- Tomás Baliño, and Lorena Zamalloa
- Published Date:
- September 1997
© 1997 International Monetary Fund
Design and production: IMF Graphics Section
Library of Congress Cataloging-in-Publication Data
Instruments of Monetary Management: issues and country experiences / Tomás J.T. Baliño, Lorena M. Zamalloa, editors.
Includes bibliographical references.
1. Monetary policy. 2. Financial instruments. I. Baliño, Tomás J.T. II. Zamalloa, Lorena M.
Address orders to:
External Relations Department, Publication Services
International Monetary Fund, Washington D.C. 20431
Telephone: (202) 623-7430; Telefax: (202) 623-7201
Monetary policy issues have attracted the attention of both academics and practitioners over the last few years. Discussions have covered what should be the primary goal of monetary policy, an area in which a widespread consensus favors domestic price stability; what targets would best help in achieving that goal; and, finally, what instruments would be most efficient. Policymakers have an interest in international experience not only as a relevant basis for choosing among best practices, but also as an input for taking into account the likely effect of foreign developments on their own economies. These effects are likely to be larger than they were even a few years ago because of the increasing globalization of financial markets. In this connection, the availability of adequate instruments to implement monetary policy can be crucial in maximizing the benefits of capital mobility by helping the authorities improve their management of capital flows.
For all these reasons, too, the IMF has maintained a keen interest in monetary implementation issues and has encouraged its staff to analyze them and disseminate the results of that analysis. This book is but one manifestation of those analytical and dissemination efforts. It covers a key set of issues in monetary policy, specifically those that relate to the coordination and design of monetary instruments. It brings together the work of staff and consultants of the Monetary and Exchange Affairs Department of the IMF. The authors draw heavily on country experiences to support their analyses.
The broad picture that emerges is one in which the instrument mix and the characteristics of individual instruments vary significantly over time and across countries, as needed to deal with specific circumstances. Thus, while the objectives of monetary policy may be broadly the same across countries, they can be accomplished in a variety of ways. Indeed, a key task that the papers’ authors have undertaken is to examine the advantages and disadvantages of those ways in different scenarios.
The design of monetary instruments and, more broadly, the refining of monetary policy design and implementation can only be ongoing endeavors. I trust not only that this book will provide insights that will be helpful in analyzing individual situations, but also that it will stimulate further work and research on these matters.
Monetary and Exchange Affairs Department
The editors would like to thank the contributing authors for their papers, many of which have been issued as IMF Working Papers. The views expressed are those of their respective authors and should not be interpreted as those of the IMF.
The editors are particularly grateful to Manuel Guitián, Director of the IMF’s Monetary and Exchange Affairs Department, and V. Sundararajan, Deputy Director of the same department when this project began, for providing encouragement and making available the resources needed to complete it.
The editors would also like to thank their colleagues in the Monetary and Exchange Affairs Department who provided guidance, encouragement, and support for this project. Thanks are also due to IMF area departments, which provided valuable comments as well as information on countries’ experiences with the design, implementation, and coordination of the monetary instruments discussed in this volume.
Kiran M. Sastry provided able research assistance. Magally Bernal, Renée Cárdenas, Jacqueline P. Greene, and Lisa Mosczynski provided excellent secretarial assistance. This volume also benefited greatly from the editorial expertise of Elisa Diehl of the External Relations Department, who provided assistance throughout the production of this book.
Tomás J.T. Baliño and Lorena M. Zamalloa
Tomás J.T. Baliño and V. Sundararajan
Daniel C. Hardy
Bernard J. Laurens
Matthew I. Saal and Lorena M. Zamalloa
Catharina J. Hooyman
Stephen H. Axilrod
Mitra Farahbaksh and Gabriel Sensenbrenner
Anne-Marie Gulde, Jean-Claude Nascimento, and Lorena M. Zamalloa
The following symbols have been used in this book:
… to indicate that data are not available;
N.A. not applicable;
—to indicate that the figure is zero or less than half the final digit shown, or that the item does not exist;
– between years or months (e.g., 1995–96 or January–June) to indicate the years or months covered, including the beginning and ending years or months; and
/ between years (e.g., 1996/7) to indicate a fiscal (financial) year.
