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Vanuatu

Author(s):
International Monetary Fund
Published Date:
August 1996
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I. Introduction

The purpose of this paper is to review the development of monetary control instruments in five small island economies in the South Pacific (Fiji, Solomon Islands, Tonga, Vanuatu, Western Samoa) and draw some lessons from their experience. Except Solomon Islands which has extraordinarily high credit demand from the Government, these economies have large structural excess liquidity in the banking system. To manage the excess liquidity, the monetary authorities in recent years have steadily shifted from direct monetary instruments to indirect monetary instruments. With the exception of Vanuatu, which does not actively utilize instruments for monetary control, these economies have adopted open market type operations1 based on central bank securities often supplemented by high liquid asset ratios (LARs).

The paper discusses two major issues in the current monetary control instruments in the South Pacific. First, given the large excess liquidity and relatively weak balance sheets of the central banks, the use of central bank securities is likely to be constrained by concerns for the profits of central banks if there is no explicit understanding that the quasi-fiscal cost of these operations will be borne by the fiscal authorities. Second, high LARs are distorting the interest rate structure in many islands as the authorities take advantage of the captive market to have artificially low interest rates on central bank and government securities. The distorted interest rate structure could hamper the development of secondary markets and the transmission mechanism of monetary policy.

This paper draws three major policy implications from the experience of these island economies. First, the quasi-fiscal cost of monetary policy should be shared by the fiscal authorities if it constrains the autonomy of the central bank to conduct monetary policy. Second, given the large excess liquidity and the potentially large quasi-fiscal costs of open market instruments, it may be appropriate for the authorities to depend on a mix of monetary instruments and not solely rely on open market operations. Finally, some easing of restrictions on outward capital investment would lessen the amount of excess liquidity and the associated quasi-fiscal cost of monetary policy. As a step to liberalize capital transactions, the authorities may start with the easing of outward investments through foreign currency deposits at deposit money banks.

The rest of this paper is organized as follows. Section II describes the financial sector in the five economies and analyses the background for large excess liquidity. Section III reviews the developments of monetary instruments in these economies from a comparative perspective. After discussing two major issues in the current use of instruments in Section IV, Section V draws some policy implications.

II. Financial Development and Excess Liquidity

A. Financial Development

The five economies have many features in common. To start with, all these economies are small and open. Fiji has the largest population of about 760,000 followed by the Solomon Islands with about 350,000. The others have less than 200,000. While their land consist of scattered islands, they have large subsistence sectors. Their production structure is not well developed and still largely rely on primary products. Reflecting the narrow production base, they are all highly dependent on imported goods, mainly from Australia and New Zealand.2 The size of the public sector is dominant in every economy but their fiscal policy has been relatively conservative, except for the Solomon Islands, and typically run relatively modest fiscal deficits or surpluses. On the exchange rate policy, all these economies peg their exchange rates to a basket of major trading partners’ currencies except for Solomon Islands which basically follows a real exchange rate policy. Together with the high dependence on imported goods, the pegged exchange rate system has worked as a basic anchor for inflation.

Financial sectors in the Pacific Island economies are not well developed, with small number of banks and limited progress in financial deepening. Foreign branch banks play a dominant role in these economies with only a limited role being played by the domestic banks. Foreign branch banks have essentially concentrated their operations to the urban centers. Fiji has the largest number of commercial banks, totaling six, followed by Vanuatu with four banks. Solomon Islands and Tonga have three commercial banks, while Western Samoa has only two. In order to compare the stages of financial intermediation, Chart 1 shows the levels of broad money and domestic credit in percent of GDP for the five economies as well as selected ASEAN countries as of end-1994. From this chart, Fiji and Vanuatu appear to be more advanced compared to other island economies. However, the high level of broad money in Vanuatu should be discounted on account of the large foreign currency deposits held by nonresidents. For Vanuatu, broad money is shown in both vatu liquidity and total liquidity; the latter include foreign currency deposits. The share of local depositors in foreign currency deposits appears to be small given a minimum deposit requirement of US$5,000. Therefore, the stage of financial deepening in Vanuatu is better measured by vatu liquidity.

CHART 1FINANCIAL INTERMEDIATION IN SELECTED PACIFIC ISLAND AND ASEAN COUNTRIES

(As of end-1994)

Sources: IMF, International Financial Statistics; data from the national authorities; and staff estimates.

The slow progress of financial deepening in these island economies reflects the stages of economic development itself. These economies still have a large subsistence sector which often consists of small scattered islands with small population. Banks often find it too costly to expand their branches to the scattered islands where there are few business opportunities. In order to promote financial deepening, the authorities have made efforts to promote savings by maintaining positive real deposit rates. Another problem in these island economies is the short term nature of deposits which often discourage lending activities, especially those of a long term nature. As shown in Table 1, share of time deposits is low and the maturity of time deposits is relatively short. Both in Tonga and Western Samoa, almost half of the time deposits have the maturities of less than a year. Looking at vatu time deposits by residents in Vanuatu, deposits with maturities up to one month have enjoyed a large share ranging from about 30 percent to 65 percent in past several years. In Fiji, almost a quarter of time deposit has maturities of less than a year. In order to promote long-term savings, most of the island economies except Tonga created national provident funds, compulsory retirement savings institutions. Although the significance of the national provident funds defers among the islands, the assets of the funds in all islands have increased strongly in recent years while none of them is permitted to actively invest abroad.3

Table 1.Structure of Deposits(In percentage points, end-1994)
Demand

Deposits
Saving

Deposits
Time

Deposits
Total
Fiji21.422.156.5100.0
Tonga30.029.840.2100.0
Solomon Islands43.222.734.2100.0
Vanuatu
(Total deposit)18.911.469.8100.0
(Vatu deposit)30.328.541.2100.0
Western Samoa30.014.455.7100.0
Source: Annual reports of the respective central banks.
Source: Annual reports of the respective central banks.

