Tuesday, May 19,  2020 / 3:56 PM  / By Damiano Sandri, IMFBlog / Header Image Credit: Ra2studio/Istock ByGetty Images

TheCOVID-19 pandemic is impacting emerging markets through an unprecedentedcombination of domestic and external shocks. Among the latter, thepandemic has led to a sharp increase in global risk aversion and an abruptretrenchment in foreign capital flows. Based on historical experience, thesetypes of global financial shocks can significantly affect macroeconomicconditions in emerging markets, even if the exchange rate is flexible.

Our research in chapter 3 of the latest World Economic Outlook shows that emerging markets can enhanceresilience to global financial shocks using macroprudential regulation.

Emerging markets canenhance resilience to global financial shocks using macroprudential regulation.

Strengthening resilience withmacroprudential regulation

Macroprudential regulation involves a broad range ofmeasures aimed at buttressing financial stability. These may include capitalrequirements to strengthen bank balance sheets; limits on loan-to-value ratiosto curb risk taking; and restrictions on foreign currency mismatches. In thechapter, we ask whether tighter macroprudential regulation, while strengtheningfinancial stability, can also dampen the impact of global financial shocks oneconomic activity in emerging markets.

Our analysis suggests that it can. If the level ofmacroprudential regulation is low, an increase in global risk aversion (proxiedby the Chicago Board Option Exchange Volatility Index (VIX)) or an outflow offoreign capital considerably reduces economic growth in emerging markets. Forexample, a 60 percent spike in the VIX-about half of what we experienced in thefirst quarter of 2020 as a result of the COVID-19 pandemic-or a capital outflowequal to 2 percent of GDP in a quarter can push a typical emerging market intoa recession.

These negative effects become less pronounced incountries with tighter levels of macroprudential regulation. In fact, if thelevel of regulation is sufficiently stringent, global financial shocks do notseem to have a significant impact on GDP growth in emerging markets.

These dampening effects are symmetric. That is,macroprudential regulation reduces the sensitivity of domestic activity to bothpositive and negative global financial shocks. Therefore, tightermacroprudential regulation prevents sharper economic slowdowns when globalfinancial conditions tighten, but it comes at the cost of foregone economicactivity when global financial conditions are favorable. This calls for moreresearch on how to optimally adjust macroprudential regulation over timedepending on both domestic and foreign developments.

Macroprudentialregulation to support monetary policy

We also examine whether the level of macroprudentialregulation influences the monetary policy response to global financial shocks.In several emerging markets, central banks tend to increase policy rates whenglobal financial conditions tighten, possibly because of financial stabilityconcerns arising from capital outflows and the depreciation of the exchangerate. In these cases, monetary policy appears to react pro-cyclically, likelyexacerbating the impact of global financial shocks on domestic economicactivity.

Our analysis shows that macroprudential regulation canplay an important role in favoring a more countercyclical response of monetarypolicy. If the level of macroprudential regulation is low, we find that centralbanks tend to increase policy rates when US monetary policy tightens or the VIXincreases. On the contrary, if macroprudential regulation is morestringent-thereby alleviating financial stability concerns-monetary policyresponds countercyclically. When US monetary policy tightens and the VIXincreases, central banks tend to reduce policy rates, thus cushioning theimpact on the domestic economy.

Moreanalysis is needed

There are important caveats to the analysis. First,available measures of macroprudential regulation suffer from several drawbacks,for example because they generally fail to capture the intensity of changes inregulation. Therefore, the chapter's empirical findings will need to bere-assessed as more refined measures become available. Second, it will beimportant to test for the robustness of the findings using empiricalspecifications that allow for a richer interplay of macroprudential regulationwith other policy tools, especially capital flow management measures andforeign exchange intervention.

Based onWorld Economic Outlook Chapter 3, Dampening Global Financial Shocks inEmerging Markets: Can Macroprudential Regulation Help? By KatharinaBergant, Francesco Grigoli, Niels-Jakob Hansen, and Damiano Sandri (lead)

Download Here - Chapter 3: Dampening Global Financial Shocks in EmergingMarkets: Can Macroprudential Regulation Help?

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