Dampening global financial shocks: can macroprudential regulation help (more than capital controls)?

Summary

Focus

Fluctuations in global financial markets can severely destabilise emerging market economies (EMEs). The academic and policy debate on enhancing their resilience has focused on the role of capital controls and foreign exchange intervention because these tools directly target international financial transactions. In this paper, we provide a different perspective by asking whether EMEs might also rely on macroprudential regulation to protect themselves against global financial shocks.

Contribution

To tackle this question, we assemble a rich data set for 38 EMEs between 2000 and 2019. The econometric analysis examines whether a more stringent level of macroprudential regulation reduces the effects of global financial shocks on EMEs' economic activity. We also investigate whether stricter macroprudential regulation allows for a more countercyclical monetary policy response in EMEs vis-à-vis global financial shocks. Finally, we compare the results with those associated with the use of capital controls.

Findings

We find that macroprudential regulation can significantly enhance the resilience of economic activity in EMEs to global financial shocks. A broad set of macroprudential tools contributes to this result, including measures targeting bank capital and liquidity, foreign currency mismatches and risky credit. We also find that macroprudential regulation enhances monetary independence by allowing for a more countercyclical response to global financial shocks. The strength of these results is remarkable since we do not find evidence that capital controls provide similar benefits. Hence, macroprudential regulation emerges as a key instrument for bolstering the resilience of EMEs against the ebb and flows of the global financial cycle.

Abstract

We show that macroprudential regulation significantly dampens the impact of global financial shocks on emerging markets. Specifically, a tighter level of regulation reduces the sensitivity of GDP growth to capital flow shocks and movements in the VIX. A broad set of macroprudential tools contributes to this result, including measures targeting bank capital and liquidity, foreign currency mismatches, and risky credit. We also find that tighter macroprudential regulation allows monetary policy to respond more countercyclically to global financial shocks. This could be an important channel through which macroprudential regulation enhances macroeconomic stability. We do not find evidence that capital controls provide similar benefits.

JEL classification: F3, F4, E5

Keywords: macroprudential regulation, monetary policy, capital controls