The transition to indirect instruments of monetary policy causes the operational activities of the central bank and the treasury to become more intertwined than before. Lack of coordinating arrangements will impair the central bank’s operational autonomy, and hence the efficiency and effectiveness of its policy actions.
Operational coordination is particularly needed in selecting the financial instrument used to conduct the central bank’s open market operations and designing arrangements to reduce interference between monetary and debt management and stimulate financial market development.
Central banks in financially advanced countries typically intervene in the secondary markets for government securities, a practice that reduces interference between monetary and debt management to a minimum. When financial markets are undeveloped, central banks are unable to introduce genuine open market operations. They first have to influence monetary conditions by intervening in the primary securities market. If government securities are used, monetary and debt management take place in the same market, with the same instrument. Central banks sometimes prefer to use central bank paper to avoid this situation. Coordination between debt and monetary management is still necessary, however.
This paper addresses two related questions: first, does the financial instrument used in emerging open market type operations matter? Second, given the financial instrument, what are the basic requirements for a supporting arrangement to ensure (a) operational autonomy for monetary management and (b) financial market development?
The paper argues in favor of using government securities in emerging open market type operations because they are better able to serve as catalysts in financial market development and (b) there is a risk of losses associated with the use of central bank bills when absorbing large amounts of excess liquidity in the initial stages of financial reform. Although the cost of such operations has to be borne by the government on a consolidated basis, central bank losses should be avoided to preserve the institution’s integrity and autonomy.
The effective use of government securities for open market type operations requires the highest degree of coordination between monetary and fiscal authorities. The arrangement should provide for mechanisms to (a) coordinate the amounts to be issued between monetary and fiscal authorities, (b) sterilize any overfunding of the government’s budget for monetary management purposes, and (c) share the cost of this overfunding.
Reform agendas should give proper attention to these issues, as a lack of proper coordinating arrangements has been identified as a major source of delay in the transition to indirect instruments of monetary policy.