The case for macro-prudential measures to limit financial vulnerability

Kristin Forbes, Marcel Fratzscher, and Roland Straub have a new paper where they analyze capital flows management (CFM) measures in 60 countries during the 2009-11 period. They define two types of CFMs - capital controls (or restrictions on cross-border financial activity that discriminate based on residency) and macro-prudential measures (which do not discriminate based on residency but relate to cross-border or foreign currency exposure and lending).

Examining the impact of CFMs on their various targets - limiting exchange rate appreciation, reduce portfolio inflows, reduce inflation, and reduce financial fragility - they find mixed evidence,

The results indicate that certain CFMs can accomplish specific goals—especially in terms of reducing financial vulnerabilities—but most CFMs are ineffective at accomplishing other stated goals. More specifically, macroprudential measures related to international exposures can significantly improve measures linked to financial fragility, such as bank leverage, inflation expectations, bank credit growth, and exposure to portfolio liabilities. Increased controls on capital inflows can reduce private credit growth (although this effect, as well as that for portfolio liabilities, appears to fade and reverse after six months). 

CFMs, however, do not appear to have a significant effect on most other macroeconomic variables and financial market volatilities over the short and medium-term, including on equity indices, inflation, interest-rate differentials, or the volatility of exchange rates, portfolio flows, or interest-rate differentials. CFMs have limited effectiveness achieving two of their primary goals: reducing exchange rate appreciation and net capital inflows. One type of CFM—removing controls on capital outflows—can yield a significant but small depreciation of the real exchange rate (with a maximum depreciation of less than 2.5% over four months relative to the counterfactual). “Major” changes in capital controls which received more attention from investors are more likely to affect portfolio inflows, although major changes in inflow controls can also cause a significant increase in capital flow volatility and translate into no consistent, significant, or economically meaningful impact on the real exchange rate.

More evidence on why authorities in emerging economies should deploy macro-prudential instruments to limit exposure to external borrowings, especially short-term debts to specific sectors like real estate which inflate asset bubbles, and thereby minimize financial vulnerability.

The latest example of the problems arising from free capital inflows is Poland, which had allowed its citizens to take mortgages in foreign currencies. Attracted by the low Swiss interest rates and the apparent resolve of the Swiss central bank (SNB) authorities to prevent the currency's appreciation, many Poles took mortgages in franc, mainly from foreign owned banks, to finance their homes. The Polish Financial Authority estimated that in 2013 franc loans formed a third of all Polish mortgages. These people have been devastated by the SNB's decision last month to abandon the currency floor with euro which resulted in the one-day 23% appreciation of the Swiss franc against the euro.