Tag: Bank of Canada

Limiting the Effects of the Global Financial Cycle

Falling interest rates imposed on the Australian economy by the RBA have, so far at least, not been successful in driving the desired economic outcomes. Inflation is very low, alongside wage growth, household debt is sky-high, the dollar remains high, business investment is subdued, yet asset prices are inflated. Why might this be?

The phenomenon of national boom and bust cycles within countries is well known. The boom phase is associated with rising asset prices, easier access to finance, loose risk settings, and increased leverage. This may last for many years. But at some time, the worm will turn, leading to changed risk perceptions, a fall (often sudden) in asset prices and deleverage.

KeysHowever, recent analysis has shown than national financial cycles are partly subsumed by global financial cycles. These cycles are driven by the policy settings of large countries, like the USA and China, in the context of global financial markets. We see the longer for lower interest rate settings leading to global players searching for yield. As a result, the price of risk  falls. These forces collide with the local economies. So will central banks in smaller, open economies be able to make local monetary adjustments successfully when monetary policy transmission mechanism is affected by global risk factors and that these factors may move in the opposite direction to conventional monetary policy moves?

A timely Bank of Canada working paper “The Global Financial Cycle, Monetary Policies and Macroprudential Regulations in Small, Open Economies“, looks at this issue and draws some important conclusions.

Specifically, for small open economies, like Canada, and Australia, while there are large costs associated with financial crises, they suggest that the central banks’ leaning against the effects of the global financial cycle would typically be too costly. Central banks cannot rely on a combination of conventional and unconventional monetary policies alone to offset the effects of financial crises. Some form of micro- and macroprudential policies are also required to lower both the likelihood and severity of a crisis.

Here is their non-technical summary:

This paper offers an overview of the implications of the global financial cycle for conventional and unconventional monetary policies and macroprudential policy in small, open economies (SOEs) such as Canada. We start by reviewing the recent evidence on financial cycles. An important new finding is that national financial cycles may have been partly subsumed into a global financial cycle. The global financial cycle is driven, in part, by monetary policy decisions in the United States. Low-for-long U.S. policy rates cause global financial intermediaries to search for yield, which in turn leads to a decline in the cross-section of international risk premia. Risk premia form an important part of conventional and unconventional monetary policy transmission mechanisms in both large and small economies.

Next, we review the available policy actions that could be undertaken by SOE central banks and regulatory authorities to limit the effects of the global financial cycle. We show that conventional monetary policy actions in both large and small economies are affected by movements in global risk premia. The paper also examines the effectiveness of unconventional monetary policies originating in SOEs that are not coordinated with those in large countries.

If unconventional policies undertaken during financial crises are not completely effective in restoring output or inflation to their target levels, the question then arises as to whether central banks can use more aggressive conventional monetary actions to lean against the buildup of debt associated with the boom phase of the global financial cycle. We highlight new work that evaluates the potential for central banks to lean against the winds of the global financial cycle. This new work shows that the cost of leaning is quite high relative to the benefits of lowering the likelihood of either entering a house price correction episode or of triggering a new financial crisis.

We then assess to what extent macroprudential policy tools could be an alternative to curb increased risk-taking behaviour during the boom phase of the cycle. In large economies, a number of macroprudential policies are designed to break the chain that links asset allocation decisions by financial intermediaries with the resultant declines in risk premia. Such policies are likely to be less effective in SOEs, as global premia will likely not change in the face of portfolio switches by small institutions or by a relatively small number of households. At the end of the paper, we use our framework to provide suggestions for macroprudential policy reforms to improve the effectiveness of the current toolkit in SOEs.

They conclude:

New research illustrates the importance of accounting for the impact of the global financial cycle on both conventional and unconventional monetary policies as well as on macroprudential policies in small, open economies. The global financial cycle, driven in part by U.S. monetary policy decisions, affects the asset and liability allocation decisions of financial intermediaries and investors worldwide. Changes in these allocations cause time variation in global risk premia, which affects the domestic monetary policy transmission mechanism in SOEs. It also affects the conduct of macroprudential policies.