Promotion of bank lending is a more difficult task. Given their weak economic base, there is a scarcity of bankable projects, even in urban areas. In addition, traditional land tenure system in the South Pacific discourages lending activities by making it difficult to use land as collateral. Moreover, there is high default risk and the legislative framework for collecting on nonperforming loans is weak. To some extent, banks are also competing with foreign assistance (transfers and concessional loans) whose impact tends to be large because of the small size of the economies (Table 2). Foreign assistance, which reached as high as 25 percent of GDP in the case of Western Samoa, finances a significant portion of investments in these economies. Large interest rate spreads between deposit and lending rates are also often blamed for weak credit demand and are due in part to a less than perfect competitive environment (Chart 2). However, they also result from high operation costs that arise from geographical factors, small size of loans, high default risk, limited availability of collateral, and the high cost of employing expatriate staff.

Table 2.Net Official Transfers and Loans(In percent of GDP)
19901991199219931994Average

1990-94
Fiji2.94.44.42.92.73.5
Tonga14.38.613.914.914.713.3
Solomon Islands20.818.818.515.110.716.8
Vanuatu22.823.622.119.919.621.6
Western Samoa26.826.529.626.711.824.3
Source: Recent economic developments reports, International Monetary Fund.
Source: Recent economic developments reports, International Monetary Fund.

CHART 2-ASELECTED PACIFIC ISLANDS

INTEREST RATE DEVELOPMENTS, 1990-94

(In percent per annum)

Sources: Data provided by the national authorities; and IMF, International Financial Statistics.

1/ Deposits less than F$250,000.

2/ Deposits up to SI$25,000.

CHART 2-BSELECTED PACIFIC ISLANDS

INTEREST RATE DEVELOPMENTS, 1990-94

(In percent per annum)

Sources: Data provided by the national authorities; and IMF, International Financial Statistics.

1/ Treasury bills were first issued on October 11, 1990. Central bank securities were first issued on April 2, 1991.

B. Large Excess Liquidity

Another feature which these economies have in common is a large degree of excess liquidity in the banking system. It is difficult to measure and compare the level of excess liquidity across countries. One indicator of excess liquidity is the excess reserve deposited with the central bank above the level required by the laws and regulations. However, this measure has two problems. First, it is difficult to make comparison among economies because it reflects differences in monetary systems and policies. For example, if other conditions are same, an economy with a higher reserve requirement must have lower excess liquidity. Second, it does not include the excess liquidity which has already been absorbed by the authorities, for example, by central bank securities. In order to avoid these problems, “potential liquidity” was calculated for each country. Potential liquidity is calculated from the balance sheet of the central bank: reserve money minus currencies outside deposit money banks plus outstanding central bank securities. In other words, it is approximately the same as the sum of deposit money banks’ deposits with the central banks and deposit money banks’ holding of cash and central bank securities (Table 3). Potential liquidity does not include government securities held by deposit money banks although all countries, except Tonga, include government securities as part of required liquid assets. Given the fact that, in these economies, government securities have been issued for the purpose of budget financing and not for monetary controls in most cases, they are excluded from the potential liquidity and treated as claims on the government. Potential liquidity does not indicate an actual threat to the economy because it includes that money already sterilized or controlled by the authorities. Instead it indicates the magnitude of excess liquidity that potentially exists in the economy. In other words, it is a measure for the magnitude of liquidity which could fuel credit expansion once monetary control measures are completely eased.

Table 3.Asset Composition of Deposit Money Banks(In percentage, as of end-1994)
Reserves 1/CB securitiesForeign

assets
Claims on

central

government
Claims on

private

sector
Claims on non-

financial public

enterprises
Fiji7.02.85.75.269.99.3
Tonga11.135.00.05.944.43.6
Solomon
Islands4.40.04.253.537.60.3
Vanuatu4.90.062.61.930.10.5
Western
Samoa28.86.110.22.450.32.1
Source: Annual reports of the respective central banks.

Excluding central bank securities.

There are some differences in how to categorize central bank securities in the balance sheets in the IFS.

Source: Annual reports of the respective central banks.

Excluding central bank securities.

There are some differences in how to categorize central bank securities in the balance sheets in the IFS.

Table 4 shows the amount of potential liquidity for the five economies in percent of GDP as well as broad money. It is evident that Tonga and Western Samoa have an exceptionally high level of potential liquidity averaging around 25 percent of GDP during 1990-94. The significance of its potential threat to monetary stability is more clearly shown in percent of broad money which, in the past, once exceeded 90 percent and 70 percent in Tonga and Western Samoa, respectively. Looking at recent movements, the potential liquidity in Western Samoa has been continuously declining since it peaked in 1991 while that of Tonga persistently maintained the high level. Although more modest compared to these two economies, Fiji also has high level of potential liquidity averaging about 9 ½ percent of GDP and 18 percent of broad money during 1990-95. Fiji is closely followed by Vanuatu with potential liquidity averaging 5 ½ of GDP and 15 percent of vatu broad money (vatu liquidity excluding foreign currency deposits). Finally, the Solomon Islands has the lowest level of potential liquidity averaging 2½ percent of GDP and 7 percent of broad money during the same period, having risen up to 5 percent in 1992, it has been declining in recent years.

