Monetary Policy Implementation at Different Stages of Market Development

Bernard Laurens

• Publisher: INTERNATIONAL MONETARY FUND
• Year: 2005
• ISBN:
  9781589064386

NONE

Part I. A Framework for Sequencing Reforms

I Overview

Central bankers around the world generally agree on the benefits for the economy of using market-based instruments to implement monetary policy. Following a trend initiated in the 1970s in industrial countries, central banks in most developing countries and emerging market economies have attempted to regulate overall liquidity conditions in the economy through financial operations in the domestic money markets. The objective of these central banks has been to influence the underlying demand and supply conditions for central bank money. The move was the parallel in the monetary area of the trend toward enhancing the role of price signals in the economy in general. It aimed at improving domestic savings mobilization and strengthening their market allocation.

The process was not without difficulties in those countries that did not succeed in developing their money markets. A survey of country experiences shows that failure to establish a clear separation between money creation and government funding needs often limited the effectiveness of money market operations, as did limited market participation and the lack of an effective framework to determine the timing and size of the central bank’s money market operations.

The experience of countries at different stages of money market development shows that the timing and speed of moving toward reliance on money market operations to conduct monetary policy must be tailored to each country’s particular circumstances. A stylized sequencing can be mapped into a four-stage process:

• Stage zero refers to the situation of post-conflict countries. Financial reforms involve reestablishing key functions in those areas where a central bank typically has responsibilities.
• Stage one in the process involves developing financial intermediation. Monetary policy relies on rules-based instruments—that is, instruments based on the regulatory power of the central bank, such as reserve requirements or deposit or refinance facilities available to the banks on demand, under certain preset conditions.
• Stage two involves fostering interbank market development. Money market operations can be introduced at this stage, but rules-based instruments retain an important role. Countries with limited market participation—for instance due to the small size of their economy—may not progress beyond stage two.
• Stage three involves the diversification of markets. At the end of stage three, liquidity management can fully rely on money market instruments.

This paper supports the close integration of the work of the International Monetary Fund’s area departments (i.e., surveillance or use of resources) with the Fund’s technical assistance in monetary policy design and implementation. This integration is particularly relevant for countries in transition to market-based frameworks for the implementation of monetary policy.

II The Growing Reliance on Money Market Operations for Monetary Policy

Following a trend initiated in industrial countries in the 1970s (Box 2.1), central banks in emerging market economies and developing countries have moved toward reliance on money market operations for the implementation of monetary policy (Table 2.1), although they frequently continue to act as banker to the government. At the same time, they have continued to rely on reserve requirements and, at times, liquid asset ratios which create a captive demand for qualifying assets (typically, government securities). This move was the counterpart in the monetary area to the trend toward enhancing the role of price signals in the general economy. It has involved reducing direct government intervention in the economy, improving the capacity of financial institutions to mobilize domestic savings, and strengthening the role of market forces in the allocation of financial resources.

Table 2.1. Use of Monetary Instruments in a Sample of Countries

(percent of countries in the sample)

Sources: IMF, Monetary and Financial Systems Department, Information System for Instruments of Monetary Policy database. Data based on practices as of the end of 2001 in central banks from 23 developing, 23 emerging, and 23 developed countries.

The Fund has encouraged this process, and technical assistance was provided to help countries make the transition. During 1999–2004, the Fund provided assistance to strengthen monetary policy implementation in more than 100 different countries (Table 2.2). Assistance was provided through advisory missions headed by Fund staff and including experts from cooperating central banks (33 missions per year on average), through visits by central bank experts supervised by Fund staff (87 visits per year on average), and through workshops and training activities (7 per year on average). These actions involved a total of more than 100 years of human effort over the six-year period. Some regions received a larger share of the Fund assistance, including Africa and Europe. Assistance has continued at a steady pace in Africa and Asia, but declined during the period in Europe, the Middle East, and Central and Latin America.

