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March 2, 2004
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
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.
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.