Table 4.Potential Liquidity in the South Pacific 1/
1988198919901991199219931994
(In percent of GDP)
Fiji8.37.08.98.912.28.48.7
Of which: (central bank securities)0.03.14.84.47.04.24.7
Tonga26.529.428.924.324.428.225.2
Of which: (central bank securities)0.00.00.00.00.021.418.8
Solomon Islands3.41.11.42.84.71.81.3
Of which; (central bank securities)0.00.00.00.02.81.20.2
Vanuatu3.94.83.64.35.07.96.1
Of which: (central bank securities)0.00.00.00.00.00.00.0
Western Samoa12.517.228.832.024.417.915.2
Of which: (central bank securities)0.00.00.07.96.93.82.7
(In percent of broad money)
Fiji18.216.618.217.122.215.716.6
Of which: (central bank securities)0.07.29.78.412.77.99.0
Tonga86.496.986.275.785.690.874.8
Of which: (central bank securities)0.00.00.00.00.069.055.8
Solomon Islands9.43.44.18.213.35.94.1
Of which: (central bank securities)0.00.00.00.08.14.00.5
Vanuatu (based on vatu liquidity)8.914.611.112.613.220.414.1
Of which: (central bank securities)0.00.00.00.00.00.00.0
Western Samoa35.844.962.373.559.646.538.0
Of which: (central bank securities)0.00.00.018.116.99.96.7
Western Samoa35.844.962.373.559.646.538.0
Of which: (central bank securities)0.00.00.018.116.99.96.7
Memorandum items:
Vanuatu (based on total liquidity) 2/2.83.42.63.64.57.35.8
Of which: (central bank securities)0.00.00.00.00.00.00.0
Sources: International Financial Statistics and Recent economic developments reports, International Monetary Fund

Potential liquidity = reserve money - cash outside DMDs + central banks securities.

Includes foreign currency deposits.

Sources: International Financial Statistics and Recent economic developments reports, International Monetary Fund

Potential liquidity = reserve money - cash outside DMDs + central banks securities.

Includes foreign currency deposits.

C. Causes of Excess Liquidity

The key determinant of the level of potential liquidity is the relative size of domestic credit and available liquidity which is shown in Chart 1. Broad money in percent of GDP shows the amount of liquidity available and domestic credit in percent of GDP provides an indication of the number of bankable projects in the economy. Therefore, the gap between the two (“deposit-credit gap”) could be a rough indicator for possible excess liquidity. Western Samoa has the largest gap of 21 percentage points while Vanuatu has 14 percentage points followed by Tonga which has 10 percentage points.4 Fiji has 6 percentage points while the deposit-credit gap is almost nil in the Solomon Islands, which means that the amount of broad money is same as the amount of domestic credit. It is clear from the chart that the high level of domestic credit in the Solomon Islands largely stemmed from exceptionally large net credit to the Government, equivalent of about 21 percent of GDP in 1994.

Although the deposit-credit gap is a major source of potential liquidity, the different magnitude of potential liquidity in each country cannot be explained without considering other institutional factors. In particular, why is Tonga’s potential liquidity larger than that of Western Samoa and Vanuatu while its deposit-credit gap is smaller? Why is Vanuatu’s potential liquidity smaller than that of Fiji although the gap is larger in Vanuatu? One factor is the size of capital accounts of deposit money banks, which is another source of excess liquidity but not captured in broad money. This is helpful in explaining the high potential liquidity in Tonga in which deposit money banks have exceptionally large capital accounts equivalent of 17 ½ percent of GDP in 1994. Other countries have relatively smaller capital accounts: 7 percent of GDP in Vanuatu; 6 percent in Western Samoa; 3 percent in the Solomon Islands.5

Another important institutional aspect is the Government’s financial position with the central bank and deposit money banks. Even with the same amount of net credit to the Government in the monetary survey, better financial position with the central bank could lessen the level of potential liquidity. For instance, the Governments in Fiji, Vanuatu, and Western Samoa had a positive balance with the central bank while getting little financing from deposit money banks.6 In contrast, in Tonga, the Government got large net financing from the central bank, equivalent of 3 ½ percent of GDP in 1994, while holding net deposit with deposit money banks of about 4 ½ percent of GDP. This is another major reason for the exceptionally high potential liquidity in Tonga. In the Solomon Islands, the Government got large financing from both the central bank (5 ½ percent of GDP) and deposit money banks (15 percent of GDP).

Finally, restrictions on foreign exchange transactions are also nurturing large potential liquidity. By definition, the deposit-credit gap is equal to “net foreign assets minus other items (net)” which means that, assuming other items (net) same, large potential liquidity reflects large net foreign assets. For these small islands, the external position has been the vital interest to the monetary authorities and, in one sense, these economies are choosing excess liquidity for the purpose of maintaining their comfortable external balance. The significance of net foreign assets in determining the level of potential liquidity is shown in Chart 3. Effective measures to preserve foreign reserves are restrictions on exchange transactions.7 With some variations in their coverage and effectiveness,8 all the countries except Vanuatu require proceeds from exports and invisibles to be repatriated and surrendered to authorized foreign exchange dealers. On capital transactions, most countries, again except Vanuatu, control and discourage outward investments by residents. Apart from Vanuatu, Fiji is the most liberalized and has been further easing restrictions on outward foreign investments, albeit gradually, in recent years.

