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It’s been a tough few months for emerging-market currencies. The top slider, India’s rupee, has fallen 20 percent against the US dollar. The Indonesian rupiah and the Brazilian real have fallen about 15 percent; Turkey’s lira is down about 10. As the currencies fall, so do the countries’ international reserves, creating what’s known in non-technical terms as a really bad situation.

Part of the reason for these declines is the anticipated tapering off of the US Fed’s monetary stimulus. The stimulus policy created extremely low international interest rates and huge amounts of liquidity that encouraged vast inflows of capital to emerging markets. But since the Fed signaled in May that the stimulus may be coming to an end as the US economy continues to recover, net capital inflows to emerging markets have decreased significantly. That is a serious concern to emerging-markets policymakers. The results in the past of similar developments have been severe banking problems, deep credit crunches, and damaging recessions.

Countries can help smooth the boom-and-bust cycle, and avoid the worst of its consequences, with smart counter-cyclical macroprudential regulations to complement healthy monetary and fiscal policies In that regard, a few middle-sized Latin American countries are showing the way. As my co-authors (Arturo Galindo and Marielle del Valle) and I note in CGD Working Paper 319, Bolivia, Colombia, and Peru, were in the 2000s among the world leaders who established countercyclical loan-loss provisioning requirements for banks to build up loan-loss provisions during the expansionary phase of the credit cycle to provide a cushion during economic downturn. Ecuador has recently adopted this measure.

Not all Latin America countries are leaders in macroprudential regulation. In CGD Working Paper 318, my co-authors (Alejandro Izquierdo and Rudy Loo-Kung) and I explore the potential benefits of implementing counter-cyclical macroprudential regulations, Andean-style, in Central America countries. There’s more on both papers, and their lessons for emerging markets around the globe, below.  

What Is Macroprudential Regulation?

One of the most important lessons from the global financial crisis of 2008-09 was that the existing framework for financial regulation was (to say the least) inadequate and ineffective. The crisis made it clear that focusing on indicators of the financial strength of individual financial institution (a micro approach) is insufficient to prevent the build-up of excessive risk affecting the financial system as a whole, which in turn results in severe systemic banking crises, credit crunches, and contractions in economic growth.

While a number of proposals are being advanced to limit systemic financial risk, consensus is rapidly moving toward a macroprudential approach to financial regulation. This view understands aggregate risk to depend on the collective actions of financial institutions. A popular conceptualization of the approach defines systemic risk as having two components: a cross-sectional dimension and a time dimension.

The cross-sectional dimension recognizes that interconnectedness of the activities of financial institutions results in common risk exposures faced by these institutions. The time-dimension emphasizes that aggregate risk varies over time: it builds-up in good times and materializes in bad times. Therefore, a main recommendation to avoid financial crises is to smooth the pro-cyclical behavior of credit through the implementation of measures that directly affect the behavior of credit; that is: contain excessive risk-taking in the overall financial system in good times while avoiding sharp contractions in the provision of credit in bad times.

The list of counter-cyclical macroprudential financial regulations is long and includes counter-cyclical capital requirements, counter-cyclical loan-loss provisions, liquidity  requirements, and maximum loan-to-value ratios, among others. Specific recommendations for two of these macroprudential tools (counter-cyclical capital requirements and liquidity requirements) have been advanced by the Basel Committee on Banking Supervision in their Basel III regulatory framework.

Lessons from Latin America

As noted above, a few medium-sized Latin American countries, those in the Andean region, stand out for their comprehensive implementation of these regulatory tools. In CGD Working Paper 319 (“Macroprudential Regulation in Andean Countries”), my co-authors and I evaluate advances in implementing macroprudential regulations in Andean countries and how some of these regulations compare to Basel III recommendations. Again, we find that Bolivia, Colombia, and Peru are leaders in establishing dynamic provisioning requirements to cushion economic downturns.

Without a dynamic provisioning system, loan-loss provisions are a function of nonperforming loans. During the expansionary phase of the cycle, credit growth accelerates and debtors can easily serve their debt, which translates in low nonperforming loans and, therefore, low provisions. Low provisioning in turn reduces banks’ risk aversion, fueling credit growth even further. Conversely, during downturns, increased risk aversion translates into credit contractions, higher nonperforming loans, and consequently greater provisioning efforts which feed credit contraction. Dynamic provisioning breaks this cycle by requiring the countercyclical accumulations of provisions during credit expansions that can be used later during downturns. (See figure 1.)

