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Luiz Awazu Pereira da Silva Deputy-Governor Central Bank of Brazil

PANEL Session : Capital Flows and the Interaction between Macro-prudential Rules and Monetary Policy. Luiz Awazu Pereira da Silva Deputy-Governor Central Bank of Brazil. November , 2011. Introduction : Dealing with Excessive K Flows. Unusually intense & volatile capital flows to EMEs.

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Luiz Awazu Pereira da Silva Deputy-Governor Central Bank of Brazil

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  1. PANEL Session : Capital Flows and the Interaction between Macro-prudential Rules and Monetary Policy Luiz Awazu Pereira da Silva Deputy-Governor Central Bank of Brazil November, 2011

  2. Introduction: DealingwithExcessive K Flows Unusually intense & volatile capital flows to EMEs • Exacerbate financial pro-cyclicality (boom and bust cycles) in local credit and asset markets (including FX) Financial (Ins) Stability Economic (Price) Stability • Policy response(s)?

  3. Capital Inflows, Real Credit Growth, and Real Equity Prices, 1996-2010 Source: International Monetary Fund, Global Financial Stability Report (April 2011)

  4. WarningSignalsofSystemic Banking Crisis Higher Risks Source: International Monetary Fund, Global Financial Stability Report (September 2011)

  5. Outline Aiming at both Macro (price) & Financial Stability (risk) Objectives & Instruments Prudential Regulation Effectiveness to Mitigate Risk Strategies to React to Both Macro & Financial Instability Is there a Pragmatic Approach? Brazil’s comprehensive policy approach

  6. 1. Objectives (Price S & FS) & Instruments

  7. 1. Simultaneous MP and MaP Implementation • We know well: MP affect activity (quad NW), credit, then aggregate demand (demand side) • We know also: MaP reduce financial instability, affect risk (quad SE), then excessive credit growth (supply side) • Therefore both MP and MaP affect aggregate demand (two channels). • Policy challenges when both are implemented together? To address two objectives? • Clear communication (MP& MaP are complements, not substitutes) • Intense debates in the 90s-00s (Lean vs Clean)

  8. 2. MaPs Effectiveness to Mitigate Risk • FS & MaPs: many studies (BIS, IMF, academia, etc.) old and new literature: empirical evidence shows MaPs are effective (e.g., see IMF WP/11/238, October 2011)(*) in mitigating systemic risk • Cross-country regression (49 countries)  MaP dampens pro-cyclicality (LTVs, DTI, caps of Credit growth, RR, CC K reqs., dynamic provisionning) used in combination • Effectiveness does not depend on ERR, size of financial sector, AEs or EMEs, etc. (*) Lin and alii, Macroprudential Policy: What Instruments and How to Use Them? IMF WP/11/238, October 2011)

  9. Source: Lin and alii, IMF WP/11/238, October 2011)

  10. Panel Regression of Credit Growth with/without CC K Credit Growth withMaP (CC K rule) have significant & slower coefficient v-a-v GDP Growth Credit Growth withoutMaP (CC K rule) have significant & higher coefficient v-a-v GDP Growth Panel Regressions shows Credit Growth elasticity v-a-v GDP Growth is affected byMaP (CC K rule) MaP presence issignificant & produces slower coefficient of Credit Growth v-a-v GDP Growth Source: Lin and alii, IMF WP/11/238, October 2011)

  11. 3. Strategies to React to Financial Instability • Assuming communication / agency pbs solved, global crisis reformulated (old) issues (e.g., how policy should react to F(ins)S, how should FS be defined, e.g., “asset price bubbles”, “excessive credit growth”, etc.) in two directions: • (Q1) should Monetary Policy (MP) be somehow combined with Macro-Prudential Policies (MaP)? If yes, are there optimal strategies combining MP+MaP to achieve both macro & financial stability? • (Q2) should MP rules be directly responsive to (some measure of) financial (in)stability? If yes, should CBs think of a new argument in reaction function? Which one?

  12. Q1: Using both MP + MaP to moderate booms

  13. 3.1. Combining MP and MaP: effective? • Proposition needs theoretical framework (not yet available). But can be tested numerically using DSGEs (*) increasing amount of literature being produced (academia, BIS, IMF, etc.) • Ex: effect of positive risk shock using (1) MP only (Taylor rule) v-a-v using (2) MP + MaP in DGSE simulation (*) see IMF WPS/11/238

  14. 3.2. Combining MP and MaP: optimal dose? • Numerical “Optimality” can be tested using DSGE with explicit specif. financial sector (K reqendo, risk-sensitive to repaymt probability); key is adequate transmission channel. Financial Stability (FS) is defined as volatility of Housing prices; and Economic Stability = f [weights (FS & (Macro) Price Stab)] • DSGE compares property of 2 instruments in order to reach Economic Stability: • MP reacts thru Taylor rule where CB rate = f [ D(inflation – target), output gap, e3(credit) ] • MaP reacts thru a Countercyclical K buffer rule (qc) applying to banks, as in Basel 3