CHART 3-ASELECTED PACIFIC ISLANDS

SOURCES OF POTENTIAL LIQUIDITY GROWTH, 1989-94

(Changes from previous year; in percent of GDP)

Sources: Data provided by the national authorities; and IMF, International Financial Statistics.

CHART 3-BSELECTED PACIFIC ISLAND

SOURCES OF POTENTIAL LIQUIDITY GROWTH, 1989-94

(Changes from previous year; in percent of GDP)

Sources: Data provided by the national authorities; and IMF, International Financial Statistics.

III. Survey of Monetary Control Instruments

Although the development of monetary control instruments varies in the individual cases, there are several features common to the five economies. First, their goals for monetary control have been the same—how to manage excess liquidity. Second, since the late-1980s, these economies have been shifting toward indirect monetary control instruments. As shown in Table 5, Western Samoa is now the only country with direct controls on credit and interest rates. Open market-type operations were introduced in all the countries except Vanuatu, and mostly central bank securities are being used. The open market-type operations are often supplemented by LARs or statutory reserve requirements. The rate of LARs is high in Fiji, the Solomon Islands, and Western Samoa. Reflecting the excess liquidity in the banking system, discount windows and lending facilities for deposit money banks have been rarely used.

Monetary control instruments in each country can be summarized as follows.

Table 5.Monetary Control Instruments in the South Pacific (as of end 1995)
TONGAFIJISOLOMON ISLANDSVANUATUWESTERN SAMOA
Central banks (Year of establishment)National Reserve Bank of Tonga (1989)Reserve Bank of Fiji (1984)Central Bank of Solomon Islands (1982)Reserve Bank of Vanuatu (1981)Central Bank of Samoa (1984)
Open market-type operations (Year of introduction)Central bank securities (1993)Central bank securities (1989)Central bank securities (1992) and treasury billsCentral bank securities (1991)
Reserve requirement Liquid asset ratiosReserve requirement 5 percent (noninterest bearing)Reserve requirement 6 percent (interest bearing)

Liquid asset ratio 16 percent (government or central bank securities)
Liquid asset ratio (reserve requirement) 40.0 percent (till cash or treasury bills or deposit at the central bank)Reserve requirement (liquid asset ratio) 10 percent (only on vatu deposits. A very limited amount of government securities could be used to meet the requirement.Liquid asset ratio (reserve requirement) 20,25,30 percent (cash, on government securities and claims on the central bank. At least 25 percent should be held as noninterest bearing deposit with the central bank)
Interest rate ceiling/floorThe Reserve Bank guidelines on lending rates (not enforced)Maximum lending rate

Minimum deposit rate
Direct credit controlMinimum requirement for lending to agricultureA deposit-linked credit expansion formula
Discount and lending facilitiesRediscount facilityMinimum Lending Rate (MLR)Lending facility Official discount window for treasury billsDiscount window
Sources: Annual reports of the respective central banks; and recent economic developments reports, International Monetary Fund.
Sources: Annual reports of the respective central banks; and recent economic developments reports, International Monetary Fund.

A. Fiji

Fiji was the first country to introduce open market-type operations based on central bank securities in 1989. With weekly tenders of short-term central bank securities, the central bank pursues a target level of banks’ balances in their settlement accounts, usually referred to as bankers’ demand deposits. Another major instrument is the statutory reserve deposit money banks must maintain in a special account with the central bank which bears interest rate of 3.5 percent. The reserve requirement has been six percent of deposits and similar liabilities. The open market-type operations are supplemented by an Unimpaired Liquid Asset Ratio which requires banks to invest the equivalent of 16 percent of deposits and similar liabilities in eligible government and central bank securities. The ratio has not been changed at 16 percent since 198S. Outstanding central bank securities once amounted to 7 percent of GDP in 1992 but declined to about 5 percent of GDP in 1994 (Table 4). Outstanding treasury bills in 1994 were about 2 ½ percent of GDP, of which 41 percent was held by commercial banks and the rest held by nonbank institutional investors.

B. Solomon Islands

Monetary control instruments in the Solomon Islands are also designed to absorb excess liquidity by open market type-operations and high LARs Direct controls on deposit rates and lending rates were removed in 1989 and 1991, respectively. The present LAR is 40 percent and may be held in any combination of eligible assets including deposits with the central bank, treasury bills, and till cash but not central bank securities. Central bank securities were introduced in November 1992. In practice, however, given the extraordinarily large fiscal deficit in recent years, the commercial banks have ended up having to finance the Government. Deposit money banks’ holdings of treasury bills have well exceeded the amount necessary to meet the LARs since 1992. It exceeded the required amount by 34 percent in 1993 and 28 percent in 1994. As a result, outstanding central bank securities, which once amounted to 2.8 percent of GDP in 1992, declined to 0.2 percent of GDP in 1994.

