The Palestinian Monetary Authority (PMA) was created following the declaration of principles signed in September 1993 between Israel and the PLO. Although the Palestinian Monetary Authority has many of the usual powers and functions of a central bank, it does not currently issue a domestic currency. Nonetheless, theoretical considerations suggest that by using its influence on the commercial banking sector, the Palestinian Monetary Authority might still be able to implement a monetary policy that stimulates real activity in the West Bank and Gaza Strip. However, based on an empirical evaluation of these theoretical considerations in the context of the West Bank and Gaza Strip economy, it is concluded that it is neither possible nor desirable for the Palestinian Monetary Authority to use monetary policy to promote short-run growth. The Palestinian Monetary Authority can, however, contribute to creating an economic environment conducive to sustainable growth by pursuing policies that maintain and enhance financial stability in the West Bank and Gaza Strip.
Background
The responsibilities and limitations of the Palestinian Monetary Authority are delineated in the Protocol an Economic Relations - Annex V, Article IV (Protocol), signed in April 1994. The Palestinian Monetary Authority’s responsibilities include serving as lender of last resort; providing bank supervision and licensing in accordance with the principles of the “Basle Committee” and “Basle Concordat”; and acting as the Palestinian Authority’s sole financial agent. The Protocol also requires that the Israeli new sheqel (NIS) be one of the circulating currencies in the West Bank and Gaza Strip and that reserve requirements on new sheqel deposits be kept in line with those in Israel. The introduction of a Palestinian currency is mentioned in the Protocol as a future possibility and a topic for discussion by the Israeli-Palestinian Joint Economic Committee (also established in the Protocol).
Under the Palestinian Monetary Authority law, enacted in late 1997, “the objective of the PMA is to secure the stability of the banking and monetary systems, which will encourage the economic development in the areas under Palestinian jurisdiction.” The Palestinian Monetary Authority is given broad authority over the means appropriate for achieving its objective and is designated as an independent entity.
Banking Sector Developments
Since the signing of the declaration of principles there has been considerable growth in the banking sector.1 The number of banks operating in the West Bank and Gaza Strip grew from 2 banks in 1989 to 20 banks in June 1997. The banks, 8 of which are Palestinian, maintain a total of 78 branches in the West Bank and Gaza Strip. Even with this growth, the banking sector remains relatively concentrated, with roughly 80 percent of deposits being held at the three largest banks.
The banking sector has also grown rapidly in terms of assets, deposits, and claims on the private sector. From January 1996 to November 1997 total assets in the banking sector grew by 65 percent to $2.8 billion, deposits increased by 46 percent to $1.8 billion, and claims on the private sector more than doubled, increasing by 112 percent to $533 million.
Despite the rapid growth in claims on the private sector, public dissatisfaction with the private sector credit to deposit ratio has been evident. There is a perception that banks are pursuing a deliberate policy of transferring the West Bank and Gaza Strip’s wealth abroad, and that the banking sector’s unwillingness to lend domestically is contributing to the economic difficulties in the West Bank and Gaza Strip, Despite its significant growth since January 1996, the claims on the private sector to deposit ratio is still relatively low and stood at just under 30 percent in August 1997 (Figure 1).2 Indeed, the growth in this ratio has done little to reduce pressure on the Palestinian Monetary Authority to take action.
Claims on the Private Sector to Deposit Ratios, January 1996–August 1997
(In percent)
Source: Palestinian Monetary Authority.As shown in Figure 1, there are also significant differences between the currencies. The claims on the private sector to deposit ratios for the Israeli new sheqel and Jordan dinar, 51 and 30 percent respectively in August 1997, are considerably higher than the 19 percent for the U.S. dollar. The low dollar claims on the private sector to deposit ratio is especially noteworthy since, as shown in Figure 2, the U.S. dollar’ is also the most popular currency for deposits. The preferred currency for deposits is therefore the least likely to be lent domestically. The U.S. dollar, however, has also been growing in popularity for borrowing, but at over 40 percent in August 1997, the Jordan dinar still accounts for the largest share of claims on the private sector (see Figure 3). Figures 2 and 3 also show that commensurate with the movement toward using the U.S. dollar, the deposit and claims on the private sector shares for both the Jordan dinar and Israeli new sheqel have declined since January 1996.
Currency Composition of Deposits
(In percent of total deposits)
Source: Palestinian Monetary Authority.Currency Composition of Claims on the Private Sector
(In percent of claims on the private sector)
Source: Palestinian Monetary Authority.Policy Objectives
A eonsensus has emerged, in academic and policy circles, around the belief that monetary stability (i.e., low inflation) should be the primary goal of a monetary authority. However, in the West Bank and Gaza Strip, without the recourse of a domestic currency, inflation remains largely out-side the control of the Palestinian Monetary Authority. Nonetheless, the related goal of promoting financial stability, through the maintenance of a healthy banking sector, is an objective that the Palestinian Monetary Authority needs to pursue and one that could contribute significantly to creating an environment conducive to achieving sustainable growth.
As a result of the recent economic conditions prevailing in the West Bank and Gaza Strip—de-clining income and very high unemployment—expanding output and investment are high on the list of short-term Palestinian Monetary Authority objectives. In the long run, however, the development and stability of the financial sector are crucial for improving growth prospects.3 Given the preeminence placed on improving current economic conditions, the ability of the Palestinian Monetary Authority to boost short-run growth, as well as the implications of such policies for financial stability, is a major issue.
