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CGD’s work in this area focuses on strengthening financial systems in development countries through innovation and regulation.
Greater access for the poor to the formal financial system—including payments, savings, credit, and insurance—can greatly improve household stability and development prospects. CGD examines how to strengthen, broaden, and deepen financial systems in developing countries through innovation and regulation. We also study the effects of financial crises, to avoid and mitigate future shocks, and how developing countries can improve their business climates to spur inward investment.
The first thing we should be asking is why now in particular, since conditions have not really changed much in the past few months. For example, back in September, there were large uncertainties in the global economy. China’s economic slowdown was causing alarm. Volatility in international capital markets was high. The appreciation of the US dollar was hurting US exports, which could (yet) mean slower US economic growth. That was not the time for the US Federal Reserve to up interest rates. But now it is – and here’s why.
In an essay in November's LatinFinance magazine (subscription required), CGD Senior Fellow Liliana Rojas-Suarez questions how appropriate prudential financial regulation can be designed in Latin America to contain the risks from high external capital volatility. Her answer is that it can be done, but not with the current regulatory approach, which largely consists of efforts to directly control financial aggregates such as liquidity expansion and credit growth. Rojas-Suarez recommends an alternative "pricing-risks-right" approach that, she argues, can go a long way in limiting the adverse impact of high capital flow volatility on local financial markets.
According to Rojas-Suarez, traditional prudential regulatory policies cannot effectively contain the problems associated with capital flow volatility because they do not take adequate consideration of the particular risk features of financial sectors in Latin America. The reliance on capital adequacy rations, therefore, has not been effective. A better approach would be to create incentives for financial institutions in Latin America to "price right" the risks inherent to their assets. Such an approach might go a long way to mitigate the adverse effects from capital account volatility.
There are particular features that distinguish Latin America's financial markets, such as shallow financial intermediation with very small capital markets, the predominance of assets and liabilities with short maturity, and high volatility in key financial variables, including the deposit base. Rojas-Suarez argues these features reflect depositors' lack of confidence in domestic financial systems, which, in turn, makes these systems highly vulnerable to capital flow volatility.
A Two-Tiered Approach
For the least financially developed group of countries, where no capital standard works because basic conditions are not in place, the challenge is to identify and develop indicators of banking problems that reveal the true riskiness of banks. Countries such as Ecuador, Colombia, Venezuela and Nicaragua could benefit from an approach that encouraged the public offering of uninsured certificates of deposit, and that published inter-bank bid-and-offer rates to improve the flow of information of bank quality. Additionally, these countries should encourage the process of financial internationalization; market depth can only be achieved if a diverse group of investors and users of capital allow the market to become less concentrated.
For the second group of relatively more financially developed countries (such as Chile, and to a lesser extent, Brazil, Uruguay, Jamaica, Peru, Panama, and Trinidad and Tobago) the main recommendation is to design a capital standard that appropriately reflects the risk of banks' assets. There are two important policy recommendations for this group of countries. First, governments should adequately assess the risk features of their own liabilities when calculating capital requirements. Second, countries should develop risk-based regulations in loan-loss provisioning.
Last week the Latin American Shadow Financial Regulatory Committee (CLAAF), chaired by CGD senior fellow Liliana Rojas-Suarez, considered the impact of the European debt crisis on Latin America. The committee, which includes former top finance officials from the region, then released a statement concerning Latin America's outlook in light of the emerging crisis, emphasizing the region's challenges and opportunities and offering concrete policy recommendations. Rojas-Suarez explains:
Q: What's the biggest financial challenge facing the region today?
A: Large capital inflows, resulting from both external and internal factors. On the external side, the sluggish U.S. economy and the need for public and private liquidity support in Europe are pressing central banks to keep policy interest rates low. But in Latin America, the prospects for growth are quite positive, forecasted at 4 percent for 2010. The region's central banks are therefore increasing interest rates to keep inflation in check. All of this is attracting international investors to the region, who find the risk-return profile to be quite attractive. For the first time since I can remember, country-risk spreads of a number of Latin American countries are below those of a number of developed countries. Since I don't expect any significant policy change soon, I believe that the region will face this challenge at least in the short and medium terms.
Q: This seems like a good problem to have!
A: It's certainly better than capital flight! But large capital inflows are risky if they are not managed well. Two major challenges stand out: First and foremost, they significantly complicate monetary policy for central banks. They might cause local currencies to appreciate excessively, which could be destabilizing, especially if the inflows are temporary and subject to reversal should conditions change. Central banks have been dealing with this through sterilized intervention in foreign exchange markets, which basically means purchasing foreign currency (to contain the appreciation of the local currency) and then issuing bonds to prevent an expansion of monetary aggregates and, therefore, inflation. The problem, however, is that sterilized intervention increases interest rates, which in turn attract capital inflows even further.
