Macroprudential Policies

The views expressed herein are those of the author and should not be attributed to the IMF, its Executive Board, or its management.

Bank Indonesia International Workshop and Seminar Central Bank Policy Mix: Issues, Challenges and Policies

Jakarta, 9-13 April 2018

Yoke Wang Tok

Context

• IMF Board Paper discussed in July 2017

• Also sent to G20 Hamburg summit – IMF contribution to the “resilience agenda”

• Starting point: • The IMF’s 2012 “Institutional View” on the management and

liberalization of capital flows. • The Dec 2016 review of the experience with the Institutional View

• The IMF’s macroprudential framework (Key Aspects and Staff Guidance Note)

• New paper puts these frameworks “side by side” • And draws out the benefits of using macroprudential policy to

manage risks from large and volatile capital flows

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Poll: What is macroprudential policies about?

Source: Characterising the Financial Cycle, BIS WP No. 380

Source: BIS Annual Report (2014) and Borio (2012).

How does one instrument target two cycles?

Outline

1. Capital flows and systemic risk

2. Mapping macroprudential instruments to risks

3. Effectiveness of macroprudential tools

4. Role of MPMs in mitigating systemic risks associated with outflows

5. Role of macroprudential policy in the process of capital account liberalization

6. Complementarities of the two frameworks

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1. Capital Flows and Systemic Risk

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Capital Flows and Systemic Risk: Transmission Channels

Direct and indirect effects on credit growth

Effects through asset prices and perception of risk

Effect through exchange rate valuation effects

Effect through the funding structure of banks (non-core funding and FX funding)

Effects via interconnectedness

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Effects on Credit Growth and Asset Prices

Capital inflow surges may fund credit booms - Surges dominated by debt (especially bank) inflows more

likely to end in financial crises than other inflow surges (Calderon and Kubota, 2012)

Inflow surges can exert upward pressure on asset prices

- Increases in asset prices magnify credit booms via financial accelerator effects

Portfolio debt flows depress yields and lead to risk-taking incentives

- But weaker effect on credit growth for portfolio equity flows and weak or negative effects from FDI flows

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Capital Flows and Credit Growth

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Co-movement between capital (in particular debt) flows and credit growth in both AEs and EMs

Especially strong for gross (rather than net) capital flows

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Net inflows (in percent of GDP)

Change in credit in percent of GDP (rhs)

Net Capital Inflows vs Changes in Credit

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1991

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Gross inflows (in percent of GDP)

Change in credit in percent of GDP (rhs)

Gross Capital Inflows vs Changes in Credit

Effects through Exchange Rates

Credit risks from unhedged FX loans may build up • Interest rate differentials and/or expected currency appreciation can

incentivize household and corporate FX borrowing from local banks

• Strong correlation between capital flows and the share of foreign currency lending (Basso et al 2007, Ostry et al 2012).

Risks may materialize when capital flows reverse and the exchange rate depreciates • A sharp depreciation may leave unhedged borrowers unable to service their

FX loans.

• Even if intermediaries are fully hedged, unhedged final debtors can create credit risk for intermediaries

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Effects on Non-core and FX Funding

Under favorable external conditions, domestic banks may raise funding through “non-core” (wholesale) liabilities – including funding in FX This gives banks further room to extend credit, leading to

increases in loans to deposits

May also increase maturity mismatches, making banks vulnerable to funding risks, especially when funding is in FX (e.g. Korea).

Rollover risk may materialize when external conditions worsen

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2. Mapping Instruments to Risks

Macroprudential Policy: Objectives

• Intermediate objective No. 1: Macroprudential policy seeks to increase the resilience of the financial system to aggregate shocks (IMF, 2013).

- by building buffers that help maintain the ability of the financial system to provide credit to the economy under adverse conditions

• Increased resilience can protect against a range of shocks: it can help the system

- weather domestic economic shocks - withstand a bust in asset prices, or a sharp depreciation of the exchange rate - that might arise from a reversal of capital flows

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Macroprudential Policy: Objectives

• Intermediate objective No. 2: Macroprudential policy seeks to contain the build-up of systemic vulnerabilities over time (IMF, 2013). • by reducing procyclical feedback between asset prices and

credit, and containing unsustainable increases in leverage and volatile funding

• A build-up of risk can arise in a purely domestic setting, but for open economies can also be driven by • global financial conditions

• surges of capital inflows that can contribute to an increase in domestic asset prices, credit, leverage and volatile funding

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Macroprudential Policy Tools and Transmissions

• e.g. countercyclical capital buffer, leverage ratio caps, macroprudential stress tests

Broad based tools

• e.g. LTV, DTI, sectoral capital requirement (including tighter req. for unhedged FX credit)

Sectoral tools (household and corporate)

• e.g. NSFR, LCR, liquidity charges

• Including currency differentiated tools (e.g. LCR, NSFR, reserve req.)