Monetary Instruments
Most of the conventional indirect monetary instruments are not available to the Palestinian Monetary Authority. Since there is not a domestic currency, the Palestinian Monetary Authority does not have control over a domestic money supply Furthermore, the lack of government debt or a similarly tradeable security precludes the use of open market operations. In fact, without a domestic interbank market or market-based central bank credit facility, there is not even a benchmark West Bank and Gaza Strip interest rate for the Palestinian Monetary Authority to influence. The main indirect instruments currently available to the Palestinian Monetary Authority are related to reserve requirements. The Palestinian Monetary Authority determines the reserve requirements for each of the currencies in circulation, consisting primarily of Jordan dinars, Israeli new sheqalim, and U.S. dollars. In addition to setting the specific reserve requirement rates, other tools available to the Palestinian Monetary Authority include the determination of the amount of remuneration on reserves, placement of reserves, and possible imposition of multiple reserve requirements. In its capacity as bank regulator, the Palestinian Monetary Authority also has recourse to several direct monetary instruments. The Palestinian Monetary Authority has already issued guidelines placing a ceiling on foreign assets and a floor on the claims on the private sector to deposit ratios (see Chapter 2). Given the paucity of alternative monetary instruments, the use of such direct measures may be especially tempting.
Finally, the Palestinian Monetary Authority also has the option of establishing some of the indirect measures commonly used by other central banks. This would encompass not only creating the particular instrument, but also contributing to the development of the requisite market institutions. The merits, as well as the viability, of establishing the various indirect instruments are considered below.
Credit Channel: Theory and Evidence
The lack of a domestic currency, small size, and openness of the West Bank and Gaza Strip economy suggest that most common monetary transmission mechanisms—such as the interest rate, exchange rate, and asset prices—are unlikely to play a significant role in the monetary transmission process. However, monetary policy could operate, via the banking sector, through the credit channel.4 By altering the banking sector’s willingness to supply credit, monetary policy may be able to influence aggregate demand and therefore real economic activity. The magnitude of the increase in real activity depends on the degree to which any policy-induced increases in bank lending actually finance extra consumption and investment. Since there is not a corporate bond market and the stock exchange is nascent and still relatively small, the banking sector is the primary formal source of business and household credit; this suggests that additional bank credit may indeed finance expenditures that would have otherwise not taken place. Alternatively, to the extent that any additional bank credit is used as a substitute for informal sources, such as self-financing, then there would only be small changes in consumption and investment, and thus a minimal change in output.
The effectiveness of monetary policy in increasing growth, through the credit channel, therefore depends on three factors: (1) how the given policy affects the supply of credit; (2) how the change in the supply of credit affects domestic borrowing; and (3) how the change in domestic borrowing influences the macroeconomy.
West Bank and Gaza Strip Credit Markets
In order for the credit channel to serve as the conduit of monetary policy, supply factors would have to play the dominant role in determining the credit market equilibrium. In other words, if the low claims on the private sector to deposit ratios are a product of supply considerations, then policy-induced changes in credit supply have the potential to increase output via the credit channel. Conversely, if a lack of credit demand is responsible for the low claims on the private sector to deposit ratios, then there is little scope for an expansionary monetary policy, which works by increasing credit supply, to affect domestic lending and therefore growth.
Credit supply is determined by a combination of the banking sector’s portfolio decisions and its lending capacity (i.e., assets in the banking sector that are highly liquid and readily available for domestic lending). The Palestinian Monetary Authority can therefore increase credit supply by pursuing policies that either expand the banking sector’s lending capacity or alter its portfolio decisions. Examples of the former include policies such as lowering reserve requirements, extending central bank credit, and redepositing reserves. Palestinian Monetary Authority policies may also have an indirect effect on lending capacity; for example, a decrease in reserve requirements or remuneration of reserves, which lower the effective tax that banks pay for holding deposits, may induce banks to raise deposit interest rates and thus attract more deposits.
For a given lending capacity, portfolio considerations dictate the amount of credit to supply domestically. In light of the generally high risks that prevail in the current political environment in the West Bank and Gaza Strip, the banking sector’s preference for foreign assets relative to domestic lending is not surprising. Nonetheless, even though there is a significant amount of foreign assets in the banking sector’s portfolio, the domestic credit market could still be effectively supply constrained. The coexistence of low claims on the private sector to deposit ratios and a supply constrained credit market can be explained using an extension of the imperfect information model of Stiglitz and Weiss (1981).5 A key premise is that a bank is unable to obtain adequate information about the default risks of potential loans, a situation that is particularly applicable in the West Bank and Gaza Strip. For example, the lack of credit screening methods and the absence of other institutions or practices to assist banks in assessing the riskiness of a given loan are often cited as contributors to the low claims on the private sector to deposit ratios. Moreover, the informational problems are compounded by the fact that many potential applicants do not have experience preparing credit applications; do not possess a formal credit history; and do not use standard accounting procedures and other practices that would facilitate the conveyance of information relevant for determining creditworthiness (see Chapter 3).
As a consequence of imperfect information, the credit market equilibrium could be subject to credit rationing (i.e., the demand for credit exceeds the banking sector’s willingness to supply it) despite the fact that banks have plenty of liquidity. In the absence of other indicators, the lending interest rate itself serves as a signal of the riskiness of a loan. At higher interest rates, only the entrepreneurs with the riskier projects—projects with a high probability of failure but that also pay a large return if successful—are willing to borrow. From the bank’s perspective, this implies that there is a profit maximizing lending interest rate that serves as an effective interest rate ceiling.6 Credit rationing may occur because, above the effective interest rate ceiling, the lending interest rate does not adjust to clear the credit market.
