José De Gregorio: Capital flows and the interaction between
macroprudential policy and monetary policy
Keynote speech by Mr José De Gregorio, Governor of the Central Bank of Chile, at the
Central Bank of Chile Annual Conference on "Capital Mobility and Monetary Policy",
Santiago, 17 November 2011.
* * *
I am very grateful for comments and suggestions from Rodrigo Cifuentes, Kevin Cowan, Luis Oscar Herrera,
Alejandro Jara, Ernesto Pastén and Claudio Raddatz.
Welcome to the 15th annual Conference of the Central Bank of Chile, this time focusing on
"Capital Mobility and Monetary Policy". In this address, I will discuss the challenges of
dealing with macroeconomic and financial instability in the context of inflation targeting in
emerging economies and analyze the special case of capital inflows as a source of such
macroeconomic and financial instability.
The monetary policy framework based on inflation targeting and exchange rate flexibility has
been successful in providing price stability and the conduction of countercyclical monetary
policy over the last decades. Perhaps precisely because of this success, the "separability
view", that takes price stability and financial stability as independent goals, was the preferred
policy framework before the global crisis in those countries that explicitly pursue financial
stability as a policy goal.1 Nevertheless, the recent crisis and financial turmoil resulted in
increasing awareness of the linkages (spillovers) between macro and financial stability, both
at the national and the international level. This calls for a revision of this view.2
In my remarks today, I would like to start by discussing some general issues regarding the
linkages between price and financial stability and the linkages between monetary and
macroprudential policy. In the second part of this talk, I will refer to the context of
international capital flows and policy responses in a small open economy with inflation
targeting, and the relation that monetary policy has to have with macroprudential policies in
that context.
Interactions between Monetary and Financial Policies
Most central banks care not only about price stability, but also about financial stability. The
goal for price stability is usually the main mandate of central banks, and is widely understood
as maintaining low and stable inflation, which also reduces the deviations of output from its
potential. However, the central bank's mandate for preserving financial stability is less
explicitly defined; probably in part because there is less agreement on what is financial
stability and what should be considered an indicator of it. Broadly understood, it
encompasses a stable and fundamental-driven credit and asset price growth, as well as the
absence of large mismatches in the financial sector. It is not the purpose of my talk to narrow
the definition of financial stability, so I will use the term in a broad sense. There is also the
key distinction between micro and macro financial stability, and in most of what follows I will
be focusing on the systemic aspects of financial stability, unless noticed otherwise.
The recent crisis calls into question the view that macro and financial stability can be really
seen as separate objectives. In fact, it seems to have brought a reminder that in the end,
macroeconomic and financial stability are related, both directly and through the instruments
used to achieve each of them. The direct linkages are natural: it is difficult to imagine a stable
financial system operating in a volatile macro environment. Financial systems are good at
dealing with idiosyncratic risks, but their ability to deal with aggregate risk is more limited,
especially in emerging markets. Vice-versa, financial instability typically ends up creating
macroeconomic fluctuations. The uncertainty that accompanies periods of financial instability
leads investors and consumers to postpone investment plans and the purchase of durable
goods, with foreseeable consequences for output and inflation. Moreover, extreme episodes
of financial instability that lead to financial crises almost always end up in a sharp and costly
recession.
There are also indirect linkages between macro and financial stability through the main
instruments used to achieve them. The main tool used by most central banks to achieve
macro stability is the management of a short term reference interest rate. Movements of this
benchmark rate not only directly affect the consumption/saving decisions of firms and
households, but also have consequences for all asset prices (e.g. equities, bonds, exchange
rates, housing), the cost and availability of credit, and the willingness of investors to take
risks. For instance, in a stable context, persistently low interest rates may generate
incentives for investors whose income depends on absolute returns (such as hedge fund
managers and insurance companies) to invest in more risky assets. It may also make it more
profitable to engage in carry trades and create currency or maturity mismatches. On the
unintended side, the success in achieving macro stability may change the perception of
agents about the riskiness of the environment and lead them to take more risky bets in the
expectation that good times will continue indefinitely (or at least until the bet pays off). Also,
the way to deal with bubbles in monetary policy in the US, applying the so-called
Greenspanput (Blinder and Reis, 2005), may have increased the chance of bubble formation
(De Gregorio, 2011). On the other hand, micro and macro prudential regulatory tools, such
as caps on credit growth or capital requirements have direct consequences on the cost and
availability of credit, with the corresponding impact on investment, consumption,
employment, and output, and the transmission channels of monetary policy.