“Billion” means a thousand million.
Minor discrepancies between constituent figures and totals are due to rounding.
TOMÁS J.T. BALIÑO AND LORENA M. ZAMALLOA
Most countries have undertaken reforms of their monetary instruments over the last few years. Although these reforms have varied in scope and nature, most have been designed to maintain or improve the authorities’ ability to implement monetary policy at a minimum resource cost in a changing economic and financial environment. In particular, the widespread movement toward enhancing the role of price signals in the economy—including interest rates—has been a major force behind the reforms. An increasingly open economic environment and rapid financial market innovation have also pushed in the same direction. Moreover, the integration of domestic financial markets in a globalized market has put pressure on authorities to ensure that financial sector regulations—including those on monetary instruments, such as reserve requirements and liquidity requirements—allow their domestic financial market to compete while continuing to provide an appropriate degree of monetary control.
The papers in this volume deal with the design, implementation, and coordination of major monetary policy instruments, highlighting relevant country experiences. In particular, they discuss issues involved in adapting these instruments to the financial environment as well as fostering the development of this environment. Thus, the papers cover the choice of instrument mix and instrument coordination as well as two broad sets of instruments: indirect and direct instruments.1
Several themes run through the book. First, there are strong linkages among the various instruments, so that the design of one will affect the characteristics that need to be given to others. These linkages also highlight the need for coordination to avoid the possibility that one instrument will unintentionally offset the effect of another. Second, adaptation of monetary instruments is a continuous process. Thus, while transition economies and countries with underdeveloped or repressed financial markets may need to implement more profound reforms to catch up with countries whose financial markets are already developed, the latter will also need to adjust their instruments to keep up with market evolution. The changes envisaged in Europe for Stage III of European Economic and Monetary Union (EMU) are another example that illustrates this point. Third, the causality between market development and the evolution of monetary instruments runs both ways. To implement monetary policy efficiently, monetary authorities must adjust their instruments, as noted earlier. However, the choice of monetary instruments and their design will also affect the development of financial markets. Fourth, technical issues can have important implications. For instance, a system that allows required reserve balances to be held as an average over the reserve period rather than on a daily basis facilitates the functioning of the payment system, helps stabilize short-term interest rates, and reduces the need for central bank lending. Fifth, the design of monetary instruments must take into account many aspects of both the economic and financial context. For example, if a country does not have a fiscal deficit, the treasury will be less interested in issuing treasury bills, and a different instrument might be required. Also, if the market has a strong preference for short-term paper, the maturity of securities that can be issued for monetary operations will be affected.
The papers have been grouped in three parts. The first part focuses on instrument coordination issues and the design of instrument mix. The second part presents five papers that discuss the role and design of specific indirect instruments, including reserve requirements, central bank refinance, credit auctions, foreign exchange swaps, and open market operations. The third part presents two papers that discuss the role and effectiveness of specific direct instruments: bank-by-bank credit ceilings and liquid asset requirements.
Coordination of Monetary Instruments
In a country with well-functioning financial markets and a competitive banking industry structure, it should, in theory, be sufficient to have a market-based instrument operated at the discretion of the central bank and a discount window operated at the discretion of commercial banks. However, central banks use a wider set of monetary instruments and operating procedures to influence market conditions. Tomás J.T. Baliño and V. Sundararajan analyze why countries use multiple instruments and what causes variations in the mix and technical design of instruments. They suggest that problems in the structure and soundness of the banking system, unevenness in the distribution of bank liquidity, and the need to avoid excessive volatility in interest rates, as well as market development and payment system considerations together have called for the development of a wider set of instruments and operating procedures in order to foster effective and efficient implementation of monetary policy. However, because of changes in the economic environment, and in particular rapid financial innovation, the targets and instruments used to implement monetary policy must be evaluated frequently. For instance, in industrial countries, changes in monetary policy targets and the need to harmonize and coordinate monetary instruments have been key reasons, together with financial market innovation, for the reform of monetary instruments.