C. Tonga

Tonga has been most ambitious in developing indirect monetary control instruments and currently relies solely on open market-type operation and low statutory reserve requirement. Interest rate ceilings have been progressively phased out, with the last one removed in July 1991. Credit controls—which have operated mainly through a maximum loans-to deposits ratio, reinforced by direct lending limits in case reserves fell through a specified floor-were eliminated in early 1993. At that time, Tonga introduced two new indirect instruments. First, in March 1993, the maximum loans-to deposits ratio was replaced by a requirement that deposit money banks hold 5 percent of their deposits as non-interest bearing statutory reserves at the central bank. This reserve requirement was designed to serve both prudential and monetary policy functions, although it was envisaged that the ratio would not be changed frequently unless monetary conditions preclude the use of other instruments that may have a more delayed and less certain effect.9

Second, in April 1993, Tonga started to issue central bank securities on a weekly basis. Although only one type of note, with a 56-day maturity, was initially offered, since February 1994, the range of securities has been broadened to include maturities between 28 days and five years. The central bank has been moving toward an auction system for issuing its securities since mid-1995 but rates are still decided at the central bank’s discretion. The size of outstanding central bank securities is the largest in the five economies amounting to 19 percent of GDP and 56 percent of broad money in 1994 (Table 4). Although these securities can be purchased by any entity in Tonga, more than 90 percent have been acquired by deposit money banks, with the balance being obtained by the Tonga development Bank. The share of central bank securities in deposit money banks’ assets was 35 percent in 1994. Following the introduction of central bank securities, the central bank also opened a rediscount facility, which currently operates on a limited case-by-case basis, with interest rate determined at the central bank’s discretion.

D. Vanuatu

Vanuatu does not actively utilize any monetary instruments. There is a reserve requirement, which has been fixed at 10 percent since its introduction in 1988, mainly for prudential reasons. Although there have been central bank guidelines on lending rates since mid-1980s, these are not enforced.10 Despite having the most liberal foreign exchange regime of the Pacific Island economies, commercial banks in Vanuatu have persistently been holding reserves well above the required level. Given the absence of an active interbank market, banks have been holding excess balances to meet fluctuations in their own liquidity needs. The reserve requirement is applied only to domestic currency deposits. Foreign currency deposits, which are twice as large as domestic currency deposits, are not currently subject to the reserve requirement. The reserve requirement has some features of a LAR because a limited amount of a certain type of Government securities (i.e., those carrying a fixed interest rate of 1.5 percent with maturities of 91 days) could be used to meet the requirement; however, the amount of this type of securities is frozen at vatu 200 million. As of end-1994, total outstanding government securities amounted to 7 percent of GDP of which about one-fourth were held by deposit money banks. Vanuatu at present does not use government securities for short-term monetary management and does not issue central bank securities.

E. Western Samoa

Western Samoa makes very little use of indirect monetary control instruments. Monetary policy is still based on direct controls on credit outstanding, via a deposit-linked credit expansion formula11 and controls on interest rates (which set maximum lending rates and minimum deposit rates). Commercial banks are also required to hold a minimum proportion of deposits in the form of liquid assets (notes and coins, government securities, and net claims on the central bank). The shorter the maturity of a deposit, the higher the proportion of liquid assets that must be held against it.12 A further constraint is that a quarter of a banks’ minimum required liquid asset must be held in noninterest bearing deposits with the central bank (the Statutory reserve requirement).

While continuing to rely on direct instruments, some progress has been made to introduce some indirect instruments. Treasury bills and central bank securities have been issued for open market-type operations since October 1990 and April 1991, respectively. Since their issuance, central bank securities have surpassed treasury bills with respect to the volume and treasury bills have not been issued since December 1992. The amount of outstanding central bank securities once reached 8 percent of GDP in 1991 but went down to about 3 percent of GDP by the end of 1994 (Table 4). In order to introduce an auction system for central bank securities, the authorities received technical assistance from the IMF in early 1995.

IV. Issues in Monetary Control Instruments

In this section, based on the experience of these island economies, two current issues of monetary control instruments are discussed. First, the large cost of absorbing excess liquidity is presently shouldered solely by the central banks and it has sometimes constrained the central bank’s autonomy to conduct monetary policy. The recent Tongan experience highlights this problem and the central banks in other island economies could be subject to a similar risk. Second, distortions on interest rates, especially those on securities, exist in most of the economies as these countries have often taken advantage of high LARs.

A. Monetary Policy Costs and Central Bank Profits

Without exception, open market-type operations in the South Pacific islands are currently based on central bank securities. As discussed in Quintyn (1994), a typical problem of relying on central bank securities is its threat to the central bank’s profitability when the authorities try to absorb large excess liquidity. In 1994-95, this problem arose in Tonga and a concern for its profit constrained the central bank’s ability to tighten monetary conditions. During 1994-95, Tonga experienced a surge in credit to the private sector and associated decline in foreign reserves. With a large amount of central bank securities outstanding, the central bank could not raise interest rates on the securities to respond to the situation because its cost was too large compared to its already small profit. Instead of using open market-type operations, it used a moral suasion to slow down lending by commercial banks. Interest rates on central bank securities remained unchanged well below deposit rates and credit growth remained at a high level. As the foreign reserve situation continued to deteriorate in late-1995, the central banks finally raised the rates on the securities by two percentage points. In addition, the central bank raised its reserve requirement ratio for the first time from 5 percent to 10 percent effective February 1996.

In general, the constraint imposed on interest rate policy by concerns for central bank profitability, could take place in other island economies given the large size of potential liquidity and vulnerable central bank balance sheets. Financial positions of other central banks in the region are not so better than that in Tonga. Table 6 shows financial outcomes of the central banks shown in their annual reports. In most cases, gross operating incomes (before paying any interest rate for its liabilities) and operating profits are declining. In particular, the central bank in Western Samoa had operating losses for two consecutive years in 1993 and 1994. The decline or stagnant growth in gross income of the central banks in the first half of the 1990s is rooted to their balance sheet structure. Unlike typical central banks in developing economies, the central banks in the region (except the Solomon Islands) rely almost solely on interest rate earnings on external reserves with little claims on the Government and deposit money banks. In the integrated balance sheet figures of central banks in low-inflation developing countries compiled by Fry (1993), gold and foreign exchange had a 20 percent share in total assets while government securities and loans to the banks had shares of 64 percent and 14 percent, respectively. In contrast, the shares of foreign assets in the central bank’s total assets were almost 100 percent in Fiji, 98 percent in Vanuatu, 95 percent in Western Samoa, 82 percent in Tonga, and 45 percent in the Solomon Islands in 1994. Needless to say, the exceptionally low share in the Solomon Islands is due to the large amount of credit extended to the Government.

