The Wisdom of Crisis Prevention
Regardless of how differently governments may formulate policy, ensuring financial stability is their common responsibility. This calls for real and effective policy coordination and an overarching macro-prudential governance framework at both the domestic and international levels.
The simple truth is that the cost of preventing financial crises is much lower than the costs imposed by them after they erupt. After all, financial crises are directly linked to significant output declines and unemployment spikes; and, equally important, they often severely damage social cohesion.
Five years from its outbreak, the fallout from the financial crisis and recession triggered by the collapse of the US investment bank Lehman Brothers continues. In many advanced economies, real GDP remains lower than its pre-crisis level. Unemployment rates and budget deficits are higher, and public debt/GDP ratios are at record levels.
Macro-prudential policies are not a substitute for sound macroeconomic policies; nonetheless, they are essential to preventing large asset bubbles and distortions in financial markets, and thus to reducing the risk of adverse shocks to both markets and the real economy.
For example, Turkey’s 2001 financial crisis stemmed mainly from the lack of an effective regulatory and supervisory framework for the banking sector. The crisis led to a 30-percentage-point jump in the public-debt ratio. Real GDP contracted by 5.7%, and unemployment rose by 4.9 percentage points.
Since then, Turkey has focused on financial stability and structural reforms, which have strengthened economic performance and made the country more resilient to shocks. Indeed, Turkey did not have to spend a penny of taxpayers’ money on bank recapitalization or rehabilitation during the global financial crisis. But the cost of bank bailouts during Turkey’s self-inflicted crisis 12 years ago amounted to approximately 25% of GDP.
Thanks to Turkey’s strong fundamentals and macro-prudential framework in 2008, the global financial crisis has left no lasting impact on the Turkish economy. Recovery was rapid and strong, with real GDP growth averaging nearly 9% in 2010-2011. Turkey’s unemployment rate is currently at its lowest point in a decade, and the public-debt ratio is significantly below the pre-crisis level.
Turkey’s experience suggests that the design of a macro-prudential framework should take into account both domestic and international financial linkages. The international framework should, above all, capture the risks and spillover effects arising from systemically important financial institutions. The development and implementation of the Basel III banking standards are essential to introducing countercyclical capital buffers and additional loss absorbency for these institutions.
In terms of domestic measures, a country’s institutional architecture is a core element in ensuring financial stability and effective policy coordination and cooperation. Turkey has established a Financial Stability Committee to oversee effective and timely implementation of policies directly affecting the financial sector, and an Economy Coordination Board to monitor and evaluate issues concerning overall economic stability. Both bodies have served to enhance the operational design and implementation of macro-prudential policies.
For example, the inflation-targeting regime implemented by the Central Bank of Turkey has been revised to incorporate financial stability, and a new monetary-policy framework has been in effect since the end of 2010. Monetary policy is now drawing on a more comprehensive toolkit, such as the policy rate, the interest-rate corridor, required-reserve ratios, and the reserve-option mechanism.
Turkey’s Banking Regulation and Supervision Agency and other authorities have also adopted macro-prudential measures. In 2011, for example, the BRSA adopted a loan-to-value regulation on mortgages in order to limit rapid credit expansion stemming from growth in consumer loans. Earlier, in 2009, the BRSA adopted another important measure that barred households from borrowing in foreign currency, thus sparing them the effects of exchange-rate volatility.
Regarding the banking sector, stress tests have been applied since 2004, and a target capital-adequacy ratio of 12% has been maintained since 2006. Even during the crisis, banks’ capital-adequacy ratios were higher than the Basel II requirement of 8%, and their distribution of profits has been under the BRSA’s close supervision since 2008. As a result, ample reserve funds have been created on the banks’ balance sheets and return on equity has remained high.
Turkey has also amended its tax laws to penalize excessive external borrowing by non-financial firms and to introduce significant incentives aimed at encouraging long-term household savings.
Yet, despite these measures, the situation remains worrying. With the outbreak of the global crisis, major advanced economies employed unconventional monetary policies, leading to massive capital flows to emerging-market economies, which lowered borrowing costs and increased access to credit. While emerging-market countries’ public-sector balance sheets are stronger than ever – with low deficits and debt accompanied by large foreign-currency reserves – household and corporate leverage have risen. This has increased the vulnerability of many emerging markets to a sharp reversal in capital flows.
This is particularly true of emerging countries that, like Turkey, have been running large current-account deficits. With Turkey’s external deficit equivalent to 6% of GDP, the authorities have adopted a macro-prudential framework that combines policies to reduce exchange-rate volatility in the very short term with measures to increase domestic savings and promote the real sector’s international competitiveness in the long run. It is a model that other emerging economies should consider as well.
Copyright: Project Syndicate/Global Economic Symposium, 2013.