Central Banking and Financial Crises:

An Asian Perspective Masahiro Kawai University of Tokyo

2014 ADBI-Keio Executive Training in

Macroeconomics Keio University

Tokyo, 5 November 2014 The views expressed in this presentation are the views of the author and do not necessarily reflect the views or policies of the Asian Development Bank Institute (ADBI), the Asian Development Bank (ADB), its Board of Directors, or the governments they represent. ADBI does not guarantee the accuracy of the data included in this paper and accepts no responsibility for any consequences of their use. Terminology used may not necessarily be consistent with ADB official terms.

Outline 1. Introduction: Central banking 2. Evolving scope of central bank

mandates 3. Central bank independence and

policy coordination with government 4. Spillovers of US monetary policy

changes 5. Conclusion

2

1. Introduction: Central banking • The period of “great moderation” affirmed the

conventional wisdom that the technical problems of monetary policy had largely been resolved in an elegantly simple fashion

• Focus on “price stability”: Inflation targeting was considered the appropriate policy framework, and the short-term interest rate was the appropriate policy instrument

• A central bank should be “independent” to avoid high (not to mention hyper) inflation

• In a world of floating exchange rates, monetary policy spillover effects were considered absent

3

The GFC and EZFC rudely shattered this conventional view

• Financial crises erupted following "great moderation": Should central banks have paid more attention to financial stability issues?

• The crises required near-zero interest rate policies, including unconventional monetary policies when policy rates hit (near-)zero (Japan, US)

• Have central bank mandates been expanded to achieve high employment and growth?

• Have central banks lost their “independence” during and in the aftermath of financial crises?

• US monetary policy changes are affecting many emerging economies: Can emerging economy central banks retain their monetary policy independence?

4

2. Evolving scope of central bank mandates

• Should a central bank have dual mandates of maintaining price stability (or low inflation) and maintaining maximum employment, like the US Fed?

• Should a central bank have dual mandates of financial stability in addition to price stability, like the BOE?

• To what extent can and should a central bank continue to purchase sovereign debt when the magnitudes of both fiscal deficits and sovereign debt are large, like the BOJ?

5

Some evidence in favor of a mandate for output or employment in addition to inflation

• The Taylor-rule monetary policy framework includes both inflation and output “gaps”

• The US Fed eased monetary policy aggressively during the GFC, while the ECB moved slowly due to its sole focus on inflation

• Some degree of flexibility on the inflation target, both in terms of range and time frame, introduces scope for focusing on output as well

• Focus on inflation worked well when the main objective was to reduce inflation, but not so well in a deflationary or "lowflation" environment

6

Balancing the dual objectives of price stability and financial stability

• Key lesson: Financial instability often occurs in an environment of price stability (i.e., the Minsky Moment)

• As long as the central bank defines price stability from a medium-term perspective and adopts a forward-looking approach, it can take financial imbalances into account without any conflict of objectives

• Possible short-term conflicts in the event of signs of asset price bubbles in a low inflation environment: The central bank needs two tools to achieve two objectives

• The GFC has decisively shifted the debate in favor of “leaning” rather than “cleaning”

• Rapid cleaning (quick resolution of bank NPLs in post-crisis periods) remains important to avoid “Japanization”

7

2,000

2,500

3,000

3,500

4,000

4,500

1980 1985 1990 1995 2000 2005 2010

Japan

15,000

17,500

20,000

22,500

25,000

27,500

30,000

32,500

1980 1985 1990 1995 2000 2005 2010

Finland

16,000

18,000

20,000

22,000

24,000

26,000

1980 1985 1990 1995 2000 2005 2010

Italy

200

225

250

275

300

325

350

375

1980 1985 1990 1995 2000 2005 2010

Sweden

25,000

30,000

35,000

40,000

45,000

1980 1985 1990 1995 2000 2005 2010

United States

0

5,000

10,000

15,000

20,000

25,000

1980 1985 1990 1995 2000 2005 2010

Republic of Korea

3,000

4,000

5,000

6,000

7,000

8,000

9,000

10,000

11,000

12,000

1980 1985 1990 1995 2000 2005 2010

Indonesia

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

90,000

1980 1985 1990 1995 2000 2005 2010

Thailand

5,000

10,000

15,000

20,000

25,000

30,000

1980 1985 1990 1995 2000 2005 2010

Malaysia

5,000

6,000

7,000

8,000

9,000

10,000

11,000

12,000

1980 1985 1990 1995 2000 2005 2010

Argentina

Real GDP following financial crises since 1990

Real GDP measured in constant local currency values

Note: 1000 yen for Japan; 1000 won for Korea; and 1000 rupiah for Indonesia . Source: Kawai and Morgan (2014), “Banking Crisis and ‘Japanization’: Origin and Implications.” in PIIE volume.