While the global financial cycle complicates the implementation of conventional and unconventional monetary policies, it does not imply that these policies are ineffective. The research does point out that the monetary policy transmission mechanism is affected by global risk factors and that these factors may move in the opposite direction to conventional monetary policy moves. This suggests that monetary policy may have to be more aggressive in the future, given the future lower level of the neutral rate. Unconventional policies may become much more conventional.
The buildup of debt during the boom phase of the global financial cycle raises the likelihood of a subsequent financial crisis. New research shows that the central banks can lean against the growth of the debt stock by keeping policy rates higher than warranted by current conditions. This is effective in lowering the likelihood of either a large house price correction or of a financial crisis over the long run. However, these effects are not large enough to overcome the negative consequences for borrowers who face a higher cost of debt. Thus the basic message of Svensson remains: In general, monetary policy should clean, not lean.

However, the costs of risk-taking behaviour induced by accommodative monetary policy should not be discussed in isolation from its benefits. The easing of monetary policy was needed to foster macroeconomic stability prior to and during the crisis, and premature removal of monetary stimulus to alleviate risk-taking behaviour could fall short of having a significant impact on the financial imbalance, hinder the recovery that it helped generate, or, under low capital or liquidity levels, even lead to a credit crunch. In addition, low interest rates may have direct positive effects on financial stability. For example, higher profit margins and lower delinquency and default rates may decrease risk aversion and raise prices of legacy assets or collateral assets, leading to healthier balance sheet.

Thus, central banks cannot rely on a combination of conventional and unconventional monetary policies alone to offset the effects of financial crises. Clearly, some form of micro- and macroprudential policies are also required to lower both the likelihood and severity of a crisis. The research surrounding the global financial cycle suggests that macroprudential policies in SOEs need to be coordinated carefully across borders and within the country itself. While capital controls may potentially diminish the impact of global financial cycles, the additional cost that they impose is likely too large. Discussions on potential use of capital controls should also be mindful of the limited evidence of their effectiveness, the absence of adequate cost-benefit analysis in the literature, their potential spillovers (i.e., the potential to divert capital flows to other countries), as well as the limited data available to assess their impact on developed-country capital markets.

Note: Bank of Canada staff working papers provide a forum for staff to publish work-in-progress research independently from the Bank’s Governing Council. This research may support or challenge prevailing policy orthodoxy. Therefore, the views expressed in this paper are solely those of the authors and may differ from official Bank of Canada views. No responsibility for them should be attributed to the Bank.

 

FinTech and the financial ecosystem – evolution or revolution?

Separating hype from reality was the theme of Ms Carolyn Wilkins, Senior Deputy Governor of the Bank of Canada, speech, in which she argues FinTech, has created a lot of excitement, but also quite a lot of hype, depending on your perspective. Google searches for “finTech” have increased by more than 30 times in the past six years. FinTech has also attracted real money: over the same period, around 100 fintech start-ups in Canada have raised more than $1 billion in funding. At a global level, almost $20 billion was poured into fintech last year alone. She says now is the time for financial institutions, new entrants and policy-makers to work together. The opportunity cost of sitting back and waiting for the dust to settle is too great.

Financial institutions and infrastructure operators are making important strategic decisions about which parts of their businesses they want to defend and grow and which ones they want to scale back. This urgency is not only coming from fintech contenders. Banks are also dealing with a more demanding regulatory environment and exceptionally low interest rates around the world that are squeezing profit margins. Banks already spend close to $200 billion a year on IT globally, so replacing legacy systems will mean difficult and critical investment decisions.

For the Bank of Canada, our priority is to see upgrades made to the core payment systems that the financial system relies on and that the Bank oversees: the Large Value Transfer System (LVTS) and the Automated Clearing Settlement System (ACSS). These systems have served us well, but both require investments that are needed to fully meet our oversight requirements. Investment will also help the systems better meet the modern needs of participants and their customers.

