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Emerging Markets

MONETARY POLICY: How to avoid the next crisis

The international crisis offers several lessons for central banking, including making financial stability a key goal for every monetary authority on the planet, says Argentina's central bank governor <b>Martin Redrado</b>

The international crisis has pointed to several lessons for the world economy. In central banking, it has become evident that we need a more comprehensive view, including making financial stability a key goal for every monetary authority on the planet.

After this crisis, financial stability will definitely start to play a role it never played before in central banks’ lists of priorities. Both developed and emerging countries have had to adjust monetary schemes focused on the interest rate as the single instrument to maintain stability. In fact, financial stability objectives were implicitly and explicitly added, and instruments were adjusted to new priorities. Within this framework, many central banks have had to revisit their usual regulation, operation and intervention mechanisms.

The literature is lagging behind. We have reached a point at which economic theory is having a hard time keeping up with praxis. The literature has presented results that are ambiguous or contrary to those produced by the usual “technology”, especially in relation to the approach that relies on the interest rate as the single instrument. The same applies to managed floating exchange rate regimes. Recent empirical papers that refined the analysis made by several academics argue against sharp fluctuations in the domestic currency, mitigating excessive volatility, especially in developing countries with rather shallow capital markets and limited access to hedging instruments.

In the case of Argentina, our monetary and financial framework has been fully consistent with our history, our idiosyncrasies and, thus, with the instruments available.

The decades of macroeconomic instability and recurrent crises that we have faced were not harmless in terms of welfare. Although Latin American countries have experienced lower economic growth rates and higher macroeconomic volatility than other regions, the problem of our country is on a different scale. Over the past 30 years, the average growth in Latin America was less than half of Asia’s, with volatility at nearly twice Asian levels. In that period, Argentina’s growth was three times lower than that of emerging Asia, and volatility eight times greater.

This process triggered enormous economic and social losses, hindering on our chances to develop, and leading to changes in our citizens’ behaviour. Indeed, the consequences of this process include portfolio dollarization; fiscal, financial or external dominance; obstacles to developing a long-term credit market; and the marked negative correlation between changes in retail deposits and foreign exchange fluctuations.

These factors, which undermined the power of some traditional monetary policy instruments, have played a key role in the design of our monetary and financial policies. In these cases, it is essential to ensure systemic stability and build “buffers”, which give priority to avoiding "the next crisis" that manifests in the minds of the people and minimize the effects of disruptions. In particular, our risk management strategy based on four pillars – convergence between supply and demand in the monetary market, a managed floating exchange rate regime, countercyclical build up of external liquidity buffers, and appropriate financial regulation and supervision – is fully compatible with these aims as well as with the tools available.

This approach, which was carefully and persistently developed along recent years, now allows us to overcome each volatility episode in the new international context, minimizing the impact on the real economy and avoiding inconsistencies that might make that impact unsustainable over time. We can now claim that our strategy is so sound that it has enabled us to overcome four stress episodes in the past 20 months: July-October 2007, April-June 2008, September-November 2008 and March 2009. It has proved adequate to go through these hard times with unusual stability.

Despite the current scenario, and for the first time in decades, the Central Bank of Argentina has acted as an anchor, ensuring monetary and financial stability and exchange rate predictability. These public goods have not been present in the last three decades.

This has not occurred by chance. It was a consequence of the Central Bank’s deliberate strategy, which prepared us to deal with the new scenario. One of the main structural reforms in our system has been, for example, the design of a specific regulatory framework preventing currency mismatches, reducing exposure to the public sector, and maintaining prudence when introducing financial innovations. In addition, we accumulated international reserves during the “good times”, when the opportunity cost of doing so was low, so now we have a sizeable stock to weather financial turmoil.

In turn, the implementation of a sterilization policy to keep money supply in check enables us to count with domestic liquidity management mechanisms that have been tested and are now very useful for injecting money into the system, if necessary. This is also reflected in the foreign exchange regime, which has always worked to mitigate excessive volatility, avoiding abrupt fluctuations that could jeopardize the economy's financial stability.

Moreover, in contrast with what happened in previous episodes, emerging economies have had the chance to participate in making decisions about how to design the new international financial architecture. For example, Argentina takes part systematically in international bodies such as the G20, with a view to making an intellectual contribution to the world economy.

Another example is the participation of emerging economies – and of Argentina as a full member – in the newly created Financial Stability Board (FSB) and the Basel Committee on Banking Supervision (BCBS). The FSB is beginning to play a key role in the new system. The inclusion of emerging countries – with more experience in adjusting regulatory frameworks to avert crises or mitigate their impact – will provide a new perspective to the Board. We will have higher quality standards and, thus, a greater probability of adequately applying them at the national level.

Through our direct participation in the Standing Committee for Vulnerabilities Assessment, the Central Bank of Argentina is working towards opening private sector access to credit, policy sustainability and strategies for exiting the crisis.

Also, we take part in the BCBS, where we have proposed concrete steps towards liquidity management and the regulatory treatment of currency mismatches. This is an area where emerging markets that suffered significant macroeconomic crises in the past have valuable experience to share.

We have made a proposal about how regulation can deal with the risk arising from currency mismatches in debtors’ balance sheets. As was strongly exemplified by recent events in eastern Europe, depreciation of local currencies decrease debtors’ ability to meet their obligations denominated in foreign currency, because their income is generated in local currency. As a result, there is an increase in credit risk in banking portfolios. If the effects of currency mismatches are not properly considered by banks, then supervisors should consider imposing additional capital requirements to deal with the potential negative effects resulting from the deterioration of debtors’ income capacity.

To summarize, the world is facing a new stage where our region has to take a leading role. Many of the world financial crises in the past few decades started, and expanded, in and among emerging economies. These traumatic experiences taught us a lesson. Our economies started adopting sound policies which have allowed us to withstand the contagion effect of the crisis. The challenge is to ensure this framework persists after the crisis is over, so that our countries may be inserted in the global economy in a less asymmetric and more effective way. By less asymmetric I mean the need and possibility to reduce the “cost” of being insured against financial crises. In my opinion, this is the path to a more stable, balanced system which is less prone to inconsistencies that jeopardize the sustained development of our nations.

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