A growing literature documents that fluctuations in global financial markets can severely affect financial and macroeconomic conditions in emerging markets – for example, a sudden spike in global risk aversion as triggered by the COVID-19 pandemic (Corsetti and Marin 2020) – can considerably depress economic activity in emerging markets.
According to conventional macroeconomic theory, emerging markets should be able to offset the impact of global financial shocks by relying on exchange rate flexibility. However, a floating exchange rate falls short of providing full insulation for emerging markets (Rey 2015, 2016). In search for additional policy tools, the discussion often centres on the role of capital controls and foreign exchange intervention, as these tools directly target international financial transactions.
However, there is growing evidence that macroprudential policies can also play an important role in stabilising financial conditions.1 Building on these insights, in Bergant et al. (2020) we examine whether macroprudential regulation can effectively dampen the macroeconomic impact of global financial shocks on emerging markets. The underlying idea is that by reinforcing balance sheets, preventing excessive risk taking, and limiting foreign currency mismatches, macroprudential regulation can strengthen the resilience of the domestic financial sector and thus enhance macroeconomic stability.
Our analysis uses panel regressions of GDP growth in emerging markets over a set of global financial shocks and their interactions with the stringency of macroprudential regulation. We consider three types of global financial shocks: US monetary policy shocks to capture changes in the international risk-free rate (Iacoviello and Navarro 2019), VIX as a proxy for risk premia, and net capital inflows instrumented with gross flows to other emerging markets to capture shocks to the supply of foreign capital. In our estimation, we exploit that the tightness of macroprudential regulation when global financial shocks materialize is largely pre-determined by past policy decisions.
The dampening properties of macroprudential regulation
We find that macroprudential regulation can considerably dampen the effects of global financial shocks on economic activity in emerging markets (Figure 1). At the lowest level of macroprudential regulation in the sample, an increase in the VIX or an outflow of capital significantly reduce economic growth in emerging markets. For example, a 60% spike in the VIX – about half of what we experienced in the first quarter of 2020 as a result of the COVID-19 pandemic – can push a typical emerging market into a recession. Macroprudential regulation can considerably dampen these effects. In fact, if the level of macroprudential regulation is sufficiently tight, the VIX and net capital outflows no longer have statistically significant effects on emerging markets’ GDP.
Figure 1 GDP responses in emerging markets to global financial shocks
a) Response to 100 percent VIX increase (percent)
b) Response to 3pp net outflows (percent)
c) Distribution of macroprudential regulation in EMs (density)
Source: Authors’ calculations.
Notes: The horizontal axis denotes the level of macroprudential regulation. Panels 1 and 2 show the GDP response to global financial shocks for different levels of macroprudential regulation; panel 3 shows the probability density function of macroprudential regulation in the sample. Net capital outflows are scaled by the HP-trend of GDP. The shaded areas correspond to 90 percent confidence intervals computed with Driscoll-Kraay standard errors.
In our paper, we document further important policy insights. First, the dampening effects of macroprudential regulation are not driven by a specific instrument. A broad range of measures – boosting bank capital and liquidity, limiting foreign exchange exposures, and averting overly risky forms of credit – all contribute to enhancing macroeconomic resilience to global financial shocks. Second, the dampening effects of macroprudential regulation are symmetric to positive and negative shocks. Maintaining a high level of macroprudential regulation to dampen adverse financial shocks is thus not costless since it implies foregoing growth opportunities when global financial conditions are favourable. Third, we find evidence that that a higher level of macroprudential regulation in one country tends to enhance macroeconomic stability in other countries, possibly because it supports more stable trade and financial linkages.
Macroprudential regulation allows for a more countercyclical monetary policy
In some emerging markets, central banks tend to increase policy rates when global financial conditions tighten, possibly to limit fluctuations in exchange rates and capital flows that may undermine financial stability (Obstfeld et al. 2005, Aizenman et al. 2016, Aizenman et al. 2017, Han and Wei 2018, Cavallino and Sandri 2020, Bhattarai et al. 2020). Against this backdrop, we ask whether macroprudential regulation – by mitigating financial stability concerns – can allow for a more countercyclical monetary policy response to global financial shocks.
