Cross-country macroprudential policy coordination and financial stability in advanced and systemic middle-income economies.

Abstract

Cross-country macroprudential policy coordination is increasingly recognized as a vital tool for mitigating international financial crises and addressing systemic risks in advanced systemic economies (ASEs) and systemic middle-income countries (SMICs). ASEs and SMICs control the largest financial systems, making them key sources and amplifiers of global financial disturbances. However, for effective policy coordination, these economies must first meet three essential prerequisites: strong financial integration, the availability of effective macroprudential policy frameworks, and the presence of common measures of systemic risk. This study aims to assess whether ASEs and SMICs satisfy these conditions. The study is structured around three core objectives. First, it examines the degree of financial synchronisation between these economies, utilising a dynamic factor model and Bayesian vector-autoregression model with data spanning 1960Q1 to 2023Q4. The results indicate that there is a common factor driving much of the variation in the financial cycles of ASEs and SMICs. Additionally, shocks in ASEs' financial cycles explain nearly 40% of future variations in SMICs' financial cycles, and vice versa, demonstrating significant financial synchronisation between the two groups. Second, the study assesses the effectiveness of macroprudential policies in these economies, employing the dynamic common correlated effects model and the panel structural vector model using data from 1980M1 to 2023M12. The findings reveal that tightening macroprudential policies lead to relocation effects—capital flows decrease in tightening jurisdictions but increase in those with looser regulations. Furthermore, countryspecific policies generally reduce credit and asset prices, while common policies stimulate these factors, uncovering trade-offs between different policy approaches. Third, the study constructs a common financial cycle to capture shared systemic risk, using the Markov switching dynamic regression factor model. It identifies asset prices, capital flows, central bank policy rates, and the Volatility Index (VIX) as key systemic risk drivers, with peaks in the common cycle coinciding with financial crises. Therefore, the common financial cycle captures the evolution of risk in these economies in ASEs and SMICs. Overall, the findings suggest that ASEs and SMICs meet the conditions for cross-country macroprudential policy coordination. Therefore, it is recommended that ASEs and SMICs establish a supranational prudential authority to coordinate and supervise macroprudential policies on behalf of member states. Furthermore, discussions should be held to develop mechanisms for effectively managing the trade-offs between country-specific and common macroprudential measures.