Within the set of indirect instruments, reserve requirements play an important role.2 In industrial countries, reserve requirements are mainly being used to facilitate interbank settlement and automatically smooth daily variations in short-term interest rates, but are not actively managed by the monetary authorities. In developing countries and economies in transition, however, reserve requirements are still an important monetary instrument. Daniel C. Hardy examines the role and design of reserve requirements. He notes that these requirements may help stabilize the demand for base money and thus facilitate the use of other instruments in the implementation of monetary policy. In the absence of more flexible instruments, reserve requirements may themselves be varied as a means of implementing monetary policy. The paper discusses key design issues of this instrument, such as the definition and monitoring of the requirement base, the eligibility of assets, the measurement of the base, averaging rules, the rate of remuneration, and the penalty for noncompliance.
Standing facilities can also play a critical role as an indirect instrument by allowing commercial banks to borrow funds from or deposit them with the central bank at their own discretion. Typically, central banks offer standing facilities at preannounced rates. The joint implementation of standing facilities and money market instruments allows central banks to make the monetary policy stance explicit.3 For instance, the plans for Stage III of EMU envisage the use of standing facilities to keep interest rates within a set range, or “corridor.” Central bank refinance is the most common standing facility. Bernard J. Laurens reviews the use of refinance instruments in a sample of industrial countries and discusses how central banks use them to influence short-term interest rates and to manage banks’ reserves. Although the quantitative importance of refinance instruments has diminished in recent years, they play an important role as an instrument of emergency funding to finance end-of-day imbalances. The design of refinance instruments must take into consideration the exchange rate regime, the need to foster the development of the interbank market, and the need to minimize central bank credit risk in refinance operations.
While standing facilities can allow monetary authorities to keep short-term interest rates within a specific range in the short term, central banks need market-based instruments that they can operate at their own discretion. Using these instruments, they can attain their monetary targets—a short-term interest rate, such as the overnight interest rate—or a monetary aggregate, such as bank reserves. The second part of the book discusses three such market-based instruments: credit auctions, foreign exchange swaps, and open market operations.
Credit auctions have been used in industrial and developing countries and in economies in transition from centrally planned to market-based systems to manage bank liquidity and short-term interest rates. However, although the monetary operations of central banks in market economies are supported by well-functioning interbank markets, adequate risk management—including the use of collateral—and effective banking supervision, these features may be insufficiently developed in economies in transition. Matthew I. Saal and Lorena M. Zamalloa examine the use of credit auctions and aspects of their design, including collateralization and access rules intended to minimize adverse selection, moral hazard, and collusion problems. They survey the implementation of credit auctions in Eastern Europe, the Baltic countries, Russia, and other countries of the former Soviet Union. In many of them, the early use of auctions has been associated with a phased reduction in the structural dependence on central bank credit, as well as with further development in other areas of central bank responsibility, notably bank supervision and the payment system. As part of such reform packages, credit auctions appear to have helped in managing monetary conditions and in developing market-based money and financial markets until more refined open market operations such as repurchase auctions could be implemented.
Foreign exchange swaps are another market-based monetary instrument that industrial and developing countries have used to affect domestic liquidity, to manage foreign exchange reserves, and to stimulate domestic financial markets. Catharina J. Hooyman discusses how foreign exchange swaps work and how central banks have used them in implementing monetary and exchange rate policy and in managing their international reserves. Markets price foreign exchange swaps according to the covered interest parity condition, after allowing for factors such as maturity, tax treatment, transaction costs, and default, settlement, and sovereign risk. If cover is not maintained, a swap may expose the participants to significant foreign exchange risk. Central banks use swaps especially when a deep domestic securities market is lacking and when they wish to avoid the direct effect on the spot exchange rate of outright foreign exchange operations. However, the popularity of swaps has declined as other instruments have been developed. Also, inadequately pricing swaps, motivated by efforts to defend an unsustainable exchange rate, has caused heavy losses to some central banks.
