We think that the Banco Central do Brasil (BCB) has an important role in preventing the ...... http://www.bcb.gov.br/htms/relinf/port/2011/09/ri201109b5p.pdf. 11.
INDEPENDENT STUDY PROJECT
MONETARY AND MACROPRUDENTIAL POLICIES FOR PREVENTING
FINANCIAL DISTRESS:
AN EVALUATION FROM AN EARLY WARNING SYSTEM FOR BRAZIL
Jasmina Bjeletic Emmanuel Claessens Sergio Rodriguez Apolinar Daniela Ruiz
1
I.
Introduction
After some decades of high instability, since the 2000’s the fundamentals of the Brazilian economy have improved significantly. In fact, nowadays Brazil is considered one of the most promising emerging economies. However, more efforts are needed to ensure sustainable growth rates for the forthcoming years for which macroeconomic stability will be a necessary condition. Nevertheless, the policies applied until now might not be enough to silence the alarms of an economic distress. After the 2008 Crisis and until the first half of 2011, the main focus was on the risk of an economy growing at very high rates and attracting huge floods of capital. After the second half of 2011 the concerns have been more related to a possible deceleration associated to a detrimental situation in the Euro Zone. We think that the Banco Central do Brasil (BCB) has an important role in preventing the damages that can cause a turmoil scenario on the financial stability. Specifically, we would like to answer which of the policy toolkit measures the BCB and the other regulatory institutions should use to stabilize macroeconomic and financial indicators in order to prevent a crisis: (i) relax its monetary policy, (ii) impose controls to short-term inflows or (iii) perform regulatory actions, well known as macroprudential policies, on the domestic financial system. In line with this objective, we will diagnose the current situation for Brazil in order to detect its main vulnerabilities. For this purpose we will evaluate the situation under an Early Warning System (EWS) based on a slighter version of Kaminsky-Lizondo-Reinhart (KLR) and RoseSpiegel EWS.This will help us to detect if there are indicators in state of alert. Accordingly to this, in the Section II we will describe briefly what has been the recent situation of Brazil. The Section III includes the theoretical and methodological background of the EWS and the analysis of the macroeconomic indicators. Finally, the Section IV based on the previous exercise; focus on policy recommendations. We will narrow the relevant instruments to the use of reference interest rate, capital account restrictions, and macroprudential regulation in its basic version. We then end by remarking some conclusions. II. a.
Brazil’s Overview Before 2008: Building Strong Economic Foundations
The Brazilian economy is one of the brightest economies for the forthcoming years 1. This is due to the significant economic development registered over the last decade, after almost thirty years of stagnation and frequent crises episodes. Although the impact of the crises in the 70’s and 80’s had severe economic implications, the events that occurred after 1994 supported the introduction of important economic reforms that determined what Brazil is nowadays, being the first effort the “Real” plan, which put an end to the hyperinflation period. Nevertheless, it caused structural deficits that gave rise to a Currency Crisis in 1999. In consequence, new economic policies to promote fiscal discipline, diminish inflation rates and reduce external imbalances were introduced and were the bases for the good performance observed the last decade. For instance, new mechanisms were implemented such as a monetary regimen based on inflation targeting 2, a floating exchange system, as well as a “Fiscal Responsibility Law” to control public 1
In 2011 Brazil overtook UK, becoming the sixth-largest economy. However, per capita GDP remains third of UK´s. During the past two decades most central banks have adopted an inflation target. The short-run monetary policy is influenced through movements in interest rate and the way central banks set the interest rate is via the Taylor rule.
2
2
expenses. Although some volatility remained for some years, the instability registered the first years of the new decade was mainly driven by political events. Given this, since 2004 Brazil entered into a period of continuous growth (see Chart 1), supported by a robust export performance and a domestic market recovery, which went along with an improvement of the main macroeconomic indicators, only slightly deteriorated by the Financial Crisis. Furthermore, Brazil strengthened its position in global markets, which was translated into an enlargement of foreign investment flows, a rising amount of foreign reserves, a downward trajectory in the external debt, among other indicators (see Chart 2). It is worth noting that this expansionary period was supported partially by the boom phase registered by commodity prices which have an important role on the economy. As well, an expansion of private credit played a substantial role in this pattern.
Chart 2: External indicators 120.6%
63.4%
Dec03 42.4%
21.5%
17.0%
12.1%
Short Term Debt External Debt/GDP Deb/Intl. Reserves Services/Exports Source: Central Bank of Brazil
b.
After the Financial Crisis: Two different scenarios
The Brazilian economy was not isolated from the effects of the Financial Crisis with many indicators deteriorating: (i) a significant GDP drop, (ii) exchange rate depreciation, (iii) credit growth rate deceleration, (iv) terms of trade reversion, among other indicators. However, after a short period of turmoil and as many other emerging economies, Brazil left the crisis stronger and faster than expected, showing a resilience not exhibited in previous crisis 3. After the global crisis of 2008 we can clearly distinguish two different scenarios in Brazil as displayed by the Diagram 1. The first one goes from the third quarter of 2009 to the first half of 2011. In this period, the strong fundamentals accompanied with the large interest rate differential were the main determinants of the large arrive of procyclical capitals into the Brazilian economy.
3
As pointed by the IMF, this good performance was based on the three pillars of Brazil's macroeconomic stability: control of inflation, floating exchange rate and fiscal discipline.