Financial stability objective difficult to monitor and implement

• In pursuing price stability, a central bank can rely on: A relatively clear and precise definition of its objective A body of theory and empirical evidence relating to (a)

the determinants of inflation rates and (b) the relationship between the policy instrument(s) and the ultimate objective

Relatively comprehensive data on the variables relevant for carrying out the mandate

• It is difficult to monitor and implement financial stability (real estate price, credit growth, capital inflows), but this does not reduce its importance

9

A central bank needs to be in charge of financial stability

• A financial crisis significantly affects central bank policies

• A country’s central bank tends to be best suited to conduct macroeconomic-financial surveillance, with a broad view of economy and financial system

• It has oversight of payments & settlement infrastructure • Even basic monetary policy tools can affect financial

stability Crisis prevention: interest rates, credit growth Crisis management: liquidity provision/lender of last resort

(LOLR) function, and “unconventional” monetary policy • Some central banks have additional crisis prevention

powers Bank supervision Macroprudential policy tools (debt to income ratio, LTV ratio, etc) Measures to affect capital flows for emerging economies

10

Cap on loan to value (LTV) ratio

PRC; Hong Kong, China; Indonesia, India; Malaysia; Philippines; Taipei,China; Thailand; Turkey

Loan to deposit ratio requirement

PRC, Republic of Korea

Increase in reserve requirements

Argentina, Brazil, Indonesia, India, Malaysia, Peru, Turkey

Direct controls on lending to specific sectors

Republic of Korea, Malaysia, Philippines, Singapore

Countercyclical capital requirements

Brazil, PRC, South Africa

Countercyclical provisioning

PRC, India

Liquidity requirements PRC, India, Korea, Philippines, Singapore

Caps on foreign or domestic currency lending

Indonesia, Poland, Viet Nam

Macroprudential policy measures

Source: Committee on the Global Financial System (2010), Chua, Endut, Khadri and Sim (2013)

Recent developments in central bank mandates

Bank of England •Responsible for financial stability as well as price stability •In charge of macroprudential policy •Supervisory responsibility for banking sector Bank of Japan •Adopted official CPI inflation target of 2% •Power to examine banks on-site, but no macroprudential policy tools European Central Bank •Established a Single Supervisory Mechanism for major banks •ECB President chairing the European Systemic Risk Board US Federal Reserve •Responsible for supervision of systemically important financial institutions, but without the formal mandate of financial stability •Identification of financial stability risks

12

Examples of financial stability architecture

Country Coordinating

entity Entities included Chair Sub-entities

Macro-prudential instruments designated

Australia Council of Financial Regulators

RBA, APRA, ASIC, Treasury

RBA None ?

EU European Systemic Risk Board

European System of Central Banks, national financial supervisory authorities, ECB, EC, three ESAs and EFC

President of ECB (General Board)

Steering Committee (14 members of General Board)

Yes

India Financial Stability and Development Council

MoF, RBI, SEBI, IRDA

Finance Minister Subcommittee (chaired by RBI)

No

Indonesia Financial System Stability Forum

MoF, BI, IDIC Finance Minister Steering Committee (7 members of Executive Board)

No

Japan Informal meeting MOF, BOJ, FSA Bank of Japan None ?

Republic of Korea

Informal meeting MSF, BoK, FSS Finance Minister None ?

UK Bank of England, MOU between PRA and FCA

BOE, Financial Conduct Authority

N/A None Yes

US Financial Stability Oversight Council

Treasury, Fed, SEC, CFTC, OCC, FHFA, NCUA, FDIC

Treasury Secretary None Yes

13 Source: Author’s compilation

3. Central bank independence and policy coordination with government

• We needed “central bank independence” when containing high inflation was a key policy priority

• Do we still need it at the time of financial crises, or deflation or "lowflation"?

