Do emerging market prudential policies lessen the spillover effects of US monetary policy?

Andra Coman and Simon Lloyd

Prudential policies have grown in popularity as a tool for addressing financial stability risks since the 2007-09 global financial crisis. Yet their effects are still debated, with sanguine and more pessimistic viewpoints. In a recent Bank of England Staff Working Paper, we assess the extent to which emerging market (EM) prudential policies can partially insulate their domestic economies against the spillovers from US monetary policy. Using a database of prudential policies implemented by EMs since 2000, our estimates indicate that each additional prudential policy tightening can dampen the decline in total credit following a US monetary policy tightening by around 20%. This suggests that domestic prudential policies allow EMs to insulate themselves somewhat from global shocks.

Reflecting the ‘global financial cycle’, financial conditions in EMs tend to be particularly sensitive to US monetary policy and advanced economy financial markets more generally. Even policymakers in advanced economies have recently become more concerned about potential ‘spillbacks’ from EMs. Higher US interest rates tend to be associated with lower lending in EMs, creating challenges for policymakers in EMs, who have to balance internal objectives against external positions. This raises questions around the appropriate mix of policy tools—including prudential policies and capital flow measures—that policymakers can draw upon. Our research speaks directly to this, assessing the role of EM prudential policies in the face of spillovers from US monetary policy.

Prudential policies in the face of foreign shocks

Over the last two decades, a variety of prudential policies have been pursued in EMs. Banks have been asked to hold additional capital against specific exposures. Limits have been placed on loan-to-value ratios for mortgage lending. Financial institutions have increased their reserves, in domestic and foreign currency, in order to fulfil liabilities. Although many of these policies are likely to have direct effects on the lending decisions of the financial sector within a country, they may also have altered how banks and, as a result, EM macroeconomic outcomes respond to foreign shocks and associated capital flows. For instance, a bank holding more reserves or issuing mortgage loans with lower loan-to-value (LTV) ratios may be better placed to handle a downturn in house prices due to higher global interest rates and, in turn, may reduce its lending to domestic households by less than a bank with fewer reserves or higher LTV ratio loans.

Can EM prudential policies lessen US monetary policy spillovers?

Using data on the prudential policy actions of the 29 EMs between 2000 and 2017, we estimate how the spillovers from tighter US monetary policy vary with an EM’s prudential policy setting. Our empirical setup controls for a range of other factors that could influence the magnitude of spillovers from US monetary policy—including the degree of capital flow restrictiveness.

Before assessing the interaction between US monetary policy and EM prudential policy, we first document that tighter US monetary policy is associated with tighter financial conditions in EMs. The black line in Figure 1 demonstrates this, plotting the average response of EM total credit following an illustrative +1pp tightening of US monetary policy over a two-year period. Following the change, the average fall in total credit for EMs is around 7% after 12 to 18 months, substantially larger than the average response of total credit in advanced economies (red line).

Figure 1: US monetary policy spillovers to total credit for emerging markets and advanced economies

Note: Black line denotes the average spillover from a 1pp US monetary policy tightening to an emerging market (EM). The grey shaded area around it denotes the 90% confidence interval. The solid red line plots the average spillover from a 1pp US monetary policy tightening to other advanced economies (AE). The red dashed lines denote the 90% confidence band. Data spans 29 EMs and 34 AEs (excl. US) from 2000:Q1-2018:Q2. See Staff Working Paper for more details.

Turning to the interactions, we use information on a range of prudential policy instruments to assess the role of the overall prudential policy setting. We cumulate prudential policy actions over a two-year period, prior to a change in US monetary policy. The prudential policy variable therefore takes positive and discrete values if, on net, prudential policy was tightened over a given two-year period. As a result,our empirical model can tell us whether tighter prudential policy, activated in advance of the US monetary policy tightening, can reduce the spillovers to total credit.

The results are shown in Figure 2, where the blue line plots the average spillover of a +1pp US monetary policy tightening to a country with no prudential policy actions in place and the green line documents the spillover for an illustrative country that tighten prudential policy in the two years before a US monetary policy tightening. While the average decline in total credit is around 7% for an EM with no prudential policy actions, the spillover to a country with a single prudential policy tightening is around 5.6% after 18-months. This implies that each additional prudential policy tightening can reduce the spillover to EM total credit by 1.4pp, equivalent to 20% of the 7% average decline for a country with no prudential policy actions in place.

Figure 2: US monetary policy spillovers to total credit for different levels of aggregate prudential policy in recipient EMs

Note: Blue line denotes the average spillovers from a 1pp US monetary policy tightening shock to an EM with no prudential policy actions in place. The green line denotes the comparable spillover estimate for an EM with one prudential policy tightening action in place. See Staff Working Paper for more details.

Importantly, our findings control for both the level of a country’s capital flow restrictiveness, and its interaction with spillovers from monetary policy. This implies that the, predominantly domestically-focused, prudential policies in our analysis can provide some offset to the spillovers from US monetary policy independently from controls on cross-border capital flows.

Which policies most strongly interact with US monetary policy spillovers?

In addition to summarising the overall setting of prudential policy in an EM, the dataset provides granular detail on five categories of prudential policies: (i) LTV ratio limits, (ii) reserve requirements, (iii) capital buffers, (iv) interbank exposure limits, and (v) concentration ratio limits. Using this categorisation, we assess the interaction of US monetary policy with specific EM prudential policies, asking which are most effective.

Within our framework we find that LTV ratio limits and reserve requirements significantly interact with US monetary policy spillovers to EMs, suggesting that these policies act to dampen global cyclical fluctuations associated with US monetary policy. We do not find evidence of a significant interaction for capital requirements, interbank exposure limits and concentration ratio caps — the latter two of which were used to a limited extent by EMs in our sample.

These findings chime with a widely cited distinction of prudential policy instruments based on their ability to influence cyclical variations versus increase financial system resilience. Although the mapping from specific instruments to these two classifications is not direct, some have suggested that LTV ratio limits and reserve requirements typically fall into the former category—dampening the cycle—while the latter three are more often linked to financial system resilience. Our results provide support for this distinction, suggesting that policies that dampen the cycle are also more effective at offsetting foreign shocks.

Conclusions

Overall, our results indicate that EMs with more developed prudential policy frameworks do appear to be better equipped to deal with moves in US interest rates, even when accounting for other policies available to them (such as restrictions on capital flows). EMs with tighter prudential policies tend to face smaller reductions in lending to households following an increase in US interest rates. Although the effects of prudential policies in EMs are more wide ranging than our study captures, our results identify an important channel of their effectiveness, namely their ability to help lessen the spillover effects of foreign shocks.

Simon Lloyd works in the Bank’s Global Analysis Division. This post was written whilst Andra Coman was working in the Bank’s Global Analysis Division.

If you want to get in touch, please email us at bankunderground@bankofengland.co.uk or leave a comment below.

Comments will only appear once approved by a moderator, and are only published where a full name is supplied. Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed here are those of the authors, and are not necessarily those of the Bank of England, or its policy committees.

One thought on “Do emerging market prudential policies lessen the spillover effects of US monetary policy?

  1. “domestic prudential policies allow EMs to insulate themselves somewhat from global shocks.”
    How surprising, that’s what my parents always opined about their own domestic economy

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