Monetary Policy and Financial Stability in Emerging Markets

Kristin Forbes, MIT and NBER, and Michael Klein, Tufts University and NBER

Shifting from a Salsa to a Waltz: The Consequences of Policy Responses during Global Booms

Forbes and Klein address a longstanding question--are policy choices which could moderate economic booms and their negative consequences? In order to answer this question, it is necessary to control for selection bias - the fact that countries which select certain policies tend to be different than countries which do not. They use propensity-score matching to address this concern and estimate the effect of six policies (increasing interest rates, tightening fiscal policy, allowing exchange rate appreciation, accumulating reserves, increasing controls on capital inflows and strengthening macroprudential regulations) during the boom period of 2002-2007. They find that many of these policies have large and meaningful effects on the occurrence of bank credit booms, equity booms, banking crises, and non-performing loans - but each policy which moderates certain aspects of booms simultaneously aggravates other risks. Some policies do not have consistently significant effects, which may result from either shortcomings of the econometric approach or limits to the policy's effectiveness in tempering booms and their consequences.

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Emmanuel Farhi, Harvard University and NBER, and Ivan Werning, MIT and NBER

Dilemma not Trilemma? Capital Controls and Exchange Rates with Volatile Capital Flows

Farhi and Werning consider a standard New Keynesian model of a small open economy with nominal rigidities and study optimal capital controls. Consistent with the Mundellian view, they find that the exchange rate regime is key. However, in contrast with the Mundellian view, they describe a case for capital controls even when the exchange rate is flexible. Optimal capital controls lean against the wind and help smooth out capital flows.

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Laura Alfaro, Harvard University and NBER; Anusha Chari, University of North Carolina, Chapel Hill and NBER; and Fabio Kanczuk, University of Sao Paolo

The Real Effects of Capital Controls: Credit Constraints, Exporters and Firm Investment

Alfaro, Chari, and Kanczuk evaluate the effects of capital controls on firm-level stock returns and real investment using data from Brazil. Theory suggests that the imposition of capital controls can drive up the cost of capital and curb investment. Credit constraints are also more likely to bind for firms that are more dependent on external finance. The data suggest that there is a significant decline in cumulative abnormal returns for Brazilian firms following the imposition of capital controls in 2008–9 consistent with an increase in the cost of capital. Conditioning on firm characteristics such as firm size and export status, the data suggest that large firms and the largest exporting firms are less affected by the controls. However, firms that are more dependent on external finance are more adversely affected by the controls. The evidence is consistent with the hypothesis that capital controls increase market uncertainty and reduce the availability of external finance, which in turn lowers investment at the firm level.

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Cecilia Dassatti, Central Bank of Uruguay, and Jése-Luis Peydró, Universitat Pompeu Fabra

Macroprudential and Monetary Policy: Loan-Level Evidence from Reserve Requirements

Dassatti and Peydró analyze the impact of liquidity and reserve requirements on credit supply. For identification, they exploit a change in regulation in Uruguay - an increase of the requirements for short-term funding, especially from (retail and interbank market) non-resident funds - in conjunction with the credit register that follows all loans granted to non-financial firms. Following a difference-in-difference approach, the authors compare lending to the same firm before and after the policy change among banks with different exposure to the funds targeted by the policies. They find that restrictions to short-term deposits for banks imply a reduction of credit supply; more affected banks increase their exposure into riskier firms, and larger banks mitigate the effects. Their results suggest that foreign short-term capital inflows and liquidity requirements affect credit supply and risk-taking of banks.

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Markus Brunnermeier, Princeton University and NBER, and Yuliy Sannikov, Princeton University

International Credit Flows, Pecuniary Externalities, and Capital Controls

Brunnermeier and Sannikov develop a dynamic two-country neoclassical stochastic growth model with incomplete markets. Short-term credit flows can be excessive and reverse suddenly. The equilibrium outcome is constrained inefficient. First, an undercapitalized country borrows too much since each individual firm does not internalize that an increase in production capacity undermines their output price and thereby worsens their terms of trade. From an ex ante perspective, each firm undermines the natural "terms of trade hedge." Second, sudden stops and fire sales lead to sharp price drops of illiquid physical capital, another pecuniary externality. The analysis also provides a full characterization of the endogenous volatility dynamics and welfare. Imposing capital controls that limit short-term borrowing as a macroprudential policy measure can improve welfare.