Take the ACSS, for example, which still handles most retail transactions today. It was implemented over 30 years ago, when everyone wanted a Commodore 64. The ACSS may have been at the forefront in 1984, but we are far from the efficient frontier now. Cheques take up to four days to clear, and some information needs to be re-entered manually.

Now is the time to make our core systems more efficient and competitive. For consumers and business users, we need to move closer to real-time access to funds. In both the ACSS and LVTS, we need to collect richer data on transactions and, ideally, make them interoperable to avoid having to manually re-enter information. This effort is not change for change’s sake. If we can leverage some of the existing infrastructure and still achieve our goals, that is all the better.

For our part, policy-makers and regulators need to address innovation in financial services in a few proactive ways.

The first is to develop a solid analytical framework to understand and assess the benefits and challenges of something so new. This is something the Financial Stability Board is working on. Authorities will make their assessments through many lenses, including consumer protection, financial inclusion, market integrity, competition policy and financial stability. That is why other international groups such as the Committee on Payments and Market Infrastructures, the Basel Committee on Banking Supervision, and the International Organization of Securities Commissions are also involved. The Bank of Canada, together with our domestic colleagues, is actively contributing to these efforts. Since fintech is a global phenomenon, it is critical that this regulatory effort be global. We must also learn from emerging-market economies that are further along in some areas.

While fintech innovations promise to solve some current problems, they could also create new ones. Let me give you an example: I worry that network effects, which underpin the success of many payment applications, could lead to an excessive concentration of payment service providers. If this happens, households and businesses may not benefit from cost savings. This is clearly an issue for competition authorities.

It also is an issue for financial stability because “too big to fail” could emerge in a new form outside the current regulatory perimeter. Once again, payments are a great example. I worry that players not covered currently by regulation could become important to the system even if they never take on bank-like risks, such as maturity transformation or leverage, or become big enough to be considered systemically important. The move to increased direct access means that even smaller players could very well create critical dependencies within the financial system, particularly if they connect directly to core payments infrastructure. This could give rise to moral hazard. At a minimum, authorities need to put a large enough weight on operational dependencies when looking at systemic importance, particularly in light of cyber risk. When a payment system grows to be prominent or systemically important, the Bank of Canada’s job is to oversee it. Even before we reach that point, regulatory measures should be considered to address specific issues, such as operational resilience and consumer protection.

I also wonder how DLT-based infrastructures could affect the financial ecosystem. Ever-increasing automation through, say, smart contracts, could increase efficiency and certainty but could also increase financial volatility. Would that volatility be short-term, such as flash crashes? Or would it entail procyclical dynamics or new channels of contagion?

There are also questions about whether the regulatory perimeter is adequate, given new entrants and risks of regulatory arbitrage. In my view, the field of inquiry should include the inherent risk and systemic importance of an activity, regardless of what entity is performing it. Even as we strive to implement a regulatory response that is proportionate to the risk, we need to keep in mind that maintaining a level playing field is important. Some of these issues are not too different from those that authorities face in their work on shadow banking, another area where new entrants are challenging traditional players.16 And, big or small, operational risk deserves much greater attention.

The second way to address innovation in financial services is active engagement between authorities and the private sector. Some countries, such as the United Kingdom, Australia and Singapore, have created official regulatory “sandboxes.” These sandboxes allow start-ups to experiment with services without jumping through all the usual regulatory hoops.

Here in Canada, we are consulting with fintech entrepreneurs. The Bank of Canada is also partnering with Payments Canada, Canadian banks and R3 – which leads a consortium of financial institutions – to test drive distributed ledgers. Our only goal at this stage is to understand the mechanics, limits and possibilities of this technology. The plan is to build a rudimentary wholesale payment system to run experiments in a lab environment.

Our experiment includes a simulated settlement asset used as a medium of exchange within the system. It is very much like the settlement balances in LVTS, except it is using DLT. Because it cannot be used anywhere else, it is a different animal altogether from a digital currency for widespread use.

This is an experiment in the true sense of the word. I cannot think of a better way to understand this technology than to work with it. Other frameworks need to be investigated, and there are many hurdles that need to be cleared before such a system would ever be ready for prime time.