Figure 2 shows that macroprudential regulation can indeed support a more countercyclical monetary policy response to US monetary policy and the VIX. Panel 1 and 2 show that at low levels of macroprudential regulation, emerging markets tighten monetary policy in response to a hike in US policy rates or an increase in the VIX. A sufficiently high level of macroprudential regulation allows instead central banks in emerging markets to react countercyclically by lowering policy rates when US policy rates and the VIX increase. This is possibly an important channel through which macroprudential regulation enhances macroeconomic resilience in emerging markets.
Figure 2 Policy rate responses in emerging markets to global financial shocks
a) Policy rate response to a 1pp US rate hike (percentage points)
b) Policy rate response to a 100 percent VIX increase (percentage points)
c) Distribution of macroprudential regulation in EMs (density)
Source: Authors’ calculations.
Notes: The horizontal axis denotes the level of macroprudential regulation. Panels 1 to 2 show the policy rate response to global financial shocks for different levels of macroprudential regulation; panel 3 shows the probability density function of macroprudential regulation in the sample. Net capital outflows are scaled by the HP-trend of GDP. The shaded areas correspond to 90 percent confidence intervals computed with Driscoll-Kraay standard errors.
Restricting capital flows is not a substitute for macroprudential regulation
To put the benefits of macroprudential regulation in perspective, we test whether capital controlscountries can provide similar gainsenhance macroeconomic resilience by restricting capital flows. Following the same empirical approach used to analyse macroprudential regulation, we ask whether more stringent capital controls can also dampen global financial shocks and support a more countercyclical response of monetary policy. Using a broad set of capital control indicators, we do not find evidence that tighter capital controls provide similar benefits to those of tighter macroprudential regulation. Therefore, capital flow restrictions do not appear to be a valid substitute to a well-rounded macroprudential framework for countries that want to enhance macroeconomic resilience to global financial shocks.
Authors’ note: The views expressed in this column are those of the authors and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.
Aizenman, J, M D Chinn, and H Ito (2016), “Monetary Policy Spillovers and the Trilemma in the New Normal: Periphery Country Sensitivity to Core Country Conditions”, Journal of International Money and Finance 68: 298–330.
Aizenman, J, M D Chinn, and H Ito (2017), “Financial Spillovers and Macroprudential Policies”, NBER Working Paper 24105.
Araujo, J, M Patnam, A Popescu, F Valencia, and W Yao (forthcoming), “Effects of Macroprudential Policy: Evidence from over 6,000 Estimates”, IMF Working Paper.
Bergant, K, F Grigoli, N-J Hansen, and D Sandri (2020), “Dampening Global Financial Shocks: Can Macroprudential Regulation Help (More than Capital Controls)”, CEPR Discussion Paper 14948.
Bhattarai, S, A Chatterjee, and W Y Park (2020), “Global Spillover Effect of US Uncertainty”, Journal of Monetary Economics, forthcoming.
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Han, X and S-J Wei (2018), “International transmissions of monetary shocks: Between a trilemma and a dilemma”, Journal of International Economics 110: 205–219.
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Obstfeld, M, J C Shambaugh, and A M Taylor (2005), “The trilemma in history: tradeoffs among exchange rates, monetary policies, and capital mobility”, Review of Economics and Statistics 87(3): 423–438.
Rey, H (2015), “Dilemma not trilemma: the global financial cycle and monetary policy independence”, NBER Working Paper 10591.
Rey, H (2016). “International channels of transmission of monetary policy and the Mundellian trilemma”, IMF Economic Review 64(1): 6–35.
1 See literature reviews by Galati and Moessner (2018) and Araujo et al (2019).