Empirical Analysis
The primary objective of the empirical analysis is to assess whether credit to the private sector is constrained by supply considerations. Credit to the private sector in the West Bank and Gaza Strip consists primarily of overdrafts and loans. Overdrafts, which account for 60 percent of claims on the private sector (August 1997), effectively serve as a line of credit. This means that the dominant form of private sector credit is most likely not being used to finance fixed investment. Loans, which account for 33 percent of claims on the private sector (August 1997), correspond more closely to the type of credit considered in the theoretical section. To determine if the credit market is supply constrained, regressions using both claims on the private sector and loans were evaluated for each of the currencies in circulation. In addition, the sensitivity of deposits to interest rates, which is used in the subsequent section, was also measured. The regressions are discussed in the Appendix; the main results are summarized below.
Overall, there is some evidence to suggest that supply considerations affect the equilibrium quantity of credit. The Jordan dinar and Israeli new sheqel loan markets display characteristics consistent with credit rationing. However, while being the theoretically appropriate measure, loans account for only a small share of credit. Therefore, even though these loan markets appear to be supply constrained, the small quantities involved could disguise an overriding lack of credit demand, which would ultimately limit the ability of the Palestinian Monetary Authority to increase output through the credit channel. In other words, as increases in supply eliminate the excess demand for credit (i.e., credit rationing), an underlying lack of credit demand could be revealed that would prevent further expansions in credit supply from increasing credit and therefore output. Furthermore, these results are also consistent with there being significant segments of the market that are not subject to credit rationing but nonetheless do not desire credit.7 If this is the case, then the low claims on the private sector to deposit ratios are fundamentally the product of demand considerations. Therefore, even if the evidence in favor of supply constraints was stronger, the existence of supply constraints—while necessary for Palestinian Monetary Authority policy to influence output—does not preclude the possibility that the low claims on the private sector to deposit ratios are ultimately the result of a lack of credit demand. Finally, and most important, the broader measure of credit (claims on the private sector), while responding to supply considerations, does not appear to be subject to credit rationing.
Policy Options
The following analysis of the Palestinian Monetary Authority’s policy options examines the effectiveness of available indirect instruments in increasing short-run growth; the consequences arising from the enactment of various direct measures; and the merits of creating or utilizing alternative indirect instruments.
Existing Instruments
The instruments most readily available to the Palestinian Monetary Authority are related to reserve requirements. These include (1) determination of reserve requirement rates, (2) remuneration of reserve deposits, (3) placement of reserves, and (4) institution of differentiated reserve rates based on the composition of a bank’s assets (dual or multiple reserve requirements). In order to put an upper bound on the efficacy of using these instruments, the broader measure of credit (claims on the private sector), for all three currencies, is assumed to be subject to credit rationing. Since this is actually in contrast to the empirical evidence, which suggests that only the narrow measure of credit (loans) is potentially subject to credit rationing, the actual magnitude of the effect on growth is likely to be substantially smaller than what is reported below.
Three policy options are evaluated for each currency: (1) placement of $10 million in the domestic banking sector; (2) a one percentage point decrease in the reserve requirement rate; and (3) full remuneration of reserves at the existing international deposit interest rates. The maximum quantitative impact of these policies is displayed in Table 1, which is calculated as follows.8 First, the policy’s initial impact on lending capacity, which consists of direct and indirect effects, is measured. For example, the direct effect of lowering reserve requirements refers to the funds that banks formerly deposited with the Palestinian Monetary Authority as reserves that would be made available for lending by the reduction in reserve requirements. The indirect effect of a decrease in reserve requirements, which lowers the banks’ costs and thus allows them to increase deposit interest rates, refers to the growth in deposits following from the increase in deposit interest rates. The total change in claims on the private sector is calculated using a money multiplier formula appropriate for the West Bank and Gaza Strip. Finally, assuming that the price level is not affected, the change in real GDP is derived by multiplying the increase in the domestic money supply by West Bank and Gaza Strip velocity.
