The unprecedented integration of domestic and international financial markets in recent years has shifted the policy landscape for central banks. In opening remarks, Eduardo Aninat, Deputy Managing Director of the IMF, emphasized that globalization of financial markets is a double-edged sword. It affords opportunities for greater economic growth and prosperity but also carries the danger of greater financial vulnerability. Member countries and the IMF are keenly aware of those dangers, observed Stefan Ingves, Director of the Monetary and Exchange Affairs Department, and Mohsin Khan, Director of the IMF Institute, and financial vulnerability is now a major focus of the IMF’s work.
Fix or float?
Choosing the right exchange rate regime is an issue that has faced many central banks. But there are particular complications, observed Richard Webb, Governor of Peru’s Central Reserve Bank, when a country has a partially dollarized economy. The limited use of U.S. dollars for transactions and wages (currency substitution or real dollarization) coupled with the vulnerability of Peru’s open economy to external shocks suggest a floating exchange rate is appropriate. But with a large share of private sector liabilities denominated in U.S. dollars (financial dollarization), any large depreciation could translate into financial instability, which implies an exchange rate fixed to the dollar might be best. In Peru’s case, monetary policy options are further constrained by a lack of financial instruments denominated in domestic currency.
What to do? Webb noted that Peru has been able to maintain a floating exchange rate and an explicit inflation targeting framework because its low degree of real dollarization—and thus low “pass-through” from exchange rate movements to domestic prices—allows an independent monetary policy. Alain Ize, Advisor in the Monetary and Exchange Affairs Department, remarked that dollarization can lead to a vicious circle from currency instability to financial instability to excessive foreign exchange intervention that can lead to more dollarization. Dollarization can thus be “cured,” he said, through a gradual commitment to the domestic currency in the form of an inflation target and better prudential regulation.
When monetary unions are the answer
The challenges posed by globalized financial markets may enhance the advantages of monetary unions, but this option comes with its own set of practical difficulties, according to Gert-Jan Hogeweg, Director General of Economics of the European Central Bank. Drawing from Europe’s experience, he laid out a list of actions essential for a successful monetary union:
• Create, as a precondition, single markets for goods, capital, money, and labor among participating countries.
• Establish infrastructure through financial market integration, harmonization of legal systems, and area-wide payment and settlement systems.
• Pursue economic convergence. The European Monetary Union’s convergence criteria served as a transparent basis for judging which countries could join. Structural reforms in goods and labor markets are also needed for economic growth.
• Develop an independent central bank, an unambiguous mandate for price stability, and a framework for sound management of public finances.
• Unify the currency (requiring a far-reaching and long-lasting process of institutional and political reshaping, made possible by a sustained political consensus).
Inflation targeting “lite”
There are special challenges, too, for countries that want to use an inflation target to define monetary policy but that cannot fully commit to a full-fledged inflation targeting regime. Mark Stone, Senior Economist in the IMF’s Monetary and Exchange Affairs Department, termed the approach that countries may adopt in these circumstances inflation targeting “lite.” Countries that go this route, he said, do so because a fixed exchange rate would leave them vulnerable to speculative attack; a monetary target is impractical given instability in money demand; and full-fledged inflation targeting is not feasible because they lack a sufficiently strong fiscal position and a fully developed financial sector.
Countries that opt for inflation targeting “lite” generally aim to bring inflation down to single digits and maintain financial stability, using a relatively interventionist exchange rate policy. Their central banks may want to announce a long-term commitment, he said, to either a hard exchange rate peg or a full-fledged inflation target to bring forward the benefits of a single-anchor monetary regime. In his comments, Jerzy Pruski, Member of the National Bank of Poland’s Monetary Policy Council, described inflation targeting “lite” as a means of buying time to undertake the structural reforms needed for a single nominal anchor.
Balancing financial and monetary stability
For a small open economy such as Denmark’s, the central bank’s role in managing both international debt and reserves provides an important element of financial stability, according to Hugo Frey Jensen, Assistant Director and Head of the Capital Markets Department of Denmark’s central bank. This dual responsibility for international debt and reserves, he said, is an efficient way to use scarce resources and develop a broad knowledge of financial markets in a single institution. Jensen also suggested that a clear and transparent framework for debt and reserve management offers the best way to handle the various trade-offs between monetary policy and debt management and to minimize long-term government borrowing costs.
