Monetary Policy Implementation: Lessons from the Crisis and Challenges for Coming Years Julio Velarde Governor Central Reserve Bank of Peru Kuala Lumpur, Malaysia October 2011
Content 1. Introductory remarks 2. Lessons from the global financial crisis 3. Peru s experience 4. Challenges for the years ahead 2
Introductory remarks Traditionally, central banks have oriented their policies and instruments towards one of the three following objectives: (i) monetary stability (keeping inflation low and stable); (ii) financial stability (lender of last resort to ensure adequate liquidity and a fluent functioning of the payments system); (iii) exchange rate stability During the period that preceded the global financial crisis, a growing number of independent central banks adopted monetary strategies aimed at preserving price stability with exchange rate flexibility. 3
Introductory remarks Financial stability used to be considered a natural by-product of monetary stability, of deep and sophisticated financial markets, and of an adequate assessment of financial risks. In this context, financial regulation with a micro-prudential approach sought to ensure the solvency of market participants, regardless of the risks involved in the interaction between them. Also, from the mid-1980s, declining inflation and economic volatility in developed economies, together with a greater emphasis on financial innovation, resulted in strong deregulation, which in turn promoted an extraordinary development of the international financial system. 4
Introductory remarks These developments led to a perception that: Monetary stability was a sufficient condition to ensure financial stability; and Shocks with the potential to create systemic risks in the financial system were too unlikely to be factored into the design of monetary policy. The global financial crisis showed that these perceptions were overly optimistic and in some cases plainly wrong. 5
Content 1. Introductory remarks 2. Lessons from the global financial crisis 3. Peru s experience 4. Challenges for the years ahead 6
Lessons from the Global Financial crisis The financial crisis has shown that macroeconomic stability is not sufficient to preserve financial stability. The use of a single monetary instrument the short-run interest rate proved insufficient to preserve financial stability. It has now been recognized that it is necessary to put in place a set of additional policies and instruments known as macro-prudential measures to secure financial stability and prevent systemic risks Such instruments have the common objective of deterring financial market participants from taking excessive risks and protecting the financial system against low-probability but high-impact events. 7
Lessons from the Global Financial crisis The financial crisis highlighted the importance of financial stability for the effectiveness of monetary policy. Changes in the policy interest rate may not influence other interest rates in the economy in periods of acute financial stress, as the latter can stunt the monetary transmission mechanism (as during the demise of Lehman Brothers). The jump in the TED spread (the difference between the LIBOR and the federal funds rate) from 209 to 463 basis points between August and October 2008 resulted in higher bank financing costs in spite of a reduction in the federal funds rate. 8
Lessons from the Global Financial crisis The crisis also showed that economic dynamics can become highly non-linear, and that shocks may involve considerable tail risks. In such cases, the monetary strategy must emphasize risk management to reduce the impact of external events with a high adverse impact on the health of the financial sector and the wider economy. Otherwise, the risk of being driven towards a zero interest rate is higher, given that the likelihood of suffering greater shocks increases considerably. 9
Lessons from the Global Financial crisis Most emerging markets did not deregulate their financial markets as aggressively as developed economies, nor did they confine monetary policy to a single instrument. Central banks have made cyclical use of reserve requirements, caps on foreign exchange positions, and liquidity requirements to limit potential disequilibria caused by surges in short-term capital inflows. A key difference with developed countries is that central banks in emerging economies have operated under greater uncertainty, with recurrent financial crisis episodes. 10