• Do central bank purchases of government bonds on a sustained basis (as in the case of the BOJ) undermine central bank independence, particularly when levels of fiscal deficits and sovereign debt are large?

• Does the kind of central bank-government joint statement made in Japan undermine central bank independence?

14

Need to distinguish between goal independence and target independence • It is perfectly reasonable for government to

determine the central bank’s mandate, including a specific inflation target (Australia, NZ, BOE)

• The central bank has independence in choosing policy instruments, and the government should not change the target arbitrarily

• If a central bank fails to meet the target, it needs to explain clearly reasons for failure in the congress/parliament (accountability)

15

Coordination between the central bank and government

• Macroeconomic management requires coordinated monetary and fiscal policies In recession times, fiscal austerity can put greater burden on

monetary policy (ECB, US Fed) In boom times, lack of fiscal contraction requires greater

monetary policy tightening • Financial stability requires close coordination

Crisis prevention requires coordination between monetary and macroprudential policies

Crisis resolution involves significant fiscal resources • Structural rigidities (such as those in labor markets)

call for greater roles of monetary policy in recession • A sharp rise of government debt after the GFC

highlighted the interdependence of fiscal, monetary and financial (banking) policies 16

Key aspects of ‘Abenomics’ Government-BOJ policy coordination

Supporting structural reforms by expansionary monetary and fiscal policies

Monetary policy • Achieving 2% CPI inflation “at the earliest possible time” • Doubling of monetary base by end-2014 “Flexible” fiscal policy • Fiscal stimulus to offset negative impacts of cons. tax hike • Establish a sustainable fiscal framework with a view to

ensuring the credibility of fiscal management Supply side structural reforms • Greater labor market flexibility, deregulation (health, agri. etc) • Promoting energy security • Expansion of trade and FDI through EPAs Creating 2% inflation can raise Japan's potential

GDP by re-invigorating animal spirits 17

Japan's nominal and real GDP

18

85

90

95

100

105

110

115

120

200

250

300

350

400

450

500

550

1980 1985 1990 1995 2000 2005 2010

Nominal GDP (left-axis) Real GDP (left-axis) GDP price deflator (right-axis)

Note: Real GDP is at constant 2005 prices. Data for 2013 are based on IMF projections. Source: Cabinet Office, Government of Japan; IMF, World Economic Outlook database

(trillion yen) (2005=100)

GDP Deflator

Nominal GDP Real GDP

-2.5

-2

-1.5

-1

-0.5

0

0.5

1

1.5

2

2.520

0501

2005

0420

0507

2005

1020

0601

2006

0420

0607

2006

1020

0701

2007

0420

0707

2007

1020

0801

2008

0420

0807

2008

1020

0901

2009

0420

0907

2009

1020

1001

2010

0420

1007

2010

1020

1101

2011

0420

1107

2011

1020

1201

2012

0420

1207

2012

1020

1301

2013

0420

1307

2013

1020

1401

Headline Core Core-Core

Note: Core excludes fresh food; Core-core excludes food (less alcoholic beverages) and energy Source: Statistics Japan, website.

Japanese economy getting out of deflation

(%; year-over-year)

Avoiding deficit financing

• The central bank needs to avoid direct financing of the government deficit over a sustained period It carries substantial risks, and may be difficult to unwind It damages credibility of low inflation when inflation rises

and containing inflation becomes an issue • The BOJ's QE is different from deficit financing

BOJ happens to purchase government bonds as they are the largest and most liquid financial instruments for conducting monetary policy easing

Governor Kuroda warns government to seriously consolidate the budget through consumption tax rate hikes

Otherwise long-term interest rates can shoot up and make the BOJ's monetary policy easing difficult

20

4. Spillovers of US monetary policy changes

• The US Fed's launch of QE prompted emerging economies' criticism that it was a launch of currency wars which would lead to currency depreciations worldwide

• The QE policy likely affected global growth (positively), commodity prices, capital flows to emerging economies, and their currency values

• The indication of QE tapering signaled by Bernanke in May 2013 caused financial market volatility globally, inviting another criticism from emerging economies