The third way to address innovation proactively is to do fundamental research on the effects of new technology. The Bank of Canada’s research over the past few years has focused on new payment methods, the adoption and competitiveness of digital currencies, and the essential benefits of private e-money. We are continuing this work and broadening it to include other developments, such as peer-to-peer lending and uses of DLT.

We also want to understand how new financial technologies will address the underlying forces that created the need for financial intermediation in the first place. In theory, new technology could enable a different framework for addressing the same frictions, potentially one that does not require financial intermediaries at all. The names and faces may change, but I do not see technology changing the need for maturity transformation, loan monitoring, intermediation of borrowers and lenders, and trust. This is a good question for academics.

Monetary/fiscal policy mix has implications for debt and financial stability

The mix of monetary and fiscal policies in an economy has important implications for debt levels and financial stability over the medium term, Bank of Canada Governor Stephen S. Poloz said.

In the Doug Purvis Memorial Lecture given at the Canadian Economics Association’s annual conference, Governor Poloz used the Bank’s main policy model to construct three “counterfactual” scenarios of events from the past 30 years that show how different policy mixes can influence the amount of debt taken on by the private and public sectors.

Tight monetary policy with easy fiscal policy may lead to the same growth and inflation results as easy monetary policy paired with tight fiscal policy in a given situation, the Governor explained. However, the consequences for government and private sector debt levels would be quite different.

Recent experience in Canada and elsewhere shows that debt levels—whether public or private—can provoke financial stability concerns, said Governor Poloz. The insight about policy mix is important as authorities worldwide work to incorporate financial stability issues into the conduct of monetary policy, he added.

The Governor stressed that the counterfactuals are intended to illustrate the impact of the policy mix on debt levels; they aren’t meant to be taken as an opinion about what the best policy mix was in the past or is now.

“Hindsight is always 20:20 and such a discussion would have little meaning,” Governor Poloz said. “The best mix of monetary and fiscal policy will depend on the economic situation.”

There should be a degree of coordination between the monetary and fiscal authorities that allows both to be adequately informed of each other’s policies and consider their implications on debt levels over the medium term, the Governor said. In Canada’s case, the central bank operates under an explicit inflation-targeting agreement with the federal government that enshrines its operational independence, while allowing for both parties to share information and judgment, Poloz said. This framework represents “a simple yet elegant form” of policy coordination, he noted.

The lecture honours Doug Purvis, a Canadian macroeconomist and Queen’s University professor. In 1985, Purvis delivered the Harold Innis Lecture, in which he argued that rising government debt levels would eventually compromise the ability of authorities to implement stabilization policies. Governor Poloz said his lecture today is meant to build on Purvis’ initial insights by bringing more advanced macroeconomic models to bear on the topic, and linking them to the topical issue of financial stability.

 

What Is Behind the Weakness in Global Investment?

A newly released Bank of Canada Staff Discussion Paper explores why the recovery in private business investment globally remains extremely weak more than seven years after the financial crisis.

The global financial crisis resulted in a broad-based collapse of business investment, with the level of investment falling well over 10 per cent in most member countries of the Organisation for Economic Co-operation and Development (OECD).

Investment---CanadaAn uneven recovery followed, led by oil-exporting regions, which benefited from a rebound in energy prices. The post-crisis recovery in business investment has been underwhelming. Annual investment growth in OECD countries averaged a mere 2.2 per cent between 2010 and 2014, compared to around 3.5 per cent in the decade leading up to the financial crisis.

The bulk of this weakness was unexpected, and has resulted in investment consistently underperforming relative to forecasts of both public and private forecasters. Over the past few years, several institutions, including the OECD, the International Monetary Fund (IMF), the Bank for International Settlements and the Banque de France, have investigated this “investment puzzle” to identify some of the factors that standard models might fail to capture.

This paper contributes to the ongoing policy debate on the factors behind this weakness by analyzing the role of growth prospects and uncertainty in explaining developments in non-residential private business investment in large advanced economies since the crisis. Augmenting the traditional models of investment with measures of growth expectations for output and uncertainty about global demand improves considerably the ability to explain investment growth.

