Information about Asia and the Pacific Asia y el Pacífico
Chapter

IV. Implementation of Monetary Policy

Author(s):
Robert Corker, and Wanda Tseng
Published Date:
March 1991
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The financial liberalization undertaken by nearly all Asian countries during the past decade has significantly changed the environment in which monetary policy operates. The resulting structural changes in the financial system have affected the linkages between monetary policy and the domestic economy, the meaning of monetary aggregates, and the relative effectiveness of different monetary policy instruments. This section examines some of the issues that have arisen concerning the implementation of monetary policy in an environment of reforms. It discusses how the reforms have affected both the channels of monetary policy and the choice of targets and instruments of monetary policy. It then reviews the two major changes in the implementation of monetary policy during the 1980s: the liberalization of interest rates and the greater reliance on indirect monetary instruments, particularly open market operations. Conclusions are presented at the end of the section.

Financial Liberalization and Channels of Monetary Policy

The channels through which monetary policy operate depend on the financial structure of an economy. Specifically, the channels of monetary policy are influenced by the maturity and depth of financial markets, the flexibility of interest and exchange rates, and the degree of external capital mobility.

Underdeveloped financial systems are typically characterized by interest rate regulations, domestic credit controls, the segmentation of financial markets, an absence of money and capital markets, and restrictions on international capital flows. In this environment, monetary policy works mainly by directly affecting the availability of credit. When bank credit is the major source of finance, a tightening of monetary policy usually takes the form of credit rationing, changes in reserve or liquidity requirements, or reducing banks’ access to rediscount facilities. The reduced availability of financing lowers aggregate demand, curbs inflation, and improves the balance of payments. Expansionary monetary policy, by easing credit rationing, works conversely. While direct controls, such as credit ceilings, selective credit controls, and directed credit, certainly can transmit impulses from financial markets to the real economy, they tend to be inefficient. Specifically, they create incentives for disintermediation as funds are channeled outside the regulated banking system and they distort savings and investment decisions.

The emergence of new financial institutions and markets, together with the liberalization of interest rates, create a greater role for interest rates to transmit the effects of monetary policy. Restrictive monetary policy, implemented through open market operations, or increases in discount rates or reserve requirements, tends to raise interest rates, increase the demand for financial assets, and reduce aggregate demand, especially for investment.31 Higher interest rates may also have adverse supply-side effects because they increase the cost of working capital.32 As financial markets become more integrated, changes in interest rates are transmitted more rapidly and pervasively to all sectors of the economy, enabling interest rates to play a greater role as a channel for monetary policy.

While the channels of monetary policy are limited to credit availability and, when possible, interest rates in a closed economy, exchange rates and international capital flows provide additional transmission channels in an open economy. It is now generally accepted that, in an open economy with fixed exchange rates, the monetary authorities are not in full control of the money supply because changes in the money supply can occur through monetary movements brought about by changes in international reserves—that is, by balance of payments surpluses or deficits.33 Control over the money supply in these circumstances would require the monetary authorities to sterilize balance of payments imbalances. However, sterilization may be difficult to sustain if the monetary authorities do not have enough holdings of securities or foreign exchange reserves, and realistically, the monetary authorities would have control only over that part of the money supply that is created internally through domestic credit. With fixed exchange rates, disparities between the supply of and demand for money created by changes in domestic credit are eliminated through the balance of payments. For example, a tightening of domestic credit reduces the supply of money relative to demand, everything else being constant: this improves the balance of payments as domestic residents replenish their money balances by reducing absorption.

The difficulty of controlling the money supply under fixed exchange rates is exacerbated by international capital mobility which prevents domestic interest rates from deviating substantially from international levels. For example, a decrease in the money supply would increase domestic interest rates and attract capital inflows. These capital inflows would reverse both the reduction in the money supply and the rise in interest rates. In effect, capital flows negate control over the money supply and interest rates and, as a consequence, domestic prices would be largely tied to international levels.

Under a more flexible exchange rate regime, control of the money supply returns, particularly if capital is mobile. In these circumstances, the exchange rate becomes an increasingly important channel for the transmission of monetary policy. Monetary restraint, for example, puts upward pressure on domestic interest rates and induces capital inflows. But, in contrast to the case of fixed exchange rates when these capital inflows would have negated the effects of restrictive monetary policy, under flexible exchange rates the domestic currency would appreciate in response to the excess supply of foreign exchange. This appreciation reinforces the effects of monetary contraction by curbing demand for domestically produced tradable goods and reduces inflationary pressures.