Maximum Impact of Different Palestinian Monetary Authority Policies
Maximum Impact of Different Palestinian Monetary Authority Policies
| Initial Increase in Lending capacity | Total change | |||||||
|---|---|---|---|---|---|---|---|---|
| US$ millions | Growth in percent | |||||||
| US$ millions | Percent of lending capacity | Claims on the private sector | GDP | Claims on the private sector | GDP | |||
| Policy | Currency | Direct | Indirect | Total | ||||
| Placement of $10 million | JD | 10.00 | 0.00 | 1.50 | 3.66 | 3.49 | 1,73 | 0.11 |
| NIS | 10,00 | 0.00 | 3.67 | 6.96 | 7,12 | 4.52 | 0,22 | |
| US$ | 10.00 | 0.00 | 1.51 | 1.90 | 1.90 | 1.47 | 0.06 | |
| Lower reserve requirements by one percentage point | JD | 0.00 | 1.00 | 0.15 | 0.37 | 0.35 | 0.17 | 0.01 |
| NIS | 2.93 | 1.27 | 1.54 | 2.92 | 2.95 | 1.89 | 0.09 | |
| US$ | 7.37 | 0.63 | 1.21 | 1.52 | 1,50 | 1.18 | 0,05 | |
| Fully remunerated reserves | JD | 0.00 | 14.05 | 2.11 | 5.14 | 4.84 | 2.43 | 0,15 |
| NIS | 0.00 | 10.16 | 3.73 | 7,07 | 7,13 | 4.57 | 0.22 | |
| US$ | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 | |
Maximum Impact of Different Palestinian Monetary Authority Policies
| Initial Increase in Lending capacity | Total change | |||||||
|---|---|---|---|---|---|---|---|---|
| US$ millions | Growth in percent | |||||||
| US$ millions | Percent of lending capacity | Claims on the private sector | GDP | Claims on the private sector | GDP | |||
| Policy | Currency | Direct | Indirect | Total | ||||
| Placement of $10 million | JD | 10.00 | 0.00 | 1.50 | 3.66 | 3.49 | 1,73 | 0.11 |
| NIS | 10,00 | 0.00 | 3.67 | 6.96 | 7,12 | 4.52 | 0,22 | |
| US$ | 10.00 | 0.00 | 1.51 | 1.90 | 1.90 | 1.47 | 0.06 | |
| Lower reserve requirements by one percentage point | JD | 0.00 | 1.00 | 0.15 | 0.37 | 0.35 | 0.17 | 0.01 |
| NIS | 2.93 | 1.27 | 1.54 | 2.92 | 2.95 | 1.89 | 0.09 | |
| US$ | 7.37 | 0.63 | 1.21 | 1.52 | 1,50 | 1.18 | 0,05 | |
| Fully remunerated reserves | JD | 0.00 | 14.05 | 2.11 | 5.14 | 4.84 | 2.43 | 0,15 |
| NIS | 0.00 | 10.16 | 3.73 | 7,07 | 7,13 | 4.57 | 0.22 | |
| US$ | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 | |
The results in Table 1 show that even the most effective of these policies is not likely to result in even a .25 percent increase in annual real GDP. For example, placing $10 million in all three currencies (for a total of $30 million) would generate less than $13 million in new output—implying a multiplier that is actually less than one. The total stock of reserves available for placement is not large enough to overcome the small impact that domestic placements have on growth.
Table 1 also shows that lowering reserve requirements by one percentage point produces an even smaller increase in output. In fact, fully eliminating reserve requirements on any given currency would not even yield a 1 percent increase in GDP. Since Jordan dinar reserves are already fully placed back into the banking sector, the effect of reducing dinar reserve requirements is partially offset by the need for the Palestinian Monetary Authority to make a commensurate reduction in domestic placements. Since U.S. dollar deposits are already remunerated, this policy option is only applicable to Israeli new sheqalim and Jordan dinars. Even full remuneration of these reserves would not significantly impact GDP or claims on the private sector.
Hamed (1996, Section 6.5.3) proposes that the Palestinian Monetary Authority could increase domestic lending by lowering reserve requirements on the portion of money lent domestically (i.e., dual reserve requirements). However, an upper bound on the effectiveness of this policy is the negligible impact resulting from a complete elimination of reserve requirements. In addition, dual reserve requirements may affect domestic lending through an induced change in the relative cost of different assets. In this case, a policy of dual reserve requirements closely resembles, and is for the most part equivalent to, offering a subsidy for domestic lending or imposing a tax (such as an increase in reserve requirements) for the portion of funds placed abroad. Such policies would alter banks’ desired portfolio causing a change in the credit supply curve. However, given the limited resources of the Palestinian Monetary Authority, it is unlikely that a subsidy could offer sufficient incentives to significantly affect lending. Likewise, a tax on other bank assets would decrease bank profits, reduce deposit interest rates, and risk disintermediation.
In a study of reserve requirements Hardy (1993) identifies four primary functions of reserve requirements: (1) tool for monetary control, (2) policy instrument, (3) revenue source, and (4) safeguard of bank liquidity. The above analysis focused on the second of these objectives and the first one, without a domestic currency to control, is not applicable to the West Bank and Gaza Strip. However, the policy options considered also have ramifications for the other reserve functions as well as the more general monetary objectives.
Reduction in reserve requirement rates, remuneration, and, to a lesser degree, dual reserve requirements each have negative consequences for Palestinian Monetary Authority revenue. Indeed, reserve requirements are implicitly the Palestinian Monetary Authority’s major source of finance. The above policies, with the exception of placements, would be quite expensive in terms of lost revenue; for example, full remuneration at market rates or flat-out elimination of reserves would completely close down this source of revenue.
The liquidity safeguard role of reserves is jeopardized by policies such as reducing reserve requirements and placing reserves in the domestic banking system. This is a potentially serious consideration as the practice of placing reserves may exacerbate a liquidity shortage. In order to meet its obligations during a liquidity crisis, the Palestinian Monetary Authority itself would be forced to withdraw deposits from the banking system and thus potentially contribute to a further deterioration of the situation. A localized (i.e., at one or a few banks) liquidity problem could thereby be spread to other parts of the banking system. However, provided that they are sufficiently liquid, the banks’ large holding of foreign assets would be a good safeguard against a liquidity shortfall.
As described above, the Protocol sets strict guidelines for reserve requirement rates for deposits of Israeli new sheqalim. This limits the scope for the Palestinian Monetary Authority to adjust the actual new sheqel rates directly but does not preclude the use of remuneration or placements. By depositing a portion of new sheqel reserves with the bank of origin without accepting interest the Palestinian Monetary Authority can effectively skirt the reserve requirement restrictions. Adjusting Jordan dinar reserve requirement rates, although not in violation of any formal agreements, may elicit a negative response from the Jordanian financial community.