Lessons from the Global Financial crisis Many of the macro-prudential tools used in emerging economies were introduced at the end of the 1990s in the wake of the 1997 Asian crisis and the 1998 Russian crisis. Macro-prudential instruments have been tailored to the needs and economic and financial structure of each country. A main feature of most macro-prudential instruments used in the region is their discretionary component, which allows greater flexibility in view of the difficulties in measuring systemic risks. Lately most Latin American central banks have intensified the use of these kinds of policies, which likely have contributed to enhancing financial resilience. 11
Content 1. Introductory remarks 2. Lessons from the global financial crisis 3. Peru s experience 4. Challenges for the years ahead 12
Inflation targeting with dollarization risks Peru s experience Objective: Price Stability Inflation Target: 2% Operative Target: Interbank Interest Rate Conventional Monetary Policy + Measures to control risks from financial dollarization High reserve requirements on FX obligations to: - Moderate credit cycles associated with capital inflows. - Keep adequate FX liquidity in the banking system. FX market intervention to: - Reduce extreme exchange rate volatility, particularly associated with domestic agents' transitory portfolio shifts. Non-Conventional Instruments 13
Peru s experience Since the beginning of the 1990s, dollarization has been a significant concern to Peru s monetary authorities in view of its potential risks to the financial system. 90 80 70 60 Dollarization Ratio (%) Broad money dollarization Credit dollarization 50 40 45,5 37,8 30 20 10 0 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 14
Peru s experience Reserve requirements are intended to: (i) create a high reserve equate international liquidity to face potential bank runs and sudden capital reversals; (iii) reduce pressure on bank credit growth in the face of low international interest rates and high and persistent capital inflows; and (iii) internalize risks from financial dollarization. % 60 55 50 45 40 35 30 25 Average required Marginal Before 2008 Crisis Foreign currency reserve ratios (As percentage of TOSE) 55 38,9 20 Jan-06 Jun-06 Nov-06 Apr-07 Sep-07 Feb-08 Jul-08 Dec-08 May-09 Oct-09 Mar-10 Aug-10 Jan-11 Jun-11 15
Peru s experience High reserve requirements on short-run run obligations encouraged banks to lengthen foreign funding maturities, thereby increasing their resilience to sudden capital stops 12 000 External Liabilities of Banking Entities (Balance in US$ millions, ratio in %) 90 10 000 Long-term financing increased after the exemption of long-term external liabilities from reserve requirements 82 70 80 70 8 000 60 6 000 4 000 31 45 50 40 30 2 000 17 20 10 0 0 Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Jan-11 Mar-11 May-11 Long-term external liabilities Short-term external liabilities Long-term external liabilities /Total external liabilities 16
Peru s experience The Central Bank intervenes in the foreign exchange rate market to reduce volatility, thus minimizing negative balance sheet effects. Nominal Exchange Rate and Net Forex Intervention Exchange rate (PEN per US dollar) 3,350 3,250 3,150 3,050 2,950 2,850 2,750 During the 2008 crisis US$ Millions Net Purchases Net maturity of CDR-BCRP Net placements of CDLD Acummulated 2007 10 306 0 0 Acummulated 2008 2 754-1 421 0 Acummulated 2009 108 1 421 0 Acummulated 2010 8 963 0 160 Acummulated Octuber 3, 2011 1 493-590 -160 Acummulated 2007-2011 23 624-590 0 After the 2008 crisis 600 400 200 0-200 -400 2,650-600 Dec-07 Jan-08 Feb-08 Mar-08 Apr-08 May-08 Jun-08 Jul-08 Aug-08 Oct-08 Nov-08 Dec-08 Jan-09 Feb-09 Mar-09 Apr-09 May-09 Jun-09 Jul-09 Aug-09 Sep-09 Oct-09 Nov-09 Dec-09 Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Dec-10 Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11 Net FX Purchases (millons of US dollars) Net FX purchases CDR BCRP Exchange rate 17
Peru s experience Central Bank Forex intervention has not generated a real exchange rate misalignment, nor has prevented a sustained dedollarization process. 110 Real Equilibrium Exchange rate 110 108 108 106 106 104 104 102 102 100 100 98 98 110 Real Exchange Rate Index (Multilateral Index Dec. 2001=100) 96 94 92 Model Uncertainty Range Real Equilibrium Exchange Rate Multilateral Real Exchange Rate 96 94 92 105 90 2007 2008 2009 2010 2011 90 100 Full Range Average 100,6 95 90 85 Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09 Mar-09 May-09 Jul-09 Sep-09 August 2011: 98,75 Monhtly % Var.: -0,33 Annual % Var.: 4,02 18 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Jan-11 Mar-11 May-11 Jul-11