While exchange rate flexibility enhances control over domestic monetary conditions in some respects, it also places other constraints on monetary policy. In particular, monetary conditions abroad become a more important concern to domestic monetary authorities, particularly if the economy is small. For example, a tightening of monetary policy abroad would lead to downward pressure on the exchange rate and upward pressure on domestic prices unless domestic monetary policy is also tightened. Also, the interest rate and exchange rate effects of domestic monetary policies need to be taken more into account. The greater scope to pursue an independent monetary policy is tempered by the need to coordinate monetary with exchange rate policy.

Targets and Instruments of Monetary Policy

Financial reforms have created a number of problems for the conduct of monetary policy in Asian countries. With greater flexibility in interest rates and liberalization of financial markets, monetary authorities have had to decide whether to target mainly prices, such as interest rates, or quantities, such as monetary or credit aggregates. Within the latter, there is the further question of whether the targeted aggregates should be narrow or broad money. While narrowly defined aggregates are easier to control, their usefulness has diminished with the development of new financial instruments and institutions. Broader aggregates may be more closely related to nominal incomes, but are less susceptible to control.

The choice of targets is further complicated by financial innovations and institutional changes that have altered the characteristics of the assets included in the aggregates and by the development of markets in areas where statistical coverage is weak. Moreover, as discussed in Section III, the relationship between money demand and income and interest rates, a fundamental building block of monetary policy, has been affected.

Financial liberalization has also prompted a reassessment of the instruments of monetary policy. As discussed in Section II, the effectiveness of traditional instruments of monetary control had eroded over time. Consequently new, indirect monetary policy instruments that can be more effective in the liberalized environment had to be developed and strengthened.

Targets of Monetary Policy

The choice of targets of monetary policy, for example, between interest rates and monetary or credit aggregates, is influenced by the exchange rate regime and the degree of capital mobility. As discussed earlier, in an open economy with fixed exchange rates, the money supply is not amenable to control by the monetary authorities. Moreover, with increased capital mobility, there exists little scope for interest rate targeting as small countries with fixed exchange rates must import their interest rates from abroad. In this environment, targets of monetary policy tend to focus on domestic credit, either that extended by the central bank or by the banking system.

The situation is quite different if the exchange rate is flexible because the monetary authorities have more autonomy in the conduct of monetary policy. The choice between interest rate and money supply targets is then guided by the ability of each target to minimize deviations of output and prices from their objective levels. Such deviations could result from a variety of disturbances, including shifts in the public’s portfolio preferences and changes in the terms of trade. It has been suggested that interest rates are likely to be the preferred target of monetary policy when the dominant source of instability emanates from the financial sector, whereas the targeting of monetary aggregates would be preferable when real sector disturbances are more important.34

In practice, of course, exchange rates are not fully flexible and international capital flows are seldom completely unregulated. In general, therefore, the monetary authorities will have some control over domestic monetary developments. The practical question is then to select the target that has the best empirical relationship to the ultimate policy objectives of securing sustainable growth and stable prices.

If money were selected as the target of monetary policy, for instance, it would remain to determine which monetary aggregate should be targeted. The choice would depend on which monetary aggregate was the best leading indicator of economic activity and price pressures. For countries undertaking financial reforms, there tends to be increased substitutability between different forms of financial assets—for example, the distinction between narrow and broad money becomes blurred as new financial instruments can have both liquidity and investment features—resulting in greater volatility in the narrower aggregates. Under these circumstances, a broader definition of money may be more appropriate. However, monetary authorities may find it difficult to achieve targets for broad money given available instruments. This could be further exacerbated by the presence of unorganized money markets and nonbank financial institutions outside of central bank control.

The general relaxation of capital controls and the shift from fixed toward more flexible exchange rate arrangements, together with financial reforms undertaken by many Asian countries, have all affected the choice of targets of monetary policy. While some countries continue to focus on credit aggregates (Myanmar. Nepal, and Sri Lanka), there has been a shift to interest rate or monetary targets owing to the greater scope for monetary autonomy and access to alternative sources of credit (including credit from abroad).

Indonesia adopted interest rate targeting following the financial reforms in 1983 because of concerns that targeting monetary aggregates in the wake of major financial sector changes and large portfolio shifts would result in undue increases or instability in the level of interest rates, with possible adverse effects on output.35 In mid-1987 when the rupiah came under speculative pressures, policy shifted to protecting international reserves, and interest rates became more flexible.

