowest in the region. This can be
illustrated with the reluctance of the Central Bank to tighten monetary policy in 2015 despite
a 49 percent devaluation in 2014-2016, and without affecting 24-months-ahead inflation
expectations, which remained anchored at the target level.
As the 2007 financial crisis unfolded and its effects spread-out, this framework helped us to
avoid large costs and evade financial problems despite our strong ties with the global
economy. In the aftermath of the crisis the local currency depreciated around 45 percent in
seven months, while the monetary policy rate was reduced from a relatively high level of
8.25 percent in December 2008 to a point five percent in July 2009, remaining there for about
a year. Together with lowering the interest rate, the Central Bank implemented a program of
liquidity provision that significantly reduced the market interest rates to a level much closer
to the monetary policy rate. Additionally, in the middle of 2009 it established a term liquidity
facility for banking institutions, granting 90- and 180-day liquidity at the prevailing monetary
policy rate, signaling a more expansionary path for the monetary policy rate than the market
expected.
The active monetary policy response, together with an expansionary fiscal policy, favored by
a healthy fiscal position that was achieved thanks to a fiscal rule where expenditures are
determined as a function of long-run copper prices and economic growth, facilitated a rapid
adjustment. After only one period of negative annual growth in 2009, the economy was able
to sustain growth rates above 4 percent in the years that followed. The inflation rate fell well
below the target range for about a year, but inflation expectations remained well anchored at
our target of 3 percent in the two-year horizon.
Undoubtedly this is the strongest countercyclical macroeconomic policy response we have
ever implemented to a shock of this magnitude, and it was possible thanks to a sound
corporate sector, a well-capitalized and resilient financial sector, and a solid position in terms
of international liquidity.
Importantly for the discussion ahead, this was the result of careful regulation and supervision
of individual financial institutions. This scheme hails back to the banking crisis of the 1980s,
and it has been constantly adapted and improved since then.
In Chile, financial services are regulated and supervised by different institutions according
to the type of service; securities and insurance, the pension system and unemployment
insurance, and banks. In the case of banks, the Superintendence of Banks and Financial
Institutions and the Central Bank are in charge. Different schemes have been designed to
facilitate coordination between institutions. This effort has led recently to the creation of the
Financial Market Commission, which will be headed by an autonomous board of directors
and will transform the financial supervision and regulation scheme to an integrated one, with
a systemic view of the stability and risks facing the financial sector and more flexibility to
deal with critical situations.
enjoys a special independent status under the Bank's
The Central Bank of Chile
Constitutional Organic Law. Besides specific regulatory tasks with regard to the banking
sector, the Central Bank oversees the foreign exchange regulations and monitors closely and
constantly all the industries making up the financial sector. A central task performed by the
Central Bank aimed at financial stability is the publication of the Financial Stability Report,
twice a year.
The banking regulation has evolved gradually and steadily, adopting proven international
standards and best practices. A new General Banking Law will provide for a gradual
convergence to the Basel III framework, which will raise the quality, consistency and
transparency of the capital base; strengthen risk hedging; introduce leverage limits; promote
a countercyclical capital framework; and introduce a global liquidity standard. These
requirements will be implemented gradually through 2019. They will provide higher stability
to Chile's reputation and access to international markets.
and sustainability and contribute
Chile largely complies with the Principles for Financial Market Infrastructure established by
the BIS. An assessment made by the World Bank and the IMF last year identified a high
level of compliance with the principles on the part of the entities assessed, as well as the
authorities. The main conclusion was that Chile has sound and robust financial market
infrastructures, in line with international standards and best practices on risk management,
the finality and irrevocability of settlement, efficiency and transparency.
The Chilean financial market is, in general, deeper than those of other Latin American
countries, with larger institutional investors and greater maturity. Banks' capital adequacy
indicators are similar to those of other economies in the region, but lower than in OECD
countries, while their exposure to credit risk is low relative to both OECD and emerging
economies. The World Economic Forum Banking Strength index shows that the Chilean
banking sector is very strong, as it ranks in the 11th place in the world.
Let me finish by pointing out the relevance that the exchange rate derivatives market has had
in favoring both financial stability and the conduct of the flexible inflation targeting scheme
in Chile.
This market is not as deep as it is in developed countries, but it has experienced significant
growth of more than 10-fold since 1998, fueled in part, as I already mentioned, by the floating
exchange rate regime. The role of pension funds has been significant as well, as they maintain
a large positive foreign financial position, and keep hedging against exchange rate risk even
above the regulatory requirements, especially in the aftermath of the last crisis.
Thanks to these factors and a favorable regulation, Chile shows a high level of penetration
of financial derivatives compared to other emerging economies and countries in the region.
All this has contributed to a limited exchange rate mismatch of corporations. Today the share
of firms with a mismatch over 10 percent of their assets is below 10 percent, down from
around 20 percent before the Crisis. Hence monetary policy can be conducted in a
countercyclical manner, without the need to manage the exchange rate. However, as the
recent experience in developed countries has revealed, the rapid development of derivatives
markets also poses challenges to regulators due to their complexity and potential
concentration of risks in a few entities.
An additional strength of the Chilean economy in the context of emerging countries, which I
think is very important for the topic to be discussed during these days, is the relevance of
institutional investors, particularly pension funds. Their role in financial stability has gone
well beyond the development of derivatives markets. They have contributed to the deepening
of capital markets, portfolio diversification, and the development of new financial products,
among other features. Moreover, with their peso-denominated liabilities and large foreign
position, which is around 35 percent of GDP in the case of pension funds, they have
facilitated the conduct of monetary policy being an important source of liquidity in foreign
currency when needed. Acknowledging this, the financial regulation has gradually expanded
the scope of possible investments for institutional investors, including raising the limits for
investments abroad.
Let me finish by thanking the distinguished group of economists that have joined us to present
and discuss issues concerning monetary policy and financial stability. I would like to thank
also Alvaro Aguirre, Markus Brunnermeier, Diego Saravia and Catalina Larraín for putting
together the program, and Paloma Navarro and Carola Besa for helping with the organization.