Macroprudential policy stabilizes EM banks against geopolitical risk
A South African Reserve Bank paper calibrates a DSGE model for emerging economies, showing that geopolitical risk shocks depreciate exchange rates, are inflationary, and harm bank balance sheets. Macroprudential policy can stabilize credit and output conditions from these shocks.
Geopolitical shocks hit EM balance sheets
Geopolitical risk (GPR) shocks significantly impact small open emerging market economies, leading to a depreciation of domestic nominal and real exchange rates and increased inflation.
These shocks reduce aggregate demand and prompt a rise in nominal interest rates.
Furthermore, GPR hampers financial conditions by increasing both domestic and foreign borrowing rates, which in turn causes a decline in the net worth of banks.
This deterioration tightens banks' borrowing constraints, reduces their assets, and increases the spread between the expected return on capital and the risk-free rate.
The resulting rise in the cost of credit for non-financial borrowers leads to a further decline in output and investment, exacerbating the negative feedback loop on bank balance sheets.
Empirical evaluation shows a heterogeneous but evident relationship between GPR and country risk across emerging markets, depending on the nature of the geopolitical event.
Policy mix for stability
The study evaluates the stabilization ability of a combination of monetary policy, macroprudential, and capital flows management policies.
Policy experiments demonstrate that macroprudential policy can effectively stabilize credit, investment, and output conditions in response to negative GPR shocks.
However, the implementation of such a policy causes an inflation-output trade-off.
The research indicates that applying an optimal macroprudential policy rule, in addition to the standard Taylor rule, provides additional welfare benefits compared to a combination of the standard Taylor rule and capital flows management policies.
This highlights the complementary role of macroprudential tools in enhancing macro-financial stability, particularly when economies face external shocks like GPR.
Timely insights, complex realities
This paper offers a valuable quantitative framework for understanding the complex interplay between geopolitical risk and financial stability in emerging markets, a critical yet under-researched area.
While the DSGE model provides robust insights into policy effectiveness and trade-offs, the inherent unpredictability of geopolitical events suggests that real-world policy implementation remains challenging.
Nevertheless, the findings strongly underscore the growing importance of proactive and well-calibrated macroprudential tools in navigating an increasingly volatile global economic landscape.