A consensus has emerged that the sole objective of monetary policy is price stability, however, the interrelationship between monetary policy and financial stability is receiving increased attention. These twin objectives are subject to the same forces, where policies targeting one may affect or even contradict the other, especially since the transmission mechanism of monetary policy, is not independent of the specific structure of financial markets. Under certain conditions, the interplay between market structure and capital regulation may not only block the transmission of monetary policy but even reverse it.
Our focus is on the interdependence between the transmission of monetary policy and market structure, in particular capital regulations. The problems identified in the nexus debate are particularly relevant for currency dependent economies where the same policy variable, the exchange rate, affects price setting in the goods and financial markets, but in opposite directions. This implies that capital regulations can neutralize monetary policy, and conventional monetary policy can be procyclical. We suggest that these effects can be mitigated by requiring bank lending in foreign currency to be denominated in the same currency units. The resulting capital charges would be caught the cyclical while the same time empowering monetary policy.
In a wide range of countries, emerging market economies and small open economies alike, a substantial proportion of domestic liabilities are currency linked. In these currency dependent economies (CDEs), credit and currency risk is integrated in current capital regulation, and will be even more so when Basel–II is implemented. This is not a problem for diversified large economies with negligible currency risk. However, in CDEs, domestic debtors carry a substantial amount of unhedged currency linked loans. In these economies, currency risk is already a significant part of the systemic risk facing the economy, with exchange rate movements strongly procyclical. Capital regulations are known to be procyclical, (see e.g. Borio et al., 2001), and their introduction into currency dependent economies further exasperates the procyclicality induced by the exchange rate.
Regardless of the clarity of policy goals, outcomes in CDEs may be ambiguous. The central bank may want to react both to inflationary pressures and growing imbalances in the financial sector but the transmission of the policy is distorted or delayed depending on bank capital and capital regulations. On one hand, the exchange rate has strong pass–through effect on price determination in the goods market while also determining the size of banks balance sheets, i.e. principal of currency denominated loans, and thus their capital charges. An exchange rate appreciation for the purpose of price stability could perversely lead to increased financial instability by reducing the amount of regulatory capital. Thus the key challenge for CDEs is the clearing of the monetary policy channel, which must take into consideration current capital regulations, and the eventual impact of the Basel–II Accord.
