Volatile Capital Flows: their Sources and the Policy tools to manage Them

1. Volatile Capital Flows: their Sources and the Policy tools to manage Them Presentation by G. Russell Kincaid, St. Antony’s College, Oxford High-Level Seminar Organized the Central Bank of Bosnia and Herzegovina and SEESOX, June 5 and 6, 2014

2. Sources of Volatile Capital Flows • New Normal in Advanced Economies—low interest rates and the search for yield followed by interest rate “normalization” • Surges and sudden stops also possible in currency union—common monetary policy does not fit all members • Beware nominal convergence running far ahead of real convergence, or optimal currency criteria • Deleveraging by financial institutions—balance sheet repair driven in part by markets • Euro-area reforms—tackling the crisis by fixing its architecture—fiscal, MIP, and financial • Basel III—pushing for more and better capital will make banking more expensive

3. European Banking Union— Three Key Pillars

4. Banking Union—An Early Assessment • Important, but incomplete, progress; most progress on single supervisor and least on unified deposit insurance; resolution mechanism is complex and potentially too cumbersome in a crisis • AQR is major test for ECB; it must not repeat past EBA mistakes; all eyes are on Italy • In preparation, euro-area banks have shed assets—7 percent in 2013 alone and built up capital; still estimated capital shortfalls has wide range--Euro 50-300 billion or ½-3 percent of euro-area GDP • EC staff have estimated that in a crisis, banking union would benefit the euro-area as a whole only slightly with big gains to periphery at modest cost to core. Creditor bail-in at national level provides roughly same distribution of gains. No estimate of spillover outside euro area.

5. Regulatory Action—Possible Impacts • Spread impact would be equivalent to one/two customary-sized interest rate increases • Concerns about unintended consequences for trade finance and project finance have been voiced by G20; CRD IV accommodates but only partially • AML/CFT rules could hit remittances, which are sizable in region on average 6½ percent of GDP, although much higher in some cases. • 100 billion in capital supports some 1,250 billion in risk weighted assets or 3,300 billion in total assets; capital needs induce more deleveraging

6. Tri-lemma, or the Impossible-”Unholy” Trinity as Applied to South-East Europe • EU-mandates that no restrictions on capital movements are allowed within EU or with other countries. • Foreign banks—principally from the euro area—are the dominant owners of SEE banking systems—85 percent of the bank assets on average excluding Slovenia. • As regards exchange rate regimes, three countries have adopted the euro, two countries have currency boards linked to the euro, and two countries have fixed exchange rate linked to the euro. Three countries have managed exchange rates. • Even for these three counties, the high share of euro-denominated lending/deposits constrains the conduct of monetary policy, lender-of-last-resort duties in a foreign currency, and limits scope for exchange rate flexibility. • With tri-lemma or currency union, policymakers lose an instrument. • Close trade links to EU add another spillover channel.

7. Macroprudential policies to the Rescue? • Macroprudential policy adds an instrument. But does it also add a target—financial stability? • What are nature and type of macroprudential tools? Cross section/structural, and time varying LTV/DTI/risk weights and capital/liquidity buffers Quantity/price oriented Calibration/effectiveness • Capital flow measures—can deal with surges and sudden stops; can increase effectiveness by curtailing leakages • “Jurisdictional reciprocity” introduced by BCBS for counter-cyclical capital buffers; needs to be expanded to other macropru instruments • ECB and ESRB have overlapping macroprudential responsibilities

8. Key Lessons From Five Case Studies in the Region • In all cases (Bulgaria, Croatia, Romania, Serbia and Turkey), macroprudential measures tackled primarily macro-imbalances and not financial instability. On the whole, time-varying or cyclical tools were exercised. Multi-tools were utilized simultaneously, making it difficult to asses individual tools. • Only Turkey, which was outside the EU, employed CFMs. However all countries utilized FX-denominated measures. Romania had to modify some macropru tools in light of EU concerns. • Monetary policy was not tightened, suggesting that macropru may have been a substitute rather than a complement. Fiscal balances improved during boom phase owing to buoyant revenues but in all cases structural fiscal balances deteriorated, leaving no fiscal space when the bust came. • In general, bank credit growth slowed at these briefly (1-2years); however, macroprudential measures were circumvented via several channels—mainly regulatory arbitrage and foreign leakages. • Macropru measures did nevertheless increase the resiliency of these banking systems because capital and liquidity buffers were enhanced. Risk transfer abroad also contributed but not transfers to domestic nonbanks with close links to banks.

9. Types of Macroprudential Tools Utilized