Several countries have adopted the targeting of monetary aggregates. In Korea, M2 has been used as the target of monetary policy. The choice of M2 reflected, on the one hand, the lack of a relationship between narrower aggregates, such as M1, and economic activity (discussed in Section III), and, on the other hand, the difficulty of controlling a broader aggregate, such as M3, owing to the rapid growth of nonbank financial institutions. Sri Lanka also used M2 as the target of monetary policy. In the Philippines, the monetary target was changed from net domestic assets of the monetary authorities to base money in 1984 after the adoption of a floating exchange rate system. This reflected the high priority attached to arresting inflation as well as the need to contain the effects of possible substantial, unanticipated capital inflows.36 Other countries (Malaysia and Thailand) have monifored a number of monetary targets and economic variables.

In contrast. Singapore does not rely on credit or monetary targets. Because of the high degree of capital mobility, monetary aggregates are essentially demand determined—any disequilibrium being resolved quickly through external capital flows—and domestic and foreign interest rates tend to move in line. Instead, Singapore relies on the exchange rate to influence domestic wages and prices through its effect on tradable goods prices.

Instruments of Monetary Policy

During the 1980s, a number of Asian countries moved toward a greater reliance on market-based instruments of monetary policy and away from direct controls. These changes complemented financial reforms because they enlarged the scope of monetary policy instruments while at the same time facilitating the dismantling of regulations and controls in the financial system. One advantage of using indirect instruments is that economic decisions are left to the markets, resulting in a more efficient allocation of resources. This advantage is particularly important given the difficulties of directing credit in the increasingly complex economic and financial environment of many of these countries. The shift toward indirect monetary controls has generally entailed a greater reliance on open market operations, less dependence on reserve requirements, and a change from selective to generalized rediscounting.

Nearly all Asian countries (Indonesia, Korea, Malaysia, Nepal, the Philippines, Sri Lanka, and Thailand) have introduced or intensified the use of open market operations. However, open market operations were often limited by the absence of government debt instruments and the thinness of private money markets. Thus, the shift toward open market operations has been accompanied by the issuance of central banks’ own debt instruments, the use of private money market securities for open market operations, and measures to encourage the development of interbank markets and private secondary markets in government securities. These developments have often necessitated bringing the yields on government securities in line with market levels and/or discontinuing the practice of forcing the central bank and commercial banks to absorb government securities. Also, more restrictive access to discount facilities and increases in discount rates were implemented to preclude financial institutions from circumventing the effects of open market operations through the discount window.

The shift toward open market operations was accompanied by changes in other instruments of monetary policy, particularly those that affect bank reserves. As the absorption and injection of bank reserves could now be influenced by open market operations, the reliance on reserve requirements was reduced. This reflected the recognition that changes in reserve requirements are too blunt as instruments—small changes in the required reserve ratio call for relatively large and potentially disruptive shifts among commercial bank assets. Also, there were concerns that high non-interest-bearing reserve requirements, which are effectively a tax on the banking system, may encourage disintermediation. Indonesia, Korea, and Malaysia substantially lowered reserve requirements. In Nepal and Sri Lanka, reserve requirements were made more flexible by adopting averaging procedures for meeting reserve ratios and by unifying reserve ratios for different deposit liabilities to encourage more flexible portfolio management by banks. In the Philippines, interest began to be paid on reserves held at the central bank.

To strengthen monetary control, the use of central bank discount facilities was reduced or phased out in some countries (Indonesia, Korea, and the Philippines), Discount policies in the Asian countries, as in many developing countries, typically involve subsidy elements or credit allocation requirements to ensure low-cost credit to priority sectors. Consequently, central banks often found it difficult to reduce discount financing, even when warranted for macroeconomic reasons, because the reduction imposed unsustainable losses on commercial banks and had disruptive effects on priority sectors. Some of the countries reduced the range of special discount facilities in favor of generalized, last-resort lending by the central bank. Discount rates were also adjusted in line with market conditions.

Experience with Interest Rate Liberalization and Indirect Monetary Policy Instruments

The liberalization of interest rates and the move toward indirect monetary policy instruments were, perhaps, the two most important changes in the implementation of monetary policy in the Asian countries during the 1980s. As discussed in Section II, the liberalization of interest rates contributed to increases in nominal and real interest rates in most of these countries. While the repressive effects of low real interest rates had been the concern during the 1970s, the experience with interest rate liberalization in developing countries during the 1980s focused attention on the destabilizing effects of high real interest rates: this is the subject of the first part of this subsection.

