Már Guðmundsson: Financial integration and central bank policies in
small, open economies - what are the key lessons from the crisis?
Remarks by Mr Már Guðmundsson, Governor of the Central Bank of Iceland, in a plenary
session on monetary policy and policies of central banks at the Singapore Economic Review
Conference, Singapore, 5 August 2015.
* * *
A revised and extended version of this talk will be published in a forthcoming Singapore
Economic Review.
Chairman and participants,
I would like to thank the organisers for inviting me to speak at your conference here in
Singapore, a country that I have long respected for its economic management.
My remarks today bear the title Financial integration and central bank policies in small, open
economies: what are the key lessons from the crisis? They are motivated by my experience
as a policy-maker from a very small, open, and what used to be financially integrated
economy, and my tenure at the Bank for International Settlements.1
There is a widespread sense that global financial integration can be problematic for the
conduct of monetary policy in small, open economies. Why is that?
It is well known that the transmission mechanism of domestic monetary policy evolves as
domestic financial markets develop, and that this in turn affects the relative effectiveness of
different monetary instruments. The same applies to external liberalisation of domestic
financial systems and the cross-border financial integration it gives rise to. Initially, it can give
a boost to domestic financial market development. But as it progresses and we at the global
level get closer to the limiting case of free and frictionless capital movements, then real risk
adjusted asset returns increasingly become equalised across countries. As that happens,
less and less of the transmission of monetary policy goes through what I call the interest rate
channel. There would still be an interest rate channel at the global level, but that would be
determined by the big countries. The small, open economies that have adopted a floating
exchange rate could still achieve their inflation targets through the exchange rate channel.
The scope for short run output stabilisation would be more limited, however.
Is this necessarily a problem? If the exchange rate channel were relatively well behaved -
i.e., if it provided smooth adjustment based on fundamentals and uncovered interest rate
parity broadly held over relevant horizons - then the answer might be no. The problem is,
however, that experience has shown that uncovered interest parity does not hold except
perhaps over long horizons. Interest rate differentials give rise to widespread carry trading,
which is by nature a bet against UIP. Exchange rates therefore diverge from fundamentals
for protracted periods, followed by sharp corrections. So the exchange rate often seems to
be as much a source of shocks and instability as a tool for adjustment and stabilisation.
In what I have said so far, there is no presumption that small, open, and financially integrated
inflation-targeting countries with floating exchange rates cannot reach whatever inflation
target they choose and determine short-term domestic interest rates. You might then ask:
how is it that their capacity to affect long-term domestic rates is undermined, and how is this
consistent with the theory that long-term rates are determined by expected short-term
interest rates (with the addition of risk premia)? The answer is that, insofar as the theory
holds, it is global short-term rates that increasingly drive domestic long-term rates in small,
open economies as global financial integration comes closer to the limiting case.
Enough of theory. To what degree does the evidence support that this was indeed relevant
for monetary policy in small, open, and financially integrated economies during the build-up
to the GFC? There is significant literature on this, including one or two pieces of my own.
Overall, the data are consistent with the suggestion that a significant progress of financial
globalisation took place during the decade and a half before the GFC. This could be seen by
quantity measures such as gross external positions and saving-investment correlations. The
correlation of asset returns also reached high levels. In some advanced IT countries, the
correlation of changes in domestic long-term interest rates with US rates was very strong
(over 90%), at the same time as the correlation of domestic short-term rates with long rates
was weak - and even non-existent, if lags were taken into account. The GFC reversed this
process somewhat, as risk premia skyrocketed, cross-border banking retreated back to
home base, and restrictions on capital movements were in some cases reintroduced. But it
has come back to a significant degree.
There is an important caveat here, which is that the observed patterns could have other
explanations. Thus co-movements in asset returns could be due to common shocks and the
low level of correlation between short and long rates due to monetary policy credibility.
Looking at the totality of the evidence and case studies, however, it seems difficult to escape
the conclusion that global financial integration was a big underlying driver, although there
were also other factors at play. New Zealand appears to be a relevant example here. During
significant parts of the 2000s - before the GFC - the policy rate in New Zealand was raised
to counteract demand pressures at the same time as the US maintained an easy stance.
New Zealand's long rates were flat or falling for most of this period. I could tell a similar but
slightly more complicated story from my own country.
The tendencies that I have described can be problematic in their own right but in no way
fatal, as the experience of New Zealand and others attests to. It is when they interact badly
with other economic and financial risks that can face small, open and financially integrated
economies - such as the global credit cycle, domestic financial vulnerabilities, policy
conflicts, and asymmetric shocks - that we can have a lethal cocktail. This was the case in
Iceland.