3
Diagram 1: Two Scenarios
Due to the floods of foreign capital and the improvement of terms of trade, some economic and financial indicators begun to reflect a risk of “overheating”. Among these were: (i) an increasing demand fuelling by credit expansion; (ii) output gap closing very fast; (iii) accelerating inflation that had already been risen due to higher commodity prices; (iv) unemployment at historic low level; and (v) overvaluation of the currency generally translated into a deterioration of the current account (see Chart 3). Charts 3: Indicators of Overheating Credit to Private Sector
Inflation
(as % of GDP)
(%)
Nominal Exchange Rate ( Var %)
Argentina
Chile
India
Brazil China
6.5%
Brazil
-5.04%
2011 2010
Russia
Russia 2011
South Africa
2010
Colombia
Peru
Peru
Chile
South Africa
China
India
Colombia
Argentina 0
5
10
15
-14%
-9%
-4%
1% 4
6%
To contain this overheating risk, the policymakers implemented different restrictive measures 4. For instance, interest rate hikes considering this was “the adequate strategy to guarantee the convergence of inflation to the target” as claimed by the BCB 5. Nevertheless, this measure implied a trade-off between a high interest rates that attract even more capital inflows and strengthen the Real and in the other side the effects that a restrictive monetary policy to contain the rising inflation. Therefore, to diminish the detrimental effects associated with the higher Selic, the benchmark rate, the authorities complemented the monetary tightening with other policies. Since the last quarter of 2009, the BCB introduced capital controls to restrain speculative capitals and shift to more long-term and stable inflows. Additionally, the monetary authority implemented some macroprudential measures to slow credit growth by imposing restrictions to auto loans, personal loans and payroll loans. Then, since the third quarter of 2011 a different scenario showed up, which explains the sluggish growth rate of 2,7% registered in 2011. This deceleration was mainly caused by the restrictive policies applied before and the uncertainty outlook in the Euro Zone. In order to shield the economic growth, the Brazilian economic authorities have been using different measures: SELIC reduction; large fiscal stimulus packages and a reverse of some of the macroprudential measures implemented during the previous months 6. III.
An EWS for Banking and Currency crises: Theory and Application for Brazil
Although the set of fundamental determinants of crises may differ for each crisis episode, it is clear that the “good times” contain the “seed” of financial distress. In present times, this kind of “optimistic” shocks in the financial sector are often fueled by commodity booms, excess of capital inflows (financial or trade liberalization) and/or global liquidity, which make credit easily accessible by private and public agents (low interest rates, little credit screening). Economies with fragile fundamentals could be susceptible to enter into a Currency and/or to a Banking collapse 7. The approach used in Kaminsky and Reinhart (1999), which we will follow in this paper, points to a vicious circle between currency and banking crises: “good times” come with a boom in capital inflows which leads to currency appreciation and excess liquidity. This situation usually sponsors excessive leverage in the private sector (consumers, firms and banks), asset overvaluation, government external financing, trade balance and current account deterioration. Some of these regularities might be easily captured in the data through an EWS as stressed by Kaminsky, Lizondo and Reinhart (1998) and although it might not have and absolute predictive ability it can help to identify some common vulnerabilities in the verge of financial crises. 4
See Appendix 1 for a detail review of the measures implemented in Brazil after the 2008 Crisis. Between April 2010 and July 2011 the Central Bank increased the Selic by 275 bp from 9,75% to 12,5%. 6 In this context, domestic demand continued being the engine of the economy, supported by credit of public banks. 7 On one hand, a monetary crisis is related with depreciations and speculative attacks, with a fall in reserves or/and an increase in short term interest rates. On the other hand, a banking crisis is associated with the inability to recover credits, with a detrimental of macroeconomic conditions (through contraction of production, exchange rate variations capital outflows, fall in asset prices, and terms of trade (Gupta, 2002), inefficient regulation/supervision, premature liberalization processes, and fulfilling prophecies (Agénor, 2000). Moreover, liberalization of capitals has increased the probability of both crises to occur. However, it is subject to debate whether the causality goes from a monetary to banking or vice versa. 5
5
c.
EWS as a mechanism to anticipate crises episodes
An Early Warning System (EWS) is conceived as a mechanism to anticipate the occurrence of financial turmoil with enough time to be prevented. Since the appearance of the seminal papers by Kaminsky, Lizondo and Reinhart (1998) and Kaminsky and Reinhart (1999) on the onset of the Mexican Peso Crisis and the Asian Tigers Crisis, several attempts with similar and different specifications have tried to reproduce Kaminsky-Lizondo-Reinhart (KLR) results with more upto-date data. These more recent results vary in flavor given that they go from conditional support to a definite rejection of KLR’s propositions. In practice, an EWS is the sum of three components: (1) a crises identification mechanism (which implies defining what a currency and a banking crisis episode is); (2) a set of optimal thresholds for the indicators used as possible determinants of the crises (financial conditions, asset markets conditions, external conditions, policy conditions, economic activity); and (3) a goodness of fit test (usually involves examining the behavior of the indicators relative to the optimal thresholds estimated in (2) in the years prior to the occurrence of the critical episodes that were identified in (1)). If the goodness-of-fit test is successful (a significant number of indicators displayed alerts with enough anticipation) a current diagnosis of each economy can be performed. In the recent works by Rose and Spiegel (2009, 2011) the effectiveness of this approach is highly questioned although they contribute by introducing relevant signalers of crises: housing prices, price-earning ratios, short-term government debt, bank healthiness, institutional quality and financial development. There is also a greater role for foreign reserves in terms of the indicators analyzed. However, the EWS framework they finally apply keeps sharing many of the features of Kaminsky and Reinhart’s EWS. It is worth notice that the approach of multiple determinants, multiple determined variables of Rose and Spiegel (2009, 2011) is performed in a cross-country static framework rather than in a time-series fashion. Crises Dates The definitions of a currency or banking crisis episode have been in the center of an ongoing debate, given the difficulty to identify the starting and final point of a critical episode. In the case of currency crises, they used to be usually associated with shifts in the exchange rate regime or an excessive depreciation of the currency. However, in recent times, in a widespread fashion of flexible exchange rate regimes and more responsible central banks, these simplistic definitions are facing obsolescence. But if the definition of currency crises has proved problematic, the definition of a banking crisis is not even better: banks bail-outs, bankruptcy, excessive deposit withdrawals are also traditional identification strategies to define the exact starting point of a banking crisis. However, it has been pointed out in many works (including Kaminsky and Reinhart (1999), Demirgüc-Kunt and Detragiache (1997) and Von Hagen and Ho (2004)) that these events might just be the final expression of increasing turbulences in the months before that. For both types of financial crises we have decided on going for a more numerical approach, making use of the market turbulence indexes to identify the dates of crises. For currency crises we built the definitions compared in the work by Lestano and Jacobs (2004) including the indexes specified by Kaminsky et al (1998), Eichengreen et al (1995), Frankel and Rose (1996) and Zhang (2001).