But should financial stability be an explicit central bank objective on a par with other, particularly monetary and inflation objectives? Roger W. Ferguson, Jr., Vice Chair, Board of Governors, U.S. Federal Reserve System, noted that the U.S. central bank views its financial stability objectives primarily through the lens of its macroeconomic goals—price stability and sustainable long-run growth. Today, he said, it is more important than ever for central banks and other financial authorities to share information, coordinate crisis prevention measures, and cooperate in crisis management actions.
In Ferguson’s view, some of the more urgent central bank issues are whether a central bank should take preemptive actions to head off potential financial instability (even when such actions may not be fully justified by the outlook for inflation and output); how much weight to give to financial stability versus other objectives, and whether a high degree of activism could lead to higher variability of economic variables. André Icard, Deputy General Manager of the Bank for International Settlements, came down on the side of greater central bank activism in financial stability concerns, although he stressed the potential difficulties arising from the shorter time horizon for monetary objectives than for financial objectives, as well as the risk of moral hazard.
Role of financial soundness indicators
As V. Sundararajan, Deputy Director, and R. Sean Craig, Senior Economist, of the Monetary and Exchange Affairs Department, noted in their presentations, financial soundness indicators can provide early warning signals for the three dimensions of financial stability: robust financial infrastructure, effective supervision, and adequate macroprudential surveillance.
The indicators’ effectiveness can be strengthened, they said, by exploiting the interdependence among them and by using them in combination with other surveillance tools, such as stress testing of bank balance sheets, and assessments in relation to core principles and codes and standards. Extending the coverage of the indicators to nonbank financial institutions and the nonfinancial corporate sector could further improve their effectiveness. The indicators can also help focus assessments on the risks to financial stability originating in the prudential and infrastructure dimensions.
In the eye of the storm
In a concluding session, Mario Blejer, former governor of Argentina’s central bank, provided a lively, firsthand account of what transpires on the frontlines of a financial crisis. Blejer analyzed the roots of the crisis, attributing the collapse of Argentina’s peso to inconsistencies between the currency board and the country’s fiscal stance. He noted that the subsequent banking crisis was largely caused by sovereign risk and the government’s decision to impose below-market-price securities on the banking sector.
In November 2001, Blejer continued, Argentina imposed partial withdrawal restrictions (the corralito), abandoned the currency board, devalued the currency, and “pesoified” bank assets and liabilities at different rates. Pesoification meant the central bank could provide the liquidity needed to finance the bank run, but it had no money market or debt instruments with which to sterilize open market operations. And getting liquidity right was fraught with dangers. Too much liquidity risked hyperdepreciation and hyperinflation; too little liquidity risked a total collapse of the banking sector.
In this situation, Argentina’s central bank opted for an intermediate approach—providing liquidity to banks under attack while using new instruments to sterilize and stressing the difference between the central bank and the rest of the public sector. The country actively developed the market for short-term central bank instruments, initially with 7-day maturities, and then 14- and 28-day maturities, in pesos and dollars. Interest rates reached 140 percent before declining. Meanwhile, the central bank kept up payments on its own foreign obligations and intervened in the foreign exchange market to slow the pace of depreciation and avoid chaotic conditions.
By mid-June 2001, Blejer noted, the trends started to reverse. Thereafter, deposit withdrawals slowed; the need for liquidity from the central bank largely declined; central bank interest rates fell to 40-50 percent; and the central bank regained about half of the initial stock of intervention.
For a central bank in crisis, Blejer said, the bottom line is to persevere to the point where “greed exceeds panic”!
See also Financial Soundness Indicators: Analytical Aspects and Country Practices, IMF Occasional Paper No. 212. Copies are available for $20.00 each (academic price, $17.50) from IMF Publication Services. See page 334 for ordering details.
Photo credits: Denio Zara, Padraic Hughes, Pedro Márquez and Michael Spilotro for the IMF; Anne Boher for Reuters, p. 321; Agence France Presse, p. 330; and Anwar Mirza for Reuters, p. 331.