Central Banking and

Financial Crises:
An Asian Perspective
Masahiro Kawai
University of Tokyo
2014 ADBI-Keio Executive Training in
Macroeconomics
Keio University
Tokyo, 5 November 2014
The views expressed in this presentation are the views of the author and do not necessarily reflect the views or
policies of the Asian Development Bank Institute (ADBI), the Asian Development Bank (ADB), its Board of
Directors, or the governments they represent. ADBI does not guarantee the accuracy of the data included in this
paper and accepts no responsibility for any consequences of their use. Terminology used may not necessarily be
consistent with ADB official terms.

Outline
1. Introduction: Central banking
2. Evolving scope of central bank
mandates
3. Central bank independence and
policy coordination with government
4. Spillovers of US monetary policy
changes
5. Conclusion
2

1. Introduction: Central banking

The period of great moderation affirmed the
conventional wisdom that the technical
problems of monetary policy had largely been
resolved in an elegantly simple fashion
Focus on price stability: Inflation targeting
was considered the appropriate policy
framework, and the short-term interest rate
was the appropriate policy instrument
A central bank should be independent to
avoid high (not to mention hyper) inflation
In a world of floating exchange rates, monetary
policy spillover effects were considered absent
3

The GFC and EZFC rudely shattered

this conventional view
Financial crises erupted following "great moderation":
Should central banks have paid more attention to
financial stability issues?
The crises required near-zero interest rate policies,
including unconventional monetary policies when
policy rates hit (near-)zero (Japan, US)
Have central bank mandates been expanded to
achieve high employment and growth?
Have central banks lost their independence during
and in the aftermath of financial crises?
US monetary policy changes are affecting many
emerging economies: Can emerging economy central
banks retain their monetary policy independence?
4

2. Evolving scope of
central bank mandates
Should a central bank have dual mandates of
maintaining price stability (or low inflation)
and maintaining maximum employment, like
the US Fed?
Should a central bank have dual mandates of
financial stability in addition to price stability,
like the BOE?
To what extent can and should a central
bank continue to purchase sovereign debt
when the magnitudes of both fiscal deficits
and sovereign debt are large, like the BOJ?
5

Some evidence in favor of a mandate for

output or employment in addition to inflation
The Taylor-rule monetary policy framework
includes both inflation and output gaps
The US Fed eased monetary policy aggressively
during the GFC, while the ECB moved slowly due
to its sole focus on inflation
Some degree of flexibility on the inflation target,
both in terms of range and time frame, introduces
scope for focusing on output as well
Focus on inflation worked well when the main
objective was to reduce inflation, but not so well in
a deflationary or "lowflation" environment
6

Balancing the dual objectives of price

stability and financial stability
Key lesson: Financial instability often occurs in an
environment of price stability (i.e., the Minsky Moment)
As long as the central bank defines price stability from a
medium-term perspective and adopts a forward-looking
approach, it can take financial imbalances into account
without any conflict of objectives
Possible short-term conflicts in the event of signs of
asset price bubbles in a low inflation environment: The
central bank needs two tools to achieve two objectives
The GFC has decisively shifted the debate in favor of
leaning rather than cleaning
Rapid cleaning (quick resolution of bank NPLs in postcrisis periods) remains important to avoid Japanization
7

Real GDP following financial crises

since 1990
Real GDP measured in constant local currency values
Japan
4,500

Italy

Finland
26,000

32,500

United States

Sweden
45,000

375
350

30,000

24,000

4,000

40,000

325

27,500
3,500

25,000

22,000

300

3,000

22,500

20,000

275

35,000

20,000

250

2,500

17,500

225

15,000

2,000
1980 1985 1990 1995 2000 2005 2010

200

16,000
1980 1985 1990 1995 2000 2005 2010

1980 1985 1990 1995 2000 2005 2010

90,000

11,000

80,000

10,000

70,000

25,000
1980 1985 1990 1995 2000 2005 2010

Malaysia

Thailand

Indonesia
12,000

9,000

30,000

18,000

1980 1985 1990 1995 2000 2005 2010

Republic of Korea

Argentina

30,000

25,000

25,000

20,000

20,000

15,000

9,000

15,000

10,000

8,000

10,000

5,000

12,000
11,000
10,000

60,000

8,000
50,000
7,000
40,000

6,000
5,000

30,000

4,000

20,000

3,000

7,000
6,000

5,000

10,000
1980 1985 1990 1995 2000 2005 2010

1980 1985 1990 1995 2000 2005 2010

5,000

1980 1985 1990 1995 2000 2005 2010

1980 1985 1990 1995 2000 2005 2010

1980 1985 1990 1995 2000 2005 2010

Note: 1000 yen for Japan; 1000 won for Korea; and 1000 rupiah for Indonesia .
Source: Kawai and Morgan (2014), Banking Crisis and Japanization: Origin and Implications.
in PIIE volume.