Table 2.2. Fund Technical Assistance in Monetary Policy Implementation (1999–2004)

Source: IMF, Monetary and Financial Systems Department.

¹ Europe includes the Baltics, Russia, and other countries from the former Soviet Union.

Box 2.1. The Conduct of Monetary Policy

To conduct monetary policy, a central bank may choose to regulate money creation by commercial banks through administrative measures that set limits on the price (interest rate controls) or the quantity (credit ceilings) of bank borrowing and lending operations. Alternatively, it may seek to exploit its monopoly in the creation of base money (currency and commercial banks’ balances with the central bank that can be converted into currency) to regulate overall liquidity conditions in the economy by influencing the underlying demand and supply conditions for central bank money. It does so by exchanging financial assets (domestic assets or foreign exchange) for its own liabilities (transactions hereafter referred to as “money market operations”), or by requiring banks to maintain minimum balances with the central bank (reserve requirements). All of these are aimed at influencing the balance sheets of the commercial banks, either directly through administrative measures or indirectly through the balance sheet of the central bank (money market operations and reserve requirements). The use of money market operations also allows the central bank to influence financial markets.

In the 1970s, industrial countries started to move from a reliance on credit or interest rate controls toward a reliance on money market operations. This was a result of the increasing inefficiency of the former in a context where financial markets had become more integrated both domestically and internationally. In addition, allowing market forces to distribute financial resources was associated with increased economic efficiency and growth. While the instruments in use have varied by country, common trends can be observed:

• less frequent recourse to open-ended/standing facilities which banks may use at their discretion to place funds with or borrow funds from the central bank under certain preestablished conditions;
• increased use of market-based operations conducted at the discretion of the central bank to add or withdraw liquidity from the system; and
• reduced reliance on reserve requirements, with a concomitant reliance by governments on markets, rather than central banks, to finance their needs.

The experience of emerging market economies and developing countries has been mixed. Smaller countries have found that a lack of competition in financial markets has complicated their move toward greater reliance on money market operations, at times forcing them to resort to moral suasion. For larger countries, the process has been gradual and at times difficult. Some countries have been able to overcome the difficulties, but others, despite lengthy periods of adjustment, still cannot fully rely on money market operations for liquidity management. The problems can be traced to weaknesses in the market infrastructure needed to ensure the effectiveness of money market operations. The country experiences show that reliance on money market interventions for the conduct of monetary policy is most effective when the following initial conditions are met:

• stable macroeconomic environment and sound fiscal policies;
• sound and competitive financial system and adequate supervisory framework; and
• a sufficient degree of institutional autonomy and operational capacity at the central bank.

Money market operations can be introduced before these conditions are met, but their effectiveness will likely be somewhat limited until progress is made toward meeting these initial conditions.

This study assesses which guiding principles a central bank can apply to design an action plan to develop strong operational frameworks for monetary policy implementation. Given the variety of country circumstances, a “one-size-fits-all” approach is unrealistic. To be successful, policymakers need to follow these steps: (1) take stock of existing market infrastructure conditions; (2) draw an action plan to address existing weaknesses; and (3) adjust the mix of monetary instruments as progress is made.

The policy conclusions in this study are relevant both to small countries unable to develop diversified financial markets because of a lack of demand for financial products and to countries for which the challenge is to eliminate the obstacles to market development. The study relies on an assessment of the experiences of a dozen countries or groupings of countries.¹ The group includes small countries with limited scope for developing diversified markets, some of which have been able to set up effective monetary policy frameworks, and larger countries which at some point had not yet managed to establish a strong market infrastructure due to weaknesses in policy implementation. Section III summarizes the country experiences embodied in the case studies by grouping the market infrastructure conditions into three broad categories: (1) macroeconomic conditions; (2) market participation; and (3) central bank institutional and operational position. Section IV discusses the implications for policy design and coordination. Section V proposes an agenda for action to strengthen monetary policy. Section VI discusses the sequencing of reforms, and Section VII analyzes the implications for Fund operations. Part II includes the 12 case studies.