However, the links between macro and financial stability as goals, as well as in the cross
impact of their main tools, do not mean that they can be dealt with using a single type of
instruments. While, as highlighted above, interest rate movements affect credit and asset
prices, they are not the most appropriate for addressing financial stability concerns. For
instance, raising the interest rate could in principle tame stock- or house-price growth in a
closed economy, helping to prevent the formation of bubbles or bursting them at an early
stage, before they threaten financial stability. But even if it were possible to identify a bubble
from a fundamental-driven asset price increase, controlling asset price growth may require
substantial increases in the interest rate, which will reduce credit supply and the prices of
other assets that may or may not be part of the bubble, having negative consequences on
output and inflation. In other words, the impact of such policy would be felt across the board
in financial markets, on top of the detrimental impact it would have in the real economy by
unnecessarily depressing output, employment and real investment.
In an open economy, such policy may be ineffective in controlling asset price growth and
may even worsen the prospects for financial stability. I will tackle this further in my coming
discussion of capital flows.
The same criticism applies to the use of regulation to achieve macro stability. It could be
possible to use bank capital requirements to control inflation through the supply of credit and
real activity, but it would raise the cost of capital and would hit especially hard
bankdependent firms and consumers while other borrowers would turn to other sources of
financing. Furthermore, the relatively high-frequency changes that managing macro
conditions may require may create unnecessary policy-driven volatility in financial markets.
All this indicates that it is more appropriate to tackle each goal with its own type of tool.
The separation of the instruments does not necessarily mean that the achievement of the
goals can be separated operationally. Because of the dual causality of price and financial
stability, monetary and financial policies should be explicitly coordinated. How this
coordination is achieved varies across countries. At the very least, instances to monitor
global risks to financial stability should exist. Central Banks should be involved in these
monitoring instances (or should centralize the monitoring and supervision functions) because
of their relative advantages in providing a macro view of the economy and their market
contacts, due to the implementation of monetary operations. In addition regulation that could
have systemic implications should be discussed in these instances.
In the case of Chile, the supervisory landmark is made up of three superintendencies
(including banks). In this setting, coordination for systemic stability is achieved at two levels.
One the one hand, the Central Bank is involved in several aspects of financial regulation
directly by dictating regulation, or by participating in consultations with other agencies. On
the other hand, the Central Bank participates in two coordination instances with the
superintendents and finance ministry. The experience during the last years has shown that
during periods of financial turmoil, mainly as result of external shocks, the Central Bank, the
Finance Ministry, and the financial regulation agencies have indeed worked in close
coordination, and, as the global financial crisis testifies, results have been positive.
Moreover, in Chile, as banking supervision takes place outside the Central Bank it is key that
it is not out of touch with the broader macro environment, so that financial system stance
visà-vis the risks perceived in the macro-outlook is the natural first step in the supervisory
process.
Recently, these instances have been formalized with the creation of a Financial Stability
Council, headed by the Finance Minister. This council will, amongst other things, identify
systemic risks and mitigation policies, and discuss the systemic impact of regulation.
Summing up, monetary and prudential policies are closely connected, first because
macroeconomic and financial stability are closely interlinked, and second because
instruments designed to achieve stability in each front have cross effects. This
interconnection suggests the need for coordination of both types of policy. There are
arguments, however, that call for specialization of some functions. So far, we have seen in
Chile a banking supervisory agency that takes into consideration the macro-systemic aspects
and a central bank concerned about both price and financial stability, arrangement that has
permitted the necessary coordination in dealing with situations of financial distress.
