- Tomás Baliño, Charles Enoch, and William Alexander
- Published Date:
- July 1995
1. There is a strong case for implementing indirect instruments of monetary policy based on the following observations:
• Moving to indirect instruments of monetary control leads to efficient financial intermediation.
•Indirect instruments can provide effective monetary control, especially in circumstances where direct instruments have been largely circumvented. This is particularly likely as new financial instruments develop and the opening of the capital account provides a wider range of financial alternatives. In such a setting, the shift to indirect instruments becomes a matter of necessity.
•Indirect instruments permit the authorities to choose from a larger set of targets than is possible with direct instruments. This is especially important when the relationship between particular aggregates, such as a credit variable, and the final objectives of the authorities, such as price stability, has been weakened or has become hard to establish. Often this is brought about by economic reform or financial innovation.
2. The development of indirect instruments is a complex process that usually requires considerable time to be completed. While some countries have succeeded in making a rapid and relatively smooth transition, the experience of others suggests that substantial difficulties and costs can be encountered and that the transition can be protracted if adequate concomitant measures are not adopted. Typically, such countries experience a temporary reduction in the effectiveness of monetary control, and some of them halt temporarily (and sometimes reverse) their reform efforts. Key concomitant reforms are needed to minimize these difficulties and ensure as smooth a transition as possible. They need to be part of a comprehensive approach to the introduction of indirect instruments that includes the following elements:
•Monetary policy needs to be insulated from the pressure of financing the government’s fiscal deficit. The authorities must curtail monetary financing of the fiscal deficit and ensure that the government accepts market rates of interest on its debt and refrains from pressuring the central bank to keep market interest rates low. Enhancing central bank independence can help to achieve these goals. Limits on central bank credit to the government must be supported by a comprehensive program to develop public debt management and government securities markets.
•Weak and segmented money and interbank markets need to be strengthened. As liquidity management by the central bank provides the fulcrum of indirect methods of monetary control, indirect instruments cannot work well unless the interbank and short-term money markets can transmit the central bank’s actions rapidly and transparently. The central bank must play an active role in the development of the market infrastructure, including the payments and settlement system, the legal and regulatory framework of the markets, and the introduction of suitable market instruments and techniques. At the same time, the central bank needs to stimulate trading in these markets. Introducing at an early stage some market-based indirect instruments that can be transacted at market interest rates can be the catalyst in developing the money and financial markets needed before full reliance on indirect instruments is possible.
•The banking system often needs to be restructured to create healthy banks and foster competition. Generally, financial restructuring needs to deal with nonperforming loans and problem banks and with strengthening the managerial capacity of weaker banks, which may be poorly equipped to adapt to the newly competitive environment. The privatization of state-owned banks can contribute to this end.
•The supervisory and regulatory framework needs to be reinforced. All too often, experience has been that, in the absence of such measures, financial liberalization leads to financial crisis. Thus, safeguards—in the form of minimum capital standards, standards for provisioning for doubtful loans, limits on loan concentration, collateral requirements and collateral valuation standards, and adequate enforcement mechanisms—are needed to encourage prudent behavior. Financial reporting and disclosure standards are also needed to improve transparency, so that the market can play its role in ensuring financial discipline.
•The technical capacity of the central bank needs to be strengthened. Reliance on indirect instruments requires that the central bank develop a forecasting framework for short-term reserve money in order to project the demand and supply of currency and bank reserves and their effect on broader credit and monetary aggregates. That framework requires timely and accurate data—including early working indicators—on financial sector developments as well as on the central bank’s balance sheet and must be based on a quantification of key monetary relationships. A comprehensive research program is often required.
3. Implementation of indirect instruments is easier and less likely to suffer reversals if the authorities can do it gradually, in line with the speed with which concomitant measures can be introduced and financial markets developed. Sometimes, though, a rapid introduction of indirect instruments is necessary, for instance, when direct instruments have become ineffective or too costly to operate. In these circumstances, especially where the institutional reforms and concomitant policy measures are both lacking and unlikely, the introduction of indirect instruments may be costly and there may be reversals. If, however, direct instruments are still effective and concomitant reforms are not yet in train, full reliance on indirect instruments could be premature.
4. Countries should introduce indirect instruments even if there is doubt about their immediate effectiveness for monetary management. A key question is when to abolish direct controls. Again, the precise answer depends on the specifics of the case. A gradual phaseout—a belt and braces approach—is often appropriate. In that approach, some pre-existing controls—such as credit ceilings—are used as a backstop until full reliance on indirect instruments becomes possible.
5. Sequencing has varied among countries, but a stylized path can be established. The first stage normally requires the use of both reserve requirements to absorb liquidity and a credit facility—such as a credit auction—to provide for the growth of domestic credit. An overdraft or Lombard facility at a penal interest rate is also needed. Liberalization of interest rates must begin at this stage.
•In the second stage, the authorities should introduce auctions of short-term government or central bank securities. This not only assists the development of financial markets but also gives the authorities more flexibility in managing monetary operations and allows for a reduction in reserve requirements. At this stage, the authorities operate a mix of market-based instruments to foster both monetary control and market development.