The second part of this subsection assesses the experience with the use of indirect monetary policy instruments in six Asian countries.37 This assessment is constrained, among other things, by the difficulty of distinguishing the effects of monetary policy from the many other influences affecting the broader economy during the relatively short period of time when indirect instruments were actively used. The assessment, therefore, is limited to a somewhat narrower perspective, that is, to an examination of the effectiveness of indirect instruments in controlling domestic monetary conditions, given the macroeconomic context.

Interest Rate Liberalization

While interest rate liberalization can improve allocative efficiency, the experience of several Southern Cone countries (Argentina, Chile, and Uruguay) illustrates the potential problems with interest rate liberalization. These countries deregulated interest rates during a period of pronounced macroeconomic instability in the 1980s. In the deregulated environment with imperfect and oligopolistic financial markets, real interest rates rose to very high levels.38 This not only discouraged investment and slowed economic growth but also led to widespread insolvency of firms which, in turn, precipitated a crisis in the financial system, exacerbating macroeconomic instability. At the same time, the removal of capital controls amid severe macroeconomic instability put further upward pressure on interest rates because of expectations of further devaluations of the domestic currency. The sharp increase in domestic interest rates and a rate of domestic currency depreciation that fell short of the differential between domestic and foreign interest rates induced large capital inflows, which, in turn, added to inflationary pressures and undermined monetary control. The capital flows also contributed to appreciation of the domestic currency, adversely affecting output and the balance of payments.

The experience of the Southern Cone countries was, however, not shared by most of the Asian countries. During the 1980s, real interest rates were high in several of these countries, including Korea. Malaysia, and Thailand, but only Indonesia and the Philippines had to face unusually high real interest rates—real lending rates reached nearly 20 percent annually in 1986 in both countries. In Indonesia, the apparent downward rigidity in real interest rates may have been due to persistent expectations of rupiah depreciation that raised inflationary expectations even during a period of relative price stability; domestic interest rates were particularly sensitive to exchange rate expectations because of the openness of the capital account. In the Philippines, high and volatile inflation, a balance of payments crisis, and political turmoil all contributed to upward pressures on domestic interest rates; the capital account was also largely unrestricted.

In both of these countries, the high level of real interest rates contributed to a weakening of the profitability of firms and enlarged the size of non-performing loans in banks’ portfolios. Central banks, therefore, intervened to maintain confidence in the financial system. In the Philippines, the infusion of central bank credit to bailout failing financial institutions greatly complicated stabilization policies. In Indonesia, liquidity credit programs with subsidized credit were retained, contrary to the objectives of financial liberalization, so as to lessen the impact of high interest rates.

Shift to indirect Monetary Policy Instruments

The timing, scope, and effects of the shift to indirect instruments varied widely among the Asian countries, but recent experience suggests that these instruments enhanced the effectiveness of monetary policy. The effectiveness of indirect monetary policy instruments is analyzed in terms of their impact on monetary aggregates following the change in the operating procedures for implementing monetary policy.

The growth of the money supply can be decomposed into the growth of reserve money and the money multiplier. During the 1980s, reserve money growth was the primary determinant of the growth of the money supply in these countries, although a rise in the multiplier also had a marked impact in Indonesia and Thailand (Table 4). The reforms in the instruments of monetary policy discussed above, namely the liberalization of interest rates and reductions in reserve requirements, tended to increase the money multiplier in most countries,39 while greater reliance was placed on open market operations to manage reserve money growth.

Table 4.Asian Countries: Growth Rates of Monetary Variables, 1980–89(Average annual percent change)
Broad MoneyReserve MoneyBroad Money Multiplier1
Indonesia25.313.810.1
Korea18.716.51.9
Malaysia10.89.61.2
Myanmar13.310.62.5
Nepal19.818.41.2
Philippines20.621.2−0.5
Singapore13.810.13.4
Sri Lanka15.717.1−1.2
Thailand19.011.86.5
Source: International Monetary Fund, International Financial Statistics.

Ratio of broad money to reserve money.

Source: International Monetary Fund, International Financial Statistics.

Ratio of broad money to reserve money.

The main factors affecting reserve money can be grouped into “autonomous” factors, that is, those that are not deliberately used as tools of monetary policy, and “policy” factors. The policy factors can identification of autonomous or policy factors,40 they are useful in providing indications of the broad effects of the shift toward indirect policy instruments. In this discussion, the autonomous factors include changes in the central banks’ net holdings of foreign assets and net claims on government. The policy factors include central banks’ lending related to preferential, rediscount, and special liquidity support measures and the use of indirect monetary policy instruments to influence bank liquidity such as sales or purchases of treasury bills, central bank bills, repurchases, and foreign exchange swaps. The effects of indirect monetary policy instruments are, therefore, represented by the impact of policy factors on reserve money growth.

