VI Implications for Fund Operations
- Tomás Baliño, Charles Enoch, and William Alexander
- Published Date:
- July 1995
Performance criteria in IMF-supported financial programs typically include a ceiling on the expansion of net domestic credit, which can be defined in various ways.58 These criteria may be viewed as a special case of the intermediate target that is often specified in a more general framework for formulating monetary policy. Within this general framework, such targets can be implemented using indirect instruments; thus, these instruments can also be used in implementing domestic credit ceilings in IMF-supported programs.
The primary objective of IMF-supported programs is balance of payments viability, which requires control over domestic financing in order to bring aggregate expenditure to a sustainable path. The rationale for focusing on domestic credit rather than money supply is that, in an open economy under a fixed or incompletely flexible exchange rate, a given quantity of money is compatible with different levels in international reserves that may not be consistent with the balance of payments objective. On the other hand, the authorities can determine the division of the supply of money between foreign and domestic assets through control over domestic credit and thus attain a foreign asset position consistent with the desired balance of payments position.
The literature on balance of payments crises has shown that the viability of a fixed exchange rate (or a preannounced crawling peg) depends on the growth of domestic credit not exceeding the growth of the demand for money.59 Excess growth of domestic credit relative to the demand for money results in a loss of foreign exchange reserves. Thus, control of credit expansion has been a cornerstone of IMF-supported programs. In combination with reductions in fiscal deficits, the contraction of credit growth under IMF-supported programs has typically resulted in improvements in current account balances and increases in reserves.
In cases in which the exchange rate is not firmly fixed, indirect instruments can be aimed at a range of credit or monetary aggregates—some of the latter quite narrowly defined. Indeed, few countries without IMF-supported programs currently specify credit as an intermediate target; instead, monetary policy in these countries aims at intermediate targets, such as interest rates or various definitions of the money supply, or directly at final objectives, such as inflation. Thus, the use of indirect instruments gives access to other targets, presenting additional options for the design of IMF-supported programs.
The ability to control broad monetary and credit aggregates with indirect instruments is likely to be imprecise in the short run.60 For purposes of establishing performance criteria in IMF programs, therefore, it could be desirable to set target ranges rather than specific point ceilings.
The use of target ranges is consistent with the flexibility in conditionality that the IMF has long espoused. Target ranges or review of performance criteria can be particularly helpful in cases in which prospective instability in the demand for money, credit, or reserve money over the program period—or the limitations of the measures within the control of the authorities—prevents the setting of precise quantitative targets at the outset. The implementation of indirect monetary instruments, coupled with target ranges or reviews of performance criteria, could be particularly useful if control of inflation becomes an explicit goal of a macroeconomic program.
Formulating program targets at the level of the central bank (that is, reserve money or central bank credit), rather than at that of the banking system, becomes an increasingly attractive option when indirect monetary instruments are used.61 As a general principle, performance criteria should apply to variables that not only have a close link to the ultimate objectives of the program but also over which the authorities have adequate short-term control. Applying this principle implies setting targets at the level of the central bank when indirect instruments are used. This would have a number of benefits.62
- The link between the instruments and the operational targets of policy would be closer, since the indirect instruments of monetary control operate at the level of the central bank balance sheet.
- The ability to achieve short-term targets would be greater since the central bank balance sheet is under the direct control of the monetary authorities.
- Close monitoring of the program would be possible since information on the central bank balance sheet is more readily available than that for the banking system.
- Controlling reserve money rather than the banking system as a whole is preferable as it frees the banking system to respond more naturally to market forces, reducing the distortive effects of controls.
- The behavior of reserve money or central bank net domestic assets may be less subject to shifts in the wake of financial liberalization than other quantitative targets, such as broader monetary or credit aggregates.
Notwithstanding the above points, the decision of whether to program at the level of the central bank or at the level of the banking system will also depend on empirical considerations and on the development of the financial system. In particular, it will depend on the stability and predictability of the link between credit extended by the central bank and overall credit expansion. For example, if the demand for broad money is substantially more stable than that for base money, a case could be made for setting targets at the level of the banking system. In the final analysis, the choice between ceilings on central bank or banking system variables should depend on which target is judged most likely to meet the ultimate policy objective.63
Role of Technical Assistance
As the preceding sections have made clear, central banks face numerous technical issues in using indirect instruments of monetary policy. The successful introduction of such instruments hinges on appropriate policies, structures, and procedures being in place. Moreover, much of what is known about implementation is based on the analysis of actual experiences. Therefore, IMF members can avoid some pitfalls in the introduction of indirect instruments by making efforts to analyze the experiences of other members.
The IMF supports those efforts by providing technical assistance in the monetary and exchange fields. In addition to the IMF’s unique position to facilitate the analysis and exchange of information on practical experiences, the objectives of successfully introducing indirect instruments—strengthening monetary control and making financial intermediation more efficient—are crucial to the success of IMF-supported programs. This assistance has in many cases taken a comprehensive multitopic approach. In addition to providing advice specifically on the modalities of introducing indirect instruments (for instance, suggesting an appropriate instrument mix to achieve a chosen target, what form of securities should be issued, and what the auction modalities should be), assistance focuses on money and financial market development, debt management, banking legislation, banking supervision, accounting, payments systems, monetary and economic research and analysis, monetary programming, information systems, and central bank management.
Assistance has been given on restructuring the portfolios of the commercial banks (and sometimes the central bank). Because of the links between domestic and foreign market developments, support is also given to developing a market-responsive foreign exchange system and to the associated reforms of exchange arrangements and markets. Assistance from the Monetary and Exchange Affairs Department in these areas is carefully coordinated with other departments of the IMF providing assistance in related fields and with other donors and cooperating central banks.
Since the adoption of indirect instruments requires careful planning and takes time to accomplish, technical assistance involves following the process through its various stages. This assistance may be provided through a combination of staff visits, visits of experts from cooperating central banks, missions (which include experts as well as staff), and longer-term expert assignments, including series of visits or the placement of one or more advisors within the central bank for an extended period. Workshops and seminars are also effective tools to provide assistance. The mix of resources provided by the IMF depends on the circumstances, including the central bank’s needs, its demonstrated commitment to reform, and its track record in implementing technical assistance advice.