Liquidity tools

• e.g. Caps on interbank exposures, changes to market structure

Structural MPP

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Reduce interconnectedness

More resilient funding structure

Increase resilience to shocks Contain excessive credit growth

Lower currency or maturity mismatches

Resilience

Procyclicality

Benefits of Macroprudential Tools

• Macroprudential tools can help contain systemic risks from volatile capital flows

- even when the measures do not target capital flows per se.

• Can reduce the scope for capital inflows to generate procyclical dynamics between asset prices or exchange rates and credit.

- by constraining bank leverage - by curbing excessive credit to local borrowers (including in FX)

• Can reduce the scope for capital outflows to result in financial stress

-by building capital buffers to protect against indirect credit risk from borrowing in FX (local borrower default as a result of depreciation) -by reducing volatile wholesale funding (including in FX)

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3. Effectiveness of Macroprudential Tools

Effectiveness: empirical evidence

Not fully known yet, but some promising results

Sectoral capital requirements • By definition successful in increasing resilience w/ more buffers

• But evidence of the effects on credit growth is mixed

Limits on LTV and DSTI ratios • Some success in cooling off both house price and credit growth

• Help in reducing default rates, dampening fire-sale dynamics, and thus enhancing resilience

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Example: Effects on Intermediate Targets

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Source: “Cookbook” paper; Arregui et al 2013, WP/13/167

Example : Singapore’s Property Cooling Measures

20 Source: Nai, Wong, Aloysius Lim, Siang, Wong, “ Using Macroprudential Tools to Address Systemic Risks in the Property Sector SEACEN Financial Stability Journal March 2015

Private Property Price Index and Property Market Measures (1996 to 2008)

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Private Property Price Index and Property Market Measures (2009 to 2014)

Example : Singapore’s Property Cooling Measures

Effectiveness

• Measures that have the most impact are tax measures such as Sellers Stamp Duty and Additional Buyer Stamp Duty

• Credit measures helped to reduce leverage of households

• Property transactions would have been 31% higher and prices 17% higher if not for the cooling measures (between 2010 Q1 to 2014Q2)

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Source: Nai, Wong, Aloysius Lim, Siang, Wong, “ Using Macroprudential Tools to Address Systemic Risks in the Property Sector SEACEN Financial Stability Journal March 2015

Impact: Foreigner’s share of total transactions fell sharply after implementation of Additional Buyer’s Stamp Duty

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MAPs: Issues

• Implementation:

– Big bang or incremental - How to calibrate?

– Consider distortions to financial industry and economy

– Political costs

– People will find ways to circumvent

– Is the policy symmetric and asymmetric? (up-cycle, do you remove it when risks has dissipated?)

• When to exit? -- Do you release before downturn or during downturn?

• How to exit? – Do you unwind at once or do it in small steps?

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4. Role of MPMs in Mitigating Systemic Risks Associated with Outflows

Role of MPMs in Mitigating Systemic Risks Associated with Outflows

• Capital outflows should be handled primarily with macroeconomic, structural, and financial sector policies • Outflow controls a last resort: only in crisis situations or

when a crisis is imminent

• The potential to relax MPMs can give countries an additional set of tools to respond to outflow-related risks, although decisions on relaxation needs to recognize trade-offs.

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Role of MPMs in Mitigating Systemic Risks Associated with Outflows

• Relaxation of MPMs can be considered when (IMF 2014): • Buffers are in place • Outflows are generating financial stress • Expectation that releasing the available buffer(s) will

work to relieve financial stress and support provision of credit

• Trade-offs needs to be considered carefully, as relaxation can reduce resilience to future shocks, and should consider the need to maintain confidence and regulatory minima • Building larger buffers ex ante can create policy space

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5. Role of Macroprudential Policy in the Process of Capital Account Liberalization

The Integrated Approach to Capital Account Liberalization (IMF, 2012)

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Liberalize

FDI inflows

Greater

liberalization Cap

ital

Flo

w

Lib

eral

izat

ion

Support

ing

Ref

orm

s

Greater Liberalization

Revise legal framework

Improve accounting and statistics

Strengthen systemic liquidity arrangements,

related monetary and exchange operations

Strengthen prudential regulation

and supervision, risk management

Restructure financial and corporate sectors

Develop capital markets, including

pension funds

Liberalize

FDI outflows,

other LT and

some ST flows

Including macroprudential policy

capacity

What is the Role of Macroprudential Policy in the Process of Liberalization?