6
In the case of banking crises we used two types of turbulence indexes suggested in the works by Demirgüc-Kunt and Detragiache (1997) and Von Hagen and Ho (2007). The first definition includes reductions in the deposits held by the banks as well as the increase of the highly-risk fraction in the loan portfolio. The more recent definition contained increases in the bank reserves-deposits ratio and in the lending interest rates. In general, a currency crisis episode was defined as the date in which five or more indexes were identifying a crisis and a banking crisis date was one in which any of the financial market turbulence indexes was surpassing its critical threshold. These are the dates we obtained: -
Currency Crises: Jan – Feb 1983; Dec 1989 – March 1990; Jan - March 1999
-
Banking Crises: Jan – Aug 1986; Dec 1989 – Feb 1990; June – July 1993
These dates are consistent with the existent literature in crises identification as well as the financial-press-covered events in the last three decades.
Macroeconomic Indicators Analysis We built a set of monthly and quarterly indicators to identify problematic signals in the current economic situation of Brazil. The analysis goes as follows: First, we calculated the average of each indicator in what we considered to be the tranquil months for the Brazilian case. These periods excluded of course the crises months and the 24month window before the beginning of each episode. We also excluded some turbulent periods as the one in the beginning of the 2000’s caused by the Argentinian crisis and the most critical months of the more recent global crisis. After that, we calculated the relative-to-tranquil-times versions of each indicator which tell us directly how different the fundamentals behave in the prelude of a crisis. For some cases the behavior of an indicator varies according to the type of crisis. For example, currency crises are preceded mostly by high current account deficits which are consistent with the overvaluation of the currency that comes before the depreciation crisis. However, consistently with capital reversals, economies exhibit current account surplus in the verge of banking crisis. This is important in order to determine which the relevant threshold for each variable is. In order to maintain simplicity and relevance of our argument we determined as relevant thresholds (not necessarily optimal) as the ones which were mostly surpassed in the 24-month window before each crisis. In the following set of charts we show the series of some of the indicators relative to the tranquil times (the 0-axis represents no difference with tranquil times), the 24-month signaling window (yellow for currency crises, purple for banking turbulence episodes and red for the single twin crisis identified by the method previously mentioned). The orange rectangle represents the latest 24 months of the sample on which we focus in order to identify current vulnerabilities. For some of the variables we show a relevant threshold. The indicators are organized in four sectors considered relevant by the leading literature on this topic: monetary market variables include credit indicators such and the growth of total credit as a fraction of GDP and monetary policy variables such as the growth of the M2 multiplier and the real interest rate differential. 7
Jan-80 Jun-80 Nov-80 Apr-81 Sep-81 Feb-82 Jul-82 Dec-82 May-83 Oct-83 Mar-84 Aug-84 Jan-85 Jun-85 Nov-85 Apr-86 Sep-86 Feb-87 Jul-87 Dec-87 May-88 Oct-88 Mar-89 Aug-89 Jan-90 Jun-90 Nov-90 Apr-91 Sep-91 Feb-92 Jul-92 Dec-92 May-93 Oct-93 Mar-94 Aug-94 Jan-95 Jun-95 Nov-95 Apr-96 Sep-96 Feb-97 Jul-97 Dec-97 May-98 Oct-98 Mar-99 Aug-99 Jan-00 Jun-00 Nov-00 Apr-01 Sep-01 Feb-02 Jul-02 Dec-02 May-03 Oct-03 Mar-04 Aug-04 Jan-05 Jun-05 Nov-05 Apr-06 Sep-06 Feb-07 Jul-07 Dec-07 May-08 Oct-08 Mar-09 Aug-09 Jan-10 Jun-10 Nov-10 Apr-11 Sep-11 Feb-12 Jun-89 Nov-89 Apr-90 Sep-90 Feb-91 Jul-91 Dec-91 May-92 Oct-92 Mar-93 Aug-93 Jan-94 Jun-94 Nov-94 Apr-95 Sep-95 Feb-96 Jul-96 Dec-96 May-97 Oct-97 Mar-98 Aug-98 Jan-99 Jun-99 Nov-99 Apr-00 Sep-00 Feb-01 Jul-01 Dec-01 May-02 Oct-02 Mar-03 Aug-03 Jan-04 Jun-04 Nov-04 Apr-05 Sep-05 Feb-06 Jul-06 Dec-06 May-07 Oct-07 Mar-08 Aug-08 Jan-09 Jun-09 Nov-09 Apr-10 Sep-10 Feb-11 Jul-11 Dec-11 Jun-89 Nov-89 Apr-90 Sep-90 Feb-91 Jul-91 Dec-91 May-92 Oct-92 Mar-93 Aug-93 Jan-94 Jun-94 Nov-94 Apr-95 Sep-95 Feb-96 Jul-96 Dec-96 May-97 Oct-97 Mar-98 Aug-98 Jan-99 Jun-99 Nov-99 Apr-00 Sep-00 Feb-01 Jul-01 Dec-01 May-02 Oct-02 Mar-03 Aug-03 Jan-04 Jun-04 Nov-04 Apr-05 Sep-05 Feb-06 Jul-06 Dec-06 May-07 Oct-07 Mar-08 Aug-08 Jan-09 Jun-09 Nov-09 Apr-10 Sep-10 Feb-11 Jul-11 Dec-11
External sector indicators include growth of exports, imports, the current account deficit as a percentage of GDP as well as some measure of net capital inflows. We also show the behavior of asset markets (equity and housing). Finally, we have a set of variables that depict the situation of the real sector and consumer prices. Charts 4: Monetary Market
25.00%
Credit/GDP Growth
15.00%
5.00%
-5.00%
-15.00%
-25.00%
-35.00%
-45.00%
Risky Loans Participation Growth
100.00%
80.00%
60.00%
40.00%
20.00%