Our results suggest that the main driver behind the weakness in global investment in recent years is primarily a pessimistic outlook on the part of firms regarding the strength of future demand. Lower levels of uncertainty have supported investment growth modestly over 2013–14. Similarly, diminishing credit constraints, lower borrowing costs and relatively stronger corporate profits have also supported the recovery in business investment from 2010 onward.

Our findings have two important implications for the global outlook for investment. First, the expected improvements in global growth should support a recovery in investment; however, a slowdown in growth in emerging-market economies or further growth disappointment in advanced economies could restrain this recovery. Second, the ongoing recovery in investment remains vulnerable to uncertainty shocks.

Note: Bank of Canada staff discussion papers are completed staff research studies on a wide variety of subjects relevant to central bank policy, produced independently from the Bank’s Governing Council. This research may support or challenge prevailing policy orthodoxy. Therefore, the views expressed in this paper are solely those of the authors and may differ from official Bank of Canada views. No responsibility for them should be attributed to the Bank.

Debt Overhang and Deleveraging

What is the relationship between high consume debt levels, and consumption? This is an important question for Australia, given the current record levels of personal debt, and sluggish consumer activity. Also, what will happen should house prices slip back, and households shift to a deleveraging mentality? The short answer is it will have a significant depressive economic impact – if insights from a newly published paper are true.

In a Bank of Canada Staff Working Paper, “Debt Overhang and Deleveraging in the US Household Sector: Gauging the Impact on Consumption” they use a dataset for the US states to examine whether household debt and the protracted debt deleveraging helps to explain the dismal performance of US consumption since 2007, in the aftermath of the housing bubble. By separating the concepts of
deleveraging and debt overhang—a flow and stock effect—they conclude that excessive indebtedness exerted a meaningful drag on consumption over and beyond income and wealth effects.

The leveraging and subsequent deleveraging cycle in the US household sector had a signifi cant impact on the performance of economic activity in the years around the Great Recession of 2007-09. A growing body of theoretical and empirical studies has therefore focused on explaining to what extent and through which channels the excessive buildup of debt and the deleveraging phase might have contributed to depressing economic activity and consumption growth.

They use panel regression techniques applied to a novel data set with prototype estimates of personal consumption expenditures at the state-level for the 51 US states (including the District of Columbia) over the period from 1999Q1 to 2012Q4. They include the main determinants as used in traditional consumption functions, but add in debt and its misalignment from equilibrium. They conclude that excessive indebtedness of US households and the balance-sheet adjustment that followed have had a meaningful negative impact on consumption growth over and beyond the traditional effects from wealth and income around the time of the Great Recession and the early years of the recovery. The e ffect is mostly driven by the states with particularly large imbalances in their household
sector. This might be indicative of non-linearities, whereby indebtedness begins to bite only when there is a sizable misalignment from the debt level dictated by economic fundamentals. They show that some states experienced significant deleveraging and a fall in household wealth.

Canada1Canada2 They argue that the nature of the indebtedness determines the ultimate impact of debt on consumption. The drag on US consumption growth from the adjustments in household debt appears to be driven by a group of states where debt imbalances in the household sector were the greatest. This suggests that the adverse e ffects of debt on consumption might be felt in a non-linear fashion and only
when misalignments of household debt leverage away from sustainable levels – as justfi ed by economic fundamentals – become excessive. Against the background of the ongoing recovery in the United States, where the deleveraging process appears to be already over at the national level, one might expect house-hold debt to support consumption growth going forward as long as the increase in debt does not lead to a widening of the debt gap.

Note that Bank of Canada staff working papers provide a forum for staff to publish work-in-progress research independently from the Bank’s Governing Council. This research may support or challenge prevailing policy orthodoxy. Therefore, the views expressed in this paper are solely those of the authors and may differ from official Bank of Canada views. No responsibility for them should be attributed to the Bank of Canada, the European Central Bank or the Eurosystem.

