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Piero C. Ugolini, Andrea Schaechter, and Mark R. Stone
Financial globalization, or the increased integration of global financial
markets, raises important, new challenges for central banks. What nominal anchor
is appropriate for countries susceptible to shifts in capital flows? How to
prevent financial crises, or deal with them decisively when they unfold in
real time? And how to think about difficult choices when monetary and financial
stability objectives are at odds with each other?
With financial globalization on the rise, further analysis and sharing of
experience is needed in order to meet these challenges. Against this background,
the IMF's Monetary and Financial Systems Department and the IMF Institute hosted
the ninth central banking conference in September 2002, "Challenges to Central
Banking from Globalized Financial Systems." Opening remarks were made by Eduardo
Aninat, deputy managing director of the IMF; Mohsin Khan, director of the IMF
Institute; and Stefan Ingves, director of the Monetary and Financial Systems
Department. Over two days, governors of central banks and senior officials
from more than 45 countries addressed the challenges posed by financial globalization.
This volume is a compendium of the papers and comments from that conference,
as well as several background papers.
The global integration of capital markets over the past decade has greatly
complicated the design and implementation of national monetary and exchange
rate policies. The first half of this book addresses consequences of that integration.
How, for example, to conduct monetary policy in highly dollarized countries?
What kinds of regional monetary arrangements fit the new circumstances? What
are the special challenges for countries that want to use inflation targeting
yet cannot commit to a full-fledged inflation targeting regime? What role should
a central bank play in debt and reserve management?
Financial globalization has led to increased frequency and severity of systemic
crises. The second half of this book looks at the central bank's role in addressing
the challenge of financial stability. Should stability be an explicit central
bank objective, on par with other central bank objectives? What indicators
measure and assess financial soundness? And when a financial crisis is full
blown, how should and how can the central bank respond?
Monetary and Exchange Rate Policies under Integrated Capital
Markets
Global integration of capital markets has led to greater dollarization of
private sector balance sheets, raising the potential costs of monetary policies
to the real sector. The greater susceptibility to currency crises of countries
with open capital accounts has reduced the use of exchange rate anchors. At
the same time, shifts in money demand have nearly extinguished the use of monetary
anchors. The shifting menu of credible options has led countries with open
capital accounts to consider monetary unions as a way to reduce their vulnerability
to worldwide economic shocks. Whatever the monetary regime, the surge in volume
of external financing prompted by financial globalization has ratcheted up
the importance of prudent and effective public debt and reserve management.
The Role of the Central Bank in a Highly Dollarized Economy
The challenge of choosing between a fixed or floating exchange rate regime
in the context of dollarization is the subject of the following paper by Richard
Webb and Adrián Armas (Chapter 2). In Peru, the use of U.S. dollars
for transactions and wages (that is, payments and real dollarization, respectively)
is limited. Coupled with the vulnerability of Peru's open economy to external
shocks, this would suggest adopting a floating exchange rate. On the other
hand, the large share of private sector liabilities denominated in U.S. dollars
(that is, financial dollarization) means a depreciation could result in financial
instability. This would imply the adoption of a fixed exchange rate. Monetary
policy is further limited by the lack of domestic currencydenominated
financial instruments. In fact, Peru has adopted an independent monetary policy
based on a floating exchange rate and an explicit inflation targeting framework.
This is because the degree of real dollarization is low, as well as the "pass-through" from
exchange rate movements to domestic prices.
In discussant comments to the paper (Chapter 3), Alain Ize notes that dollarization
can build in a vicious circle from currency instability to financial instability
to excessive foreign exchange intervention, in turn leading to more dollarization.
But, dollarization can be "cured" through gradual commitment to the currency
in the form of an inflation target and better prudential regulation.
Adolfo Barajas and R. Armando Morales' background paper, "Dollarization of
Liabilities: Beyond the Usual Suspects" (Chapter 4), addresses the dollarization
of liabilities that is key to explaining emerging markets' vulnerability to
financial and currency crises. The "usual suspects" are structural and long-term
factors, such as a history of unsound macroeconomic policies. Development and
institutional factors are often compounded by moral hazard opportunities related
to government guarantees. Barajas and Morales assess the empirical relevance
of these factors compared with alternative explanations. From their Latin American
sample, they find that ongoing central bank interventions in the foreign exchange
market, the relative market power of borrowers, and financial penetration are
at least as important as the usual suspects. These results suggest that central
bank policies introduce a bias in the decisions of banks and firms, leading
to the dollarization of liabilities. Further, a case can be made that adjustments
in bank regulations and monetary policy ameliorate the risks that arise from
the dollarization of liabilities.
Regional Monetary Arrangements
The challenges for monetary policy from globalized financial markets arguably
enhance the advantage of monetary unions, but they pose their own set of practical
difficulties. In Chapter 5, Gert Jan Hogeweg lays out ingredients for monetary
union success that are based on the experience of the European Monetary Union.