0.00%
-20.00%
-40.00%
-60.00%
130.00%
M2 Multiplier Growth
80.00%
30.00%
-20.00%
-70.00%
8
Jan-80 Aug-80 Mar-81 Oct-81 May-82 Dec-82 Jul-83 Feb-84 Sep-84 Apr-85 Nov-85 Jun-86 Jan-87 Aug-87 Mar-88 Oct-88 May-89 Dec-89 Jul-90 Feb-91 Sep-91 Apr-92 Nov-92 Jun-93 Jan-94 Aug-94 Mar-95 Oct-95 May-96 Dec-96 Jul-97 Feb-98 Sep-98 Apr-99 Nov-99 Jun-00 Jan-01 Aug-01 Mar-02 Oct-02 May-03 Dec-03 Jul-04 Feb-05 Sep-05 Apr-06 Nov-06 Jun-07 Jan-08 Aug-08 Mar-09 Oct-09 May-10 Dec-10 Jul-11 Feb-12 Jul-84 Feb-85 Sep-85 Apr-86 Nov-86 Jun-87 Jan-88 Aug-88 Mar-89 Oct-89 May-90 Dec-90 Jul-91 Feb-92 Sep-92 Apr-93 Nov-93 Jun-94 Jan-95 Aug-95 Mar-96 Oct-96 May-97 Dec-97 Jul-98 Feb-99 Sep-99 Apr-00 Nov-00 Jun-01 Jan-02 Aug-02 Mar-03 Oct-03 May-04 Dec-04 Jul-05 Feb-06 Sep-06 Apr-07 Nov-07 Jun-08 Jan-09 Aug-09 Mar-10 Oct-10 May-11 Dec-11
Jun-95
Feb-12
Sep-11
Apr-11
Nov-10
Jun-10
Jan-10
Aug-09
Mar-09
Oct-08
May-08
Dec-07
Jul-07
Feb-07
Sep-06
Apr-06
Nov-05
Jun-05
Jan-05
Aug-04
Mar-04
Oct-03
May-03
Dec-02
Jul-02
Feb-02
Sep-01
Apr-01
Nov-00
Jun-00
Jan-00
Aug-99
Mar-99
Oct-98
May-98
Dec-97
Jul-97
Feb-97
Sep-96
Apr-96
Nov-95
Real Interest Rate Differentials
29.00%
24.00%
19.00%
14.00%
9.00%
4.00%
-1.00%
-6.00%
Charts 5: Assets Market
Stock Market Index Growth - BOVESPA
850.00%
650.00%
450.00%
250.00%
50.00%
-150.00%
77.00
Housing Prices Index Growth - INCC
67.00
57.00
47.00
37.00
27.00
17.00
7.00
-3.00
9
1978Q1 1978Q4 1979Q3 1980Q2 1981Q1 1981Q4 1982Q3 1983Q2 1984Q1 1984Q4 1985Q3 1986Q2 1987Q1 1987Q4 1988Q3 1989Q2 1990Q1 1990Q4 1991Q3 1992Q2 1993Q1 1993Q4 1994Q3 1995Q2 1996Q1 1996Q4 1997Q3 1998Q2 1999Q1 1999Q4 2000Q3 2001Q2 2002Q1 2002Q4 2003Q3 2004Q2 2005Q1 2005Q4 2006Q3 2007Q2 2008Q1 2008Q4 2009Q3 2010Q2 2011Q1 2011Q4 1978Q1 1978Q4 1979Q3 1980Q2 1981Q1 1981Q4 1982Q3 1983Q2 1984Q1 1984Q4 1985Q3 1986Q2 1987Q1 1987Q4 1988Q3 1989Q2 1990Q1 1990Q4 1991Q3 1992Q2 1993Q1 1993Q4 1994Q3 1995Q2 1996Q1 1996Q4 1997Q3 1998Q2 1999Q1 1999Q4 2000Q3 2001Q2 2002Q1 2002Q4 2003Q3 2004Q2 2005Q1 2005Q4 2006Q3 2007Q2 2008Q1 2008Q4 2009Q3 2010Q2 2011Q1 2011Q4
Jan-80 Aug-80 Mar-81 Oct-81 May-82 Dec-82 Jul-83 Feb-84 Sep-84 Apr-85 Nov-85 Jun-86 Jan-87 Aug-87 Mar-88 Oct-88 May-89 Dec-89 Jul-90 Feb-91 Sep-91 Apr-92 Nov-92 Jun-93 Jan-94 Aug-94 Mar-95 Oct-95 May-96 Dec-96 Jul-97 Feb-98 Sep-98 Apr-99 Nov-99 Jun-00 Jan-01 Aug-01 Mar-02 Oct-02 May-03 Dec-03 Jul-04 Feb-05 Sep-05 Apr-06 Nov-06 Jun-07 Jan-08 Aug-08 Mar-09 Oct-09 May-10 Dec-10 Jul-11 Feb-12
Charts 6: External Sector
68.00%
Exports Growth
48.00%
28.00%
8.00%
-12.00%
-32.00%
-52.00%
-72.00%
4.00
CA as %GDP
3.00
2.00
1.00
0.00
-1.00
-2.00
-3.00
-4.00
-5.00
4.00
FDI as %GDP
3.00
2.00
1.00
0.00
-1.00
-2.00
10
5.00%
3.00%
1.00%
-1.00%
-3.00%
-5.00%
-7.00%
1992Q1
1992Q4
1993Q3
1994Q2
1995Q1
1995Q4
1996Q3
1997Q2
1998Q1
1998Q4
1999Q3
2000Q2
2001Q1
2001Q4
2002Q3
2003Q2
2004Q1
2004Q4
2005Q3
2006Q2
2007Q1
2007Q4
2008Q3
2009Q2
2010Q1
2011Q3
GDP Growth
2010Q4
7.00%
2011Q4
Charts 7: Real Sector
2011Q1 2010Q2 2009Q3 2008Q4 2008Q1 2007Q2 2006Q3 2005Q4 2005Q1 2004Q2 2003Q3 2002Q4 2002Q1 2001Q2 2000Q3 1999Q4 1999Q1 1998Q2 1997Q3 1996Q4 1996Q1 1995Q2 1994Q3 1993Q4 1993Q1 1992Q2 1991Q3 1990Q4 1990Q1
Jan-92 Jun-92 Nov-92 Apr-93 Sep-93 Feb-94 Jul-94 Dec-94 May-95 Oct-95 Mar-96 Aug-96 Jan-97 Jun-97 Nov-97 Apr-98 Sep-98 Feb-99 Jul-99 Dec-99 May-00 Oct-00 Mar-01 Aug-01 Jan-02 Jun-02 Nov-02 Apr-03 Sep-03 Feb-04 Jul-04 Dec-04 May-05 Oct-05 Mar-06 Aug-06 Jan-07 Jun-07 Nov-07 Apr-08 Sep-08 Feb-09 Jul-09 Dec-09 May-10 Oct-10 Mar-11 Aug-11 Jan-12
Short Term Net Inflows 11.00
6.00
1.00
-4.00
-9.00
18.00%
Industrial Production Growth 13.00%
8.00%
3.00%
-2.00%
-7.00%
-12.00%
-17.00%
-22.00%
11
CPI Inflation Rate 21.50%
16.50%
11.50%
6.50%
1.50%
-3.50%
Apr-11
Feb-12
Sep-11
Jan-10
Jun-10
Nov-10
Oct-08
Aug-09
Mar-09
Jul-07
Dec-07
May-08
Apr-06
Feb-07
Sep-06
Jan-05
Jun-05
Nov-05
Oct-03
Aug-04
Mar-04
Jul-02
Dec-02
May-03
Apr-01
Feb-02
Sep-01
Jan-00
Jun-00
Nov-00
Oct-98
Aug-99
Mar-99
Jul-97
May-98
Feb-97
Dec-97
Sep-96
Jun-95
Apr-96
Nov-95
-8.50%
The charts show us that although credit growth is increasing, the figures (around 5% higher than the level of tranquil times) are still not at a critical level, however the participation of risky loans is very close to this threshold (given that is growing around ten percentage points above the tranquil times in the last 6 months), indicating that the recent set of borrowers must be of a higher risk profile. In the assets market the situation is not as critical as thought. The charts for the M2 multiplier and the real interest rate differential also show evidence of a lax monetary policy. There are no signs of an overvaluation in the stock or real estate markets as evident from the location of both the BOVESPA index and housing prices index growth rates (steadily below its levels of critical times). However, in the external sector things are not going so well. The exports growth rate is not only below the level of tranquil times but also is worryingly around -12% in the last months. The current account deficit almost 1% below the level of tranquil times indicates among with the exports behavior that there is deterioration in the terms of trade caused possibly by