Olivier Blanchard, International Monetary Fund and NBER, and Marcos Chamon, Atish Ghosh, and Jonathan Ostry, International Monetary Fund

Capital Flow Management

How should emerging market countries, faced with the rising and ebbing tides of capital flows, combine the different elements of their policy toolkit to manage the various risks? Blanchard, Chamon, Ghosh, and Ostry offer a first pass at a tentative mapping. It is based on two simple propositions. The first is that some very short-term flows may be, on net, "bad": the liquidity they provide may not be worth the potential disruptions they create. The second is that the remaining "good flows" still pose potential threats to both financial stability and to macroeconomic stability. Given these two propositions, the authors argue that using capital controls to discourage "bad" flows, macroprudential tools to make sure that "good" flows do not threaten financial stability, and foreign exchange intervention and the policy rate to make sure that "good" flows do not threaten macroeconomic stability may be effective. These tools are sometimes partial substitutes, or complements. The authors then consider some of the costs involved if some tools are either not available or not reliable enough to be used.

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Anton Korinek, Johns Hopkins University and NBER, and Damiano Sandri, International Monetary Fund

Capital Controls or Macroprudential Regulation?

Korinek and Sandri examine the desirability of capital controls versus macroprudential regulation in a small open economy in which there is excessive borrowing and financial fragility because of externalities associated with contractionary exchange rate depreciations. They find that both types of instruments can be useful: macroprudential regulation reduces the indebtedness of leveraged borrowers whereas capital controls induce precautionary behavior for the economy as a whole, including for savers. This reduces crisis risk by shoring up aggregate net worth and mitigating the transfer problem that occurs during crises. In advanced countries where the risk of large contractionary depreciations is more limited, the role for capital controls subsides. However, macroprudential regulation remains essential to mitigating booms and busts in asset prices.

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Julien Bengui, Université de Montréal, and Javier Bianchi, University of Wisconsin, Madison and NBER

Capital Flow Management when Capital Controls Leak

What are the implications of limited capital controls enforcement for the optimal design of capital flow management policies? Bengui and Bianchi address this question in an environment where pecuniary externalities call for prudential capital controls, but financial regulators lack the ability to enforce them on the "shadow economy." While regulated agents reduce their risk-taking decisions in response to capital controls, unregulated agents respond by taking more risks, thereby undermining the effectiveness of the controls. The authors characterize the choice of a planner who sets capital controls optimally, taking into account the leakages arising from limited regulation enforcement. Their findings indicate that leakages do not necessarily make macroprudential policy on the regulated sphere less effective, and that large stabilization gains remain despite leakages. Finally, there can be significant redistributive effects across the regulated and unregulated spheres.

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Koray Alper, Mahir Binici, Hakan Kara, and Pinar Özlü, Central Bank of Turkey, and Selva Demiralp, Koc University

Required Reserves, Liquidity Risk, and Credit Growth

Following the global financial crisis, central banks in many emerging economies incorporated financial stability into their policy objectives. Reserve requirement (RR) ratios have been one of the most popular unconventional monetary policy instruments in these countries. In this paper, Alper, Binici, Demiralp, Kara, and Özlü utilize a simple model and provide empirical evidence in understanding the transmission channels of RR. Their analysis allows them to identify a new channel that they name the "liquidity channel". The channel works through a decline in bank liquidity and loan supply due to an increase in reserve requirements.

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Pablo Mariano Federico, BlackRock, Inc.; Carlos Vegh, Johns Hopkins University and NBER; and Guillermo Vuletin, Brookings Institution

Effects and Role of Macroprudential Policy: Evidence from Reserve Requirements Based on a Narrative Approach

Federico, Vegh, and Vuletin analyze the macroeconomic effects of changes in legal reserve requirements and the relationship between reserve requirement policy and monetary policy in four Latin American countries: Argentina, Brazil, Colombia, and Uruguay. To correctly identify innovations in reserve requirements, the authors develop a narrative approach, based on contemporaneous reports from the IMF and central banks, that classifies changes in reserve requirements as endogenous or exogenous to the business cycle. They show that this distinction is critical in understanding the effects of reserve requirements. In particular, they show that output falls in response to exogenous changes in reserve requirements but would increase in response to all changes because of misidentification. The authors also show that, when properly identified, reserve requirement policy acts as a substitute for monetary policy rather than as a complement. For instance, in bad times reserve requirements are lowered to stimulate output while interest rates need to increase to prevent rapid depreciation of the domestic currency.