• Greater capital flow liberalization should be supported by a progressive strengthening of capacity to deploy macroprudential tools. • along the sequence of steps envisaged under the integrated

approach. • in particular, in the context of the liberalization of banking and

portfolio debt flows

• The capacity to deploy tools effectively requires adequate institutional arrangements and toolkits, as well as information to assess risks and calibrate policy tools appropriately.

• Where supervisory capacity or relevant data to operationalize macroprudential policy are lacking, this would argue for caution with further liberalization.

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6. Complementarities of the Two Frameworks

Macroprudential Measures vs Capital Flow Management Measures

MPMs primarily prudential tools to limit systemic

risk (IMF 2013, 2014, IMF-FSB, BIS 2016)

• Aim to (i) build resilience, (ii) contain build-up of systemic risk over time

• Can help limit systemic risk from capital flows even when not designed to limit capital flows

• Policy approach should be well calibrated to contain systemic vulnerabilities based on an assessment of systemic risk

• Prudential tools are precautionary by nature

• A broad range of MPMs may be needed to attain objectives

CFMs tools designed to limit capital flows (IMF

2012, 2016)

• The IV considers a broad macro policy package to handle capital flows

• CFMs should not substitute for warranted macroeconomic policy adjustment

• CFMs can be appropriate in certain circumstances

• CFMs should be transparent, targeted, generally temporary, and non-discriminatory

• CFMs on inflows only in capital flow surges

• CFMs on outflows only in (imminent) crisis situations

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Distinguishing between MPMs and CFM/MPMs

For a measure to be assessed as an MPM it needs to be geared towards containing systemic risk.

This hinges on two conditions: 1. the identification of a potential source of systemic risk that needs to be addressed; 2. the identification of a path of transmission of the measure along which the

measure can reasonably be expected to contribute to a reduction in systemic risk

• All relevant information should be considered to help guide the determination of whether an MPM is also a CFM, i.e. a measure designed to limit capital flows • Context (e.g., whether the measure was adopted during a surge), • Calibration of the measure (e.g. scope and intensity), • Other country-specific circumstances

• Thus seemingly similar measures in different countries could be assessed differently and a measure that is initially an MPM may become a CFM/MPM

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Appropriate use (IV)

A MPM can be put in place pre-emptively before an inflow surge occurs or permanently to limit systemic risk.

Can also be tightened in response to increases in risk (e.g., in the context of a surge).

A CFM/MPM may be useful to limit systemic financial risks stemming from a capital flow surge, provided that

• They are not used as a substitute for necessary macroeconomic adjustment

• They are the most effective, efficient, and direct, and the least distortive

• They seek to treat residents and nonresidents in an even-handed manner

A CFM/MPM may be maintained until after the capital flow surge abates, but their usefulness relative to their costs needs to be evaluated on an ongoing basis

• A key part of the assessment is whether there are alternative measures to address the systemic risk that are not designed to limit capital flows

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A flow chart guide to assess CFM/MPM

Source: IMF (2017), “Increasing resilience to large and volatile capital flows.

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Case 1. Reserve Requirement on Inflows into the Government Bond Market

• Circumstances: • Capital inflows into country A are limited relative to historical averages, but

they are nevertheless pushing down bond yields as the market is rather illiquid and flows are weakening the effects of monetary policy tightening on long-term interest rates

• The exchange rate is a bit overvalued, the economy is overheating, fiscal policy is neutral, monetary policy has been tightened, and FX interventions have resulted in more than adequate FX reserves

• The financial system is well protected with prudential measures

• Policy response: • A special one-year, 40 percent reserve requirement on portfolio flows into

the government bond market is introduced to safeguard adequate transmission of monetary policy and thereby macroeconomic stability

Is this a MPM or CFM? Is it appropriate?

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Case 2. Stamp Duty on Property Transactions by Nonresidents

• Circumstances: • Country B faces a capital inflow surge especially to the property market

amid ample global liquidity conditions

• The exchange rate is fairly valued, the economy is overheating, macroeconomic policy settings are appropriate

• International reserves are above adequate levels

• The financial system is well protected with prudential measures, but house prices have recently risen rather rapidly relative to income levels

• Policy response: • A stamp duty on property transactions by nonresidents is introduced amid

concerns over housing affordability, in particular young households´ capacity to become home owners

Is this a MPM or CFM? Is it appropriate?

The End