Financial stability objective difficult to

monitor and implement

In pursuing price stability, a central bank can

rely on:

A relatively clear and precise definition of its objective

A body of theory and empirical evidence relating to (a)
the determinants of inflation rates and (b) the
relationship between the policy instrument(s) and the
ultimate objective
Relatively comprehensive data on the variables
relevant for carrying out the mandate

It is difficult to monitor and implement financial

stability (real estate price, credit growth, capital
inflows), but this does not reduce its importance
9

A central bank needs to be in charge of

financial stability
A financial crisis significantly affects central bank
policies
A countrys central bank tends to be best suited to
conduct macroeconomic-financial surveillance, with a
broad view of economy and financial system
It has oversight of payments & settlement infrastructure
Even basic monetary policy tools can affect financial
stability

Crisis prevention: interest rates, credit growth

Crisis management: liquidity provision/lender of last resort
(LOLR) function, and unconventional monetary policy

Some central banks have additional crisis prevention

powers

Bank supervision
Macroprudential policy tools (debt to income ratio, LTV ratio, etc)
Measures to affect capital flows for emerging economies
10

Macroprudential policy measures

Cap on loan to value (LTV)
ratio
Loan to deposit ratio
requirement
Increase in reserve
requirements
Direct controls on lending
to specific sectors
Countercyclical capital
requirements
Countercyclical
provisioning
Liquidity requirements
Caps on foreign or
domestic currency lending

PRC; Hong Kong, China; Indonesia,

India; Malaysia; Philippines;
Taipei,China; Thailand; Turkey
PRC, Republic of Korea
Argentina, Brazil, Indonesia, India,
Malaysia, Peru, Turkey
Republic of Korea, Malaysia,
Philippines, Singapore
Brazil, PRC, South Africa
PRC, India
PRC, India, Korea, Philippines,
Singapore
Indonesia, Poland, Viet Nam

Source: Committee on the Global Financial System (2010), Chua, Endut, Khadri and Sim (2013)

Recent developments in central bank

mandates
Bank of England
Responsible for financial stability as well as price stability
In charge of macroprudential policy
Supervisory responsibility for banking sector

Bank of Japan
Adopted official CPI inflation target of 2%
Power to examine banks on-site, but no macroprudential policy tools

European Central Bank

Established a Single Supervisory Mechanism for major banks
ECB President chairing the European Systemic Risk Board

US Federal Reserve
Responsible for supervision of systemically important financial
institutions, but without the formal mandate of financial stability
Identification of financial stability risks
12

Examples of financial stability architecture

Country
Australia

Coordinating
entity

Entities included

Chair

Sub-entities

Macro-prudential
instruments
designated

Council of Financial RBA, APRA, ASIC, RBA

Regulators
Treasury
European Systemic European System President of ECB
Risk Board
of Central Banks, (General Board)
national financial
supervisory
authorities, ECB,
EC, three ESAs
and EFC

None
Steering Committee
(14 members of
General Board)

Yes

Financial Stability
and Development
Council
Financial System
Stability Forum

MoF, RBI, SEBI,

IRDA

Finance Minister

Subcommittee
(chaired by RBI)

No

MoF, BI, IDIC

Finance Minister

No

Japan

Informal meeting

MOF, BOJ, FSA

Bank of Japan

Steering Committee
(7 members of
Executive Board)
None

Republic of
Korea
UK

Informal meeting

MSF, BoK, FSS

Finance Minister

None

EU

India

Indonesia

US

Bank of England, BOE, Financial

N/A
None
MOU between PRA Conduct Authority
and FCA
Financial Stability Treasury, Fed, SEC,Treasury Secretary None
Oversight Council CFTC, OCC, FHFA,
NCUA, FDIC

Source: Authors compilation

?
?
Yes

Yes

13

3. Central bank independence and

policy coordination with government
We needed central bank independence when
containing high inflation was a key policy priority
Do we still need it at the time of financial crises, or
deflation or "lowflation"?
Do central bank purchases of government bonds on
a sustained basis (as in the case of the BOJ)
undermine central bank independence, particularly
when levels of fiscal deficits and sovereign debt are
large?
Does the kind of central bank-government joint
statement made in Japan undermine central bank
independence?