Table 6.Central Bank Profits and Potential Liquidity
19901991199219931994
Tonga
Gross operating income (T$ mn.) (a)4.34.73.83.63.7
Central bank profit (T$ mn.)2.62.21.00.90.8
Central bank securities (T$ mn.)0.00.00.042.639.2
Potential liquidity (T$ mn.) (b)42.541.845.056.052.5
(a)/(b) (percentage)10.111.28.46.57.1
Fiji
Gross operating income ($ mn.) (a)29.135.035.237.916.6
Central bank profit ($ mn.)14.213.515.819.81.1
Central bank securities ($ mn.)96.295.4163.9108.9126.6
Potential liquidity ($ mn.) (b)179.5193.5287.2216.4234.6
(a)/(b) (percentage)16.218.112.317.57.1
Solomon Islands
Gross operating income (SI$ mn.) (a)9.39.711.49.99.7
Central bank profit (SI$ mn.)3.64.75.21.31.5
Central bank securities (SI$ mn.)0.00.017.49.91.5
Potential liquidity (SI$ mn.) (b)5.814.328.714.712.8
(a)/(b) (percentage)160.967.839.667.575.5
Vanuatu
Gross operating income (VT$ mn.) (a)531.6417.3178.8162.2167.8
Central bank profit (VT mn.)275.4232.7173.8141.5119.7
Central bank securities (VT mn.)0.00.00.00.00.0
Potential liquidity (VT mn.) (b)636.0860.01,055.01,781.01,450.0
(a)/(b) (percentage)83.648.516.99.111.6
Western Samoa
Gross operaing income (WS$ mn.) (a)13.411.57.94.94.3
Central bank profit (WS$ mn.)6.43.41.2-0.4-0.3
Central bank securities (WS$ mn.)0.021.520.212.19.2
Potential liquidity (WS$ mn.) (b)75.487.371.256.452.5
(a)/(b) (percentage)17.813.211.18.68.2
Source: International Financial Statistics, International Monetary Fund, and annual reports of the respective central banks.

Gross operating income is operating income before paying interest costs.

Source: International Financial Statistics, International Monetary Fund, and annual reports of the respective central banks.

Gross operating income is operating income before paying interest costs.

Given the heavy dependence on foreign reserve earnings, the profitability of these central banks relies on the differentials between international and domestic interest rates as well as exchange rate developments. With little information on the composition of foreign reserves in these economies, the impact of exchange rate developments on foreign reserve earnings is difficult to measure. In theory, they can avoid foreign exchange rate risk by allocating the currency composition of reserves in line with the currency basket to which their own currencies are pegged. Still, some countries are reportedly making revaluation losses by pursuing a different strategy. The interest rate differentials have apparently had an adverse effect on central bank profit. As shown in Chart 4, interest rates in these economies showed downward rigidity while international interest rates declined in the first half of the 1990s.

CHART 4SELECTED PACIFIC ISLANDS

INTEREST RATE COMPARISON, 1990-94

(In percent per annum)

Source IMF, International Financial Statistics

While profitability of the central banks declined or remained stagnant, potential liquidity continued to grow indicating mounting pressures on the central banks’ financial positions. The ratio of gross operating income and potential liquidity shows a potential threat of monetary policy costs to central bank profits. The threat is potential because the central banks can alter the cost of absorbing the potential liquidity by changing the combination of monetary control instruments. For example, Tonga could lessen its monetary policy cost by raising the noninterest-bearing component of its reserve requirement ratio as it actually did in February 1996. Looking at the ratios, Tonga and Western Samoa have had similar levels. Fiji has had a smaller potential threat, but it deteriorated in 1994 with a sudden decline in its profit.13 The threat to the Solomon Islands appears to be negligible because of its exceptionally low level of potential liquidity.

B. High LARs and Interest Rate Distortions

Another major problem in the monetary control instruments in the South Pacific is distortions in interest rates, especially those on securities, which appear to be related to high LARs. In Fiji and Western Samoa, high LARs enabled the authorities to pay low interest rates, sometimes lower than deposit rates, on treasury bills and central bank securities by creating a captive market (Chart 2). In Fiji, bond equivalent yield on treasury bills allotted to banks has been below deposit rates for similar maturities during 1992-94. Western Samoa, whose central bank made losses for two consecutive years in 1993 and 1994, has set the rate for central bank securities well below deposit rates since the second half of 1993. Although the LAR is moderate at 10 percent, interest costs on government securities are also below deposit rates in Vanuatu. Banks in Vanuatu can hold up to 50 percent of their reserve requirement only by treasury bills with a fixed rate of 1.5 percent which is significantly lower than deposit rates. Solomon Islands has the highest LARs in the region; however its interest rate structure is somewhat less distorted because of the tight liquidity conditions. While deposit money banks’ holdings of treasury bills have been above the required level for sometime now, the large fiscal deficit has led to additional issues; during 1990–1994, the outstanding amount of government securities increased by more than four times. In order to encourage banks to buy treasury bills above the legal requirement, treasury bill rates continuously ranged between deposit rates and lending rates during 1991-1994.14

