Gill Marcus, former Governor, South African Reserve Bank; former Professor, Gordon Institute of Business Science; former Deputy Minister of Finance (South Africa); and former Chair, Absa Group.
Has the experience of the crisis changed your view of the central bank policy toolkit?
Governor Marcus: Prior to the global financial crisis, central bank toolkits had become whittled down to, with a few exceptions, the policy rate. At that time there were two widely accepted propositions: first, that monetary policy would become ineffective at the zero lower bound; and second, that monetary policy should not deal with financial stability issues. The general trend was for monetary policy to focus on inflation, with bank supervision either moving out of central banks or focused on microprudential issues. Although there were debates about whether or not asset price bubbles should be dealt with by monetary policy or central banks, the general view was that central banks could not recognize bubbles, and at best they could respond to inflationary impacts of asset price developments, and clean up afterwards in the event of the bubble bursting.
The global financial crisis has taught us that both of these presumptions were wrong. The experience of the advanced economies has shown that the zero lower bound does not place a limit on the effectiveness of monetary policy and that quantitative easing (QE) is an additional tool. This is not something that has been of direct relevance for emerging markets, where in general, inflation rates have been higher than those in advanced economies, resulting in policy rates quite some distance from the zero lower bound. However, emerging markets have been on the receiving end of some of the consequences of QE policies, as the search for yield resulted in strong capital inflows, with implications for exchange rates and asset prices. Currently, the challenge is to deal with the reversal or potential reversal of these flows, as the United States prepares for monetary policy normalisation.
With respect to financial stability, the crisis has taught us that central banks cannot ignore these issues. The questions that then arise relate to what instruments should be used and who should be responsible for financial stability or macroprudential policies. Some of the macroprudential tools that are envisaged in some countries are very similar if not the same as the tools that had been used in previous decades as monetary policy instruments, but had since been discarded. During the 1970s and 1980s, such tools included loan-to-value ratios, reserve requirements and capital controls. Over time, these tools were not deemed effective as monetary policy instruments for dealing with inflation. However, they may be better suited to more targeted objectives. So whereas loan-to-value ratios, for example, were not generally successful in dealing with excess credit creation generally in the economy, and therefore did not deal effectively with credit-induced inflation, such policies may be more effective in dealing with housing market bubbles.
Broadly, the view in South Africa is that the repurchase rate should remain the main monetary policy instrument, while financial stability risks should be dealt with by a broader set of instruments. This then raises a number of important questions: first, should monetary policy lean against asset price bubbles, in other words, should the policy rate be part of the financial stability arsenal? Second, should these decisions be taken by different committees or institutions? As with the development of new instruments, these issues are still work in progress in South Africa. While the repurchase rate will remain focused on the inflation objective, some leaning against emerging risks to financial stability cannot be ruled out. But using the policy rate on its own to deal with such risks could result in excessively large moves in interest rates, with significant costs to the economy. The approach is therefore one of separation of goals and instruments, with the Monetary Policy Committee focusing on its inflation objective with the repurchase rate as its main policy instrument, while the Financial Stability Committee has the responsibility of dealing with financial stability risks, with a broader range of instruments. Overlapping membership of these committees allows for better coordination of these policies (all members of the MPC are automatically members of the FSC).
Where should we be looking for financial stability risks?
Governor Marcus: There are three areas that I would highlight at this point in time:
First, risks posed by volatile global capital flows. As I mentioned earlier, the era of low interest rates and quantitative easing caused problems for emerging markets. Currently, the prospect of monetary policy normalisation in the United States is causing volatility in exchange rates and asset prices, as the timing and degree of tightening remains highly uncertain. It is generally accepted that some form of capital flow management in emerging markets is appropriate for dealing with ebbs and flows of capital movements. However, there is an assumption about the efficacy of these controls that may be overstated. How effective controls will be will differ from country to country, and be dependent in part on the openness and size of domestic financial markets.
A second emerging risk to financial stability could arise from the unintended (although perhaps not unforeseeable) consequences of global financial market regulation. For example, these new regulations are a result of regulatory failures in a number of advanced economies. However, the new regulations coming out of the Basel committees may have adverse consequences for those countries that did not experience financial stability issues or risks to their banking sectors. In particular, the proposed net stable funding ratio could have severe implications for a country like South Africa where the banking system weathered the global financial crisis but has traditionally been dependent on wholesale funding.
Finally, and related to the issue of regulation, is the issue of emerging risks from shadow banking, and more risks posed by asset management companies, which are relatively unregulated compared with the traditional banking sector, and where the extent and potential for unregulated leverage is largely unknown.
Implicit in the above is the extent of interconnectedness. This relates to interconnectedness at various levels, whether between banks and shadow banks, or even between countries. The onset of the financial crisis showed how the lack of awareness of the interconnectedness of products, institutions and markets across countries led to unexpected financial stability risks far removed from the original source. Regulations that do not recognise the risks posed by interconnectedness are therefore incomplete and are bound to fail.
What do we need to do to preserve the benefits of global finance?
Governor Marcus: By the benefits of global finance, I presume you are referring to the benefits of liberalization of capital flows. There are dangers that recent developments can cause a reversal of the trend towards open capital markets, as not all of the benefits have been obvious, not least in terms of the volatility, and risks to financial stability that they sometimes entail.
Emerging markets are often told that they can reduce their vulnerability to volatile capital flows by liberalising and developing their financial markets. Yet it is precisely those countries with deep and liquid financial markets that are more likely to attract inflows, and more likely to experience the reversals, because of ease of entry and exit. This conclusion has been confirmed in a number of studies. These inflows and outflows have significant implications for monetary policy through the inflation pressures from exchange rate changes. That is not to say that financial market development should not be encouraged, but the limitations and vulnerabilities associated with it should be recognised. This is particularly the case when these countries face sizeable flows in response to monetary policy actions in the advanced economies.
There is therefore a strong case for more coordinated monetary policy globally. Although it is not only the emerging markets that are vulnerable to monetary policy decisions in advanced economies, they are the most affected. This is a reality that they have been living with for some time, but it does not mean that there cannot or should not be more serious effort in this regard. At the very least, monetary policy in advanced economies has to be sensitive to the impact of their actions on other countries. Immediate attention should be given to the establishment of bilateral credit lines beyond those countries that have been granted them. There also needs to be clear international coordination of lender of last resort function among central banks (e.g. currency swaps among central banks) when liquidity is required. Both of these measures should be considered as a priority in the appropriate forums, and preferably have a decision made in principle and when there is no immediate need or request on the table.
While recent communications by the U.S. Fed have attempted to recognise the possible spillover effects of their actions, the ultimate test will be in the actions of the advanced economies, and their willingness to go beyond talk. Failure to address these concerns could lead to a reversal of capital account liberalisation, and more focus on management or controls of inflows and outflows.