the appreciation of the Real. Given that the FDI has continued increasing in the recent period, the trend reversal in the very last months might reflect the effects of the capital controls and the reductions in the reference interest rate. The situation in the real sector is also complicated: both aggregate and industrial production growth rates are well below their tranquil-times levels (around 3% and 9% below them, respectively). The identified critical threshold is being evidently surpassed by the industrial production growth rate. Finally, although there are some voices of concern about the inflationary pressure, the EWS shows inflation below its level of calmer periods. Therefore, the crucial points that should be addressed by the policy framework are: (1) the increase in the risk profile of borrowers in the credit market as well as the growth rate of total credit; (2) the evidence of a lax monetary policy; (3) terms of trade deterioration with a slowdown in FDI, and (4) downturn in real economic activity.
12
IV.
Policy Recommendations
Taking into account what the EWS indicates and given the recent outlook of the Brazilian economy, in this section we will assess which would be the most suitable combination of policies that could ensure the financial stability of the Brazilian economy. Monetary Policy, Capital Controls and Macroprudential Regulation should be applied as toolkit to ensure a healthy economic growth, while preventing from the risks of an expansion of poor quality credits. Monetary Policy: Policy oriented to limit inflationary risks
a.
Our recommendation is that the BCB should keep the policy interest rate in the current level (8,5%), decision that we support with the following argument. With a Selic at a lower level than 8%, the real interest will stand around 3%, historically low for Brazil (see Chart 8). Although the real interest rate has been declining in the last years due to the implementation of the inflation targeting and better economic fundamentals, a low level can increase inflationary pressures. Chart 9: Inflation Chart 8: Selic (yoy, %) (%)
Source: Central Bank of Brazil
Mar-12
Lowe r infalti on
Oct-11
May-11
Dec-10
Jan-01 Sep-01 May-02 Jan-03 Sep-03 May-04 Jan-05 Sep-05 May-06 Jan-07 Sep-07 May-08 Jan-09 Sep-09 May-10 Jan-11 Sep-11 May-12
6
High inlfation Jul-10
8.5
5.0
Feb-10
11
4,5% Inflation targeting
Sep-09
Historic low
Apr-09
16
Nov-08
21
Jun-08
26
8.0 7.5 7.0 6.5 6.0 5.5 5.0 4.5 4.0 3.5
Jan-08
31
Source: Central Bank of Brazil
Therefore, there are several considerations that should be taken into account when deciding the optimal interest rate. The inflationary expectations are moving upwards. The BCB has continuously affirmed that the inflation is converging toward target but the successive increases in inflation expectations could divert inflation from its target of 4,5% (see Chart 9). However, the most recent BCB Survey (see Chart 10) showed that consumer prices will increase 5,22% percent in 2012, up from the estimate of 5,08% four weeks ago. Also, the agents raised their forecast for 2013 when the inflation will reach 5,53%, above the 5,5% of one month ago. Therefore, the consensus indicate that the inflation will not converge to the 4,5% target, as the BCB point out, and as a result of the laxer than expected monetary policy there will be higher pressures on inflation in the coming months and even further in 2013. Furthermore, although the recent data and the outcome of the EWS shows some signals of deterioration in the real sector, the expectations point to a recovery of the domestic demand in
13
the second part of the year. In this way, the Chart 11 exhibit that after growing 2,0% y/y in the first two quarters, GDP should expand around 4,0% y/y in the remaining part of the year. The 8 GDP will be bolstered by a large fiscal stimulus policy , robust credit growth and a buoyant labor market. Also, the still high commodity prices will have a positive impact on the exports and the industrial sector will be benefited by a weaker currency. In this sense, is important to bear in mind that the effect of a change in Selic is not translated immediately in the economy. There are some lags in the effects of monetary policy on prices and activity. The BCB reckons that the initial impact of changes in the Selic on activity and prices occurs after 1-2 quarters and 2-3 quarters, respectively; while the maximum effect on output and inflation takes, respectively, 3-4 quarters and 5-6 quarters to materialize. So, we believe that given the lagged effect of the interest rate reductions, the impact on activity of the recent easing cycle could materialize in the second half of this year and also that further monetary easing may explode and raise inflation expectations in the coming months. Chart 10: Inflationary expectations 6.0 5.5 5.0
Inflation Forecast (%, end of period)
4.5 4.0
Consensus Central Bank
2012 5,2% 4,4%
2013 5,5% 5,2%
Feb-09 Apr-09 Jun-09 Aug-09 Oct-09 Dec-09 Feb-10 Apr-10 Jun-10 Aug-10 Oct-10 Dec-10 Feb-11 Apr-11 Jun-11 Aug-11 Oct-11 Dec-11 Feb-12 Apr-12
3.5
High Growth
Deceleration Forecast
Source: IBGE and Central
b.