In summary, the empirical evidence suggests that reserve requirements are not an effective tool for achieving the Palestinian Monetary Authority’s monetary policy objectives of promoting growth or increasing lending to the private sector. Moreover, using reserves as a policy instrument could generate adverse consequences ranging from a significant decline in Palestinian Monetary Authority revenue to the possibility of aggravating any nascent liquidity crisis. In light of these factors—ineffectiveness, costs, and potential risks—there is essentially no scope for reserves to be used as an instrument of policy.
Direct Measures
The Palestinian Monetary Authority has al-ready turned to direct instruments in an effort to support economic growth. A rule has been issued limiting foreign assets to 90 percent of a bank’s total assets, as well as one requiring each bank to maintain a minimum claims on the private sector to deposit ratio of 30 percent. With foreign assets accounting for only 60 percent of total assets and the claims on the private sector to deposit ratio at just less than 30 percent, compliance with these rules should, in the aggregate, require only minor (if any) changes in the banks’ portfolios. Nonetheless, recourse to such direct measures is counter to the prevailing international trend toward indirect instruments and away from direct ones.
These policies are unlikely to noticeably increase domestic lending, promote growth, or contribute to financial stability. In fact, use of the above direct instruments is actually likely to have deleterious consequences. By instituting distortionary quantitative restrictions, such policies impede the development of a vigorous banking sector and may therefore lead to disintermediation. Furthermore, these policies signal a general willingness to resort to such direct interference in the market, which may inhibit potential market participants and thereby interfere with the formation of deeper financial markets.9 A more direct repercussion is that in order to comply, banks may be forced to make inappropriate lending and portfolio decisions and thus jeopardize the soundness of individual banks, as well as the banking sector as a whole. Finally, these policies also create an incentive for the banks to employ creative accounting practices in an effort to satisfy the quantitative restrictions. Not only does this contribute to the regulatory burden of the Palestinian Monetary Authority, but such accounting practices may also undermine the overall quality of reported data.
Developing Indirect Instruments
Despite the lack of a domestic currency, there are circumstances in which use of domestic market-based (i.e., indirect) instruments would be advantageous. For example, there is likely to be sufficient demand to support the establishment of domestic liquidity management facilities if transaction and other costs of operating in foreign markets are higher than in a local one; if some, perhaps smaller, banks in the West Bank and Gaza Strip do not have ready access to foreign markets; and if political crises periodically impede or preclude banks in the West Bank and Gaza Strip from effectively managing their liquidity abroad.
Currently, there is not a transparent and efficacious method for the Palestinian Monetary Authority to address localized liquidity shortages. Opening a discount window (i.e., Lombard or overdraft facility) is preferable to the current discretionary and opaque practice of placing reserves.10 The creation of such a facility offers several distinct advantages: it is transparent; easy to create; available at the initiative of the banks; and could actually increase Palestinian Monetary Authority revenues while simultaneously contributing to the development of an interbank market. For example, by setting an interest rate above the market rate, only banks that do not have ready access to alternative (i.e., cheaper) sources of credit would choose to borrow from the Palestinian Monetary Authority. This in turn might encourage interbank lending to occur at an equivalent, if not more competitive, interest rate.
In operating such a discount window, the Palestinian Monetary Authority would have to be especially prudent in its monitoring of borrowing banks. The window should only be used to alleviate temporary liquidity shortfalls. Banks with more fundamental problems and whose solvency may be in doubt should not be allowed to use the window. Another potential problem is that the Palestinian Monetary Authority may not have sufficient resources, based on its holding of reserves that would represent the ultimate constraint on borrowing, to effectively manage the window. To address this problem, the Palestinian Monetary Authority could create a deposit taking window using the interest rate to attract liquidity as needed. The Palestinian Monetary Authority would then essentially be serving as the market maker in a nascent interbank market. Not only would the Palestinian Monetary Authority gain experience in using interest rates as a policy tool, but it would also contribute to the development of a new domestic financial market with the potential to increase the efficiency of the West Bank and Gaza Strip banking sector.
Hamed (1996) and the Palestinian Economic Policy Research Institute and World Bank (1997), as well as Chapter 3, propose several structural, rather than monetary, measures directed at increasing domestic lending. For example, improving property registration, enhancing the legal system, and facilitating the credit application and approval process have been mentioned. Structural measures such as these would potentially improve the functioning of the credit market, lower the lending interest rate, and increase lending to the private sector whether or not credit rationing is present. However, to the extent that investment (and therefore the need for credit financing) is constrained by demand considerations (see Chapter 3), the low claims on the private sector to deposit ratios may be reflecting economic considerations largely unrelated to the market for credit.
Conclusion
Is monetary policy capable of boosting output, at least in the short run, in the West Bank and Gaza Strip? Despite the lack of a domestic currency, the Palestinian Monetary Authority may conduct monetary policy using the credit channel transmission mechanism; thus, in principle this question may be answered in the affirmative. However, the effectiveness of the credit channel depends on the degree to which credit markets are constrained by supply considerations. Even though West Bank and Gaza Strip banks have sufficient liquidity, as demonstrated by the share of foreign assets in their portfolios, the domestic credit market could in theory still be subject to credit rationing, and therefore effectively be supply constrained. In order for the Palestinian Monetary Authority to have the potential to influence real activity using indirect monetary instruments, domestic lending to the private sector must be predominantly constrained by supply considerations.