In Indonesia, capital flows responding to interest rate differentials and exchange rate expectations were a major source of monetary disturbances. The new indirect monetary policy instruments that were developed after the financial reforms initially played a minor role in offsetting the monetary effects of the autonomous factors in1983 (Table 5).41 Consebe broadly grouped into instruments of directed credit and instruments to influence banks’ liquidity. While these distinctions are somewhat artificial because the purpose of each type of central bank operation cannot be unequivocally established and the available data do not always permit the clear quently, there was a high degree of monetary variability. The central bank’s ability to control bank liquidity was hampered by the continuation of the liquidity credit scheme (even in a modified scale) and the desire to stabilize interest rates to support the economic recovery. Moreover, during the speculative attack against the rupiah in December 1986, the central bank injected liquidity through open market operations to offset upward pressures on interest rates, contributing to a substantial loss of international reserves. However, when the rupiah came under renewed pressures in mid-1987, the central bank moved to protect international reserves by allowing interest rates to rise. This was followed by modifications to money market procedures designed to strengthen the central bank’s ability to control bank liquidity.42 These policies contributed to the increase in net foreign assets in 1987/88, the monetary impact of which was partly offset by open market operations. In 1988/89, the continued active use of open market operations, strengthened by additional reform measures.43 contributed to containing monetary growth despite the rapid expansion of liquidity credits and the rise in the money multiplier owing to the reduction in liquidity requirements.44

Table 5.Indonesia: Factors Affecting Reserve Money, 1984–891(Change as a percent of reserve money at beginning of period)
198419851986198719881989
Autonomous factors19.7−19.012.9−18.617.3−17.6
Net foreign assets55.030.55.014.739.7−26.7
Net claims on Government−38.5−50.717.9−26.222.38.5
Net claims on private sector2−10.8−3.02.12.92.21.8
Net other items14.04.2−12.1−10.1−46.9−1.1
Policy factors10.231.716.833.3−23.1−3.2
Liquidity credit to banks12.425.016.415.616.531.8
New indirect policy instruments−1.13.40.28.9−19.8−17.5
New Bank Indonesia facilities37.119.9−7.4−12.20.2
Open market operations4−1.1−3.7−19.716.3−7.6−17.8
Reserve money31.09.329.55.814.0–3.3
Source: Data provided by the Indonesian authorities.

Tear ending March. Positive sign indicates an increase in assets or a decline in liabilities, that is, an expansionary factor; negative sign indicates a decrease in nssecs or an increase in liabilities, that is, a contractionary factor.

Until 1985, data include claims on nonfinancial and financial public enterprises and the private sector. From 1986, data include claims on financial public enterprises and the private sector

New central bank facilities for discounting of money market papers.

Central bank debt certificates—Sertificat Bank Indonesia (SBI).

Source: Data provided by the Indonesian authorities.

Tear ending March. Positive sign indicates an increase in assets or a decline in liabilities, that is, an expansionary factor; negative sign indicates a decrease in nssecs or an increase in liabilities, that is, a contractionary factor.

Until 1985, data include claims on nonfinancial and financial public enterprises and the private sector. From 1986, data include claims on financial public enterprises and the private sector

New central bank facilities for discounting of money market papers.

Central bank debt certificates—Sertificat Bank Indonesia (SBI).

In Korea, during the first half of the 1980s, indirect monetary policy instruments proved to be effective in containing the rate of monetary expansion, even while the money multiplier was increasing owing to the decline in reserve requirements and increases in interest rates associated with the financial reforms (Table 6).45 In 1983–85, despite the extension of credit to banks to forestall a financial crisis in the banking system because of potential bankruptcies in certain industries, the rate of monetary expansion did not accelerate owing to offsetting operations by the central bank. During the second half of the 1980s, the full range of indirect instruments was brought to bear on the task of absorbing the monetary impact of Korea’s external payments surpluses. The main burden of monetary control during this period fell on open market operations, mainly the sales of monetary stabilization bonds (MSBs). The scope of preferential discounting, especially for export industries, was also reduced; rediscount rates on most bank loans were raised; reserve requirements were increased; and in 1989, marginal reserve requirements were introduced on most bank deposits. In addition, owing to the difficulties of absorbing large inflows of liquidity from abroad, intermittent use was made of informal direct controls on credit toward the end of the 1980s.