14

Need to distinguish between goal

independence and target independence
It is perfectly reasonable for government to
determine the central banks mandate,
including a specific inflation target (Australia,
NZ, BOE)
The central bank has independence in
choosing policy instruments, and the
government should not change the target
arbitrarily
If a central bank fails to meet the target, it
needs to explain clearly reasons for failure in
the congress/parliament (accountability)
15

Coordination between the central bank

and government
Macroeconomic management requires coordinated
monetary and fiscal policies

In recession times, fiscal austerity can put greater burden on

monetary policy (ECB, US Fed)
In boom times, lack of fiscal contraction requires greater
monetary policy tightening

Financial stability requires close coordination

Crisis prevention requires coordination between monetary and

macroprudential policies
Crisis resolution involves significant fiscal resources

Structural rigidities (such as those in labor markets)

call for greater roles of monetary policy in recession
A sharp rise of government debt after the GFC
highlighted the interdependence of fiscal, monetary
and financial (banking) policies

16

Key aspects of Abenomics

Government-BOJ policy coordination
Supporting structural reforms by expansionary
monetary and fiscal policies
Monetary policy
Achieving 2% CPI inflation at the earliest possible time
Doubling of monetary base by end-2014

Flexible fiscal policy

Fiscal stimulus to offset negative impacts of cons. tax hike
Establish a sustainable fiscal framework with a view to
ensuring the credibility of fiscal management

Supply side structural reforms

Greater labor market flexibility, deregulation (health, agri. etc)
Promoting energy security
Expansion of trade and FDI through EPAs

Creating 2% inflation can raise Japan's potential

GDP by re-invigorating animal spirits

17

Japan's nominal and real GDP

550

(2005=100)

(trillion yen)
500

120

115

Nominal GDP

Real GDP

450

110

400

105

350

100

GDP Deflator
300

95

250

90

200

85
1980

1985

1990

Nominal GDP (left-axis)

1995

2000

Real GDP (left-axis)

2005

2010

GDP price deflator (right-axis)

Note: Real GDP is at constant 2005 prices. Data for 2013 are based on IMF projections.
Source: Cabinet Office, Government of Japan; IMF, World Economic Outlook database

18

Japanese economy getting out of deflation

2.5
2

(%; year-over-year)

1.5
1
0.5
0
-0.5
-1
-1.5
-2

200501
200504
200507
200510
200601
200604
200607
200610
200701
200704
200707
200710
200801
200804
200807
200810
200901
200904
200907
200910
201001
201004
201007
201010
201101
201104
201107
201110
201201
201204
201207
201210
201301
201304
201307
201310
201401

-2.5

Headline

Core

Core-Core

Note: Core excludes fresh food; Core-core excludes food (less alcoholic beverages) and energy
Source: Statistics Japan, website.

Avoiding deficit financing

The central bank needs to avoid direct financing
of the government deficit over a sustained period

It carries substantial risks, and may be difficult to unwind

It damages credibility of low inflation when inflation rises
and containing inflation becomes an issue

The BOJ's QE is different from deficit financing

BOJ happens to purchase government bonds as they

are the largest and most liquid financial instruments for
conducting monetary policy easing
Governor Kuroda warns government to seriously
consolidate the budget through consumption tax rate
hikes
Otherwise long-term interest rates can shoot up and
make the BOJ's monetary policy easing difficult
20

4. Spillovers of US monetary
policy changes
The US Fed's launch of QE prompted emerging
economies' criticism that it was a launch of
currency wars which would lead to currency
depreciations worldwide
The QE policy likely affected global growth
(positively), commodity prices, capital flows to
emerging economies, and their currency values
The indication of QE tapering signaled by
Bernanke in May 2013 caused financial market
volatility globally, inviting another criticism from
emerging economies
21

Launch of QE by the US Fed

Was the launch of QE the same as the launch of a
currency war?

