Domestic Markets and Financial Stability in Emerging Economies
Mario BergaraCentral Bank of Uruguay
19th Dubrovnik Economic ConferenceJune 13, 2013
Domestic Markets and Financial Stability
Outline
On the Governance of Financial Stability Institutions
Domestic Markets and Financial Stability
Outline
On the Governance of Financial Stability Institutions
Foreign investors used to stay out of domestic markets:Lack of informationTransaction costsOperational risksLower creditor protectionOther macro issues
However, this fact is rapidly reverting
Lacking arbitrage, these markets were seen as stable sources of funding
In small emerging economies, domestic markets are essentially local bonds markets
What domestic markets are expected to do for financial stability?
Local Markets and Financial Stability
Underdeveloped domestic financial markets
Reliance on foreign funding and less capacity
to issue domestic currency debt
Overexposure to external shocks
Frequent non-country specific crisis and sudden
stops
What domestic markets are expected to do for financial stability?
Local Markets and Financial Stability
Reliance on external sources renders the country more subject to external shocks and non-country specific financial crisisLocal markets development as a means to reduce financial fragilityKeys to develop local markets and reduce currency mismatches:
Stronger institutionsWell defined creditor rightsLow inflation
More developed domestic financial market helps reduce the volatility of capital flows to emerging economiesHowever, domestic market development entails new problems when considering the impact on financial stability
What domestic markets are expected to do for financial stability?
Local Markets and Financial Stability
Implications of volatile capital flows formacroeconomic and financial stability
Growthdifferentials
Appreciating and volatile exchange rates in emerging markets
Uncertainty and volatility in the global environment
Interest ratedifferentials
Differentialexpectations onexchange rates
Liquidityconditions and
marketsentiment
Risks of asset price bubblesand bank lending boom
Risks of capital flowstop or reversal
Local Markets and Financial Stability
Inbound capital movements set the grounds for currency appreciation beyond the limits of other fundamentalsAnother secular trend of new markets discovery by massive investment funds adds further pressure on the exchange rateInvestment funds increasingly search for new alphas, encouraged by historically low interest rates and buoyant international liquidityNot only the real sector suffers, but is also subject to foreign and domestic sources of real exchange rate shocksThe domestic financial sector may be subject to solvency issues related to sharp changes in this relative price
Inbound capital might generate trends of currency appreciation
Local Markets and Financial Stability
As foreign investors find more attractive to enter domestic markets, they increase the aggregate demand for domestic assetsHigher demand implies higher prices and lower yields, making harder for the monetary authority to pursue an interest rate targetThe Central Bank is forced to perform sterilized purchases of foreign currency, to prevent sharp short term currency appreciation and to satisfy the demand for domestic assetsFX market tensions risk diverting the monetary authority from its primary target and might as well generate pressure on the financial system
Prudential regulation and supervision have to pay special attention to FX risk issues
Capital reallocation dampens the ability of monetary policy to cope with internal stabilization issues
Local Markets and Financial Stability
Central Banks in emerging economies have use reserve requirements and caps on foreign exchange positions to limit potential imbalances derived by surges in short-term capital inflows
Macroprudential instruments to limit the exposure of the financial system to systemic risks
Exchange rate flexibility acts as an automatic buffer to cushion against external shocks and contribute to provide an adequate incentive structure in the economy
Foreign exchange market intervention: reduce excessive volatility and currency appreciation in the current (circumstantial) financial environment, but not against long term fundamentals
The macroprudential perspective contributes with more instruments to deal with short term capital flows, without affecting macroeconomic and financial stability
Financial Stability and Policy Options
Local Markets and Financial Stability
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Globalization dampens the role of domestic markets as firewalls
Local Markets and Financial Stability
External financial episodes directly affect domestic interest rates, weakening the control by the monetary authority.As emerging markets yields tend to correlate, non-country specific financial distress equally produces domestic turmoilInvestment funds tend to follow pro cyclical herding behaviors in face of bad newsAs a result, while domestic financial markets tend to channel home-biased sources of funding in a stable fashion, their development and increasingly global arbitrage might generate some negative side-effects that may have consequences on financial stability if not correctly addressed.