Table 6.Korea: Factors Affecting Reserve Money, 1980–891(Change as a percent of reserve money at beginning of period)
1980198119821983198419851986198719881989
Autonomous factors−23.34.640.6−13.0−28.416.051.489.9146.75.3
Net foreign assets24.0−25.314.4−31.4−5.3−15.950.1137.7105.116.4
Net claims on Government3.826.67.76.4−9.9−1.6−6.3−37.1−38.2−4.7
Net other Items3−31.13.418.412.0−13.333.57.613.242.4−6.4
Policy factors16.8−18.3−4.120.132.2−14.4−36.9−39.5−84.426.5
Claims on banks418.223.517.528.845.448.510.067.77.517.1
Open market operations50.1−34.926.2−41.014.0−55.2−123.7−91.0−21.8
Monetary Stabilization Account−1.4−6.9−47.732.3−13.3−76.98.316.4−1.031.2
Reserve money–6.5–13.636.57.13.71.716.248.930.231.8
Source: Data provided by the Bank of Korea.

Positive sign indicates an increase in assets or a decline in liabilities, that is, an expansionary factor; negative sign indicates a decrease in assets or an increase in liabilities, that is, a contractionary factor.

Including swaps with nondeposit money banks and the Bank of Korea’s foreign currency deposits with deposit money banks.

Including interest payments on monetary stabilization bonds.

Including claims on the private sector.

Monetary stabilization bonds.

Source: Data provided by the Bank of Korea.

Positive sign indicates an increase in assets or a decline in liabilities, that is, an expansionary factor; negative sign indicates a decrease in assets or an increase in liabilities, that is, a contractionary factor.

Including swaps with nondeposit money banks and the Bank of Korea’s foreign currency deposits with deposit money banks.

Including interest payments on monetary stabilization bonds.

Including claims on the private sector.

Monetary stabilization bonds.

In Malaysia, the central bank was able to maintain a fairly stable growth rate of reserve money (Table 7). Whereas the net foreign assets of the central bank were subject to large year-to-year fluctuations as a result of the volatile nature of exports and capital flows, the impact on reserve money was largely neutralized by opposing movements in net domestic assets. For monetary management, the central bank continued to resort actively to adjustments in statutory reserve requirements; however, other indirect instruments were increasingly utilized. Prior to 1987, these involved mainly foreign exchange swaps and the recycling of government deposits (i.e., the movement of government deposits between the central bank and commercial banks); after 1987, these instruments were increasingly replaced by open market operations in government as well as central bank securities. The central bank also operates a rediscount facility, but its use has remained infrequent. The issuance of central bank certificates in 1987 helped to offset the injection of liquidity to support ailing financial institutions. Again in 1989, the liquidity operations of the central bank through money market intervention vis-à-vis the banking sector helped to offset the expansionary effects related to the rehabilitation of financial institutions and the purchases of shares of public enterprises from the Government.

Table 7.Malaysia: Factors Affecting Reserve Money, 1984–891(Change as percent of reserve money at beginning of period)
198419851986198719881989
Autonomous factors6.10.64.05.07.347.2
Net foreign assets3.633.042.630.3−10.327.5
Net claims on Government29.3−8.6−2.9−4.00.6−4.9
Net claims on private sector1.3−1.10.4−0.18.11.7
Net other items3−8.2−22.7−36.2−21.29.023.0
Policy factors−1.50.91.2−0.24.5−19.5
Claims on banks4−1.50.91.27.44.5−26.2
Bank Negara certificates−7.66.7
Reserve money4.51.55.24.811.827.8
Source: Data provided by the Malaysian authorities.

Positive sign indicates an increase in assets or a decline in liabilities, that is, an expansionary factor; negative sign indicates a decrease in assets or an increase in liabilities, that is, a contractionary factor.

Including recycled government deposits and government securities used for monetary control purposes.

The changes in other items net in 1988 and 1989 include the acquisition of government shares of M$ 1,050 million in the Malaysian Airlines System and the Malaysian International Shipping Corporation.

Including commercial banks, finance companies, merchant banks, and discount houses.

Source: Data provided by the Malaysian authorities.

Positive sign indicates an increase in assets or a decline in liabilities, that is, an expansionary factor; negative sign indicates a decrease in assets or an increase in liabilities, that is, a contractionary factor.

Including recycled government deposits and government securities used for monetary control purposes.