The first precondition, he argues, is a single market for goods, capital, money,
and labor among the participating countries. Second, an infrastructure must
be established through financial market integration, the harmonization of legal
systems, the creation of area-wide large value payment and security settlement
systems, and the availability of area-wide statistics. Third, economic convergence
of members is important—in the EMU, for example, convergence criteria served
as a transparent basis on which to judge whether countries were ready to join.
Further, structural reforms in the goods and labor markets are needed in support
of economic growth. Central bank independence and an unambiguous mandate for
price stability, as well as a framework for sound management of public finances,
are also needed to safeguard the central bank's mission of preserving price
stability. Finally, a unified currency requires far-reaching and long-lasting
institutional and political reshaping, which is made possible by a sustained
political consensus.
The role of monetary unions within the international financial architecture
is highlighted by K. Dwight Venner (Chapter 6). As a response to the challenges
from globalized financial systems, regional currency arrangements have recently
been discussed for Africa, Asia, and Latin America. However, even if the number
of currencies is reduced, there is still risk from misalignment among the three
major currencies, implying that any new regional arrangement must choose appropriate
relationships carefully.
Inflation Targeting Lite
In Chapter 7, Mark Stone explores the special challenges for countries that
want an inflation target to define their monetary policy, yet cannot completely
commit to a full-fledged, inflation targeting regime. He calls the resulting
policy regime "inflation targeting lite" (ITL). Countries might adopt ITL for
several reasons—a fixed exchange rate would leave them vulnerable to speculative
attacks, a monetary target is not practical owing to instability in money demand,
or full-fledged inflation targeting is not feasible owing to the lack of a
sufficiently strong fiscal position and a fully developed financial sector.
ITL countries want inflation in the single digits and financial stability,
often employing relatively interventionist exchange rate policies. ITL central
banks may want to announce a long-term commitment—given sufficient credibility—to
either a hard exchange rate or a full-fledged inflation target that would bring
forward the benefits of a single monetary anchor.
In his comments (Chapter 8), Jerzy Pruski describes ITL as a transitional
regime used to buy time to make the structural reforms needed for a single
nominal anchor. Once these reforms are in place, countries typically make the
move to full-fledged inflation targeting.
A growing number of emerging market countries have adopted a full-fledged
inflation-targeting monetary framework, and many others are considering doing
so. For industrial countries—with comparatively long experience in this area—the
initial conditions for adopting inflation targeting are relatively well understood.
In contrast, the initial conditions to adopt inflation targeting are far less
clear for emerging market countries. The background paper by Alina Carare,
Andrea Schaechter, Mark Stone, and Mark Zelmer, "Establishing Initial Conditions
in Support of Inflation Targeting" (Chapter 9), addresses the initial conditions
that emerging market countries can establish in support of an inflation-targeting
monetary framework. They divide the initial conditions in support of an inflation-targeting
framework into four groups. First and foremost is a mandate to pursue an inflation
objective and the accountability of the central bank in meeting this objective.
The second set of conditions regards the need to ensure that the inflation
target will not be subordinated to other objectives. The third set of conditions
ensures that the financial system is developed and sufficiently stable to implement
the framework. The need for proper tools to implement monetary policy in support
of the inflation target is the final set of conditions. These conditions need
not stand in the way of the adoption of inflation targeting, but most are probably
required for a credible policy framework.
The Central Bank's Role in Debt and Reserve Management
The surge in external financing prompted by financial globalization has ratcheted
up the importance of effective public debt and reserve management. Experience
has shown that public debt and reserve management cannot only enhance monetary
policy, but can also improve financial stability. Chapter 10 by Hugo Frey Jensen
discusses the dual role of Denmark's central bank in international debt and
reserve management, a particularly important element of financial stability
for a small, open economy. The central bank's responsibility in both areas
is an efficient way to utilize resources in a small country, where knowledge
of most aspects of the financial markets resides within a single institution.
A clear and transparent framework is the best way to handle the various trade-offs
between monetary policy and debt management and to minimize long-term government
borrowing costs. Further, practical knowledge arises from continuous contact
with the market. This is helpful for financial stability and central bank participation
in the formation of national financial legislation. The development of risk
assessment systems has also revealed differences in the respective objective
functions for foreign reserves and government debt.
In response (Chapter 11), Michael Reddell points out a number of advantages
for not providing debt management responsibility to the central bank, as in
New Zealand. Separation of responsibilities allows the central bank to treat
the government as simply another borrower. Despite the need for coordination,
an arm's-length relationship tempers the potential scope for political influence.
He also argues that the oft-cited signaling issues and risk associated with
public debt management are overstated.