Second, most Latin American countries have a number of economic distortions and fiscal budgetary processes that are not as efficient as they could be, leading to some wasteful investments. If funds are inappropriately allocated and the capital inflows suddenly reverse, then Latin American governments, financial institutions, and corporations might find themselves facing severe difficulties serving debt obligations.
Q: You have written that Latin America's financial sector is among the most open in the developing world, so committee members must have a lot of experience dealing with this type of challenge. What does the committee recommend policymakers in the region do now?
A: Latin America needs to carefully monitor the degree of debt in the private and public sectors and implement policies to contain an excessive expansion of banking credit. I should note upfront, though, that the region is in a much better position to deal with the challenges now than in previous episodes of large capital inflows. Strong fiscal positions, low debt-to-GDP ratios, and increased flexibility in managing exchange rates create the foundation for financial stability even with highly volatile international capital markets. Most importantly, central banks have accumulated large foreign exchange reserves. Therefore, this time around the Committee believes that the region is more likely now to deal successfully with large capital inflows than before, when major macroeconomic and financial vulnerabilities led to severe crisis when the inflows suddenly stopped.
Some of the most important recommendations are to (a) implement (or increase when the policy exists) liquidity requirements on domestic and foreign short-term banking-sector liabilities; (b) adopt counter-cyclical loan-loss provisions, which basically means banks setting aside resources in good times to deal with bad loans in difficult times; and (c) adopt multi-period, cyclically adjusted budgetary frameworks to ensure that governments save part of the increased fiscal revenues during expansionary periods. Some countries have begun taking on such changes, but there's a way to go still.
Q: How will we know if the region is managing this challenge well? What warning signs will you be watching for to see if problems are emerging?
A: Bad signs would be exploding levels of credit extended by local financial systems and accelerated increases in other assets, including housing prices. I'd also be worried about decreasing ratios of banks' provisioning to total loans and about increasing debt-to-GDP ratios in both the public and private sectors Basically, if any of the conditions that I mentioned before are not met, then that will be cause for concern.
Q: Is the prospect of prolonged large capital inflows a unique phenomenon in Latin America?
A: No, they're also in Asia. Both regions weathered the storm of the 2008–09 financial crisis and recovered much more quickly than other developing regions and many advanced economies. And both are now faced with the mixed blessing of large capital inflows. The issue now is how they will respond to the new challenge. I believe that both regions will be successful. However, I also believe that Asia is more likely than Latin America to implement capital controls to contain inflows. I think that Latin America will make more use of macro-prudential regulations as a mechanism to limit the impact of capital inflows in the local financial systems.
Q: The committee focused on the implications of the debt crisis in Europe. Does this mean you are confident that the recovery in the United States will be sustained?
A: "Confidence" is a tricky word under current circumstances. I give a relative high probability that the United States will maintain a slow and fragile recovery for a prolonged period of time. However, I cannot discard the risk of a double dip recession. A number of events can lead to this. If, for example, intensified problems in Europe lead global demand to decrease significantly or if international financial turbulence aggravates drastically, remaining vulnerabilities in the United States might renew the deterioration in consumers and investors' perceptions about the economy. Under those conditions, recessionary pressures in the United States are a clear risk.
Q: Your scenario also assumed that Europe would manage the current crisis without allowing a financial collapse: no country defaults and no Lehman-style collapse of a major financial institution. Are you confident of that?
A: I think so, but as I mentioned earlier, I prefer to speak of probabilities. I give a larger probability to having no major financial crash associated with events in Europe. My reasoning is twofold: First, and most important, I perceive a strong commitment by the European Central Bank, European governments, and multilateral organizations to prevent a collapse. The €700 billion package arranged by the IMF and EU in April to help contain the crisis is evidence of this commitment. Second, recent fears have been based on emerging problems in the financial system in Spain (a much larger system than Greece!), which derives a significant proportion of revenues from investment in Latin America. Those investments are very profitable, so in sharp contrast with the past, Latin America is now a source of support for the global financial system. Amazing, right?
Q: This year the committee is observing its 10th anniversary, and you have been the committee chair throughout. During this period the committee has issued 22 statements on financial challenges and opportunities for the region. What have you learned?
A: First, Latin America is capable of breaking its reputation of a crisis-prone region. Second, there is a long way to go. Ten years ago, Latin America was in overcoming the exchange rate crisis in Brazil and about to enter the Argentinean crisis of 2001. By 2002, no analyst could have predicted that Latin America could stand strong and resilient through something as major as the 2008–09 global financial crisis. While the region has met with flying colors some of the most pressing difficulties, the remaining challenges are many and hard to deal with. The bottom line, however, is that the resilience of the region during the ongoing global turbulence is giving Latin America a renewed sense of hope.