Capital controls: No more barriers to capital inflows in the short term
After the 2008 Crisis, Brazilian authorities, as many in other emerging economies, have used capital barriers as an amplifier of monetary policy. The main purpose of the use of capital controls was as a way to stop the tsunami of inflows and curb the currency appreciation that threat to hurt their domestic industry. However, in some cases these measures have been considered as Macroprudential tools, since could also prevent a rushing credit expansion. We suggest that there are not necessary additional control barriers to be implemented in the short run. We based our proposal in the following evidence. Since the last quarters of 2011 as the Chart 12 displays, the Brazilian economy has been registered stabilization in capital flows, particularly from portfolio investors. The moderation in the inflows reflects a faster than expected deceleration in the economic activity which lead to a 8
In May 2012, Brazilian authorities have launched a stimulus package of USD 10 bn to support economic growth. Among the more relevant measures: a reduction in the IPI industrial tax on vehicles and in IOF tax for individual borrowers. These policies complement those introduced at the end of 2010: tax cuts on some appliances and food.
14
more aggressive reduction of the benchmark interest rate and also a higher global uncertainty associated with the sovereign crisis in Europe that can trigger the flee of capital from emerging markets to high-quality assets. In this context, even the Real reached a 12-year high against the dollar in July 2011, since the end of February 2012, the currency has declined 15 percent against the dollar, the most of the major currencies. The attractiveness of the Real has decreased amid a range of defensive policy measures took by the government to protect the national industry, including the extension of the financial transactions tax. Undoubtedly the reduction of the benchmark interest rate has also contributed to the weakening of the currency 9. Chart 12: Current account and Exchange rate
2
2.4
Reintroduction of IOF tax
1
2.1
0 -1 1.8 -2 -3 1Q12
3Q11
1Q11
3Q10
1Q10
3Q09
1Q09
3Q08
1Q08
3Q07
1Q07
1.5
Current Account (as % of GDP, lhs) Exchange rate (Real/USD, rhs) Source: Brazil Central Bank
Moreover, in 2011 a large increase in the stock of foreign direct investment was one of the features of the Brazil’s economy. In this year, FDI flow reached USD 66,7 bn, 40% higher than in the previous year. So, it seems that the implementation of some capital controls have been effective in altering the composition of inflows. In this way, as the Chart 13 reflects the stock of FDI increased from about 30 percent in 2009 to 51% percent in 2011. As the BCB noticed 10, the FDI flows in general have been characterized by low volatility and more recently, there was a recovery of these flows reaching 3% of GDP, large enough to be the Brazil’s biggest source of external funding. This improvement is related with the sound macroeconomic policy. Capital inflows’ potential damage on the financial stability depends on the maturity term of the flows. Capital controls can serve also as a tool to change the maturity composition of capital flows. Actually, empirical evidence has found a positive effect of the controls applied on the composition of these flows for the Brazilian case 11.
9
A potential concern regarding a further real depreciation is in which extend it can fuel inflation pressures, but it seems that this threat is under control. Previous estimations show that the pass-through, the effect of the exchange rate in domestic prices, has been fallen in the last years and is relatively low for the Brazilian economy. 10
http://www.bcb.gov.br/htms/relinf/port/2011/09/ri201109b5p.pdf See Cardoso, E. and Goldfajn, I. (1998), “Capital Flows to Brazil: The Endogeneity of Capital Controls,” IMF Staff Papers, Vol. 45(1), pp. 161–202.
11
15
Although restrictions to capital inflows could help to limit currency appreciation the evidence show ambiguous results 12. This could be because large firms frequently find a way to encompass these restrictions by making use of currency derivatives contracts, specially taking into account that in Brazil the sophisticated derivative market may have decreased the effectiveness of the IOF tax. Capital controls in order to be effective should find the way to reduce carry trade. As a capital control is effective to reduce currency trade, Central Banks gains independence to control interest rate. Even though the recent moderation on capital flows, is necessary to consider than over the long term, Brazil will continue to attract capital flows. The forthcoming sport events, the World Cup and Olympics, have to be financed and so capitals are going to pour into Brazil, but mainly as foreign direct investment (FDI) rather than portfolio flows. The former is more beneficial since is less volatile and not so exposed to the investors’ mood.
c.
Macroprudential Policy: Measures to strengthen the Financial System
Monetary policy and control barriers are not the only tools that policy makers can use to reduce financial fragility. There is also a third type of instruments that interacts with them, the macroprudential regulation 13. According to the IMF, “the macroprudential policy uses primarily prudential tools to limit systemic financial risk, thereby minimizing the incidence of disruptions in the provision of key financial services that can have negative effects for the real economy”. Macroprudential policies’ importance lays on the concerns that emerged from the possible correlation between acceleration in credit and financial crises. Macroeconomic tools in general have been focused on two characteristics of credit: procyclicality, and the cross-sectional dimension. Accordingly to the IMF the measures can be aggregated in: (i) capital requirements, dynamic provisioning and leverage ratios; (ii) liquidity requirements; (iii) debt-to-income ratios; (iv) loan-to-value ratios; (v) reserve requirements on bank liabilities (deposits and nondeposits); (vi) instruments to manage and limit systemic foreign exchange risk; and, (vii) reserve requirements. We recommend a strengthening of the Macroprudential Regulation in order to have a healthier Financial System. During the last years, the economic growth has been boosted, among other factors, by a development of the financial system 14. Total credit as a percentage of GDP doubled between 2004 and 2011, reaching a percentage of 50%, one of the highest in the region after Chile, but still far below of those registered by advanced economies. Real credit to the private sector has risen by nearly 100 per cent since 2007, and the country’s big banks forecast loan growth of 20 per cent this year.