Simply easing monetary policy, even if it takes place as QE,

cannot be equated with a currency war, though it may lead to
currency depreciation as a consequence
Key question is whether or not a central bank embarking on
monetary policy easing directly intervenes in forex markets to
purchase foreign assets

Policy spillovers were both positive and negative

US QE likely had positive growth impacts

US QE1, but not QE2/QE3, most likely had significant spillover
effects on global commodity markets, emerging economies
When setting monetary policies, advanced economy central
banks must pay attention to spillovers, as foreign central bank
reactions may come back to them
IMF and regional institutions (like AMRO in Asia) need to
monitor and analyze spillover effects
22

Simulated output impact of US QE

Source: IMF, IMF Multilateral Policy Issues Report: 2013 Spillover Report, August 2013

US Fed QE and capital inflows to

emerging economies

PRC

PRC

Source: IMF, World Economic Outlook, October 2014

How should EMEs respond to advanced

economy ultra-easy monetary policies?
Maintain macroeconomic stability by:

allowing a certain degree of currency appreciation if there

is an inflationary concern; or
intervening in the forex market to keep the exchange rate
stable when domestic inflation is not a significant concern

Monitor financial sector soundness given possible

large-scale capital inflows from developed
economies

Use macroprudential policy measures, including capital

inflow control (which is now supported by the IMF)

Prepare for possible capital outflows in the future as

they can create currency crises

Build up foreign exchange reserves

Strengthen global and regional financial safety nets

25

Exchange rates of Japan and other

Northeast Asian economies (2010=100)
120

Real Effective Exchange Rate

110
100
90
80

200801
200804
200807
200810
200901
200904
200907
200910
201001
201004
201007
201010
201101
201104
201107
201110
201201
201204
201207
201210
201301
201304
201307
201310
201401
201404

70

Japan

PRC
China

Taipei,
Taiwan

Korea

China

Note: Real exchange rate is based on CPI indexes

Source: BIS database

26

Impacts of the end of US QE

Former Fed Chairman Bernanke signaled the
beginning of QE tapering in May 2013, which
generated financial volatility in emerging
economies, such as currency depreciation and
stock price declines
The end of QE is based on the Feds assessment
that the US economy is on solid recovery, so it
should be good news
But the end of QE and the eventual interest rate
hike with a lack of consistent communication with
the market could adversely affect emerging
economies, particularly the fragile five

Output impact of US monetary policy

normalization
A

A: Smooth normalization
B: With term-premium
shocks
C: Without higher growth
Source: IMF, IMF Multilateral Policy Issues
Report: 2013 Spillover Report, August 2013

The Fragile 5 have experienced large

nominal currency depreciations

Note: The "fragile 5" refer to Brazil, India, Indonesia, South Africa, and Turkey.
Source: IMF, World Economic Outlook, April 2014

Emerging economy exchange rate changes

affected by the current account & inflation
Explanatory variables

Eq. 1

Eq. 2

Constant

-2.859
(2.329)
0.589**
(0.193)
-0.084
(0.050)
---

0.066
(2.322)
0.507**
(0.181)
-0.059
(0.045)
-0.859**
(0.350)
22
0.430

Current account balance/GDP

Gross public debt/GDP
Inflation rate
Number of observations
Adjusted R-squared

22
0.263

Note: Exchange rate changes are the rates of change in nominal exchange rates
against the US dollar between 22 May and 29 August 2013, with positive values
indicating appreciation. Eq.1 uses 2012 data for the explanatory variables, while
Eq. 2 uses 2013 projections for the explanatory variables. Projections are from
IMF, WEO database.
Source: Kawai, M. (2013), International Spillovers of Monetary Policy: US Fed
Policy and Abenomics. Unpublished manuscript

30

Market-based expectations of future

US policy interest rates

Source: IMF, World Economic Outlook,

October 2014

Source: IMF, Global Financial Stability Report, October 2014

Fears of a 1997-like crisis unwarranted but

countries with weaker fundamentals vulnerable
Select Vulnerability Indicators (1996/97 vs. latest available data)
Fiscal Balance Current Account
(% GDP)
(% GDP)

China, Peoples Rep. of

Hong Kong, China
India
Indonesia
Korea, Rep. of
Malaysia
Philippines
Singapore
Taipei,China
Thailand
Viet Nam