The case of Tonga shows that, even without LARs, interest rates on securities could be set at artificially low levels. As describe in detail already, profitability concerns kept interest rates on central bank securities well below deposit rates since early 1994. Nevertheless, deposit money banks continued to hold a large amount of central bank securities because it was still better than depositing the liquidity with the central bank, which does not provide any interest earnings. The question arises as to why banks did not lower deposit rates despite the fact that they made losses on the interest differentials between deposit and central bank securities. This kind of downward rigidity of interest rates is not unusual in other economies in the South Pacific (Chart 4). For example in Vanuatu during 1990-94, banks experienced a large shift of money from foreign currency deposits to domestic currency deposits; foreign currency deposits declined by VT 3.3 billion in the four years while vatu deposits increased by VT 4.5 billion. The shift reportedly reflected differentials between international and domestic interest rates. As a result, potential liquidity in Vanuatu increased from 3 ½ percent of GDP in 1990 to 8 percent of GDP in 1993 before dropping to 6 percent of GDP in 1994. Even in this case, banks continued to build up excess liquidity at noninterest bearing deposit at the central bank without adjusting domestic currency deposit rates to international rates.

Several explanations are possible for this downward rigidity of interest rates in the South Pacific, although they are difficult to prove quantitatively. First, even after abolishing floors for deposit rates, the authorities tried to maintain real deposit rates positive to encourage financial deepening. Thus, in some countries, banks are subject to moral suasion from the authorities to maintain a certain level of deposit rates. Second, given the already low level of deposit rates and the lack of other investment opportunities, reduction in deposit rates may not reduce deposits so much. Third, because of the volatile nature of liquidity represented in a large share of deposits with short-term maturities, banks may find it safer to maintain a certain level of excess liquidity even if this entails paying some costs. Finally, satisfied with a certain level of profits guaranteed by limited competition and associated wide margins between deposit and lending rates, banks might have little incentive to adjust their balance sheet structure quickly.

V. Policy Implications

Based on the experience of the five economies, this section draws some policy implications for the Pacific Island economies.

A. Burden-Sharing of Monetary Policy Costs

Most importantly, given large excess liquidity, the associated cost of monetary policy should be shared by the fiscal authorities especially if it constrains the central bank’s ability to conduct monetary policy. Under the current arrangements, the cost of monetary policy is shouldered only by central banks and, consequently, monetary policy is likely to be constrained by concerns of profitability. Moreover, the concern for profitability may also risk prudent foreign asset management by the central bank if it takes more risks in pursuing profits. Although the fiscal authorities can share the cost of monetary policy under the current arrangements through the transfer of profits, the fiscal authorities have been less than willing to do so. To ensure the monetary authorities’ autonomy, institutional arrangements or explicit understandings should be worked out carefully so that the fiscal authorities clearly share the cost of monetary policy (more precisely, the interest rate cost of securities used to absorb excess liquidity).

The most desirable arrangement for the fiscal authorities to share the cost of monetary policy depends on the circumstances of each country. For example, the establishment of an automatic mechanism to transfer the cost of issuing central bank securities to the fiscal authorities was recommended by the IMF technical assistance mission to Western Samoa in early 1995. One way to do this is the creation of equivalent loans, from the central bank to the fiscal authorities, for the new central bank securities issued. In this manner, the repayment of the central bank securities would coincide with the repayment of counterpart loans from the fiscal authorities to the central bank.

Another option is to establish open market operations based on government securities. Government securities may be more desirable than central bank securities since it would improve transparency by making the cost directly visible in the Government budget. Market operations through government securities however require close cooperation with the fiscal authorities. In particular, when issuing government securities for monetary policy purposes, it is important that the proceeds from the sales are kept separate from the normal budget activities so that they do not undermine fiscal discipline. In the case of the Philippines,15 proceeds from any excess sales of treasury bills are placed in fixed-term deposits with the central bank and remuneration of the deposits is determined during periodical meetings between the fiscal and monetary authorities. In Israel, the proceeds from the sales of government securities are deposited in a government account at the central bank. Although the Government can borrow from this account under very specific conditions, the credit has to be paid before the end of the fiscal year.

B. Diversification of Monetary Instruments

Second, given the large cost of absorbing excess liquidity, some diversification of monetary control instruments may be appropriate in these economies without relying solely on open market-type operations. While open market-type operations should play a central role in monetary control, LARs and reserve requirements may be also needed as prudential policy instruments as well as supplemental monetary instruments to manage the high level of excess liquidity. Although a modest LAR can remain for prudential purposes, it is important that the pricing of securities by the authorities should be consistent with deposit and lending rates and should not take advantage of the captive requirement of the LAR. Distortions in interest rates, especially those on securities, hamper the development of secondary markets for securities, as well as the transmission mechanism of monetary policy.

As a supplemental tool for open market operations as well as a part of prudential policies, reserve requirements could also remain as long as the requirements are low and not changed frequently. If requirements are changed frequently, banks will have a greater incentive to hold excess reserves. Also, reserve requirements will tend to drift upward because it is often tempting to raise reserve requirements to tighten monetary conditions but few occasions are found to reduce them.