Overall, the empirical evidence does not indicate that domestic lending to the private sector is primarily constrained by supply considerations. While the empirical evidence for the narrow measure of domestic lending to the private sector (loans) appears to show that Jordan dinar and Israeli new sheqel loans, but not U.S. dollar loans, are subject to credit rationing, the broader measure of private sector credit (claims on the private sector) does not appear to be subject to credit rationing. Moreover, even assuming that the broader measure of credit is subject to credit rationing, the empirical exercises indicate that Palestinian Monetary Authority policies would have, at best, only a negligible impact on real GDP. Furthermore, the use of reserves as a policy instrument, aside from being ineffective, could be expensive in terms of lost revenue and be destabilizing to the banking sector.
Although not able to influence short-run growth, there is a constructive role for the Palestinian Monetary Authority to play in the development of the West Bank and Gaza Strip economy. The Palestinian Monetary Authority can pursue policies that create a stable financial environment, consisting of a sound and thriving banking sector, and thereby contribute to the long-run growth prospects in the West Bank and Gaza Strip. Specifically, this can be accomplished by eliminating recently enacted rules (i.e., direct instruments); refraining from using direct instruments in the future; diligently fulfilling its prudential supervisory and regulatory responsibilities; and contributing to the development of the financial sector, including establishing a credit window and facilitating the creation of a West Bank and Gaza Strip interbank market. The existence of well-functioning financial markets would also increase the ability of the Palestinian Monetary Authority to manage, using indirect monetary instruments, a Palestinian currency in the event that one is issued. In essence, the Palestinian Monetary Authority is best able to serve the economy of the West Bank and Gaza Strip by closely adhering to its legally defined objective: “to secure the stability of the banking and monetary systems, which will encourage the economic development in the areas under Palestinian jurisdiction.”
Appendix: Domestic Credit and Deposit Regressions
In order to test for the presence of credit rationing (or more generally the importance of lending capacity in determining the amount of credit to the private sector), regressions were run on the following equation.
where c and lc are, respectively, the natural logarithm of credit and lending capacity, W is the average number of workers in Israel, X is a matrix of other explanatory variables (such as a time trend, constant, or interest rate), u is a vector of residuals, and the βs are coefficients to be estimated. Under credit rationing, the elasticity of credit with respect to lending capacity should be unitary (βc = 1) and credit should be independent of demand factors (βw = 0) as proxied for by the number of workers in Israel.11 More generally, βc > 0 is a prerequisite for the Palestinian Monetary Authority to be able to increase credit by enhancing the banking sector’s lending capacity. Alternatively, if the credit market equilibrium is primarily determined by demand considerations, then lending capacity would not influence credit (βc = 0) while changes in demand would be accommodated (βw = 0). However, the number of workers in Israel may not be a good proxy for credit demand. Business investment, which in general (although not in the West Bank and Gaza Strip) is a major source of credit demand, is dependent on a firm’s expectations of future profits. These expectations are based on many factors (see Chapter 3, which examines the ones pertinent for the West Bank and Gaza Strip), and may only respond moderately, if at all, to the transitory and periodic fluctuations in the number of workers in Israel. Nonetheless, in the absence of a viable alternative measure of credit demand, it is used in the subsequent analysis.
The results for the regressions using loans as the explanatory variable are presented in Table 2. The positive and significant coefficients on lending capacity, for the Jordan dinar and the Israeli new sheqel, are supportive of the credit rationing hypothesis. Whereas both are significantly different from zero at the 10 percent level, neither is statistically different from 1. In contrast, the negative and insignificant coefficient on lending capacity for the U.S. dollar suggests that U.S. dollar loans are not constrained by supply considerations.12
Loans as a Function of Lending Capacity1
Parameters are estlmated via Seemingly Unrelated Regressions (SUR); the U 3$ equation includes an adjustment for serial correlation.
Loans as a Function of Lending Capacity1
| Currency | |||
|---|---|---|---|
| Parameter | Jordan dinar | Israeli new sheqel | U.S. dollar |
| Constant | ‒1.61 | ‒10.85** | 5.39** |
| (2.97) | (5.55) | (2.65) | |
| Time trend | 0007 | 0.03 | .06* |
| (.011) | (.02) | (.01) | |
| Lending capacity | .89** | 2.25** | ‒0.31 |
| (.48) | (1.00) | (.43) | |
| R-squared | 0.54 | 0.37 | 0.93 |
Parameters are estlmated via Seemingly Unrelated Regressions (SUR); the U 3$ equation includes an adjustment for serial correlation.
Loans as a Function of Lending Capacity1
| Currency | |||
|---|---|---|---|
| Parameter | Jordan dinar | Israeli new sheqel | U.S. dollar |
| Constant | ‒1.61 | ‒10.85** | 5.39** |
| (2.97) | (5.55) | (2.65) | |
| Time trend | 0007 | 0.03 | .06* |
| (.011) | (.02) | (.01) | |
| Lending capacity | .89** | 2.25** | ‒0.31 |
| (.48) | (1.00) | (.43) | |
| R-squared | 0.54 | 0.37 | 0.93 |
Parameters are estlmated via Seemingly Unrelated Regressions (SUR); the U 3$ equation includes an adjustment for serial correlation.
On balance, this evidence is supportive of the hypothesis that the loan markets for Israeli new sheqel and Jordan dinar are supply constrained, whereas the U.S. dollar one is not. However, these results should be interpreted somewhat cautiously. Although efficiency was enhanced by running the equations as a system, a larger sample would contribute to the precision of the estimates and, therefore, improve the reliability of the results. In addition, given the scarcity of monthly data series, it is difficult to rule out the possibility that the positive relationship between lending capacity and loans is not due to an omitted variable. For example, deposits (the primary component of lending capacity) and loans may each respond positively to overall perceptions concerning the future prospects for the West Bank and Gaza Strip. As prospects improve, expectations of higher profits increase the demand for credit, while confidence about future conditions encourages people to deposit their money inside the West Bank and Gaza Strip banking system.
