Macroprudential Instruments and Monetary Policy: The Brazilian Experience

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1 Macroprudential Instruments and Monetary Policy: The Brazilian Experience Arnildo Correa Research Department VIII Meeting of Central Bank Monetary Policy Managers Lima Peru, June 2012

2 The views presented here are those of the author and do not necessarily reflect the position of the Central Bank of Brazil.

3 Outline I. Policy Strategy Before the Financial Crisis II. Lessons from the Financial Crisis III. Brazilian Experience with Macroprudential Policies IV. Conclusions

4 Inflation Targeting Before the Crisis Orthogonality between monetary and financial policy The modeling framework in central banks and part of academia did not incorporate financial frictions as source of propagation and amplification of business cycles. The main goal of monetary policy was to minimize inflation and output gap volatility. Prudential regulation and supervision was designed to prevent financial instability. It was focused on the soundness of individual financial institutions (microprudential) and no on the interaction between financial and macroeconomic stability Propensity to the clean after view Authorities should not respond to possible asset price bubbles, but react after the bubble burst to stabilize both output and inflation.

5 Lessons from the Crisis Financial disruptions can have greater impact on the business cycle than initially thought Real GDP in the US declined -1.3% in 2008:4, -5.4% in 2009:1 and -6.4% in 2009:2 (annual rate) The economic costs in the aftermath of the crisis is very high Huge losses of aggregate output and sharp increase in unemployment Financial crisis is followed by very slow growth, undermining potential output in the long-run Important deterioration in governments budgets Inflation under control and output stability are not enough to ensure financial stability

6 Rethinking the Framework The lessons from the crisis do not invalidate the benefits of following an inflation targeting regime. But we can also benefit from some rethinking. Recognize that market failures are important and, consequently, there is a case for MaP s: conventional monetary policy and flexible exchange rates alone cannot deal with these failures Strengthening prudential regulation and financial infrastructure Credit Market: Countercyclical capital requirements; reserve requirements; dynamic loan loss provisions Measures to constrain capital flows; interventions

7 Brazilian Experience with MaP

8 Central Bank of Brazil Main Activities Differently from many countries, the BCB has both mandates: monetary policy, financial regulation and financial supervision. This fact is evidence of a clear understanding that they are not orthogonal. The wide scope of Central Bank s authority helps to minimize problems related to policy coordination Monetary Policy Financial Regulation Financial Supervision

9 Brazilian Policy Response MP (Selic rate) to reduce inflationary pressures Conventional monetary policy was applied Complemented by fiscal policy tightening MaP to reduce excessive financial risks Calibrate consumer credit growth Monitor household indebtedness Reducing excessive bank and firms exposures in FX

10 Macroprudential instruments Brazil has recently resorted to some macroprudential tools to achieve financial stability and reduce macroeconomic uncertainty. Reserve requirements Capital requirements (above Basel recommendations) FX interventions Measures to reduce excessive capital inflows (e.g. tax on financial operations IOF)

11 MaP in Brazil: Two Examples Two different periods in which MaP s were used: MaP measures to face the crisis MaP measures taken during the period

12 Measures to Face the Crisis

13 Crisis: Context 1) shortfall of credit in Brazil: Credit supply collapses worldwide an important fraction of credit supply came from foreign sources; 2) interbank market stagnation caused mismatches on transactions among banks; 3) large and unexpected depreciation of the Real; 4) derivatives exposure of non-financial firms deteriorated credit conditions.

14 Crisis: Consequences credit supply collapses worldwide 1) broad credit crunch in Reais; 2) strong credit restriction to exporters; 3) reduction in economic activity in credit sensitive sectors; 4) some enterprises under severe financial stress 5) top Brazilian banks dealing with firms with significant derivatives exposure. The Central Bank acted to reduce the damages

15 MaP Measures: Liquidity Injection Significant reduction in reserve requirement: R$ 99.8 billion Liquidity to smaller institutions: R$ 42.2 billion BCB authorized deposit insurance up to R$ 20 million for small institutions; privately funded Credit lines through public sector financial institutions (BNDES, BB and CEF) for trade, energy & infrastructure sectors; and temporary permission for them to expand their portfolio

16 MaP Measures: FX Management Shortage in spot markets BCB sold US$ 14.5 bi spot auctions Lack of external funding, particularly for exporters; shortage in credit markets BCB lent US$ 24.5 bi repo auctions Shortage in future markets BCB sold forward US$ 33.0 bi swap auctions

17 Monetary Policy Monetary policy easing: Selic rate was reduced 5p.p. (from 13,75% to 8,75%)

18 The Policies Effects More moderate than in most countries Main effect: liquidity shortage Medium and small banks were the most affected Central Bank acted promptly to restore liquidity No bankruptcies of financial institutions No need for government bailout Important: These effects reflect the whole body of policies (monetary, fiscal and macroprudential). Not only macroprudential policies.

