Volatile Capital Flows and Economic Growth: The Role of Macroprudential Regulation
Kyriakos C. Neanidis
Macroprudential policies, their use, implementation and effectiveness, have been at the centre of a heated debate since the onset of the global financial crisis. This note sets the emphasis on the long-run growth effects of financial regulation. It finds that macroprudential regulation promotes economic growth by mitigating the adverse effects of financial volatility.
Macroprudential regulation and economic growth
The global financial and economic crisis of 2007–09 has highlighted weaknesses in macroeconomic and regulatory practices and market failures that contributed to a buildup of systemic risks. At the international level, this led to the setup of macro-prudential oversight frameworks with the aim to contain systemic risks and achieve greater financial stability, and in this way reduce the adverse consequences of financial volatility for the real economy.
Although recent work has examined the effectiveness of macroprudential regulation in reducing systemic risk and financial instability, by focusing on the credit and housing markets, little is known about the effectiveness of these rules on the broader objective of economic growth. To close this gap, in a new paper (Neanidis, 2015) we examine empirically the relationship among macroprudential regulation, financial volatility, and economic growth. In particular, we assess the success of macroprudential policy in reducing systemic risks by dampening the procyclicality and volatility of financial flows, expected to give rise to a growth-promoting effect.
Broadly defining financial volatility as the volatility of international capital flows and using aggregated indicators of macroprudential regulation, we investigate the effect of volatile capital flows on growth in the presence of macroprudential policies. In our panel data framework, the sample covers about 80 countries over the period 1973-2013.
The results indicate that although more variable capital flows reduce economic growth, macroprudential regulation mitigates this negative growth effect. This means that macroprudential policies, by encouraging a greater buildup of buffers, attenuate the adverse growth effects of unstable capital flows and, by so doing, are effective in limiting financial system vulnerabilities.
Further findings are summarised as follows:
- The outcomes are mainly restricted in the sample of middle-income countries, since it is this group of countries that have relied more on macroprudential policies.
- In Sub-Saharan Africa and, within it, Francophone SSA, macroprudential regulation has the capacity to attenuate the growth-distorting effect of volatile flows to a much greater degree.
- The effectiveness of macroprudential regulation diminishes in magnitude in economies that are relatively open, with deeper financial systems, and exposed to greater macroeconomic instability.
Traditionally economists have examined the implications of monetary and fiscal policies for economic growth. With the recent design of regulatory frameworks in the form of macroprudential rules, another set of policies has emerged that could be used to enhance economic growth by simultaneously ensuring financial stability. Our analysis shows that macroprudential regulation can achieve this dual objective making it an important part of a policymaker’s toolkit, especially for countries exposed to large and volatile movements in financial flows. This, in turn, justifies efforts for international cooperation and coordination in setting macroprudential rules and standards as a way of combating and minimizing financial volatility and its consequences on the real economy.