When Raghuram Rajan was the governor of Reserve Bank of India (RBI), he highlighted the spillovers to emerging market economies (EMEs) like India from changes in US monetary policy stance and their impact on global financial markets. He has repeatedly suggested the possible need for some “rules of the game” in managing cross-border monetary spillovers.
Hélène Rey of London Business School observed that regardless of a country’s exchange rate regime, prices of risky financial assets globally tend to co-move, largely driven by global risk perceptions (proxied by VIX index) and the Fed Funds Rate. She has opined that if EMEs wanted to use monetary policy to have an impact on the domestic economy, the only way to do so would be by imposing capital controls, as the insulating properties of exchange rates are minimal at best.
Several academic papers since then have suggested that the Rajan-Rey thesis of complete “helplessness” of the EMEs to global financial cycles is exaggerated. Evidence suggests that countries with more flexible exchange rate regimes have generally been better able to buffer themselves against external shocks compared to those with more heavily managed regimes. This is an important message in the current environment where quantitative easing (QE) policies in the US are being wound down and those in the eurozone may follow soon.
However, the spate of financial crises globally over the last few decades has illustrated the importance of maintaining financial stability, something which financial globalization has made much more complex. Exchange rates and interest rates are grossly inadequate instruments and too blunt to deal with financial stability concerns as the primary objective.
Some countries in Asia have been among the leaders in the active use of macroprudential policies (MPPs) to correct asset price misalignments and limit systemic risks by moderating the pro-cyclical build-up of vulnerabilities and financial imbalances. The use of these tools has intensified globally since 2009.
MPPs take many forms—price-based instruments such as higher taxes or duties on certain transactions, or quantity-based ones such as debt-to-income limits on mortgages and other bank loans, ceilings on loan-to-value (LTV) ratios, and such. Singapore has been especially aggressive in using housing-related MPPs, especially caps on LTV ratios on home loans, ceilings on total debt service ratios (TSDRs), limits on housing loan tenures, and the taxation on housing transactions (in the form of stamp duties). Property is, after all, the largest component of household wealth and real estate market stability is usually closely linked to overall financial stability. Hong Kong, with its US dollar-based currency board arrangement, has also been proactive in imposing MPPs aimed at the housing sector.
Apart from these two smaller economies, India too has been known to actively use MPPs such as time-varying risk weights and provisioning norms in a counter-cyclical manner to prevent potential build-up of financial vulnerabilities in certain sectors, including housing, commercial real estate and non-banking financial companies (NBFCs). Unlike in Singapore and Hong Kong where MPPs are under the direct jurisdiction of their central banks, India created a Financial Stability and Development Council (FSDC) in 2010 to supervise the use of MPPs. The FSDC is chaired by the finance minister and has members from RBI and other financial sector regulatory bodies.
Despite their growing popularity, given that MPPs are still in their infancy, policymakers have limited guidance on their best practices, leading to a great deal of “trial and error” in their use. Unlike frameworks for interest rate and exchange rate policies which are by now well-established, MPPs remain highly discretionary. Much work remains to be done on fundamental issues such as which instruments are most effective under what circumstances, when and how to exit successfully from these policies, how best to communicate these policies to markets, and how to evaluate and manage any adverse distributional consequences.
An important concern with MPPs is that they are highly susceptible to leakages within the country, which undermine their effectiveness (i.e. risk transfer as opposed to risk mitigation) or cause spillovers across countries, hence impacting the credit cycle in another jurisdiction. For instance, imposition of greater property curbs in China seem to have led Chinese developers to shift their focus to global property markets, including Hong Kong and Singapore, hence creating additional land price pressures in these economies.
Thus, while MPPs are national in nature, given their potential undesirable spillovers effects on other countries, their conduct calls for more coordinated global monetary consultation if not outright coordination. Countries in Asia and elsewhere would benefit from international rules of good conduct with regard to their use while still ensuring sufficient flexibility given differing country contexts.
The G20 Eminent Persons Group on Global Financial Governance chaired by Singapore’s deputy prime minister Tharman Shanmugaratnam—and whose members include Rajan—would be an ideal forum for discussing issues pertaining to spillovers from MPPs as well as related issues and policy trade-offs that affect the highly interconnected but rather ungoverned global financial architecture.
Ramkishen S. Rajan is a professor at the Lee Kuan Yew School of Public Policy, National University of Singapore.
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