To demonstrate this, let me take a stylised example which is, I admit, heavily influenced by
the experience of my own country. A small, open, and financially integrated economy
develops a positive output gap that is larger than in the rest of the world. The economy is
booming and is seen as a good investment by outside investors. This occurs in a situation
where the global credit cycle is in a strong upswing. The result is capital inflows and upward
pressures on the exchange rate. The country has a floating exchange rate and has adopted
a flexible inflation targeting regime. Monetary policy therefore reacts by raising interest rates
due to the risks that the booming economy poses for future inflation. This, however, widens
the interest rate differential vis-à-vis the rest of the world and sucks in even more capital
through carry trade and other channels. The currency therefore appreciates further. This
helps to limit inflation, both directly, through lower imported inflation in terms of domestic
currency, and indirectly, by directing demand abroad. But the effect of monetary tightening
on domestic demand is limited through the processes I have described, where long rates
react weakly to the increase in the policy rate. In addition, firms and households increasingly
borrow in foreign currency in order to avoid even those limited increases in domestic
borrowing costs that take place. This foreign currency borrowing is intermediated by the
domestic banking system, where the financing is more short-term than the lending. Thus the
banking system has a growing balance sheet in FX, with a maturity mismatch but limited
LOLR facilities to backstop it. In short, financial risks are accumulating, both in the financial
sector and among firms and households. At the same time, the economy is increasingly in an
unsustainable position, with an overvalued currency and big current account deficit. The
whole thing then comes crashing down when foreign financing comes to a sudden stop,
heralding a currency crisis and even a banking crisis as well.
Before I go further, let me warn you, though, that this is only part of the explanation of the
financial crisis in Iceland. The offshore activities of the banks and old-fashioned
macroeconomic mismanagement were equally important, if not more so. On this topic, I refer
you to other speeches and publications by myself and others.2
What can and should be done about the problems I have laid out? In answering that
question, we should take into account that the biggest problems occur when global factors -
cross-border financial integration and associated capital flows - and domestic vulnerabilities
interact negatively. In principle, solutions could be directed at any or all of these. Some are
obvious in their design and relatively easy to implement, especially if they can be
implemented unilaterally by individual countries. Others are more complex in their design or
require global, regional, or big-country action that is not necessarily forthcoming.
One potential solution is to enter a monetary union, thus eliminating the small country
monetary policy problem. It would also reduce the financial risks emanating from currency
mismatches and foreign currency maturity mismatches in the balance sheets of domestic
banks. But as this is currently not on the agenda in my own country and recent developments
have demonstrated that it is no panacea - with pros and cons that extend far beyond my
topic her - I will not dwell on it further.
There is no doubt that flaws in the international monetary and financial systems exacerbate
the problems that I have mentioned. Reforms that would reduce the current asymmetries in
the adjustment burdens of surplus and deficit countries, or would to a greater degree
internalise the global externalities of the monetary policies of central banks issuing major
reserve currencies, could reduce the volatility of capital flows. However, in spite of
widespread unease about the current state of affairs, such reforms do not seem likely
anytime soon. Furthermore, there are complex unsolved issues involved regarding potential
conflicts between domestic and global objectives.
That leaves us with what individual countries can do. In principle, they have three avenues to
mitigate the problem. The first is to adjust macroeconomic policy frameworks. The second is
to use prudential regulation and supervision aimed at reducing vulnerabilities and increasing
resilience in face of volatile capital flows. The third is to introduce tools aimed directly at the
financial integration part in order to regain greater monetary independence and shift the
effect of monetary policy more to the interest rate channel and towards the non-traded goods
sector. This could, for instance, be some form of a variable tax or reserve requirement that
would make the relevant capital inflows more expensive and thus limit the increase in the
effective interest rate differential vis-à-vis abroad when domestic interest rates are raised.
There are complex design, governance, and international issues involved that I do not have
time to expand on here. What should be stressed, however, is that it is not optimal that
countries are increasingly forced to take unilateral action in this domain. Credible and reliable
co-insurance is better than self-insurance. At least, the IMF should monitor the process, and
further ahead, some rules of the game regarding capital flows would be welcome so that we
are not faced with excessively sub-optimal outcomes and unintended consequences for the
global system.
Let me conclude by telling you what we are contemplating in Iceland in this regard, as this
issue is very much on the agenda as we prepare to lift the comprehensive controls on capital
outflows that were introduced at the peak of the crisis.
We will work through all of the avenues that I have just mentioned, and many of the reforms
have already been implemented. What I call IT-plus - or plus-plus - will replace IT of the
precrisis type. A managed float has already taken the place of the free float. Foreign exchange
intervention is thus used to reduce excess volatility in the FX market and lean against capital
flow cycles. The financial stability framework has been strengthened, and macroprudential
tools are being developed that should mitigate adverse interactions between capital flows, on
the one hand, and domestic credit growth and asset prices, on the other. Foreign currency
borrowing by unhedged domestic agents will be very much restricted. Prudential limits on
banks' FX balance sheets, in the form of specific LCR and NSFR in FX, have been imposed.
In practice, this will greatly limit the size of their FX balance sheets and the associated
maturity mismatch that was the proximate cause of the demise of the old banks that failed
during the crisis. Finally, a tax or other equivalent measure of the type I just mentioned is
being contemplated.3
Taken together, this will amount to a very different paradigm for economic management than
the one prevailing before the crisis. History will tell whether it is sufficient to preserve
monetary and financial stability in the rougher seas of freer capital movements that we intend
to embark upon. In any case, we need to strike a balance between dynamism and freedoms,
on the one hand, and stability, on the other.
Thank you very much.