The role of capital flows
In what follows, I will deal with the issue of capital flows as a source of financial instability
within the framework of inflation targeting and flexible exchange rate. In particular, I am
concerned with the interaction between price and financial stability when a small open
economy, like Chile, is exposed to volatile capital flows. I have to start by emphasizing that in
the current surge of capital inflows, Chile was not subject to massive inflows as was the case
in the past. However, we cannot rule out this possibility, as prospects for advanced
economies are very gloomy, while emerging markets offer very healthy returns to investment.
First, the long history of emerging markets booms and busts has shown us that frequently in
this type of economies the building up of risks is associated with periods of capital bonanzas
that fuel credit booms, asset bubbles, and exchange rate misalignments, and that frequently
end in sudden stops and reversals of capital inflows that wreak havoc in the financial system
and the real economy. The form that these flows take in many countries, short-term and
foreign-currency based, further contributes to the building up of financial mismatches with
potentially severe financial and macroeconomic consequences. Moreover, even before a
crisis occurs, capital surges have macroeconomic impacts through the expansions in activity
resulting from credit growth, the factor reallocations that may be associated with persistent
exchange rate movements, and the inflationary or deflationary pressures that may arise from
the combination of exchange rate pass-through and aggregate demand expansions.
In cases where capital flows are not excessive and driven by fundamentals, the pursuit of
macro and financial stability can be consistent with the inflation targeting framework and
exchange rate flexibility, even though it may be accompanied by moderate exchange rate
volatility and real exchange rate appreciation. Under these conditions, exchange rate
flexibility helps the efficient reallocation of resources and thus becomes the first line of
defense in avoiding the building up of risks. For example, the delayed appreciation of
exchange rates to improved domestic conditions could be a factor that accelerates capital
inflows to take advantage of artificially low asset prices. Therefore, a flexible macroeconomic
framework geared to avoiding the buildup of overheating and that allows prompt asset price
adjustment should be the main way to avoid excessive, especially speculative, capital
inflows.
But even if flows are not "excessive", agents may undertake exposures that could be
privately efficient, such as currency and maturity mismatches, but result in aggregate
vulnerabilities. In these situations of moderate and fundamental-driven capital flows, the
prevention of financial vulnerabilities resulting from exchange rate volatility should be
addressed through financial regulation and financial development. In fact, this has been the
case of Chile, where the regulation of currency mismatches has prevented banks from
excessive risk taking, and the deepening of the financial system has provided an increasing
hedging capacity of the private sector. Nonetheless, this approach is not free of situations
like those experienced in some emerging market economies like Mexico, Brazil and
South Korea after the Lehmann bankruptcy, where the un-regulated corporate sector
became systemically important after the misuse of hedge instruments increased dramatically
their exposure to exchange-rate risk. In this regard, strict rules for addressing excessive
risktaking from financial intermediaries that fund these positions should be implemented.
On the other hand, when a country is subject to a sudden surge of capital inflows due to the
incentives associated with temporary macroeconomic and financial conditions, or due to
sudden changes in the international investors' portfolio decisions, the inflation-targeting
framework may be subject to important challenges. These challenges are particularly
important when episodes of capital flows also result in inflationary pressures. Under these
circumstances, dealing with inflationary risk through interest-rate policy may generate further
incentives for capitals inflows, exacerbating exchange rate volatility and even creating an
over-appreciated currency. From the point of view of macroeconomic policies, this requires to
ensure that fiscal policy is not what is inducing capital inflows. All considered, the pursuit of
macro and financial stability in the context of an inflation target regime may call for some
exceptional departure from a fully floating exchange rate and a highly integrated international
financial market. This can take different forms, as they may require the use of
non-interestrate policy, such as reserve requirements on bank deposits instead of the conventional
interest rate policy; a temporary reduction of the degree of financial integration, through the
use of some sort of capital controls; or it can allow some exchange rate intervention, through
the accumulation of international reserves in order to avoid excessive exchange-rate
appreciation. I will comment on each of these options next.
