MACROPRUDENTIAL REGULATION WILL DAMPEN THE EFFECT OF GLOBAL FINANCIAL SHOCKS

POST BY: Sarvesh

The COVID-19 pandemic is impacting emerging markets through an unprecedented combination of domestic and external shocks. Among the latter, the pandemic has led to a sharp increase in global risk aversion and an abrupt retrenchment in foreign capital flows. Based on historical experience, these types of global financial shocks can significantly affect macroeconomic conditions in emerging markets, even if the exchange rate is flexible.

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Strengthening resilience with macroprudential regulation

Macroprudential regulation involves a broad range of measures aimed at buttressing financial stability. While strengthening financial stability can also dampen the impact of global financial shocks on economic activity in emerging markets. 

What is macroprudential regulation?

Macroprudential regulation is an approach to financial regulation, aiming to mitigate risk to the entire financial system and thus avoiding and reducing the macroeconomic costs of financial instability. The approach is used by central banks and regulators around the world. One example of macroprudential policy is the higher capital charge applied to banks that pose more risk to the system.

Another example, in a macroprudential framework, the ability of a bank to increase its capital to meet regulatory requirements is seen as favourable, without regard to how this is accomplished. But a bank that needs to increase its capital ratio (measured as a percentage of its asset) can either raise new capital or decrease assets (loans). When bank losses are increasing because the economy is weak and bank capital ratios are falling, The difference between the two approaches is consequential. If every firm were to decrease assets instead of raise capital, that action would lead to a substantive contraction of credit and cause the economy to weaken further. A macroprudential approach, in contrast, would assess and control for the mechanism that banks would implement to reach their required capital ratio, essentially encouraging them to raise capital rather than pull back on lending.

If the level of macroprudential regulation is low, an increase in global risk aversion (proxied by the Chicago Board Option Exchange Volatility Index (VIX)) or outflow of foreign capital considerably reduces economic growth in emerging markets. These negative effects become less pronounced in countries with tighter levels of macroprudential regulation. In fact, if the level of regulation is sufficiently stringent, global financial shocks do not seem to have a significant impact on GDP growth in emerging markets.

These dampening effects are symmetric. That is, macroprudential regulation reduces the sensitivity of domestic activity to both positive and negative global financial shocks. Therefore, tighter macroprudential regulation prevents sharper economic slowdowns when global financial conditions tighten, but it comes at the cost of foregone economic activity when global financial conditions are favourable. This calls for more research on how to optimally adjust macroprudential regulation over time depending on both domestic and foreign developments.

Macroprudential regulation to support 

We also, examine whether the level of macroprudential regulation influences the monetary policy response to global financial shocks. In several emerging markets, central banks tend to increase policy rates when global financial conditions tighten, possibly because of financial stability concerns arising from capital outflows and the depreciation of the exchange rate. In these cases, monetary policy appears to react pro-cyclically, likely . 

This analysis shows that macroprudential regulation can play an important role in favouring a more countercyclical response to monetary policy. If the level of macroprudential regulation is low, we find that central banks tend to increase policy rates when US monetary policy tightens or the VIX increases. On the contrary, if macroprudential regulation is more stringent—thereby alleviating financial stability concerns—monetary policy responds countercyclically. When US monetary policy tightens and the VIX increases, central banks tend to reduce policy rates, thus cushioning the impact on the domestic economy.

More analysis is needed

There are important caveats to the analysis. First, available measures of macroprudential regulation suffer from several drawbacks, for example, because they generally fail to capture the intensity of changes in regulation. Therefore, the chapter’s empirical findings will need to be re-assessed as more refined measures become available. Second, it will be important to test for the robustness of the findings using empirical specifications that allow for a richer interplay of macroprudential regulation with other policy tools, especially capital flow management measures and foreign exchange intervention.

Macroprudential policies alongside monetary policy should be strictly implemented in economies to dampen this COVID-19 recession.

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References:

https://www.imf.org/publications/WEO?page=2

https://www.brookings.edu/blog/up-front/2020/02/11/what-are-macroprudential-tools/

http://www.arthapedia.in/index.php?title=Macroprudential_Policy