The New Challenges to Financial Stability
Financial globalization has led to growing frequency and severity of systemic
financial crises. The adverse effect on economic and social welfare has raised
the stakes for making financial stability an explicit objective in the design
and implementation of monetary policy. In particular, central banks must decide
how to prioritize financial stability in day-to-day operations. Learning from
past crises (and with a view toward prevention), central banks are developing
indicators to assess financial sector stability. Finally, when crises do occur,
central banks face the demanding challenge of mitigating the crisis without
undercutting monetary stability. These are the issues addressed in the second
half of the book.
Should Financial Stability Be an Explicit
Central Bank Objective?
Roger W. Ferguson, Jr. tackles the question of whether financial stability
should be an explicit objective on a par with other central bank objectives
(Chapter 12). He describes financial stability objectives primarily through
the lens of U.S. Federal Reserve macroeconomic goals—price stability and sustainable
long-run growth. Today more than ever, central banks and other financial authorities
must share information, coordinate crisis prevention, and cooperate in crisis
management. In this vein, the work being done in several forums to develop
a deeper understanding of the international dimensions of financial instability
and to foster important structural improvements is especially important and
relevant. Yet several questions remain unanswered. Should a central bank take
preemptive actions to head off potential financial instability, even when such
policy actions might not be fully justified by the outlook for inflation and
output? How much weight should be given to financial stability relative to
other objectives? Might greater activism lead to too much economic variability?
In his response to Ferguson (Chapter 13), André Icard comes down on
the side of greater activism. He stresses, however, the potential difficulties
that can arise from the generally shorter time horizon of monetary objectives
versus the longer time horizon of financial objectives, as well as the risk
of moral hazard.
Using Financial Soundness Indicators to Assess Stability
The role of financial soundness indicators (FSIs) in crisis prevention is
discussed by R. Sean Craig and V. Sundararajan in Chapter 14. They outline
an integrated framework linking the three key dimensions of financial stability—macroprudential
surveillance, effective financial sector supervision, and a robust financial
system infrastructure. Their analytical framework links FSIs with monitoring
the financial system's strengths and vulnerabilities and with risks originating
in the nonfinancial sector. They also highlight the importance of using information
from assessments of supervision and the robustness of financial infrastructure,
such as adherence to codes and standards. In the other direction, FSIs highlight
the key prudential risks and vulnerabilities upon which supervision and its
assessments can focus.
Jarle Bergo describes the evolution of FSIs in the experience of the central
bank of Norway (Chapter 15). He emphasizes the importance of a broad set of
banking sector indicators. He also shows how FSIs can be used to evaluate the
effect of macroeconomic conditions on the debt-servicing capacity of households
and enterprises, and thereby in turn, on the credit risk of banks.
In Chapter 16, Mario Blejer provides a lively description of the general role
of the central banks in financial crises—and more specifically, the role played
by the central bank while he served as governor during the recent Argentine
financial crisis. As a response to the crisis, in November 2001, partial withdrawal
restrictions were imposed on deposits (the corralito); the currency
board was abandoned; the currency was devalued; and bank assets and liabilities
were "pesoified" asymmetrically. Pesoification enabled the central bank to
provide the liquidity to finance the bank run, but it had no money market or
debt instruments to perform sterilizing open market operations. Too much liquidity
risked hyperdevaluation and hyperinflation. On the other hand, too little liquidity
risked total collapse of the banking sector.
Facing a trade-off, the central bank took an intermediate approach—providing
liquidity to banks under attack while sterilizing with new instruments. Before
they declined, interest rates reached 140 percent. Meanwhile, the central bank
kept up with payments on its foreign obligations and intervened in the foreign
exchange market to slow the pace of depreciation, thereby helping to avoid
chaos. By mid-June 2002, the trends started to reverse. Thereafter, deposit
withdrawals slowed and the central bank was required to provide less liquidity.
Interest rates fell to 4050 percent, and the central bank has since regained
about half the initial stock of intervention. For a central bank in crisis,
the bottom line is: Persevere to the point where "greed exceeds panic."
In discussant comments (Chapter 17), Kyu-Yung Chung draws policy lessons by
comparing the financial crises of Argentina with Korea. Policy responses, he
concludes, must be decisive and clearly communicated; and if the associated
economic hardships are to be accepted, they must be based on objective principles.
Monetary and fiscal policies need to be operated flexibly in order to reinforce
the basis for economic stability and avoid prolonged negative effects. Great
effort is required to rebuild the confidence of the markets both at home and
abroad. Structural reforms designed to raise competitiveness over the medium
and long term must be pursued boldly.
Conclusion
Looking back over the decade since the IMF's first conference on central banking,
it is clear that challenges to financial stability arise—and will continue
to arise—whether we want or are ready for them. To meet these challenges,
central banks must be well equipped to perform their role. Central banks require
necessary authority to intervene in the markets when needed; and central bankers
must possess the essential tools, understanding, and skills to monitor markets
and financial developments so as to prevent crises, or in the worst-case scenario,
respond to them as they unfold. |
