IMF says macroprudential regulations and rule-based fiscal stimulus can help global economy

Emerging markets economies can become more resilient to global financial shocks through macroprudential regulation that will also help them deal with economic shocks like the coronavirus pandemic, according to the International Monetary Fund.

The Covid-19 outbreak, which battered the global economy and upended trade, has hit emerging markets hard through an unprecedented combination of domestic and external shocks, Damiano Sandri, a deputy division chief at the IMF Research Department, wrote in a blogpost on Tuesday.

The pandemic has led to a sharp increase in global risk aversion to the emerging market economies and an abrupt retrenchment in foreign capital flows that have dented macroeconomic conditions even with flexible exchange rate in some markets. Portfolio capital flows to emerging markets securities have declined significantly in February. Non-resident portfolio outflows in March surpassed anything seen previously, including during the global financial crisis in 2008, according to the Institute of International Finance.

“Macroprudential regulation involves a broad range of measures aimed at buttressing financial stability,” Mr Sandri said. “These may include capital requirements to strengthen bank balance sheets; limits on loan-to-value ratios to curb risk taking and restrictions on foreign currency mismatches.”

Macroprudential regulations aim to mitigate risk to the entire financial system. The approach, used by the central bank and financial regulators around the globe, looks to avoid and reduce the macroeconomic costs of financial instability.

Negative effects arising from economic shocks become less pronounced in countries with tighter levels of macroprudential regulation, Mr Sandri noted. If the level of regulation is sufficiently stringent, global financial shocks do not seem to have a significant impact on gross domestic product growth in emerging markets, he said citing IMF analysis.

These dampening effects, however, are symmetric as they reduce the sensitivity of domestic activity to both positive and negative global financial shocks, he noted.

“This calls for more research on how to optimally adjust macroprudential regulation over time depending on both domestic and foreign developments.”

The global economy is set to slide into the deepest recession since the Great Depression of the 1930s. Last month, the IMF projected the global output could shrink 3 per cent this year and the outlook of the economy is worse than 2008 financial crisis. The Washington-based lender expects recovery to start only in 2021.

In response, governments and central banks all over the world have introduced strong discretionary - one-off and specific - fiscal and monetary measures to counteract the economic fallout from the pandemic on their economies. An estimated $8 trillion (Dh29.4tn) has so far been poured into the global economy to help protect businesses and stem job losses.

Policymakers, however, have little room for more discretionary monetary policy action with debt levels reaching historic highs and interest rate dripping. But advanced economies could counter the shock through “rules-based fiscal stimulus” — where the stimulus is automatically triggered by deteriorating macroeconomic indicators — which can be highly effective in countering a downturn.

“With interest rates at or near zero in advanced economies, the scope for further conventional rate cuts is limited,” John Bluedorn, a deputy division chief on the World Economic Outlook and Wenjie Chen, an economist at IMF’s African department, said in a joint blogpost.

“But central banks may still use unconventional monetary policy tools more intensively — like large-scale asset purchases — to deliver additional support, as they have [done] recently in response to the pandemic,” they noted.

Relying on monetary policy alone to respond to shocks might not be enough, and it also raises questions about side effects on future financial stability and threats to central bank independence, they said.

Rules-based fiscal stimulus measures — such as temporary targeted cash transfers to liquidity-constrained, low-income households amid rising unemployment — could be highly effective in countering a downturn caused by a typical demand shortfall, the two executives said, citing an IMF study.

“Our analysis shows that adopting rules-based fiscal stimulus measures can be highly effective and more timely, particularly when central bank interest rates are close to or at their effective lower bound and monetary policy is constrained.”