The results of regression using the broader measure of credit, claims on the private sector, are presented in Table 3 and are not supportive of the credit rationing hypothesis.13 Although the coefficient on lending capacity is statistically significant (10 percent level) for the Jordan dinar and U.S. dollar, the hypothesis of a unitary elasticity may be rejected. Furthermore, in each of these cases the demand variable is statistically different from zero at the 10 percent level. For the Israeli new sheqel, neither the demand nor supply variable is statistically different from zero.
Ciaims on the Private Sector Regressions 1
Parameters are estimated via Seemingly Unrelated Regressions (SUR); the Israeli new sheqel equation ineludes an adjustment for serial correlation.
Ciaims on the Private Sector Regressions 1
| Currency | |||
|---|---|---|---|
| Parameter | Jordan dinar | Israeli new sheqel | U.S. dollar |
| Constant | 3.07* | 4.33* | 5.18* |
| (1.05) | (.95) | (1.51) | |
| Time trend | 0.018* | 0.025* | .077* |
| (.004) | (.004) | (.008) | |
| Lending capacity | .31** | .04 | .39** |
| (.17) | (.17) | (.18) | |
| Workers in Israel | ‒0.014** | ‒0.007 | ‒.036* |
| (.007) | (.010) | (.012) | |
| Interest rate | Not included |
Not included |
‒.70* |
| R-squared | 0.87 | 0.86 | 0.96 |
Parameters are estimated via Seemingly Unrelated Regressions (SUR); the Israeli new sheqel equation ineludes an adjustment for serial correlation.
Ciaims on the Private Sector Regressions 1
| Currency | |||
|---|---|---|---|
| Parameter | Jordan dinar | Israeli new sheqel | U.S. dollar |
| Constant | 3.07* | 4.33* | 5.18* |
| (1.05) | (.95) | (1.51) | |
| Time trend | 0.018* | 0.025* | .077* |
| (.004) | (.004) | (.008) | |
| Lending capacity | .31** | .04 | .39** |
| (.17) | (.17) | (.18) | |
| Workers in Israel | ‒0.014** | ‒0.007 | ‒.036* |
| (.007) | (.010) | (.012) | |
| Interest rate | Not included |
Not included |
‒.70* |
| R-squared | 0.87 | 0.86 | 0.96 |
Parameters are estimated via Seemingly Unrelated Regressions (SUR); the Israeli new sheqel equation ineludes an adjustment for serial correlation.
These results indicate that the credit market, as defined by claims on the private sector, operates differently than that defined by loans. The Jordan dinar and U.S. dollar markets resemble a “normal” credit market, with the equilibrium responding to both supply and demand considerations. The statistical significance of the demand terms, regardless of the magnitude of the supply coefficients, suggests that demand factors are a pertinent determinant of credit; therefore, the market is not subject to credit rationing. Moreover, consistent with the above discussion of overdrafts, the negative coefficient on workers in Israel indicates that credit to the private sector actually increases when there is a negative shock. This means that rather than financing new fixed investment, borrowing occurs to offset any temporary income shortfalls resulting from the reduction in income from workers in Israel. Finally, the negative coefficient on the U.S. dollar interest rate implies that banks’ redistribute their portfolio away from domestic lending to the private sector and toward (safer) foreign assets as the return on the latter increases.
The sensitivity of deposits to interest rates is also used to measure quantitative impact of Palestinian Monetary Authority policies on growth. The regression results in Table 4 show that deposits are positively related to interest rates for each of the currencies, with the U.S. dollar coefficient being the only one that is not statistically significant at conventional levels. Israeli new sheqel deposits are the most sensitive to interest rates, with the point estimate indicating that a 1 percentage point increase in the deposit interest rate would precipitate a 3.3 percent increase in new sheqel deposits. Including either the contemporaneous or the lag of the number of workers in Israel did not substantially affect the estimate of the interest rate sensitivity.
Deposit Regressions1
Parameters are estimated via SeeiTiingly Unrelated Regressions (SUR), adjusted for first order serial correlation.
Deposit Regressions1
| Currency | |||
|---|---|---|---|
| Parameter | Jordan dinar | Israeli new sheqel | U.S. dollar |
| Constant | 6.24* | 5.07* | 5.78* |
| (0.04) | (.17) | (.43) | |
| Timetrend | 0.007* | 0.010* | .024* |
| (.001) | (.002) | (.007) | |
| Interest rate | 0.024* | 0.033* | 0.064 |
| (.006) | (.011) | (.083) | |
| R-squared | 0.96 | 0.53 | 0.96 |
Parameters are estimated via SeeiTiingly Unrelated Regressions (SUR), adjusted for first order serial correlation.
Deposit Regressions1
| Currency | |||
|---|---|---|---|
| Parameter | Jordan dinar | Israeli new sheqel | U.S. dollar |
| Constant | 6.24* | 5.07* | 5.78* |
| (0.04) | (.17) | (.43) | |
| Timetrend | 0.007* | 0.010* | .024* |
| (.001) | (.002) | (.007) | |
| Interest rate | 0.024* | 0.033* | 0.064 |
| (.006) | (.011) | (.083) | |
| R-squared | 0.96 | 0.53 | 0.96 |
Parameters are estimated via SeeiTiingly Unrelated Regressions (SUR), adjusted for first order serial correlation.