•In the third stage, the central bank should accelerate the development of institutions and financial market infrastructure and begin to rely on full-fledged open market operations. Total reliance on such operations is not possible until the secondary market is working well. At this stage, any remaining direct controls should be eliminated.
6. Indirect instruments, whether specified at the level of the central bank or the banking system, can serve to attain domestic credit expansion targets in IMF-supported programs. Moreover, indirect instruments introduce a degree of flexibility that is lacking when only direct instruments are available to the authorities. This flexibility increases the range of options for selecting program targets, which may be particularly useful if greater emphasis is placed on objectives like inflation, as suggested during the recent review of IMF conditionality.
Reserve requirements are applied through regulation. However, their monetary effect is realized through the impact on banks’ demand for reserve money. Furthermore, reserve money creation is most directly monitored and controlled via the central bank’s balance sheet. Therefore, reserve requirements are classified as an indirect instrument in this paper.
Strictly speaking, the central bank can determine the supply of reserve money in the long run only under a fully flexible exchange rate regime. However, even under a pegged or managed exchange rate regime, central bank policy usually has a major influence on reserve money, at least in the short run. The scope depends ultimately on the degree of substitutability between domestic and foreign assets.
World Bank (1989) discusses how allowing market forces to distribute financial resources can be associated with increased economic efficiency and growth.
Repurchase agreements comprise the purchase of assets by the central bank under a contract providing for their resale at a specified price on a given future date; they are used to supply reserves. Reverse repurchase transactions are the sale of assets by the central bank under a contract providing for their repurchase at a specified price on a given future date; they are used to reduce reserves. See Laurens (1994)
There was a time in the United States when analysts debated whether there was any need for a discount window—see Friedman (1959, Chapter 2), Johnson (1968) and Board of Governors of the Federal Reserve System (1971).
See Laurens (1994) for a detailed review of credit Facilities to the banks. The discount facility is often justified as a form of subsidy to be used, for example, to compensate for the cost of reserve requirements.
When central banks operate in this way, the lending facility is typically not used for purposes of monetary control, which is effected through other means (such as repos in Germany and the United States). Japan, however, is an exception, since amounts available may he varied daily. For details, see Table 3.
For a more detailed discussion of technical issues in the use of monetary instruments, see Smith (1963) and Balião (1985). See Hardy (1993) for a review of issues involved in setting and using reserve requirements.
For a discussion of the advantages and disadvantages of direct and indirect instruments of monetary policy, see Lindgren (1991), pp. 323-25.
A classic example of the latter was the “round-tripping” that took place during the “corset” experience in the United Kingdom during the 1970s. See Section IV below and also Artis and Lewis (1981), Fforde (1983), and Bank of England (1982).
However, this does not exclude the possibility that during the transition period, a temporary destabilisation of money and credit aggregates or interest rates may occur, making their control or their interpretation very difficult, indeed, the latter has been a widespread problem. See Section IV below for evidence based on country experiences.
This is not to say that, because central banks can choose an independent rate of inflation, they should do so. Behind the increasing acceptance of price stability as the main goal of monetary policy is the recognition that inflation is a costly process. Thus, the degree of divergence among countries is likely to be limited. For a discussion of the extent to which a flexible exchange rate can insulate an economy from the world at large, see Guitián (1994a, 1994b).
It can be argued that the introduction of indirect instruments may result in some disintermediation, as the demand for bank deposits may be reduced following the introduction of treasury or central bank bills as interest-bearing alternatives to bank deposits. However, considering the formal financial system as a whole, reintermediation is encouraged.
In many countries, real interest rates were highly negative before financial reform, therefore penalizing financial savings. Increasing the incentive to save in this circumstance should increase the rate of saving. However, the empirical evidence on this relationship is not strong and is hampered by the fact that prior to financial deregulation and liberalization, a large share of savings occurred outside the financial system. Consequently, financial deregulation is also likely to affect the distribution of savings, apart from the volume effect. See World Bank (1989).
To some extent, lags also occur with direct instruments. However, with indirect instruments the effects on aggregate credit and interest rates are less direct and may take longer to occur.
These include the seven countries whose experiences are described in detail in Part II as well as some industrial countries whose experiences are briefly discussed later in the following section.
The references to Argentina and Chile relate to the liberalization efforts in the early 1980s.
Financial savings mobilization is measured as the ratio of deposits to GDP. Financial intermediation is proxied by the ratio of broad money to GDP and the ratio of private credit to GDP. Data from the IMF’s International Financial Statistics show that all these ratios have increased since the transition to indirect monetary instruments.
Moreover, a fiscal surplus can help to offset the initial surge of private credit following liberalization. That was the case in Indonesia (see Bisat, Johnston, and Sundararajan, 1992).
In Indonesia, the government did not borrow from the central bank even before the transition.
It is risky for a central bank to rely only on indirect instruments in cases in which a poorly functioning payments system has made banks’ excess reserves too volatile, because those instruments work by affecting the supply of excess reserves to the system.
The level of the tax depends positively on the size of the reserve requirement and negatively on the rate of remuneration, if any, that applies to required balances.