21

Launch of QE by the US Fed • Was the launch of QE the same as the launch of a

currency war? Simply easing monetary policy, even if it takes place as QE,

cannot be equated with a currency war, though it may lead to currency depreciation as a consequence

Key question is whether or not a central bank embarking on monetary policy easing directly intervenes in forex markets to purchase foreign assets

• Policy spillovers were both positive and negative US QE likely had positive growth impacts US QE1, but not QE2/QE3, most likely had significant spillover

effects on global commodity markets, emerging economies When setting monetary policies, advanced economy central

banks must pay attention to spillovers, as foreign central bank reactions may come back to them

IMF and regional institutions (like AMRO in Asia) need to monitor and analyze spillover effects 22

Simulated output impact of US QE

Source: IMF, IMF Multilateral Policy Issues Report: 2013 Spillover Report, August 2013

US Fed QE and capital inflows to emerging economies

Source: IMF, World Economic Outlook, October 2014

PRC

PRC

How should EMEs respond to advanced economy ultra-easy monetary policies? • Maintain macroeconomic stability by:

allowing a certain degree of currency appreciation if there is an inflationary concern; or

intervening in the forex market to keep the exchange rate stable when domestic inflation is not a significant concern

• Monitor financial sector soundness given possible large-scale capital inflows from developed economies Use macroprudential policy measures, including capital

inflow control (which is now supported by the IMF) • Prepare for possible capital outflows in the future as

they can create currency crises Build up foreign exchange reserves Strengthen global and regional financial safety nets 25

Exchange rates of Japan and other Northeast Asian economies (2010=100)

26 Note: Real exchange rate is based on CPI indexes Source: BIS database

70

80

90

100

110

12020

0801

2008

0420

0807

2008

1020

0901

2009

0420

0907

2009

1020

1001

2010

0420

1007

2010

1020

1101

2011

0420

1107

2011

1020

1201

2012

0420

1207

2012

1020

1301

2013

0420

1307

2013

1020

1401

2014

04

Japan China Taiwan Korea

Real Effective Exchange Rate

PRC Taipei,China

Impacts of the end of US QE

• Former Fed Chairman Bernanke signaled the beginning of QE tapering in May 2013, which generated financial volatility in emerging economies, such as currency depreciation and stock price declines

• The end of QE is based on the Fed’s assessment that the US economy is on solid recovery, so it should be good news

• But the end of QE and the eventual interest rate hike with a lack of consistent communication with the market could adversely affect emerging economies, particularly the “fragile five”

Output impact of US monetary policy normalization

Source: IMF, IMF Multilateral Policy Issues Report: 2013 Spillover Report, August 2013

A: Smooth normalization B: With term-premium

shocks C: Without higher growth

A B

C

The “Fragile 5” have experienced large nominal currency depreciations

Note: The "fragile 5" refer to Brazil, India, Indonesia, South Africa, and Turkey. Source: IMF, World Economic Outlook, April 2014

Emerging economy exchange rate changes affected by the current account & inflation

30

Explanatory variables Eq. 1 Eq. 2 Constant -2.859 0.066 (2.329) (2.322) Current account balance/GDP 0.589** 0.507** (0.193) (0.181) Gross public debt/GDP -0.084 -0.059 (0.050) (0.045) Inflation rate --- -0.859** (0.350) Number of observations 22 22 Adjusted R-squared 0.263 0.430

Note: Exchange rate changes are the rates of change in nominal exchange rates against the US dollar between 22 May and 29 August 2013, with positive values indicating appreciation. Eq.1 uses 2012 data for the explanatory variables, while Eq. 2 uses 2013 projections for the explanatory variables. Projections are from IMF, WEO database.