Using alternative monetary policy instruments to deal with inflationary pressures, such as
reserve requirements on bank deposits, may prevent the undesired credit growth associated
with capital inflows without affecting interest rate differentials. This seems to be the case of
Turkey, Peru, Brazil, China and India, which have used extensive reserve requirements to
deal with inflationary pressures in the current scenario. Other alternative is imposing a levy
on foreign exchange borrowing by banks, as the one implemented in South Korea. However,
this road is more appropriate when inflationary pressures come from excessive bank credit
related to capital inflows than in other cases. When the surge in inflows comes not only from
the banking system, these measures may only create disintermediation and the allocation of
excessive risk in other parts of the financial system.
A temporary reduction in the degree of financial integration may result in some "sand in the
wheels" of capital movements and reduce the speed of capital inflows and outflows, allowing
some further degree of monetary policy independency. This is behind the idea of using
capital controls in some emerging market economies. Although even the IMF has supported
the idea of using capital controls under extreme circumstances (Ostry et al., 2010), the
empirical literature has found only partial evidence of its effectiveness.3
Finally, the validity of alternative tools to deal with episodes of unsustainable capital inflows
may be particularly important when the concerns about real exchange rate volatility are
relatively high. For instance, in export-based economies with imperfectly developed financial
markets, exchange rate fluctuations and persistent episodes of appreciations may result in
sustained damages to the productive structure. In such situations, targeted and limited
exchange rate interventions may help reduce temporary pressures and at the same time
build up international reserves, which act as precautionary savings and self-insurance
against the potential consequences of a sudden capital outflow. This has been the route
followed in Chile, since the concern about the external scenario has not been the rise in
capital inflows, but rather the pressures on the exchange rate and the need to have an
adequate level of international liquidity. Of course, this policy is not free of cost, since holding
reserves is costly, and therefore its use is limited.4
It is difficult to recommend a particular strategy, since realities are different across countries,
not only on the nature and impact of capital flows, but also on the overall macroeconomic
policy framework and deepness and strengths of financial systems. However, the general
principles discussed above should be taken into consideration.
Final remarks
The connections between price and financial stability suggest that the central banks should
consider the cross effects of financial policies and monetary policy. In countries like Chile,
the central bank has an explicit mandate on financial stability, and many other countries are
moving in this direction as the interactions among policies have been recognized. But also, it
is important to have a close and continuous coordination among all authorities with
responsibilities on the financial system. This coordination becomes also more needed in
times of crisis or extreme distress, since the central bank has to implement its LLR functions.
In normal times, the pursuit of price stability in a small open economy is not in contradiction
with financial stability in the presence of capital flows. In this context, the potential
vulnerabilities to high exchange rate volatility can be handled with prudential regulation.
However, in episodes of capital surges that may affect macroeconomic and financial stability
a close coordination of monetary policy and prudential policies is required.
References
Bernanke, B.S. (2011), "The Effects of the Great Recession on Central Bank Doctrine and
Practice", speech delivered at the Federal Reserve Bank of Boston 56th Economic
Conference, Boston, Massachusetts, October 18th.
Blinder, A., and R. Reis (2005), "Understanding the Greenspan Standard", in The Greenspan
Era: Lessons for the Future, Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming.
Cowan, K. and J. De Gregorio (2007), "International Borrowing, Capital Controls and the
Exchange Rate: Lessons from Chile", in S. Edwards (ed.), Capital Controls and Capital
Flows in Emerging Economies: Policies, Practices and Consequences, NBER and The
University of Chicago Press.
De Gregorio, J. (2010), "Monetary Policy and Financial Stability: An Emerging Markets
Perspective", International Finance, 13:1, pp. 141-156.
De Gregorio, J. (2011), "Price and Financial Stability in Modern Central Banking", speech
delivered at LACEA-LAMES Conference, November, Santiago, Chile.
Magud, N., C. Reinhart and K. Rogoff (2011), "Capital Controls: Myth and Reality - A
Portfolio Balance Approach", NBER Working Paper N°16805.
Ostry, J., A. Ghosh, K. Habermeier, M. Chamon, M. Qureshi and D. Reinhardt (2010),
"Capital Inflows: The Role of Controls", IMF Staff Position Note, SPN/10/04.
Tinbergen, J. (1952), On the Theory of Economic Policy, Amsterdam: North-Holland.