Peru s experience The recent crisis put to the test the BCRP s IT strategy cum financial risk control. The large amount of international reserves accumulated in the previous period facilitated a prompt and effective response through: Monetary Injection Operations Flow Sep.2008-Feb.2009 Period of Implementation (millions of PEN) 1. Repo 7,877 From October 2008 2. CDBCRP 8,045 January-May 2008 3. CDBCRP_NR 16,581 From September 2008 4. Reserve Requirements 2,307 Eight reserve requirement measures between Sept. 2008 and March 2009 Total 34,810 % of 2008 GDP 9.30% A cut in the marginal reserve requirement rate in dollars from 49 to 30 percent. A cut in the marginal reserve requirement rate in soles from 25 to 6 percent. A reduction in the reserve requirement on banks short-term foreign liabilities from 49 to 0 percent. Repo maturities were extended up to a year. The central bank sold $6,843 million in the spot market and around $3,400 in the forward market. 19
Peru s experience Once money and exchange market stabilized, the central bank cut the interest rate to ease monetary conditions. 7,0 6,5 6,0 5,5 5,0 4,5 4,0 3,5 3,0 2,5 2,0 1,5 1,0 Jan-07 Mar-07 May-07 Jul-07 Monetary Policy Referential Interest Rate (In percentages) Sep-07 Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 1,25 Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Jan-11 Mar-11 May-11 4,25 Jul-11 Sep-11 7,0 6,5 6,0 5,5 5,0 4,5 4,0 3,5 3,0 2,5 2,0 1,5 1,0 20
Peru s experience The policy response cushioned the domestic financial system from the impact of the crisis and facilitated a swift and sustained recovery of credit and growth from the second half of 2009. Access to Credit Index 80 70 60 Easy access to credit 56 55 55 56 56 58 58 60 61 59 60 61 62 62 63 63 64 64 63 63 65 64 64 65 63 63 61 61 62 61 57 53 53 140 135 130 125 120 Credit to the Private Sector (Selected Countries) (Index 3Q08=100) 50 115 110 40 Difficult access to credit 105 100 30 J.09 F M A M J J A S O N DJ.10 F M A M J J A S O N D J.11 F M A M J J A S 95 90 Brazil Colombia Peru 1/ Chile 3Q-08 4Q-08 1Q-09 2Q-09 3Q-09 4Q-09 1Q-10 2Q-10 3Q-10 4Q-10 1/ Peru: includes loans made by bank branches abroad. 13,0 11,0 Non-performing bank loans (%) 126 122 GDP: Selected LA Countries (seasonally adjusted, 4Q07=100) Peru 9,0 118 7,0 114 110 Brazil Chile Colombia 5,0 106 102 Mexico 3,0 1,51 98 94 1,0 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 90 4Q07 1Q08 2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 Source: Central banks and statistics institutes. 21
Content 1. Introductory remarks 2. Lessons from the global financial crisis 3. Peru s experience 4. Challenges for the years ahead 22
Challenges for coming years One of the main lessons from the crisis is the need to put in place policies aimed at limiting the exposure of the financial system to systemic risks. This requires both an institutional framework that establishes the principles and instruments governing financial macro-regulation and a clear distinction between the mandates of monetary and macroregulatory policies. In the face of various potential sources of systemic risk, macroprudential policies require a set of instruments wider than the standard monetary policy toolkit. 23
Challenges for comming years Several central banks, especially in emerging market economies, have used instruments such as capital requirements, counter-cyclical provisioning, additional liquidity requirements, and debt limits to reduce systemic risks. At the same time, the use of these instruments represents an important challenge to the authorities, as they typically impose efficiency costs on financial intermediation, which nevertheless are lower than the benefits from preserving financial stability. Shortcomings may be limited by using the right mix of instruments especially distributing the burden of macro-prudential regulation among a wider set of tools. 24
Challenges for comming years It is fundamental to ensure an adequate flow of information from the regulatory and supervisory authorities to the officials in charge of implementing macro-prudential policies. It is also important to secure and adequate coordination between the central bank, the financial regulation entities, capital markets, and the government. To achieve these goals, financial stability committees have been introduced in the U.S. to coordinate actions by regulatory and supervisory entities, the central bank, and the ministry of finance. 25
Challenges for comming years It is important to keep in mind that macro-prudential policies can and must be implemented while preserving the two pillars of monetary policy; i.e., central bank independence and the single mandate to preserve monetary stability. Many challenges remain going forward. In particular, the limits between monetary and macro-prudential policy need to be further clarified; and additional work is required to identify areas where the complementarity between monetary and macro-prudential policies can be maximized. 26
Monetary Policy Implementation: Lessons from the Crisis and Challenges for Coming Years Julio Velarde Governor Central Reserve Bank of Peru Kuala Lumpur, Malaysia October 2011