Financial stress, economic activity and monetary policy in the ASEAN-5 economies

Abstract

This article uses a structural vector autoregression approach to analyse the impact of financial stress on the economy and the relationship between monetary policy and financial stress in the ASEAN-5 economies (Indonesia, Malaysia, Philippines, Singapore and Thailand). We find that an increase in financial stress leads to tighter credit conditions and lower economic activity in all five countries. The estimated impact on the real economy displays an initial rapid decline followed by a gradual dissipation. In Malaysia, the Philippines and Thailand, the central banks tend to reduce policy interest rates (IRs) when financial stress increases, although there is substantial cross-country variation in the magnitude and time dynamics. The lower policy IRs are found to have little significant effects in lowering financial stress, but are still effective in stimulating economic activity through other channels. These findings imply that easing monetary policy is likely necessary but insufficient to address growth slowdowns associated with financial stress. Monetary easing should instead be complemented with other policy measures which are targeted at restoring financial stress to normal levels.

Keywords:

• financial stress
• monetary policy
• small open economy

JEL Classification:

• E44
• E50
• E58

Acknowledgements

The views expressed here do not represent those of Bank Negara Malaysia. Earlier drafts were presented at the Bank of Thailand and Bank for International Settlements (BoT-BIS) 8th Annual Workshop of the Asian Research Networks 2015, the ISI Regional Statistics Conference 2014 in Malaysia and the joint meetings of the Econometric Society Australasian Meeting (ESAM) and Australian Conference of Economists (ACE) 2014. This article benefitted from comments made by the conference participants. This article also benefitted from helpful comments from Mala Raghavan, Fraziali Ismail, Mohamad Hasni Sha'ari and Ahmad Othman. All errors and omissions are ours.

Notes

¹ Defined as the difference in cost of financing an investment between internally and externally sourced funds.

² See Dell’Ariccia et al. (2008) and Mendoza and Terrones (2008) for other selected examples of empirical studies that address the relationship between credit and real economy.

³ For instance, industrial production falls rapidly for 4 months, rebounds after 7 months and subsequently overshoots before its effects gradually dissipates approximately 3 years after the uncertainty shock.

⁴ See Baxa et al. (2013) for a more extensive review of this literature.

⁵ Despite their strong stance against systematic reactions to asset prices, Bernanke and Gertler (2001) caveat that this does not preclude short-term monetary policy interventions during periods of financial instability.

⁶ The only difference is the weights are now updated every quarter instead of annually.

⁷ See Tng et al. (2012) for a discussion of financial stress in the ASEAN-5 economies during these three financial episodes.

⁸ This model also applied in Tng (2013) to analyse the exposure of the ASEAN-5 economies to external shocks. Hence, the description of the VAR model is largely similar to that article.

⁹ This reaction function is not exactly the same as the one originally suggested in Taylor (1993) as other variables enter the function in lags.

¹⁰ See Fung (2002), Disyatat and Vongsinsirikul (2003), Hesse (2007) and Raghavan et al. (2012) for some references within the VAR literature.

¹¹ More recent studies in this vein are Disyatat and Vongsinsirikul (2003) and Raghavan et al. (2012).

¹² The bootstrap methodology applied is from Hall (1992) using 100 replications. Increasing the number of replications to 500 does not materially change the results.

¹³ The large variations in exchange rate responses across countries likely reflect differences in both institutions and policy regimes that are beyond the intended scope of this study. In Singapore, the NEER serves as the monetary policy instrument, indicating essentially that the Monetary Authority of Singapore’s monetary policy stance does not systematically respond to changes in financial stress. In Malaysia, the central bank intervenes to reduce exchange rate volatility. This may explain why the depreciation is temporary – for example, upon experiencing sudden capital outflows and exchange rate depreciation as financial stress increases, the central bank intervenes to limit the abrupt exchange rate depreciation and hence reduces the overall exchange rate volatility associated with capital flow movements. Malaysia’s exchange rate dynamics is likely also influenced by changes in the exchange rate regime during the sample period.

¹⁴ See Tng (2013) for an analysis of the impact of external shocks on output and inflation using the same VAR model and sample.

¹⁵ Singapore is excluded from this analysis because its central bank uses the exchange rate instead of a short-term interest rate as its policy instrument to conduct monetary policy. The results for Singapore are therefore not comparable with the other economies, due to differences in the policy instrument and identification of monetary policy shocks in the SVAR.

¹⁶ The initial spike in Malaysia’s case is small and statistically insignificant and is thus discounted for inference.