Open market operations are widely used in many industrial countries to manage short-term liquidity and have become ever more important to developing countries and economies in transition, which are relying more on deregulation and on market forces.4Stephen H. Axilrod assesses the options available to a central bank for designing instruments to implement open market operations and encourage a competitive market architecture. To be most effective, open market operations require supportive changes in other policy instruments, such as reserve requirements and standing facilities. Transforming markets for effective use of open market instruments initially requires implementing primary market sales of government or central bank securities and, once an active secondary market develops, introducing open market operations at the central bank’s initiative. Repurchase transactions are especially useful because they aid market growth by enhancing the liquidity of the securities that serve as collateral without directly interfering with market forces.
Although few countries currently use bank-by-bank credit ceilings as a monetary control instrument, a number of countries have used them to control credit aggregates by allocating credit directly among financial intermediaries. These ceilings are usually cast as instructions telling each bank the maximum volume of lending it is allowed to have. Mitra Farahbaksh and Gabriel Sensenbrenner survey selected countries’ experiences with this instrument. They find that over time, in many of the sample countries, credit ceilings, often combined with other administrative controls, left the banking industry highly uncompetitive, inhibited the growth of banking financial intermediaries, distorted resource allocation, and encouraged banks to circumvent such ceilings. However, they argue that in some countries where monetary relationships are unstable, ceilings can be used temporarily to target the net domestic assets of the banking system. In that event, the features of the instrument must be carefully designed to minimize its many drawbacks and enhance its flexibility.
Countries have used liquid asset requirements to control credit aggregates by requiring commercial banks to hold liquid assets equivalent to a predetermined percentage of their total deposits. Anne-Marie Gulde, Jean-Claude Nascimento, and Lorena M. Zamalloa review the economic literature on the subject and argue that liquid asset requirements are a poor instrument of monetary management. They note that such requirements have a substantial monetary impact only when banks satisfy them by holding central bank liabilities or securities issued and negotiated abroad. Nevertheless, even in such a case, liquid asset requirements are generally inefficient and redundant. However, adequately designed, they can be helpful for prudential purposes in less developed banking systems or as indicators to be flexibly used in conjunction with other measures of liquidity. Moreover, liquid asset requirements can also make the banking system more resilient in contexts—such as in a country with a currency board arrangement—in which the monetary authority has limited lender-of-last-resort capabilities. Abolishing or reforming the liquid asset requirement, particularly when it serves as an important instrument, is most efficiently accomplished under conditions of a stable macroeconomic environment, sound fiscal policies, and, if necessary, a broad financial sector reform package.
and others, eds.,1995, The Adoption of Indirect Instruments of Monetary Policy, IMF Occasional Paper No. 126 (Washington: International Monetary Fund).
forthcoming, “The Use of Standing Facilities in Indirect Monetary Management: Country Practices and Operational Features,” MAE Operational Paper (Washington: International Monetary Fund).
While direct instruments set or limit prices or quantities through regulations, indirect instruments operate through the market by influencing underlying demand and supply conditions. For a discussion of direct and indirect instruments, see Alexander and others (1995), pp. 2–6.
Reserve requirements have elements of both direct and indirect instruments Although they are applied through regulations, they influence the banks’ demand for reserve money. Thus, reserve requirements are classified as indirect instruments in this volume For a discussion, see Alexander and others (1995). p. 2.
For a discussion of the use of standing facilities in monetary management, see Laurens (forthcoming).
Open market operations include primary market sales of government or central bank securities (sometimes called open-market-type operations) and secondary market operations in these securities (outright purchases or sales and repurchase operations).