III Lessons from Country Experiences

IV Implications for Policy Design and Coordination

Market infrastructure weaknesses have undermined the transmission channels of monetary policy in the case study countries. In particular, the asset price channel is largely absent because there are no developed financial markets in which asset prices can be efficiently formed. The exchange rate channel may also be nonexistent in countries with a fixed exchange rate and may be weak in countries with floating, managed floating, or adjustable peg regimes due to the maintenance of controls on capital and/or current account transactions.¹ This means that the availability of credit and the interest rate channels are likely to be the most effective transmission channels of monetary policy. Furthermore, there are few sources of funding other than bank lending, and so monetary policy is transmitted via the impact of central bank actions on the balance sheet of the banking system.

Selecting a Monetary Framework: Prices Versus Quantities

The conduct of monetary policy through reliance on money market operations is based on the central bank’s monopoly power to create money. The central bank either can set the price for base money or can target the quantity of money provided to the system. A lack of developed markets, and the corresponding lack of reliable price information, may force the central bank to rely on quantities (monetary aggregates, credit, or components of the central bank’s balance sheet) as indicators or intermediate targets for monetary policy.² Quantity variables can be more reliably measured and monitored than financial prices, which may be distorted or discontinued for reasons outlined above. Another drawback of attempting to target interest rates in shallow markets is that the historical absence of market-determined interest rates leaves the linkage between the short-term rates and monetary aggregates and inflation less clearly understood. At the same time, in the early stages of financial reforms, decisions to modify official interest rates may remain politically charged, even if the law gives the central bank full authority to adjust its policy rates, and this can cause rigidity in the upward movement of rates. In the context of such markets, quantities (for example, of base money) rather than prices (that is, the interest rate) may be used as an operating target for monetary policy. In addition, when the technical capacity of the central bank is limited, the balance is likely to be tipped further away from anchors that rely on fine, well-informed judgments by policymakers and toward relatively simpler, rules-based frameworks. Therefore, simple money rules (such as relatively mechanical money/credit growth targets) or simple exchange rate rules (such as a fixed exchange rate regime) may be the preferred option for anchoring monetary policy. Many of the countries in this sample have adopted a monetary aggregate as a nominal anchor, and a number have adopted an exchange rate anchor, at least at some point.

Despite their appeal in less well developed markets, simple monetary policy frameworks may not perform well in handling shocks and may be sensitive to errors in assumptions about the demand for money. Although there is a long-term relationship between money growth and inflation, in the short-term, the reliability of targeting credit aggregates or the monetary base as a means to manage the central bank’s balance sheet depends on the stability of their relationship to the ultimate target of monetary policy, regardless of the size or stage of development of the markets. Therefore, reliance on a monetary program for the conduct of monetary policy—in particular on a framework anchored to base money targeting—should not be overly rigid and should be accompanied by close monitoring of macroeconomic indicators to gauge the appropriateness of correcting deviations from the initial assumptions.

There is an option to start migrating away from simple rules-based monetary frameworks (such as pegged exchange rate regimes or explicit monetary aggregate targeting) and toward monetary frameworks based on informed judgments by the central bank (such as monetary regimes based on monitoring a set of indicators and inflation targeting) after the financial markets have matured and the central bank has developed a research capacity in monetary and economic analysis. In particular, in countries with shallow markets, inflation targeting is generally not easy, even though it may appear attractive in terms of providing greater flexibility and allowing greater focus on a broad range of economic developments and relevant information. Indeed, although an explicit inflation target could help stabilize inflation expectations, a framework centered ...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Contents
• Preface
• Glossary of Monetary Instruments
• Part I. A Framework for Sequencing Reforms
• Part II. Selected Country Experiences with Money Market Operations
• Appendixes
• Footnotes