The changes in other items net in 1988 and 1989 include the acquisition of government shares of M$ 1,050 million in the Malaysian Airlines System and the Malaysian International Shipping Corporation.

Including commercial banks, finance companies, merchant banks, and discount houses.

In the Philippines, since the financial reforms in 1984, open market operations have been the principal instrument used to influence monetary aggregates.46 In 1984–85, large net sales of open market instruments (primarily central bank bills) offset a large part of the expansionary effects of increases in the Central Bank’s other unclassified assets47 and the assistance provided to financial institutions. These operations contributed to a substantial deceleration in reserve money growth (Table 8). Open market operations were not actively pursued in 1986, however, and reserve money grew sharply. Toward the end of 1986, open market operations in central bank securities were replaced by weekly auctions of treasury bills, with the proceeds deposited at the Central Bank in special sterilized accounts. In 1987–88, government deposits at the Central Bank in support of open market operations constrained the expansionary effects of continued increases in the Central Bank’s unclassified assets, of emergency financial assistance to two faltering banks, and of increases in net foreign assets. In 1989, however, shortfalls in the planned sales of treasury bills contributed to a sharp increase in reserve money growth.

Table 8.Philippines: Factors Affecting Reserve Money, 1984–891(Change as percent of reserve money at beginning of period)
198419851986198719881989
Autonomous factors47.361.731.0−30.416.332.5
Net foreign assets−8.3−194.0−13.54.920.623.3
Net claims on private sector2−3.366.2−21.4−70.2−32.6−19.6
Net other items63.9189.565.934.928.228.8
Policy factors−26.7−46.71.843.50.35.5
Assistance to financial institutions21.38.45.3−1.4−0.4
Regular rediscounting−13.7−0.3−3.60.61.0
Indirect policy instruments3−34.3−54.85.537.61.74.9
Reserve money20.615.032.813.116.638.0
Source: Central Bank of the Philippines.

Positive sign indicates an increase in assets or a decline in liabilities, that is, an expansionary factor; negative sign indicates a decrease in assets or an increase in liabilities, that is, a contractionary factor.

Including government fixed deposits with the Central Bank associated with sales of treasury bills for monetary control purposes.

Repurchase or reverse repurchases, operations in central bank certificates and bills, and special reverse repurchases.

Source: Central Bank of the Philippines.

Positive sign indicates an increase in assets or a decline in liabilities, that is, an expansionary factor; negative sign indicates a decrease in assets or an increase in liabilities, that is, a contractionary factor.

Including government fixed deposits with the Central Bank associated with sales of treasury bills for monetary control purposes.

Repurchase or reverse repurchases, operations in central bank certificates and bills, and special reverse repurchases.

In Sri Lanka, the Central Bank has relied more on open market operations in the conduct of monetary policy from 1986 onward. A regular treasury bill auction was introduced;48 a number of direct credit controls were eliminated: and the remaining quantitative restrictions were not strictly enforced. At the same time, the Central Bank sought to reduce intermediation costs by lowering bank rates, rediscount rates, and the required reserve ratio.49 During 1986–87, open market operations in central bank securities and treasury bills contributed to a substantial deceleration in reserve money growth, despite the continued widening of the Treasury’s domestic financing needs (Table 9). However, the doubling of the Treasury’s domestic financing needs in 1988 swamped the Central Bank’s offsetting operations and reserve money growth accelerated sharply. In 1989, faced with a precipitous drop in external reserves and accelerating inflation, the Central Bank intensified sales of treasury bills to the nonbank sector to absorb liquidity, resulting in substantial increases in treasury bill and other interest rates.50 These measures, together with a tightening of fiscal policy, led to a contraction of the Central Bank’s net claims on Government, which more than offset a strong improvement in external reserves.

Table 9.Sri Lanka: Factors Affecting Reserve Money, 1984–891(Change as percent of reserve money at beginning of period)
198419851986198719881989
Autonomous factors23.524.50.75.030.82.0
Net foreign assets62.4−11.3−7.5−11.5−9.39.8
Net claims on Government2−32.048.814.84.443.2−8.0
Net other items−6.8−13.0−6.512.1−3.10.1
Policy factors
Net claims on financial institutions−5.4−1.36.01.91.9−2.5
Reserve money (outstanding)17.723.36.76.932.64.8
Memorandum item
Central bank securities4.84.58.5–14.3–0.1
Source: Data provided by the Sri Lanka authorities.

Positive sign indicates an increase in assets or a decline in liabilities, that is, an expansionary factor; negative sign indicates a decrease in assets or an increase in liabilities, that is, a contractionary factor.

