I. Introduction and Summary
- Robert Corker, and Wanda Tseng
- Published Date:
- March 1991
The economic and financial environment in Asian countries has changed significantly in the 1980s since the completion of the first study of monetary policy in these countries.1 The previous study covered a period when monetary policy was conducted in an environment of underdeveloped financial markets, limited international capital mobility, and fixed exchange rate regimes. During the 1980s, virtually all Asian countries liberalized their domestic financial systems. In many of these countries, this was accompanied by the relaxation of capital controls and a move toward more flexible exchange rate arrangements. These developments have altered the channels of monetary policy, affected the relationship between money demand and incomes and interest rates, and prompted a reassessment of the appropriate instruments of monetary policy. This paper focuses on these and other issues of monetary policy in the wake of the financial reforms.
Section II reviews the major financial reforms undertaken by Asian countries during the 1980s, emphasizing the common elements from their collective experience. The broad thrust of reforms was to allow market forces to play a greater role in the financial system. While the reforms accorded well with the general shift toward greater reliance on market signals to direct the allocation of resources, they were also necessitated by the growing complexity of these economies and the need to be able to respond more flexibly to external shocks.
The prereform financial systems in many of the Asian countries, which were characterized by controls on interest rates and the allocation of credit, proved inadequate in the domestic and international environment of the 1980s. The response was to liberalize interest rates and reduce direct controls on financial markets while strengthening the supervisory framework, and to promote a deepening of money and capital markets. The pace of reforms differed markedly among the countries. For some, the reforms were concentrated in major and discrete liberalization programs. For most of the others, reform was a more gradual and continuous process.
An important effect of the liberalization of interest rates was to raise real interest rates, which generally had been negative during the 1970s. This contributed to financial deepening as more resources were mobilized through the financial system. In a few Asian countries, liberalization added to the volatility in financial markets during the 1980s.
Section III investigates the implications of financial reforms for money demand in these countries. Financial liberalization might be expected to have affected the relationship between money demand and incomes and interest rates. In particular, financial liberalization might have caused onetime shifts in money velocity or changes in the responsiveness of money demand to changes in incomes and interest rates. In addition, new influences may have become important determinants of money demand after liberalization and the precision with which monetary developments can be predicted may have been altered.
Empirical analysis confirms that the relationship between monetary aggregates, income, and interest rates exhibited some instability during the 1980s for many of the Asian countries. The instability was mainly manifested through the inability of money demand functions to predict short-run developments in the monetary aggregates: over longer periods, many of the aggregates continued to move in line with their historical relationships to incomes and interest rates. The empirical results also uncover a greater role for interest rates in determining money demand than the earlier study had shown (see Aghevli and others (1979)). Furthermore, the experience in those countries that introduced more flexible interest rates suggests that broad money demand is sensitive to relative asset returns rather than the overall level of interest rates.
Section IV examines the effects of financial reforms on the transmission channels of monetary policy and the implications for the formulation and implementation of monetary policy. In particular, as direct controls on financial markets were relaxed, interest rates played a greater role in transmitting monetary effects to all sectors of the economy. Also, with greater capital mobility and more flexible exchange rate regimes, the exchange rate became an important channel for transmitting the effects of monetary policy. While these developments enhanced potential control over domestic monetary conditions, a greater need arose to coordinate monetary policy with exchange rate policy.
Financial liberalization has led to a reassessment of how monetary policy should be implemented. In general, there has been a greater reliance on interest rate and money supply targets as opposed to credit targets. However, several countries have not relied on a specific target and, instead, have monitored a number of financial and economic indicators.
Greater emphasis was placed on indirect market-based instruments, most notably open market operations, for influencing interest rates and monetary conditions as opposed to direct controls on credit and interest rates. This was both necessary, because direct controls can be increasingly circumvented in more sophisticated financial markets, and desirable, because financial resources can be allocated more efficiently if economic decisions are less distorted.
The effectiveness of open market operations in some Asian countries was constrained by the inadequate development of markets and instruments and by the continued widening of government financing needs. Nevertheless, with improvements in markets and instruments as well as progress in reducing fiscal deficits, open market operations have become the primary instrument of monetary policy in many of these countries.
Conclusions are summarized in Section V. Overall, financial liberalization and monetary policy reforms have contributed to more efficient financial systems and have enhanced the effectiveness and flexibility of monetary policy.