C. Easing Restrictions on Outward Capital Investment

Finally, as a part of the effort to diversify monetary control instruments, the authorities may consider gradually easing the restrictions on outward foreign investment so as to lessen potential liquidity and the associated cost of monetary policy. However, it should be implemented carefully and not risk the external positions of these economies. In this regard, easing of restrictions on outward investments through deposit money banks could be a good initial step. At present, with the exception of Vanuatu, the holding of foreign exchange by deposit money banks is limited to the level equivalent of a minimum working balance and the rest must be sold to the central bank. While it appears to make the control of foreign reserves easier for the authorities, this arrangement increases the potential liquidity because, by accepting foreign exchange from deposit money banks, the central bank provides them with liquidity. Potential liquidity could be reduced while securely managing foreign reserves by letting authorized banks manage foreign assets by themselves. At the same time, it is important that banks should be allowed to receive foreign currency deposits to protect themselves from foreign exchange rate risks.

Foreign currency deposits have been introduced in some countries in the region albeit gradually and in a limited manner. Vanuatu is the only country in which no restrictions exist for the holding of foreign exchange by deposit money banks and foreign currency deposits are allowed for both residents and non-residents. However, since banks require a minimum deposit of US$5,000, the foreign currency accounts are largely confined to expatriates Although no restrictions exist, foreign exchange positions of deposit money banks are broadly in balance, as practically all foreign currency deposits are placed abroad.16 In Western Samoa, foreign currency deposit accounts were introduced in February 1994 for residents who earn foreign exchange in the normal course of business. Although minimum and maximum amounts17 are set, the latter could be exceeded by approval by the central bank. The total amount of foreign currency accounts was small—less than US$1 million as of end-1994. When receiving foreign currency deposits, deposit money banks have taken matched positions in their offshore accounts to avoid foreign exchange rate risks. In Fiji, foreign currency deposits are limited to exporters and only a certain portion of export proceeds may be kept in foreign currency accounts with an authorized dealer or a foreign bank abroad with approval from the central bank. In Tonga, deposit money banks are not allowed to have foreign currency accounts except for the purpose of arranging forward exchange cover but, even in that case, their gross foreign exchange liabilities must not exceed US$1 million. Solomon Islands also does not allow banks to receive foreign currency deposits.

Needless to say any move in this direction should be introduced with caution. First, it is important to regulate and monitor foreign reserve management by authorized banks effectively, especially through prudential regulations on net open foreign asset positions to limit foreign exchange risk. Second, the monetary authorities should closely monitor interest rate differentials to avoid the possibility of large shifts between foreign currency deposits and domestic currency deposits.

References

Following Quintyn (1994), this paper refers to open market operations in the primary, or issue market as “open market-type operations.”

In most of the countries, the share of imported goods in a CPI basket exceeds 50 percent. The share of imported goods in a CPI basket is 57 percent in Tonga, 54 percent in the Solomon Islands, and 50 percent in Western Samoa. Fiji and Vanuatu do not publish a separate price index for imported goods but the share is estimated to be around 50 percent.

The figure used for domestic credit in Western Samoa is different from that in the IFS. The IFS includes the foreign assets held by the Treasury in the monetary authorities assets by making contra-entry to the liability side as the central bank deposit. Because of the large Government deposit which does not really exist, net credit to the Government in the monetary survey becomes a large negative figure almost equivalent of 14 percent of GDP in 1994. Although it is statistically accurate classification, the net credit to the Government was adjusted by the amount of the contra-entry to measure its impact on the potential liquidity.

Capital accounts for the deposit money banks in Fiji are not available in the IFS.

Measured in percent of GDP, Fiji got net credit from banks equivalent to 1 ½ percent and had a positive balance with the central bank of about ½ percent. Western Samoa had a positive balance with the central bank, equivalent of 3 percent, while getting a small net credit (0.4 percent) from banks. Vanuatu also has a positive balance with the central bank, equivalent of 8 ½ percent, while having a small negative balance with banks (1 percent).

All the five economies have accepted the obligations of Article VIII, Section 2, 3, and 4 of the IMF’s Articles of Agreement.

Fiji has gradually eased its repatriation and surrender requirement for export receipts in recent years. See IMF, Exchange Arrangements and Exchange Restrictions for more details of exchange arrangements in these economies.

In fact, the ratio was raised to 10 percent effective February 1996 for the first time having difficulties in raising interest rates on central banks securities (described more in details in the next section).

Present guidelines to commercial banks include a maximum-weighted interest rate on loans of 14 percent, with interest rates on loans to “productive” sectors, as defined by the central bank, not to exceed 14 percent. Credit to ni-Vanuatu is to be favored, but personal loans for consumer imports are to be restrained.

Under the deposit-linked credit expansion formula, a bank’s ability to increase its lending is dependent on an increase in deposits or a lengthening in the maturity structure of the deposit base. If deposits decline, or the term structure shortens, a bank’s ability to lend contracts.

Currently the required ratios of liquid assets to deposits are: 30 percent for demand, saving, and time deposits of less than three months’ maturity; 25 percent for time deposits of between 3 and 12 months’ maturity; and 20 percent for time deposits in excess of 12 months’ maturity.

The decline largely came from the loss on sale of investments as well as a decline in interest income.

The Solomon Islands Government became unable to pay interests on some of their securities in mid-1995.

Following examples are from Quintyn (1994).

For instance, as of end-1994, deposit money banks held net foreign assets of about VT$14.8 billion when the amount of foreign currency deposits was about VT$15.0 billion.

Maximum amount is set at US$50,000, A$70,000, or NZ$90,000.

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