Climate and fragmentation are key risks, say deputy governors

The risks posed by geopolitical fragmentation, climate change and the potential for regulatory arbitrage were among the topics discussed by central bank deputy governors during a panel at Central Banking’s Autumn Meetings in Rio.

The four panellists – three from jurisdictions in the Americas and one from a coastal nation in Africa – all represented emerging economy central banks.

One of the deputy governors from the Americas said geopolitical fracturing had led to short-term supply shocks and production inefficiencies. “That has an impact on monetary policy because if affects long-term neutral rates of interest,” they said. “It should mean higher rates of interest as time goes by.”

Rising fiscal debt, the deputy governor said, was “worrisome, because it tends to tighten financial conditions on a global scale”. If major economies did not engage in consolidation of their public finances, this would have an impact on smaller economies, which would see a long-term drying up of funding as a consequence.

Tariffs could have spillover effects on trade, the deputy governor said. In the event of a US-China trade war, China could flood smaller economies with cheaper goods, which the official said would have a deflationary impact in their own jurisdiction. “But obviously, you have many other impacts that go in the opposite direction,” they said. These could include a depreciation in the dollar, resulting in higher inflation in the US and tighter monetary policy on the part of the Fed – which could have a ripple effect by triggering higher inflation in smaller economies.

“The continuously deferred realisation of these risks calls for more caution,” said the deputy governor. “It calls for monetary policy that’s more gradual.”

A second deputy governor from the Americas said that “when the US sneezes, our own economy catches a cold”. Their own country was in a good fiscal position, but geopolitical fragmentation was one of the main considerations for their central bank, along with climate risk.

Climate risks and resilience

The deputy governor from an African jurisdiction spoke of how climate risks needed to be factored into their own institution’s decision making. Ports were at increased risk of floods in their country, they said.

The first deputy governor from the Americas said climate risks affected not only commodity prices but also financial conditions by creating “a state of permanent volatility” over the long term. Hedging products for certain commodities would rise significantly, and certain hedging instruments would “collapse because volatility becomes so large that insurance is no longer marketable”.

A third deputy governor from the Americas said their jurisdiction faced climate risks and risks from extreme weather events “all the time”.

“Climate risk has further implications for us in terms of debt levels and fiscal buffers,” they said. “When your buffers get reduced, this leads to complications, including over financial stability.”

Climate was the key risk for this deputy governor’s country, followed by geopolitical risk. The jurisdiction was dependent on the US as its currency was pegged to the dollar, most of its trade was with its larger regional neighbour, and tourism was a big contributor to its GDP.

The second deputy governor from the Americas said a recent extreme weather event had forced the central bank to take action in response. This initially involved ensuring, as a regulator, that the country’s lenders had “easy access to cash” by waiving the usual fees they were charged when they ordered cash from the central bank. It also involved finding alternative means of distributing cash to areas where it could no longer be accessed through cash machines.

“Whenever our banks need liquidity, we are there to give that support,” said the deputy governor. They added that their central bank’s strong reserve position had enabled it to respond to any demands from the domestic financial sector for foreign and local currency.

The third deputy governor from the Americas said their institution had a tranche of its reserves set aside for natural disasters. “Whenever there is a natural disaster, we set aside money from that tranche to get the country up and running again,” they said.

Climate risks, and the related threats to both physical infrastructure and financial stability, underlined the need for institutional resilience.

The second deputy governor from the Americas said a recent extreme weather event had shown the resilience of their own jurisdiction’s financial markets infrastructure, which had only been down for one day during the weeklong aftermath of the event. Having learned lessons from its experiences during the Covid-19 pandemic, the central bank was able to ensure that payments and other financial infrastructure systems continued to operate remotely. “So I can sit in my house and we can run our RTGS, our CSD, our FX trading platform remotely,” they said. “Covid taught us that we needed to change how we operate, and it has paid off now.”

The third deputy governor from the Americas said improving resilience started with building capacity in terms of people, systems, processes, frameworks and technology. It also involved “prudence in reserve management”, which focused on capital preservation and liquidity while generating returns. The buffer created by the jurisdiction’s dollar peg had also helped in boosting resilience, they said.

The deputy governor from an African nation said their jurisdiction’s strategic reform plans had put resilience at the centre. “We are not dealing with firefighting,” they said, adding that the institution had built a stronger legal framework and improved supervision. It had also established a new national payments system whereby every bank had its own QR code. “Resilience for us means really strong institutions, strong systems and strong oversight,” they added.

The first deputy governor from the Americas said communication about scenarios and transmission channels was “at the core” of their institution’s monetary policy strategy. They added that many of the risks to their institution’s baseline scenario for monetary policy related to geopolitics.

“The communication about scenarios is about how we should adjust the expected trajectory as a function of certain risks that have to be balanced,” they said. On the domestic front, these included the potential for fiscal shocks, though there were broader risks from external developments that also had an impact on domestic inflation expectations. These included tariffs, climate risks and fiscal consolidation in developed economies.

The deputy governor added that central banks should not communicate risks “in a mechanical fashion and make markets think that movements in the exchange rate have a deterministic implication on how monetary policy looks.” They said an essential aspect of their own communication strategy was emphasising the management of different transmission channels for monetary policy, such as financial conditions or market prices.

Regulatory arbitrage

The third deputy governor from the Americas voiced concern about the roll-back of regulations introduced in the wake of the global financial crisis.

“There is the possibility of undermining global standards,” they said. When major economies lowered their standards, “you provide the opportunity for regulatory arbitrage, and that is what leads to the race to the bottom – because everybody is trying to get lower and lower. And banks, especially the multinationals, take advantage of that.” The potential reduction in capital buffers was among the factors that could weaken the international financial system, they said.

In addition to geopolitical fragmentation, the deputy governor warned about the fragmentation of the banking system. “If one of us has high standards and another has lower standards, then what do you see? It’s no longer a level playing field for the collaboration and co-operation that has to be the new way as we innovate.”

The second deputy governor from the Americas agreed on the need for co-operation, and quoted the poet John Donne: “No man is an island. We cannot exist without collaboration.” They also agreed about the need to prevent regulatory arbitrage, and spoke of the need to regulate non-bank entities.

The deputy governor from an African nation said that they too were “really not fans of the notion of a ‘race to the bottom’”.

Stablecoins

The first deputy governor from the Americas said stablecoins had become popular in their jurisdiction for both good and bad reasons. Although the crypto assets provided a way for people to bypass foreign exchange and compliance regulations, the cross-border settlement infrastructure had also improved efficiency. They said regulations needed to close the gap between stablecoin platforms and traditional FX platforms, and ensure the former were subject to the same strictures as the latter.

However, their own jurisdiction had no plan to regulate the issuance of stablecoins, as most issuers were based outside its borders. “The strategy has to focus on making sure that the intermediaries comply with foreign exchange regulations and that our regulatory perimeter essentially accommodates most activity in these markets,” they said.

The deputy governor from an African nation said their jurisdiction did not have a fixed position on stablecoins or crypto assets more generally. With regard to dollar-backed stablecoins, they said: “As a regulator, we don’t like something we can’t control.” They said that stablecoins more generally posed anti-money laundering and countering the financing of terrorism risks, though they could also make remittance payments easier and cheaper. Their own jurisdiction planned to wait and see how stablecoin regimes in major economies, such as the US, fared before deciding on its own approach.