12
While Edwards and Rigobon (2005) found that capital controls reduced the volatility of RER in Chile, ValdésPrieto and Soto (1995) found the contrary results. For a deeper comparison about empirical evidence see International Monetary Fund (2010a). 13 The term “Macroprudential” was coined by the Cooke Committee, the precursor of the present Basel Committee on Banking Supervision. Before the Crisis, Macroprudential policies have been used mainly by policymakers in Asia 14
Since 1990, the BCB has been working to increase and improve the financial access to Brazilian population. Nowadays, all the 5.565 Brazilian municipalities have at least one point of access to financial services.
16
Although this is not pervasive per se, it is worth noting that there are some risks that have to been attached and the macroprudential regulation is an appropriate instrument to deal with these vulnerabilities. The main risks can be focused on:
Procyclicality The risk is higher during expansionary phases due mainly to credit boosts, increases in leverage, maturity mismatches and asset price bubbles. During good times the economy has to provide enough cushion to compensate during the bad times, otherwise a downturn could induce widespread and be amplify the downfall by deleveraging, and contracting financial flows to the rest of the economy. In 2011 the total credit continued buoyant and expanded at 20% percent annual pace (19% in 2010) even though in 2010 the CBC implemented measures to curb its grow (see Chart 14). It is worth mentioning that due to the recent deceleration of the economic activity, in November 2011 the Central Bank unwound most of the credit curbs that it imposed on auto loans, personal loans and payroll loans 15. The BCB announced that the adjustments are of a “prudential character” and are aligned with its mission of improving regulation of the financial system.
Chart 14:Total Credit 40 35 30 25
High Growth
High Growth
20 15
Jan-12
Jul-11
Jan-11
Jul-10
Jan-10
Jul-09
Jan-09
Jul-08
Jan-08
Jul-07
Jan-07
10
Source: Central Bank of
Our policy recommendation is to introduce Dynamic Provision similar to the one implemented in Spain in 2000, and that is also used in other emerging economies as Colombia and Peru. To explain what a dynamic provision is, we are going to take the Spanish experience because it was the first economy to implement this measure and that have been registered the complete cycle (the boom and the posterior bust). Different from the specific provisions, the dynamic provisions don’t go in line with the NPL, so in the good time when the default rates are low, banks are forced to increase the dynamic provisions thus moderating the credit growth and also building a buffer that will use in the bad times. Even, the recent banking Spanish crisis shows us that this measure was not enough; there were some failures in its design that we have to
15
http://www.bcb.gov.br/textonoticia.asp?codigo=3296&idpai=NOTICIAS. The new rules allow banks to reduce the amount of capital the set aside for some loans with shorter maturities, while requiring them to increase provisions on some other loans with longer maturities (above 60 months).
17
consider. For instance, one of them was that the loans for construction and real estate firms were classified as low risky credit. So, it is important that
Real Estate Sector and the Leverage of the Families Other sources of potential concern that were also a trigger of the recent financial crises in advanced economies are the significant growth of mortgage credit and the high leverage of families. Is this the case of Brazil? Regarding the first point, in Brazil the credit growth has been driven in part by the impulse of mortgage credit that rose above 40% annually. Even the ratio of Mortgage Credit/GDP is low in compare to other countries; it was growing very rapidly from 2% at the end of 2008 to 5% in 2011 as shown. The dynamism of the housing credit is related whit the fact that Brazil still faces a large housing deficit, especially among lower-income people 16. Taking into account the results of the EWS and assessing the recent data on housing market, the figures point to a deceleration both in the credit and the prices. The former shows a reduction in growth rate, after reaching annual rates greater than 50% in the second half of 2010. The number of housing sale contracts also presents a decreasing trend which impact is observed in the price of residential properties that slows down since August 2011 (see Chart 15).
Housing Contracts
9 to 10 years 15 to 20 years 25 to 30 years
Oct-10
Jul-10
Apr-10
Jan-10
Oct-09
Jul-09
Apr-09
Jan-09
Oct-08
Dec-11
10 Aug-11
20,000 Apr-11
20 Dec-10
30,000 Aug-10
30
Apr-10
40,000
Dec-09
40
Aug-09
50,000
Apr-09
50
Dec-08
60,000
Chart 16:Loan to values (%)
75 70 65 60 55 50 45 40
Jul-08
60
Apr-08
Chart 15: Housing Market
Jan-08
70,000
10 to 15 years 20 to 25 years
Source: Brazil Central Bank
As the EWS and the recent data revealed we can say that it is not a risk of housing bubble. The loan to value ratios that measure the mortgage credit over the house value are still in low levels, close to 65,0% (see Chart 16) and far below the standard of 80,0% registered in most of the economies. So, we conclude that the risks of a real estate bubble remain contained in Brazil.
The rise of the new middle class in Brazil has been growing very fast. In 2003, 38% of the population belonged to the middle class, but this figure has been updated to 54% in 20011 and it could reach 57% of the total population in 2014. In this context, the rise of the household debt and the quality of the credit become relevant, especially taking into account that many of the 16
According to the Brazilian Institute of Geography and Statistics, the housing shortage is 5,5 millions of houses.
18
bank clients are first-time borrowers from low-income groups, who in many cases have little or no credit history but want to access to the financial services. The surge of this new middle class has led to a significant rise in the household debt burden to 43% of net income from 23% at the end of 2005 and reinforces the concerns regarding the rapid credit expansion (see Chart 17). Moreover, the ratio of non-performing loans to total portfolio, has been increased in the last period and is higher than other Latin American countries. Moreover, for the consumer loans this ratio had been risen continually to 5,3 percent in March (see Chart 18). Leading indicators for non-performing loans, such as the default ratio for past-due loans between 15 days and 90 days, also showed some deterioration, 11,3% in the last March in compare to 9,6% one year ago. So, the main source of concern is the consumption credit. This worry was also shared with BCB, that in the 1Q 2011 indicated that growth in consumer credit of more than 15 percent needs to be monitor “very carefully.”