  15. 3.2. Combining MP and MaP: empirical results • With 50%-50% weights (of FS & Price Stab.), no trade-offs: instruments are complements not substitutes to achieve lower volatility (vertical axis) of Economic Stability: Results show positive effects of combining 2 rules (qc) and e3 Lower Volatility For Economic Stability Tighter MP rule Tighter Reg. rule Source: Agénor, Alper and Pereira da Silva , “Capital Regulation, Monetary Policy and Financial Stability”, WP series No. 237, April 2011, BCB

  16. Q2: Using new MP rule to moderate booms

  17. 3.3. Direct new MP Rule for FS: case AGAINST • CB rate too blunt an instrument (possible adverse supply-side effects); sectoral tools may be better. • MiP & MaP rules sufficient, both “old” (e.g., RR, liquidity ratios, LTV/DTI ratios) and “new” tools (dynamic provisioning, Basel 3, counter-cyclical buffers, etc.). • CB credibility pbs, adding a financial stability objective to MP may confuse markets, weaken commitment to price stability, and destabilize expectations. • Implementation pbs (timing): when and how identify adequate moment for policy intervention? No consensus about “financial (ins)stability”

  18. 3.4. Direct new MP Rule for FS: Case FOR • Loose MP correlated to excessive risk taking; compounds inherent financial procyclicality (optimistic expectations, underpricing risks in good times, etc.). • “Leaning against the (financial) cycle” MP may also help to stabilize conventional targets (output, inflation). • MiP & MaP rules IN-sufficient, to (a) prevent excessive asset growth; (b) avoid interest capture; (c) prove effective (largely untested Basel 3 new tools, despite BCBS accord) • “Cleaning after” “mop-up” proved too costly (balance sheet transfer led to 2nd phase of the Global Crisis where we are now) • If yes: then what should CB react to? Credit? Asset prices?

  19. 4. Pragmatic Approach • Theory and practice for combination of MP & MaP is under construction (not to speak about optimality). Meanwhile, is there a win-win pragmatic approach? Yes! • Implementing Coordinated Comprehensive Policies(e.g., fiscal, monetary, prudential regulatory, etc.) • Strengthening Prudential Regulation and Financial Infrastructure(e.g., G20-FSB, Basel 3 agenda  higher level & quality of K, counter-cyclical buffers, supervision, comprehensive resolution frameworks, etc.)

  20. 4. Pragmatic Agenda • More promising : smoothing financial accelerator, getting the “right” credit multiplier  reducing “excesses” in prices & quantities (leverage, asset-credit growth,…) • More promising : provisioning for white swans (forward-looking & dynamic) and K buffers for black swans • More promising : avoiding, minimizing contagion (hedging obligation, identification of counterparties, registration in CCPs, micro-prudential rules, etc.) • More promising : clear governance structure and rules for LOLR (MA) and Financial Stability Authority, 2 Committees?

  21. 5. Brazil Comprehensive Approach • Challenges (common to manyEMEspos-crisis) bylate 2010 early 2011: • Inflationary pressures from demand and supply imbalances and commodity price shocks • Large (unusual) capital inflows • Excessive domestic credit growth

  22. 6. Brazil ComprehensivePolicyResponse • MP (CB rate) to reduce inflationary pressures • conventional monetary policy was applied (policy rate increased by 175 bps) • complemented by fiscal policy tightening (primary surplus target raised to 3.15 pct of GDP for 2011) • MaP policies to reduce excessive risks • smoothing consumer credit growth (more K, LTVs, RR) • controlling household indebtedness (minimum pymt of 15 pct on CCs) • reducing excessive bank exposures in FX spot and future mkts (more K, RR and taxation)

  23. 6. Brazil – Results: CreditDevelopments Reserve Requirements (billionsof R$)

  24. 6. Brazil – Results: Inflationand Output Real GDP growth (%) *Focus: 11/nov 0.35% *

  25. 6. Brazil – Results: FX Developments

  26. Final Remarks • Challenges after the crisis: excessive volatile financial flows put additional pressure & risk to price and financial stability (sudden stops + sudden floods) • Against excessive financial pro-cyclicality: (some) prevention (leaning) now considered better than “mopping-up” (cleaning) after; pragmatic comprehensive policy response, including FP, MP and MaP works (Brazil’s data); MaP increases power of MP • Using a combination of instruments (MaP & MP+FP) to reach objectives of financial & price stability works in practice well; but more analysis needed to better understand : (a) effects of MP on risk; (b) effects of MaP on activity; and (c) transmission mechanisms of MP under various configurations of MaP

  27. Thankyou

  28. Source: BIS –Committee on the Global Financial System (CGFS), Macroprudential instruments and frameworks: a stocktaking of issues and experiences, CGFS PAPERS No. 38, May 2010

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