## Dampening Global Financial Shocks in Emerging Markets: Can Macroprudential Policies Help?

## Source details

**Canonical URL:** [Dampening Global Financial Shocks in Emerging Markets: Can Macroprudential Policies Help?](https://www.imf.org/-/media/files/oap/oap-home/2020/weoapril2020-ch3-oap-09252020.pdf)

## Other formats

- [Markdown version](/-/media/files/oap/oap-home/2020/weoapril2020-ch3-oap-09252020.pdf.md)
- [Structured JSON version](/-/media/files/oap/oap-home/2020/weoapril2020-ch3-oap-09252020.pdf.json)

---

### Introduction and research questions
- Global financial shocks can severely affect emerging markets (EMs).
- Exchange rate flexibility alone appears insufficient, prompting calls for additional tools.
- Research questions addressed:
  - Can macroprudential policy measures (MPMs) help EMs to cushion global financial shocks?
  - Can MPMs buffer the effects of global financial shocks on GDP growth?
  - Can MPMs enhance monetary independence?
  - Can MPMs entail other side effects, such as cross-country spill-overs on other EMs?

### Global financial conditions and EMs
- Data sources and indicators cited: Haver Analytics; IMF Balance of Payments and International Investment Position Statistics; IMF International Financial Statistics; Wu and Xia (2015); IMF integrated Macroprudential Policy (iMaPP) database; IMF staff calculations.
- Note: VIX = Chicago Board Options Exchange Volatility Index.
- The level of macroprudential regulation is the cumulation of net tightenings since 1990 (first year in iMaPP data).
- The US policy rate is the federal funds rate except during the zero lower bounds period, which uses the implied rate from Wu and Xia (2015).

### 1. CAN MPMs BUFFER THE EFFECTS OF GLOBAL FINANCIAL SHOCKS ON GDP GROWTH?
- Empirical framework and sample:
  - Quarterly growth rate of real GDP: Y_{i,t}.
  - Country fixed effects: α_i.
  - S_{i,t} is a vector of global financial shocks: US rates, VIX, net capital outflows instrumented.
  - MPM_{i,t} is the level of macroprudential regulation (cumulating tightening/loosening in iMaPP).
  - C_{i,t} is a vector of controls (lagged GDP growth, institutional quality, commodity TOT, etc.).
  - Sample includes 38 EMs with quarterly data during 2000-2016.
  - Framework mimics Obstfeld et al. (2019).
- Main findings on buffering GDP growth:
  - Tighter MPMs buffer the impact of VIX and capital flow shocks.
  - Buffering effects display decreasing marginal returns.
  - MPM levels are much less volatile than GDP growth, alleviating concerns of reverse causality.
- Heterogeneity and symmetry:
  - Effect is not driven by a single type of MPM: a broad range of macroprudential measures contribute to dampening effects of global financial shocks.
  - Effect is symmetric: macroprudential regulation dampens the effects of both positive and negative global financial shocks.
- Inference details:
  - Shaded areas in reported figures correspond to 90 percent confidence intervals computed with Driscoll-Kraay standard errors.

### 2. CAN MPMs ENHANCE MONETARY INDEPENDENCE?
- Theoretical context:
  - According to the trilemma, countries with open capital accounts should retain monetary independence if they have flexible exchange rates.
  - Empirically, EMs with flexible exchange rates tend to hike rates when global financial conditions tighten, displaying pro-cyclical monetary policy responses.
- Empirical specification for policy rate I_{i,t}:
  - I_{i,t} = α_i + β_j S_{i,t} + γ_j S_{i,t} * MPM_{i,t} + ζ MPM_{i,t} + κ_j C_{i,t} + ε_{i,t}.
  - Sample excludes countries with fixed exchange rates.
- Main finding:
  - A higher level of MPMs allows for a more countercyclical monetary policy response.
  - The marginal policy-rate response to shocks: ∂I_{i,t}/∂S^j_{i,t} = β + γ^j MPM_{i,t}.
- Inference details:
  - Coefficients on interaction terms between the shock and macroprudential regulation are statistically significant in panels 1 and 2 (for the reported shocks) but not in panel 3.
  - Shaded areas correspond to 90 percent confidence intervals computed with Driscoll-Kraay standard errors.
  - VIX = Chicago Board Options Exchange Volatility Index.

### 3. ARE THERE SIDE-EFFECTS OF MACROPRUDENTIAL REGULATION ON AVERAGE GROWTH OR VIA CROSS-COUNTRY SPILLOVERS?
- Possible side effects — Effect on average growth:
  - Empirical derivative examined: ∂Y_{i,t}/∂MPM_{i,t} = ζ + γ_j S_{i,t} + 2θ MPM_{i,t} + 2δ_j S_{i,t} * MPM_{i,t}.
  - Comparison between high and low MPMs uses the 25th versus 75th percentiles of the sample distribution.
  - During 2000-16, a higher level of MPMs would have:
    - considerably reduced GDP volatility;
    - without lowering average GDP growth.
  - Figures reported: panel 1 shows growth differential between 75th and 25th percentile MPM; panel 2 shows point estimate of impact on volatility; panel 3 shows impact on average GDP growth. Vertical lines correspond to 90 percent confidence intervals (Driscoll-Kraay).
- Possible side effects — Cross-country spillovers:
  - Extended regression includes foreign MPM interaction: Y_{i,t} = … + γ_j S_{i,t} * MPM_{i,t} + γ̄_j S_{i,t} * MPM̄_{-i,t} + ζ̄ MPM̄_{-i,t} + … .
  - Results:
    - No spillovers found for US rates and VIX.
    - Positive spillovers found for net outflows.
  - Bars show point estimates and vertical lines correspond to 90 percent confidence intervals (Driscoll-Kraay). (See Online Annex 3.4 for details referenced in the source.)

### Conclusions
- Can MPMs buffer the effects of global financial shocks on GDP growth?
  - Yes, a tighter level of MPMs can significantly dampen the effect of global financial shocks on GDP growth in EMs.
  - However, a tight MPM level also lowers economic activity when global financial conditions are favorable.
  - Effects are driven by a broad range of macroprudential measures.
- Can MPMs enhance monetary independence?
  - Yes, MPMs allow for more countercyclical monetary policy response.
- Can MPMs entail side effects on average GDP growth?
  - No evidence of such, but more research is needed.
- Can MPMs entail negative spillovers on other EMs?
  - No evidence of negative spillovers; positive spillovers found for net outflows.

---


_Source: https://www.imf.org/-/media/files/oap/oap-home/2020/weoapril2020-ch3-oap-09252020.pdf_