The global financial cycle, capital flows, and policy responses
Remarks by Luigi Federico Signorini
Senior Deputy Governor of the Bank of Italy
G20 RBWC Workshop
Towards a more resilient international financial architecture
Online event, 10 May 2021
The COVID-19 crisis gave rise to a synchronised sudden capital stop in March 2020, whose
magnitude exceeded that observed during the Global Financial Crisis. Fortunately, this
episode was short-lived and concentrated in the early stages of the pandemic. The pressure
on emerging market capital flows eased after the unprecedented policy interventions
carried out by both advanced economies (AEs) and emerging market economies (EMEs).
An important factor in the scale of the outflows seen at the outset of the pandemic was
the shift that had occurred over the previous decade in the composition of capital flows,
towards non-bank financial intermediaries (NBFIs), and in particular, investment funds.
This is the first of two main points I want to make.
NBFIs tend to be more volatile than other sources of finance, such as bank lending and
foreign direct investment. This was apparent during the March 2020 'dash-for-cash' stage.
Investment funds accounted for around half of the portfolio outflows observed, even
though they (by some accounts) only represent a third of the stock of global portfolio
liabilities.
Why has NBF intermediation and cross-border activity grown so much? Several factors
have contributed, but let me mention just two that are especially relevant to global flows:
- first, the Basel reforms adopted after the global financial crisis led banks to
deleverage, thereby reducing non-core assets and cross-border lending;
- second, low interest rates in developed markets encouraged investors to diversify
their assets by investing in emerging markets, often through dedicated funds (or
through increased allocations to emerging markets by globally active funds).
The growth of market-based finance is, on balance, a welcome development, notably
because it increases the diversification of funding sources. This is particularly important
for those countries and systems, such as Italy and much of continental Europe, that are
overly dependent on banks.
While funds may increase the size and liquidity of markets in peacetime, they are also
known to be a potential channel for shock amplification in the event of stress. Because of
redemption pressures coming from end-investors, fund managers may find themselves
forced to sell assets, contributing to price-liquidity spirals. This mechanism is exacerbated
when funds are allowed to run on a mismatch between redemption rules and the liquidity
of their portfolios; not surprisingly, open-end funds behaved more procyclically than
other investors did during the March turmoil. Moreover, while funds provide greater
diversification for end-investors, they typically display little diversity in their own strategies
within each investment class. State-of-the-art strategies are likely to be similar across
many funds; besides, as managers are compensated relative to benchmarks, they tend to
replicate the investment strategies adopted by peers. The resulting herd behaviour will
further amplify shocks and cause contagion. Herding is, however, very much inherent in
ETFs and passive funds, which have been shown to increase the sensitivity of peripheral
markets to global shocks.1 Finally, algorithmic and high-frequency trading, widely used by
asset managers, tends to increase market efficiency during normal times, but may break
down during high volatility episodes, increasing the procyclicality of prices and liquidity.2
The Bank of Italy had long been advocating for international financial standard setters to
tackle some of these vulnerabilities. This was largely ignored until the COVID crisis made
them obvious to all, when investment funds played a crucial role in market disruption
and, specifically, in capital flow reversals.3
NBFI reform is now very much on the FSB's agenda. The Italian presidency of the G20
has made it one of its key priorities in the Finance track. While some issues are still
controversial, progress has been palpable in some key areas, and I am confident that a
more comprehensive approach is gradually developing.
This was my first main point. My second point concerns the policy responses during
the pandemic, which proved effective in dealing with large and volatile capital flows. As
is well known, the actions taken by AE authorities after the outbreak of the pandemic,
including the introduction of swap agreements by major central banks, contributed to
improving global financial conditions; as investors' risk appetite returned, EMEs' capital
inflows recovered and tensions on foreign exchange (FX) markets eased.
The point to which I would like to draw your attention is that a number of EME policy
makers also played a crucial role during that episode, as shown for instance in a joint
paper by the Bank of England and the Bank of Italy.4 To mitigate the impact of the
COVID-19 shock on the real economy and financial sector, they used a variety of tools,
including monetary policy, FX interventions, macroprudential measures (MPMs) and
capital flow management measures (CFMs).
In the early stages of the COVID crisis, EME central banks intervened heavily in FX markets,
trying to stem currency depreciation. Interventions were later scaled down, as market
tensions and exchange rate pressures receded.
Interestingly, a few EME authorities used both conventional and, I believe mostly for
the first time, unconventional monetary policy instruments. As regards macro-prudential
measures, several EMEs relaxed their overall prudential stance, mainly by easing capital
and liquidity buffers counter-cyclically. Again, I believe this was the first time EMEs had
extensively resorted to MPMs to stabilise the economy, proving that these instruments
have become part of their policy toolkit. By contrast, capital flow measures played a minor
role in the recent episode. Many EMEs relaxed CFMs on inflows, mostly to reduce banks'
FX needs stemming from prudential requirements, and in some cases to increase liquidity
in domestic bond markets. Unlike in previous crises, only a few countries tightened CFMs
to curb outflows.
Policymakers' response to the sudden stop in March 2020 highlighted the complementarity
of different policy tools when a severe external shock hits an open economy, and will
offer ample material for reflection and research.
Tobias Adrian will give us glimpse of the Fund's efforts to develop an Integrated Policy
Framework (IPF) that would jointly consider monetary policy, FX intervention, MPMs and
CFMs. This is an ambitious and welcome project that will offer guidance on the optimal
selection of policy tools and their calibration, depending on the nature of the shocks
as well as on the cyclical and structural characteristics of individual countries. We at the
Bank of Italy shall be happy to contribute to the debate, following our well-established
tradition of research on the issue of the optimal choice of policy tools.5
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