Figure 1: The Role of Dynamic Provisioning

Another example of implementation of macroprudential regulations in Andean countries is the Peruvian authorities’ adaptation of the Basel III recommendation for a countercyclical capital buffer to their country’s particular characteristics. This capital requirement consists of an additional capital buffer that rises during periods of aggregate credit growth and falls in downturns. The proposal in Basel III defines the credit-to-GDP ratio as the reference indicator to activate the buffer buildup. Peruvian authorities, however, have set their indicator against the behavior of GDP growth. That choice is justified because Peru has very low levels of financial intermediations—a situation very different from that in advanced economies.

It is too early to determine whether these measures have been effective in reducing the volatility of credit cycles in Andean countries and in reducing the probability of a credit crunch.  However, if the recent reversal of capital inflows to Latin America were to exacerbate sharply, we might soon evidence a test to the efficacy of this type of counter-cyclical regulations. A positive verdict might encourage other emerging markets to follow this path.

As I mentioned above, not all Latin American countries are as far along as the Andeans in implementing macroprudential regulations.  Indeed, Central American countries are among those that lag significantly in this area. In the CGD Working Paper 318 (“Macroprudential Regulations in Central America”) my co-authors and I explore the potential benefits of implementing macroprudential regulations in Central American countries. The case for conducting this analysis rests on two observations. The first is that the duration of all the phases of a credit boom (from the start to the end, passing by the peak and trough) are longer (in number of quarters) in Central American countries (CAC) than in Latin America as a whole (LAC) and other emerging market regions (Asia and Emerging Europe) (see figure 2). The second is that the downturns of the credit cycles in Central America are associated with significantly lower economic growth than in the rest of Latin America.

Figure 2: Average Duration of a Credit Cycle

We conducted simulation exercises for several Central American countries that suggest that macroprudential regulations have the potential to contribute to financial stability. For example, simulating the implementation of Peruvian and Bolivian dynamic provisioning rules to El Salvador indicates that if either of these rules had been in place before the global financial crisis, Salvadorian banks would have accumulated more provisions during the pre-Lehman period (see figures 3 and 4). These reserves could have been used in the midst of the financial crisis to support credit. This would have, in turn, reduced the severity of the recession.

Lessons for Other Countries

The need for macroprudential regulation in developing countries is increasing. Data show that credit booms (and busts) are larger in emerging market economies than in industrial countries. Even though not every credit boom is associated with financial crises, most of these crises in emerging markets have been preceded by credit booms (Mendoza and Terrones, 2008). Moreover, output losses and credit crunches are more severe after lending booms that end up in crisis, and these costs are larger in developing countries (Calderon and Fuentes, 2010). In her paper at the 2013 Jackson Hole symposium, Helene Rey also joined the list of academicians supporting implementation of macroprudential regulations as a tool to deal with global financial cycles.

While I am well aware of all the limitations imposed by statistical simulations, the exercises explained above regarding Central America lend support to the recent literature favoring similar macroprudential regulatory tools in emerging markets in general. It needs to be emphasized, however, that macroprudential regulations cannot and should not be taken as a panacea to solve financial instability problems in emerging markets. Nevertheless, when complemented with adequate fiscal and monetary/exchange-rate policies as well as a strong financial supervisory framework, these regulatory measures has the potential to significantly increase the resilience of emerging markets’ financial systems to external shocks. Some of the countries most affected  by the recent reversal of capital inflows have been shy in the adoption of key counter-cyclical macroprudential regulations, limiting their macroprudential regulatory toolkit to caps on loan-to-value ratios, controlling banks’ open foreign currency exposures and, especially, introducing discretionary changes in reserve requirements (Brazil, India, Indonesia, and Turkey).  For example, only now the Central Bank of India is in the process of implementing dynamic provisioning. While a good long-term move, the policy decision might prove to be too late to face current turbulences.

Disclaimer

CGD blog posts reflect the views of the authors drawing on prior research and experience in their areas of expertise. CGD does not take institutional positions.