19 Reserve Requirements 36% Overall Taxa de effective Recolhimento rate compulsório (% of deposits) total 33% 30% 27% 24% 21% 18% 15% 12% jan/02 mai/02 set/02 jan/03 mai/03 set/03 jan/04 mai/04 set/04 jan/05 mai/05 set/05 jan/06 mai/06 set/06 jan/07 mai/07 set/07 jan/08 mai/08 set/08 jan/09 mai/09 set/09 jan/10 mai/10 set/10 jan/11 mai/11 set/11

20 Exchange Rate RR$/US$ st Measure. March, th Measure October 4, Jan 08 Apr 08 Jul 08 Oct 08 2 nd Measure October, 2010 Jan 09 Apr 09 Jul 09 Oct 09 Jan 10 4 th Measure 18 October, 2010 Apr 10 Jul 10 Oct 10

21 GDP Real Growth

22 Consumer Price Index (IPCA)

23 Opposite Direction: Period

24 New Challenges Brazil reversed most of previous anti-cyclical measures, including: Replenishment of reserve requirements Reversal of actions in foreign exchange market But the moment presented new challenges Strong recovery and high level of domestic demand: potential source of inflationary pressures High and increasing capital inflows: strong exchange rate appreciation Fast credit growth Trade-off: strong currency helps to keep inflation in check, but it may hurt the competitiveness of the Brazilian exports of manufactured goods BCB addressed these risks using macroprudential measures together with a new tightening cycle.

25 MaP Measures From February 2010 to March 2011 Brazil adopted many macroprudential measures: Measures to moderate credit growth Increase of reserve requirements over demand and time deposits Increase of capital requirements on new consumer credit operations (particularly, personal credit, payroll-deducted loans and vehicle financing, involving longer maturities or high loan-to-value ratios) Measures to deal with exchange rate appreciation Increase in taxes (IOF) on purchases with credit card abroad Increase in IOF for short run external loans Increase in IOF on fixed income inflows BCB began to increase the Selic rate in April 2010

26 Isolating the Effects of MaPs

27 Effects of MaP Effects on credit growth: Hard to measure: Identification is difficult because usually MaP measures are implemented together with MP measures Takeda and Dawid (2009) estimate the effects of reserve requirements reduction during the crisis using a dif-and-dif estimation in panel Identification strategy: Because RR structure is progressive, large (and public) banks were more affected by the measures than small banks They estimate: t is time and i is bank TimeTreat is a dummy variable with value 1 along the period Apr2009-Jun2009 Monthly data: from Mar 2008 to Feb 2011 Sample: 10 large banks and 121 small banks

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29 Effects of MaP (cont ed) Effects of MaP implemented during the period Takeda and Dawid (2010) also estimate significant effects of reserve requirements changes on new loans during the period using GMM estimation Tovar, Garcia-Escribano and Martin (2012) show that these MaP instruments have moderate and transitory effects and play complementary role to monetary policy. Effects in terms of monetary policy: In a survey conducted among market analysts, the BCB asked about their estimates of the impact of the macroprudencial policy implemented during in terms of policy (Selic) rate: the median response suggests that the impact was equivalent to an increase in the Selic rate of 0.75p.p.

30 Effects of MaP (cont ed) Effects on the exchange rate: Stone, Walker and Yasui (2009) tried to measure the effects of FX interventions made during the crisis on the exchange rate using the following equation: is the log change in the spot exchange rate BRL/US$

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32 Concluding Remarks Regulation and governance are essential to support macroprudential policies and prevent crises. Adequate macro-financial-prudential policies in Emerging Economies can reduce risks and instability and may help macroeconomic policy to achieve macro stability. Brazilian experience shows that macroprudential measures can help as auxiliary/complementary tools to monetary policy. Only MP easing during the would not be enough to reduce, for instance: risks taken by firms in FX problems of liquidity in the interbank market, etc Interactions between monetary and macroprudencial policies are important and additional studies are needed to better understand their effects.