1996

2013

1996

2013

-0.7
2.1
-5.6
1.2
2.4
2.0
0.5
8.5
-7.2
2.7
NA

-0.9
0.8
-7.2
-2.1
0.7
-4.6
-0.1
5.7
-3.1
-0.2
-5.6

0.8
-2.5
-1.2
-3.2
-3.9
-4.4
-4.3
14.4
3.8
-8.1
-8.2

1.9
1.9
-1.7
-3.3
6.1
3.9
3.5
18.3
11.7
-0.6
5.6

Short-Term
External Debt /
Reserves
Jun-97 Latesta 1997Q2 2013Q1

Import cover
(months)

10.6
4.0
0.6
5.7
2.6
4.0
3.5
7.4
9.3
5.4

23.1
7.1
6.9
6.0
8.0
7.9
14.7
8.7
18.4
7.7
2.7

28.8
280.6

191.0
232.0
69.2
105.5
245.4
26.6
157.7
53.3

16.7
85.2
53.6
59.8
48.2
26.6
21.4
81.8
12.9
19.1
51.1

Note: aRefers to Nov 2013 except for Viet Nam (May); PRC (Sep) ; Korea (Dec); Philippines (Oct)
Source: ADB, Asian Development Outlook, October 2013; IMF, WEO database, October 2014
32

Turkey and South Africa more

vulnerable to capital account shocks
once US Fed raises policy rates

Source: IMF, Global Financial Stability Report, April 2014

Lessons for emerging economies

(1) Reduce macroeconomic & financial imbalances
Avoid large current account deficits through macroeconomic
& structural policies (supply capacity through FDI, etc)
Limit short-term capital inflows and finance current account
deficits by long-term capital such as FDI
Choose an appropriate policy mix (monetary and exchange
rate policy, MPP and CFM), by taking into account the costs
and benefits of the relevant measures
(2) Deepen financial markets to enhance resilience to
future crises
(3) Strengthen crisis management & resolution capacity
(4) Coordinated policy action needed to minimize
negative spillovers of US monetary policy tightening to
emerging economies

What global policy coordination?

The US Fed as the most influential global central bank
Ideally, the Fed should design monetary policy from global
perspectives (by taking into account its policy impact on the
rest of the world and repercussions from it), not simply from
domestic perspectives
But, this is politically difficult and not its mandate
Coordinated policy action
The Fed may end QE and eventually raise the policy rate by
taking a gradual, step-by-step approach, clarifying the pace
and timeframe of policy tightening through the G20 dialogue
process, and intensively communicating with markets
Vulnerable emerging economies need to pursue structural
reforms to augment the supply side of the economy
The Fed may forge bilateral currency swaps with potentially
vulnerable emerging economies, thereby strengthening global
financial safety nets (complemented by IMF, CMIM, etc)

5. Conclusions
The GFC and the EZFC have challenged
conventional wisdom regarding the effectiveness of
monetary policy, central bank mandates, central
bank independence and spillover effects
Central bank mandates need to be extended
beyond price stability (inflation targeting)

Some evidence in favor of targeting employment or real

output in a low-growth, low-inflation environment
Promoting financial stability critical, despite the technical
difficulties involved in doing so
Strong case for coordination with fiscal policy and
macroprudential policy, or among the central bank, finance
ministry, and financial supervisor/regulators, or for having
the central bank responsible for financial stability
36

Conclusion (cont`d)
Central bank independence is not necessarily
compromised by coordination with government,
especially in a crisis period or when inflation is
undesirably low; but direct, outright deficit
financing may damage central bank credibility in
the future
Major developed economy central banks need to
be concerned about spillover effects of their policy
changes

US monetary policy reversal potentially a risk for

emerging economies which can have feedback spillovers
Emerging economies need to strengthen macroeconomic
& financial-sector management to mitigate the effects of
capital flow and exchange rate volatility
IMF and regional institutions (like AMRO in Asia) can
monitor spillovers and analyze their implications
Strengthen financial safety nets (currency swaps, CMIM)

37

Thank you
For more information:
Dr. Masahiro Kawai
Project Professor
Graduate School of Public Policy
University of Tokyo
mkawai@pp.u-tokyo.ac.jp
+81 3 5841 7641