As monthly data are not available for Argentina, Burundi, Chile, Hungary, and Poland for the specified period, these countries are not included in the sample used in this section. Thus, the sample includes Egypt. The Gambia, Ghana, Indonesia, Israel. Jamaica, Kenya, Malaysia, Mexico, the Philippines, Sri Lanka, Thailand, Tunisia, and Venezuela.
The transition period varies according to the country experience, where the pre- and posttransition periods refer to the three years preceding and following the specified transition period.
Strictly speaking, these “before and after” comparisons do not control for other developments that might have had an impact on the outcome. As a result, they cannot yield unambiguous conclusions about the efforts of implementing indirect instruments. However, as these comparisons focus narrowly on the financial sector, there can be a presumption that the results primarily reflect the effects of implementing indirect instruments of monetary control.
Chow tests are a special form of F-test that check for the stability of regression coefficients over two or more subsamples of the data. This is done by running an auto regressive regression (in first differences, in some cases, to ensure stationarity) for each variable for the whole sample, then running the same regression for the subsamples and comparing the sums of squared residuals.
However, developments in interest rate spreads are not comparable across countries as transaction costs and other factors vary across countries.
The decline in spreads could also reflect a lowering of reserve requirements, which would drive down the cost wedge between lending and deposit rates.
Deposit market share is the ratio of deposits mobilized by banks to deposits mobilized by the total financial sector (banks and nonbanks). Loan market share is the ratio of loans extended by banks to loans extended by the total financial sector. There may be some measurement problems if the banking survey has not been collected consistently across periods. The deposit data are available for only seven of the countries in the sample, and the loan data are available for only seven countries.
The five countries excluded from this section (owing to data availability) have also established positive real interest rates since the transition.
To the extent that capital controls have limited effectiveness, direct methods of monetary control may become largely ineffective even before the capital account is fully liberalized. On the limited effectiveness of capital controls, see Johnston and Ryan (1994).
By definition, financial sector liberalization involves freeing up interest rates and ending the direct allocation of credit. The liberalization program should explicitly include a conscious effort to develop new techniques and instruments, in order to maintain monetary control. In some cases, however, the need to revise the means of monetary control has been recognized only as an afterthought.
Note that a strict prohibition on monetary financing of the government is an important aspect of the Maastricht Treaty governing central banks in countries of the European Union. Thus, legal reforms may often be an important measure to insulate monetary policy from deficit financing.
A discussion of some of these efforts is included in Effros (1994) and Lindgren and Dueãas (1994). To be truly effective, however, independence must relate to the choice of instruments for achieving the goals of monetary policy and not to the determination of the latter. See Debelle and Fischer (1994).
Technical assistance has often been instrumental in effecting needed reforms.
The presence of international banks may be particularly important in small economies where limited economics of scale might otherwise prevent development of a competitive banking system. Also, home country supervision gets around the problem of weak host country supervision for those banks.
See Sundararajan and Balião (1991) for case studies analyzing the relationship between financial reform and financial crisis.
Direct instruments also require that a substantial body of information be available to policymakers.
In addition, a rapid approach has the advantage of delivering the benefits of the shift to indirect instruments earlier.
This sequencing is offered as an observation based or positive economics—what countries in the study have done in practice—rather than as a normative prescription.
Reserve requirements are included in the first stage because they can often be implemented early in the liberalization process. Moreover, countries with well-developed banking systems often find it useful to retain them, albeit at low levels, to facilitate interbank settlements, for example.
Historical reasons often account for that. For instance, in monobank systems, typically a savings bank collected the deposits of the population and the monobank made most of the credits. When the monobank was transformed into a two-tier banking system, the new commercial banks had more loans than deposits and the savings bank was in the opposite situation. Thus, the central bank had to intermediate the funds necessary to fill those gaps for some time.
The design of credit auctions requires special care to avoid their use for multiple purposes that undermine their value as monetary management instruments. For instance, using them to finance nonperforming assets in bank portfolios would be inappropriate; also, it would be inadvisable to use short-term central bank credit to finance banks* long-term loans.
Also, direct instruments can be redesigned to make them more market oriented. For instance, some countries (such as the Netherlands and Portugal) have allowed banks to trade unused credit ceilings. Note that while this makes credit ceilings less disturbing, other problems remain: since aggregate credit remains constrained, tradable credit ceilings can still result in a reserve money overhang. Moreover, rents accrue to those banks that receive the initial allocation of credits.
For the rationale, see Guitián (1973), For explanations of the role of performance criteria in IMF conditionality, see Guitián (1981, 1994b). Of the 50 IMF programs in place at end-1992. 48 targeted credit (of which 22 targeted net domestic assets of the central bank) and 2 targeted money (Guitián, 1994c).
There are imprecisions associated with the use of direct instruments as well, as discussed earlier.
When industrial countries have specified intermediate targets at the level of the central bank (such as MO in the United Kingdom and M3 in Germany), they specify a range rather than a precise target value, evidently because these countries are unwilling to accept the potential volatility in short-term market interest rates.
An additional consideration in some cases may be that, once indirect instruments are being used, setting targets at the level of the banking system may have the unintended effect of encouraging a reversion to direct controls on bank credit in order to meet program targets.