Financial stability will have to play a more prominent role in monetary policy decisions amid subdued inflationary pressure, says Veerathai Santiprabhob, governor of the Bank of Thailand.
The delayed normalisation of low or even negative interest rates further exacerbates financial stability risks, he told an audience at the 34th Annual G30 International Banking Seminar.
Debts -- both household and corporate -- are now reaching historic highs. Emerging nations, often with non-bank financial activities outside the regulatory perimeter, are more susceptible to risk buildups.
Capital flows, especially portfolio flows, now account for a much larger portion of cross-border flows than current account flows, and have a much larger effect on the exchange rates for emerging markets.
These capital flows -- a significant portion of which are non-resident activities -- are more sensitive to global financial conditions that have been dictated largely by the monetary policy stance of advanced economies and global investors' sentiment rather than textbook determinants like macroeconomic conditions in emerging markets and interest rate differentials, said Mr Veerathai.
"Moreover, due to the large foreign exchange activities by non-residents relative to the size of domestic foreign exchange markets and increases in derivatives and algorithmic foreign exchange trading activities, the exchange rate could at times act as an amplifier as opposed to a stabiliser of shocks and capital flows, especially in emerging markets with strong external positions that are considered safe havens like Thailand," he said.
While capital flows in and out of emerging markets might be small relative to global financial activities, they could have real and significant impacts on the emerging market economies and their exchange rates, said Mr Veerathai.
Concerning volatile exchange rate movements that could undermine financial stability, capital flows could affect emerging markets' monetary policy stance.
For example, with a low interest rate for a prolonged period, emerging markets may need to follow advanced economies in delaying or reversing normalisation of monetary policy to avoid appreciation of their currencies. Because of spillovers, the monetary policy of emerging markets could be distracted from their core domestic policy mandates, he said.
For emerging markets that still have a lot of ground to cover in regulating non-bank financial activities, financial stability cannot be addressed by macroprudential measures alone.
Emerging markets also need to equip themselves with policy tools to deal with rapidly changing capital flows. These tools encompass macroprudential and microprudential measures, capital flow management measures, and at times foreign exchange intervention, said Mr Veerathai.
Emerging markets that are recipients of flows are often restricted and reproached in their response to capital flows, while source countries have full flexibility in their conduct of monetary policy, he said.
"In this regard, we very much welcome the IMF's work on the Integrated Policy Framework that will allow small open countries to respond to spillovers more effectively, taking into account each country's specific context and circumstances," said Mr Veerathai.
"We hope that source countries of capital flows take into account spillover and spillback effects in their policy deliberation."
Assessments of global imbalances and implications for currency valuation need to adopt a broader view that takes into consideration not only current account imbalances but also capital flows that have become much larger than current account flows, he said.
Taking a narrow perspective of current account imbalance alone could lead to a policy misstep, said Mr Veerathai.
"When we think about policy space, we must not look at the zero lower bound, effective lower bound, or the optimal size of the central bank's balance sheet. We must also be aware of the financial stability lower bound -- how much additional financial stability risks we are willing to take," he said.
"This is so the financial market can have a realistic view of monetary policy and not expect central banks to engage in excessive easing that might result in long-term financial instability."