Older Households More At Risk In Housing Downturn

Just released is a Canadian Economic Analysis Department working paper “On the Welfare Cost of Rare Housing Disasters“, which shows that in a significant housing downturn the welfare costs are large and this risk varies considerably across age groups, with a welfare cost as high as 10 percent of annual nonhousing consumption for the old, but near zero for the young. Given the risks to the housing sector in Australia at the moment, this is potentially important and applicable research.

Since the early 2000s, house prices have increased significantly in Canada.US-and-Canadian-House-PricesThis ongoing housing boom has become an important consideration for the conduct of monetary policy and financial regulation, since currently high levels of house prices are potentially increasing the risk of a large housing market correction, which could have an adverse effect on the economy. This paper investigates the likelihood and magnitude of housing market disasters, and the value of limiting this disaster risk for the Canadian economy.

The study will be useful for both economic researchers and policy-makers to better understand the macroeconomic implications of this important market risk. This paper estimates the unconditional probability and the size of housing market disasters using the cross-country housing market experiences of twenty OECD countries.

I find that in a given OECD country, housing market disasters – defined as cumulative peak-to-trough declines in real house prices of 20 percent or more – occur with a probability of 3 percent every year, corresponding to about one disaster occurring every 34 years. A housing disaster on average lasts about 6.4 years, and house price declines range from 25 to 68 percent, with an average decline of 34 percent.

This paper quantifies the welfare impact of the housing disaster risk in an overlapping generations general equilibrium housing model. The analysis yields the following two main findings. First, despite their statistical rarity, the aggregate welfare cost of housing disasters is large, since Canadian households would willingly give up around 5 percent of their non-housing consumption each year to eliminate the housing disaster risk. The sizable welfare cost is due to the large wealth loss during the long-lasting recessions triggered by housing disasters. Second, the welfare evaluation of this risk varies considerably across age groups, with a welfare cost as high as 10 percent of annual nonhousing consumption for the old, but near zero for the young. This asymmetry stems from the fact that, compared to the old, younger households suffer less from house price declines in disaster periods, due to smaller holdings of housing assets, and benefit from being able to buy homes at the resulting lower house prices in normal periods.

The main findings from the model are twofold. First, despite their rarity, the aggregate welfare cost of housing disasters is large, since Canadian households would be willing to give up around 5 percent of their non-housing consumption each year to eliminate the housing disaster risk. Compared to the no-disaster economy, the presence of this disaster risk has two opposite welfare effects on households. On the one hand, due to a wealth effect, a realized housing disaster leads to a long-lasting economic recession. The loss in housing wealth once a disaster occurs reduces the aggregate household savings and thus the capital supply. As a consequence, the interest rate goes up and the fi…rm cuts back its investment, leading to declines in wages, output and consumption. On the other hand, due to a substitution effect, a non-trivial disaster probability results in risk-averse households’resource reallocation from the housing sector to the production sector in normal periods. This lowers both house prices and the interest rate, with declining borrowing costs leading to higher investment, output and consumption. However, due to diminishing marginal utility of consumption, the welfare gain from this resource reallocation in normal periods is dominated by the welfare loss from large recessions triggered by housing disasters, explaining why the society is willing to devote a sizable amount of resources to eliminating this disaster risk.

The second major finding is that the welfare evaluation of the housing disaster risk differs considerably in magnitude across age groups, with a welfare cost as high as 10 percent of annual non-housing consumption for the old, but near zero for the young. This asymmetry is mainly due to the hump-shaped pro…le of life-cycle housing consumption, with older households typically holding more housing assets than the young. In disaster periods, declines in house prices favor the young, who purchase houses at depressed prices, but hurt the old, who rely on house sales to …finance non-housing consumption. In normal periods, younger households also benefit more than the old from purchasing houses at lower cost, thanks to the resource reallocation from the housing sector to the production sector as discussed above. Therefore, younger households are less averse to the presence of the housing disaster risk than the old.

Note: Bank of Canada working papers are theoretical or empirical works-in-progress on subjects in economics and finance. The views expressed in this paper are those of the author. No responsibility for them should be attributed to the Bank of Canada.