Chart 17: Household debt
Chart 18: Default Rate
(as % of Net income)
(more than 90 days, as % of total credit)
45
7 6
40
5
35 30
3
25
2
20
1
Sep-11
Jan-11
May-10
Source: Central Bank of Brazil
Sep-09
Jan-09
May-08
Sep-07
Jan-07
May-06
Sep-05
Jan-05
15
Mar-05 Sep-05 Mar-06 Sep-06 Mar-07 Sep-07 Mar-08 Sep-08 Mar-09 Sep-09 Mar-10 Sep-10 Mar-11 Sep-11 Mar-12
4
Consumer Credit
Automotive credit
Source: Central Bank of Brazil
So, one of the measures that prevent high household leverage and that is applied in Peru is Debt to Income Ratio, that is the percentage of a consumer's monthly income that goes toward paying debt has to be below a threshold. For Peruvian Banks, this ratio is 30% and forced the banks to become more cautious on lending. As the Chart 19 shows even in the recent recession, the default rate on consumer credit kept in low levels supported by the good practices of the Peruvian Banking system.
19
Chart 19: Peru Consumer Credit
45 40 35 30 25 20 15 10 5 0
4.0 3.5 3.0 2.5 2.0 1.5
Annual growth (%, lhs)
Apr-12
Dec-11
Apr-11
Aug-11
Dec-10
Aug-10
Apr-10
Dec-09
Aug-09
Apr-09
Dec-08
Aug-08
Apr-08
Dec-07
Aug-07
Apr-07
1.0
Default rate (%, rhs)
Source: Banking Superintendency
It is worth mention that the Macroprudential tools that we suggest have to also be applied to the Brazilian public banks, that have a high market share of the Banking System and that currently are venturing into riskier categories, such as short-term consumer loans 17. V.
Conclusions
Despite the alarm signals of overheating faced in 2011, the Brazilian economy is confronting nowadays a different situation in which the main concern is related to the acceleration of credit. Although the results of the Early Warning System did not revealed a high risk in terms of credit growth, it showed a rise in the non-performing loans share. The EWS approach has some limitations, for example it is based mainly on the fundamentals of the economy, which means that its predictive power does not cover self-fulfilling crises. Yet, we considered it is a starting point for identifying vulnerabilities at the single-country level, even when it should not be considered as a conclusive evidence to ease monetary policy or to eliminate macroprudential policies. In contrast, we consider that there are factors that should be closely supervised, especially those related with the financial sector such as the acceleration of credit, non-performing loans. Added to this, it is worth mentioning that we detected other weaknesses of the economy such as the political influence in economic decisions, which has been seen in a high interest of government in reduce the SELIC and increase credit given by public bank. Then, taking into account the current situation and the features of the Brazilian economy, it is recommendable to: (i) keep the benchmark interest rate at 9%; (ii) track the capital inflows in order to implement properly measures in case a capital surge; and (ii) strengthen the macro prudential regulation to deter an excessive risk taken by financial institutions, specially the public banks. Finally, it is worth mentioning that the implementation of an appropriate policy mix of monetary tools, capital controls and macroprudential regulation can help to support the economic soundness in the short run, i.e. the mix of economic policies that we suggest are valid tools to fortify the economic growth in the coming months. 17
See Appendix 1 for a glance of Public Banking System in Brazil 20
The reach of the monetary, macroprudential and capital controls is to ensure stability in the macroeconomic conditions. Thus, our recommendations are not focused on policies to generate long run growth rates. For this, Brazil should introduce other structural reforms to strengthen the industrial sector and foster productive investments. The reform agenda should incorporate as well: lower the tax burden that is currently one of the highest in the world, the reduction of the current public expenditure, deregulation of labor markets; an improvement of the regulatory framework to promote investments, among others. Its implementation could enhance the perspectives of the economy for the next years.
21
Appendix 1: Public Banks A significant fraction of the recent credit growth is explained by the relevant role of the credit provided by the public banks, which grew by 24% in 2011 and up to the 2012 continue with the same trend. Public banks’ share rose from 34% at the beginning of 2008 to 44% in March 2012, level comparable to that registered at the end of the 90´s. The larger participation of the Government banks supported the quick recovery of Brazil from the 2008 Crisis since these institutions helped to provide counter cyclical credit and so offset the lower loan offer from the private banks. Due to the substantial expansion of the credit provided by state-banks, is important to analyze the current situation of these financial institutions. For instance, the Basel Index of Capital Requirement for BNDES, the National Development Bank, and for other commercial banks was higher than the minimum required by the Central Bank (11.0%) and that the international standard levels. However, these levels are lower than four years ago and lower than the registered by private domestic and foreign banks. Also, the analysis of other basic ratios, such as credit/assets, credit/capital and credit/deposits, points to the same direction. This slight deterioration of some indicators does not necessary mean that the public banking system is fragile, since there are other indicators in which the performance of public banks is better than the private financial institutions, for instance the delinquency rates are lower for public banks. Nevertheless, there are some signals of a higher intervention of the Government in the public banks: (i) Banco do Brasil and Caixa Economica Federal, two of the main stateowned lender, announced they will cut rates by more than half to increase access to credit, (ii) the still high rate growth of the public bank’s credit 18, (iii) the use of subsidized resources by the BNDES that will continue increasing since the Government promise it will reduce borrowing rates for some buyers of machinery and equipment and (iv) the target of the Government to increase the Financial Inclusion, in which the public banks will have a leading role. The increasing market share of the public banks and the signals above mentioned can potentially generate some distortions in the banking system and also can threat the relative good performance of the state-owned lenders.
18
Rousseff is “exhorting” Brazilian banks to cut borrowing costs in line with the SELIC reduction. For more information see http://www.bloomberg.com/news/2012-05-10/rousserff-rate-cut-crusadeundermines-brazil-s-banks.html 22
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