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5. The Role of Macroprudential Policy for Financial Stability in Asia's Emerging Economies
- Brookings Institution Press
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138 Episodes of financial crises in both advanced and emerging economies over the past decade leave little doubt that the stability of consumer prices does not necessarily ensure financial stability. Although there is no universally accepted definition and operational measure of financial stability, wide swings in asset prices and the boom-bust credit cycles during much of the Great Moderation bear witness that price stability is not a sufficient condition for financial stability anywhere—in either advanced or emerging economies. Asia is no exception. As shown in the appendix, prices of stocks and housing display wide swings, whereas consumer prices have remained relatively stable. These divergent movements cast doubt on the presumption that price stability ensures stability of financial markets and institutions. In the run-up to the 1997–98 Asian financial crisis, the boom in real estate markets in many emerging economies in the region—a boom fueled in part by capital inflows—piled up financial imbalances that were manifested in soaring asset prices, a large increase in leverage in financial institutions and corporations, deterioration of the currency, and maturity mismatches in the balance sheets of both banks and other financial institutions. The cumulative effects of these imbalances eventually touched off a financial meltdown. In the aftermath of the crisis, Asian economies—in particular those hit by the crisis—made concerted efforts to improve the efficiency and stability of their The Role of Macroprudential Policy for Financial Stability in Asia’s Emerging Economies yung chul park 5 The author is grateful to Giovanni Dell’Ariccia, Eswar Prasad, Ilhyock Shim, Hyun Song Shin, and Philip Turner for their comments on drafts of this chapter. 12689-06_CH05-rev.qxd 10/5/11 12:27 PM Page 138 macroprudential policy in asia’s emerging economies 139 financial systems. Both banks and nonbank financial institutions strengthened risk management, improved governance, and fortified themselves with equity capital more than that required by the Bank for International Settlements (BIS). On the macroeconomic policy front, these countries embraced more flexibility in managing the exchange rate system. To complement these reforms they also amassed large foreign exchange reserves for insurance against future crises. Yet ten years after recovering from the 1997–98 crisis—that is, in 2009—some of these countries again fell victim to a global economic crisis. As it turned out, they were as vulnerable to reserve currency liquidity shortages as they had been in 1997. When foreign lenders and investors liquidated their investments in domestic financial assets or refused to renew their loans to Asian banks in the second half of 2008, countries like Republic of Korea and Singapore had to seek a currency swap line with the U.S. Federal Reserve to avoid a liquidity crisis. Most Asian emerging economies are yet to develop policy instruments effective in sustaining financial stability. In countries adopting inflation targeting, the main tool of monetary policy—the policy rate—has been tied up in anchoring expectations about the future rate of inflation. Fiscal policy, on the other hand, is mostly reserved for countercyclical aggregate demand management. In realization of the limited scope of monetary and fiscal policy for securing financial stability, the BIS advocates macroprudential policy—a recalibration of microprudential regulations for macroeconomic purposes—as a means of safeguarding the economy against the accumulation of financial imbalances. The purpose of this chapter is to analyze—in the context of the Asian economy—the role and scope of macroprudential policy in controlling financial institutions’ management of their assets and liabilities in a manner that will prevent market failures. For this purpose, the chapter identifies two major sources of financial instability that plague many of Asia’s emerging economies: speculation and the boom-bust cycle in the housing market. These and balance-sheet mismatches were at the top of the list of the financial frailties of Asia’s emerging economies at the time of the 1997–98 financial crisis. Financial Instability in a Low-Inflation Environment: Systemic Risk and Macroprudential Policy Before a series of financial crises wreaked havoc on a number of emerging economies in Asia and other parts of the world in the late 1990s and early 2000s, the dominant view had been that financial stability, however defined, was predicated on price stability.1 When examining the history of financial instability in the 1. According to Schwartz (1995), one of the major causes of financial instability is fluctuations in the inflation rate, which tend to amplify the uncertainty in estimating the potential real returns on investments; most...