Including operations in treasury bills for monetary control purposes.

Source: Data provided by the Sri Lanka authorities.

Positive sign indicates an increase in assets or a decline in liabilities, that is, an expansionary factor; negative sign indicates a decrease in assets or an increase in liabilities, that is, a contractionary factor.

Including operations in treasury bills for monetary control purposes.

In Thailand, indirect monetary policy instruments have not been a major factor affecting liquidity growth, despite their availability.51 Until 1986, the central bank’s operations in the government bond repurchase market largely involved matching the demand and supply of repurchases with limited intervention on its own account. Following the substantial improvement in the external position in 1986 and the emergence of a high level of liquidity in the banking system, the central bank actively drained liquidity through government bond repurchases and issues of central bank bonds (Table 10). These operations, however, were not sufficient to prevent a sharp increase in the growth of reserve money in 1987. In 1988–89, despite the continued expansionary impulses from the external sector, the growth in reserve money decelerated, owing largely to the substantial decline in the central bank’s net claims on the Government, reflecting the large fiscal surplus and, to a lesser extent, a reduction in commercial banks’ access to refinancing facilities at the central bank at the beginning of 1989.52

Table 10.Thailand: Factors Affecting Reserve Money, 1985–891(Change as percent of reserve money at beginning of period)
19851986198719881989
Autonomous factors0.61.513.7−1.227.8
Net foreign assets2.123.836.748.374.7
Net claims on Government10.7−10.6−6.4−43.9−40.8
Net other items−12.1−11.7−16.6−5.6−6.1
Policy factors7.710.07.416.1
Net claims on financial institutions7.712.27.314.6−11.3
Development credits6.113.47.514.2−11.9
Liquidity credits1.6−1.2−0.20.40.6
Central bank net repurchase position−2.20.21.5
Reserve money8.411.321.214.816.6
Sources: Bank of Thailand, Monthly Economic Bulletin; and data provided by the Bank of Thailand.

Positive sign indicates an increase in assets or a decline in liabilities, that is, an expansionary factor; negative sign indicates a decrease in assets or an increase in liabilities, that is, a contractionary factor.

Sources: Bank of Thailand, Monthly Economic Bulletin; and data provided by the Bank of Thailand.

Positive sign indicates an increase in assets or a decline in liabilities, that is, an expansionary factor; negative sign indicates a decrease in assets or an increase in liabilities, that is, a contractionary factor.

Conclusions

Financial liberalization in the Asian countries has had important implications for both the transmission mechanism and the operating procedures of monetary policy. Regarding the transmission mechanism, nonprice credit rationing was weakened while the role of market forces, notably interest rates, has become increasingly important in determining financial and credit flows. In addition, the relaxation of controls on international capital flows and the move toward more flexible exchange rate arrangements has increased the importance of the exchange rate as a channel for transmitting the effects of monetary policy. As a result, the monetary authorities’ potential control over domestic monetary conditions has increased, but so has the need to coordinate monetary policy with exchange rate policy.

The liberalization of interest rates has contributed to improving resource allocation, the mobilization of savings, and the efficiency of investment. On the whole, these countries were not as affected by the destabilizing effects of excessively high real interest rates as were the three Southern Cone countries. In Indonesia and the Philippines, where high real interest rates persisted, countermeasures were implemented, but they complicated stabilization policies and slowed the financial liberalization process.

Regarding the operating procedures of monetary policy, financial liberalization has affected both the setting of policy targets and the choice of instruments. In some of the countries, domestic credit targets were replaced by interest rates or monetary targets, while in others, several financial and economic indicators, including the exchange rate, are now employed.

Many of these countries placed a greater emphasis on market-based monetary instruments rather than on direct controls on interest rates and credit. The reforms in the instruments of monetary policy have both permitted the deregulation of the financial system and have been supported by the development of markets and institutions in the liberalized environment.

Most notable in the shift toward indirect monetary policy instruments has been the greater use of open market operations. At the same time, excessively high reserve requirements were lowered, and selective (usually preferential) rediscounting was gradually replaced with generalized rediscounting. However, open market operations proved inadequate to stabilize monetary growth during periods of particularly severe disturbances. This reflected a variety of factors, including the inadequate development of markets and instruments for open market operations and the government’s large domestic financing needs. Nevertheless, buttressed by measures to strengthen open market operations and by progress made in reducing fiscal deficits, open market operations are evolving as an effective instrument of monetary policy in many Asian countries.

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