Domestic asset prices are increasingly determinedby external factors
Local Markets and Financial Stability
Domestic Markets and Financial Stability
Outline
On the Governance of Financial Stability Institutions
Financial Stability in a context of Macroeconomic Stability
Micro and Macroprudencial Regulation
Monetary policyFiscal Policy
FinancialStability
Identifying relevant systemic risks and addressing externalitiesMonetary and fiscal policies can help to mitigate costs of aggregate weaknesses and individual failures“New issues” for Central Banks and Financial Regulators?
On the Governance of Financial Stability Institutions
The lack of a macro-systemic approach was clear, but was the micro-prudential regulation working properly?
Failure of the regulatory approach and of the organizational design of public intervention in financial marketsThe decentralized governance failed as well as the “light supervision” approachSupervision and regulation was poor and the organization of the Financial Safety Net was inaccurate in some places and chaotic in others
A possible (dangerous) lesson from the crisis: “Everything was right except that the macro-prudential approach was lacking.”
The discussion about the governance of macro-prudential policies might be “smuggling” a debate about the failure of the decentralized regulation and the need to move towards a more centralized fashion
We need to get back to the conceptual determinants of the optimal Financial Safety/Stability Net: conflict of objectives, incentive structures, accountability, coordination and organizational design
Current discussion influenced by situation in developed countries
On the Governance of Financial Stability Institutions
Monetary Policy
Lender of Last Resort
Prudential
Regulator and
Supervisor
Deposit Insurer
and Resolution
Agency
Explicit conflict of objectives, right incentivestructure, accountability and coordination
Financial Safety Net: Governance
On the Governance of Financial Stability Institutions
The decision-making of some crucial issues
Liquidatingfinancial institutions
Mergers andacquisitions
Short termfinancial assistance
Interveningfinancial institutions
Financial Safety Net: Governance and Conflict of Objectives
On the Governance of Financial Stability Institutions
Separation/Unification of theFinancial Safety Net agencies
Relative institutionalstrenght
Reputation andcredibility
Expertise andcapacities
Make explicit theconflict of objectives
Institutional Determinants of the Financial Safety Net Design
On the Governance of Financial Stability Institutions
The necessary consistency in supervisionand regulation across markets and agents
Capitalmarkets
Insurancemarkets
Pension fundadministrators
Financialintermediaries andnon-intermediaries
Degree of Centralization of Financial Regulation
On the Governance of Financial Stability Institutions
More centralized
Efficiency due tospecialization
Lower powerconcentration
Economies of scaleand scope
Lowerbureaucratic costs
Less centralized
Conglomerateslogic
Degree of Centralization of Financial Regulation
Lower regulatoryarbitrage
On the Governance of Financial Stability Institutions
Monetary Policy
Lender of Last Resort
Prudential
Regulator and
Supervisor
Deposit Insurer
and Resolution
Agency
Coordination and contribution for all agenciesto comply with their respective mandates
From Financial Safety Net to Financial Stability Net: Governance
Ministry of Finance/
Treasury
On the Governance of Financial Stability Institutions
Implications of systemic risks on rules and institutions
Systemic risks
Rules
Institutions
Risk-based regulation
Broad perimeter
Financial Safety Net
Financial Stability Framework
Centralized Regulation
Ownership/stockholding of non-financial entities
Corporate governance
Regulatory treatment of public entities
Exposure to common and correlated risks
Interconnectedness (players and markets)
Financial and real sector conglomerates/
cross border
New kinds of risks as markets develop
Regulatory arbitrage across entities with different licenses
On the Governance of Financial Stability Institutions
Domestic Markets and Financial Stability in Emerging Economies
Mario BergaraCentral Bank of Uruguay
19th Dubrovnik Economic ConferenceJune 13, 2013