Source: Kawai, M. (2013), “International Spillovers of Monetary Policy: US Fed Policy and Abenomics.” Unpublished manuscript

Market-based expectations of future US policy interest rates

Source: IMF, Global Financial Stability Report, October 2014 Source: IMF, World Economic Outlook, October 2014

Fears of a 1997-like crisis unwarranted… but countries with weaker fundamentals vulnerable

Fiscal Balance (% GDP) Current Account

(% GDP) Import cover (months)

Short-Term External Debt /

Reserves

1996 2013 1996 2013 Jun-97 Latesta 1997Q2 2013Q1

China, People’s Rep. of -0.7 -0.9 0.8 1.9 10.6 23.1 28.8 16.7 Hong Kong, China 2.1 0.8 -2.5 1.9 4.0 7.1 280.6 85.2 India -5.6 -7.2 -1.2 -1.7 0.6 6.9 — 53.6 Indonesia 1.2 -2.1 -3.2 -3.3 5.7 6.0 191.0 59.8 Korea, Rep. of 2.4 0.7 -3.9 6.1 2.6 8.0 232.0 48.2 Malaysia 2.0 -4.6 -4.4 3.9 4.0 7.9 69.2 26.6 Philippines 0.5 -0.1 -4.3 3.5 3.5 14.7 105.5 21.4 Singapore 8.5 5.7 14.4 18.3 7.4 8.7 245.4 81.8 Taipei,China -7.2 -3.1 3.8 11.7 9.3 18.4 26.6 12.9 Thailand 2.7 -0.2 -8.1 -0.6 5.4 7.7 157.7 19.1 Viet Nam NA -5.6 -8.2 5.6 — 2.7 53.3 51.1

32

Select Vulnerability Indicators (1996/97 vs. latest available data)

Note: aRefers to Nov 2013 except for Viet Nam (May); PRC (Sep) ; Korea (Dec); Philippines (Oct) Source: ADB, Asian Development Outlook, October 2013; IMF, WEO database, October 2014

Turkey and South Africa more vulnerable to capital account shocks

once US Fed raises policy rates

Source: IMF, Global Financial Stability Report, April 2014

Lessons for emerging economies (1) Reduce macroeconomic & financial imbalances •Avoid large current account deficits through macroeconomic & structural policies (supply capacity through FDI, etc) •Limit short-term capital inflows and finance current account deficits by long-term capital such as FDI •Choose an appropriate policy mix (monetary and exchange rate policy, MPP and CFM), by taking into account the costs and benefits of the relevant measures (2) Deepen financial markets to enhance resilience to future crises (3) Strengthen crisis management & resolution capacity (4) Coordinated policy action needed to minimize negative spillovers of US monetary policy tightening to emerging economies

What global policy coordination? The US Fed as the most influential global central bank • Ideally, the Fed should design monetary policy from global

perspectives (by taking into account its policy impact on the rest of the world and repercussions from it), not simply from domestic perspectives

• But, this is politically difficult and not its mandate Coordinated policy action • The Fed may end QE and eventually raise the policy rate by

taking a gradual, step-by-step approach, clarifying the pace and timeframe of policy tightening through the G20 dialogue process, and intensively communicating with markets

• Vulnerable emerging economies need to pursue structural reforms to augment the supply side of the economy

• The Fed may forge bilateral currency swaps with potentially vulnerable emerging economies, thereby strengthening global financial safety nets (complemented by IMF, CMIM, etc)

5. Conclusions • The GFC and the EZFC have challenged

conventional wisdom regarding the effectiveness of monetary policy, central bank mandates, central bank independence and spillover effects

• Central bank mandates need to be extended beyond price stability (inflation targeting) Some evidence in favor of targeting employment or real

output in a low-growth, low-inflation environment Promoting financial stability critical, despite the technical

difficulties involved in doing so Strong case for coordination with fiscal policy and

macroprudential policy, or among the central bank, finance ministry, and financial supervisor/regulators, or for having the central bank responsible for financial stability

36

• Central bank independence is not necessarily compromised by coordination with government, especially in a crisis period or when inflation is undesirably low; but direct, outright deficit financing may damage central bank credibility in the future

• Major developed economy central banks need to be concerned about spillover effects of their policy changes US monetary policy reversal potentially a risk for

emerging economies which can have feedback spillovers Emerging economies need to strengthen macroeconomic

& financial-sector management to mitigate the effects of capital flow and exchange rate volatility

IMF and regional institutions (like AMRO in Asia) can monitor spillovers and analyze their implications

Strengthen financial safety nets (currency swaps, CMIM) 37

Conclusion (cont`d)

Thank you For more information:

Dr. Masahiro Kawai Project Professor

Graduate School of Public Policy University of Tokyo

mkawai@pp.u-tokyo.ac.jp +81 3 5841 7641