References
Alexander, William E., Tomás J.T. Baliño, and Charles Enoch, 1995, The Adoption of Indirect Instruments of Monetary Policy, IMF Occasional Paper No. 126 (Washington: International Monetary Fund).
Barnett, Steven, 1998, “Monetary Policy in the West Bank and Gaza in the Absence of a Domestic Currency,” Mimeo. (Washington: International Monetary Fund).
Bernanke, Ben S. and Mark Gertler, 1995, “Inside the Black Box: The Credit Channel of Monetary Policy Transmission,” Journal of Economic Perspectives, Vol. 9, No. 4, pp. 27–48.
Chabrier, Paul and Oussama Kanaan, forthcoming, “What Ought to Be the Role of the State in the Financial Sector?” in The Role of the State in a Changing Arab Economic Environment, International Monetary Fund.
Hamed, Osama, 1996, “The Palestinian Banking System: Reality and Potential,” Palestinian Economic Policy Research Institute (MAS).
Hardy, Daniel C, 1993, “Reserve Requirements and Monetary Management: An Introduction,” IMF Working Paper 93/35 (Washington: International Monetary Fund).
International Monetary Fund, 1997, Recent Economic Developments, Prospects, and Progress in Institution Building in the West Bank and Gaza Strip, Middle Eastern Department (Washington: International Monetary Fund).
International Monetary Fund, 1998, International Financial Statistics, January CD-ROM.
Mishkin, Frederic S., 1995, “Symposium on the Monetary Transmission Mechanism,” Journal of Economic Perspectives, Vol. 9, No. 4, pp. 3–10.
Palestine Economic Policy Research Institute (MAS) and the World Bank, 1997, Development Under Adversity? The Palestinian Economy in Transition (Ramallah and Washington).
Stiglitz, Joseph E. and Andrew Weiss, 1981, “Credit Rationing in Markets with Imperfect Information,” American Economic Review, Vol. 71, No. 3, pp.393–411.
See Chapter 3 and IMF (1997) for recent developments.
For comparison, as of December 1996 claims on the private sector as a share of deposits (demand, time, savings, and foreign currency) was 42 percent in Lebanon, 55 percent in Egypt, 89 percent in Jordan, and 96 percent in Israel (data are from the IMF’s International Financial Statistics). Please note that data on the currency composition of private sector credit and deposits are only available through August 1997.
The Palestinian Monetary Authority is also responsible for prudential supervision and regulation of the banking sector. These responsibilities, while extremely important for maintaining a stable financial environment, are beyond the scope of the present analysis.
See Mishkin (1995) for a synopsis of the various transmission mechanisms and Bernanke and Gertler (1995) for a more comprehensive analysis of the credit channel. The credit channel in general encompasses both a “balance sheet” and “bank lending” effect. The former focuses on the transmission of policy through the impact on the balance sheet of individual firms. The bank lending channel, which is described in this analysis, is more relevant for the West Bank and Gaza Strip.
See Barnett (1998) for a detailed exposition.
An increase in the lending interest rate affects the expected return on a loan in two opposing directions: (1) the higher interest rate increases the expected return by raising the amount of interest payments a bank would receive if the loan is repaid, and (2) the higher interest rate decreases the expected return by lowering the probability that the loan would be repaid. Thus, the expected return on a loan is a concave (and initially increasing) function of the lending interest, which is maximized at the point at which the above two effects exactly offset each other.
For example, there could be a pool of potential borrowers to whom the banks would be willing to extend credit (i.e., are not subject to the imperfect information problem), but who choose not to borrow for business reasons. See Chapter 3 for an analysis of the factors discouraging investment, and therefore the need for credit financing, in the West Bank and Gaza Strip.
See Barnett (1998) for a more detailed description of the methodology used to construct Table 1.
See Chabrier and Kanaan (forthcoming) and Alexander, Balino, and Enoch (1995) for a more detailed discussion of government intervention in the financial sector.
The Palestinian Monetary Authority uses the following criteria to determine the amount of reserves to deposit and the recipient bank: compliance with Palestinian Monetary Authority regulations; capital adequacy; conformity with Basle accords; liquidity ratio; and extent of domestic lending.
If credit is constrained by supply factors, then changes in credit demand should not have a measurable effect on the equilibrium (i.e.,βw = 0). The reasoning underlying the unitary elasticity (i.e.,βc = 1) is that since portfolio considerations determine the share of lending capacity banks’ allocate to credit to the private sector, to preserve this share the quantity of credit to the private sector would have to rise in proportion with the growth in the banks’ overall portfolio.
These results are relatively robust to the incorporation of other explanatory variables. When included, neither the contemporaneous nor the lag of the number of workers in Israel is ever significant at the 10 percent level. Moreover the qualitative features of the coefficients on lending capacity are the same as above, with the only exception being that when the lag of workers is included the coefficient on Jordan dinar lending capacity is no longer significant. The addition of the deposit interest rate, which proxies for a bank’s opportunity cost of funds, did not substantially affect the results and the corresponding coefficients are never statistically significant at the 10 percent level.
The specifications used for loans are repeated for claims on the private sector. The actual specification reported in Table 3 most broadly captures the nature of the relationships as indicated by the many regressions examined. Nonetheless, the combination of a small sample, relatively large number of explanatory variables, and specification search suggests the these results should be interpreted with a good degree of caution.
