Fund-supported stabilization programs typically contain, as one of their provisions, limitations on the amount of credit that may be extended during the program period. These limitations are called credit ceilings. There is a great deal of confusion about what these ceilings are, why they are included in programs, and what happens when they are breached.
The view that monetary and credit developments affect nominal income and the balance of payments has been corroborated by both theory and experience. When domestic credit exceeds the amount of money demanded, nominal income is raised, which leads to greater expenditure on domestic goods (causing inflation) and on foreign goods (resulting in a deterioration in the external position). Credit policy, including ceilings to monitor its development, is therefore an important element in adjustment programs, which seek to manage aggregate demand, to switch expenditures toward tradable goods and investment, and to encourage domestic production. Specific measures are tailored to a member’s situation, economic structure, and social priorities and are adjusted for the impact policies have on economic targets. In particular, the amount of domestic credit permitted under a ceiling is individually determined.
Ceilings on domestic credit rather than on the money supply are used because monetary authorities in small open economies cannot control the money supply except when the exchange rate is floating—that is, when there is no change in their international reserves. As long as there is a balance of payments deficit, the external sector would have a contractionary impact on the money supply, as domestic currency is sold to the monetary authorities. Moreover, attempts to offset this effect by expanding domestic credit would, over time, be frustrated by larger external deficits. The exchange rate plays a central role in this process because it influences the size of the balance of payments deficit in foreign currency as well as in domestic currency terms. Given a balance of payments deficit in U.S. dollars, for instance, a more depreciated domestic currency would have a greater contractionary impact.
Due to insufficient data, econometric models are generally unavailable to facilitate the design of a policy package, so policymakers use national income and flow-of-fund identities, supplemented by statistical estimates. Consistent financial flows are developed within a monetary survey of the consolidated accounts of the monetary authorities and the deposit money banks. The table represents a stylized monetary survey—omitting, to simplify the discussion, items such as the banking system’s capitalization, retained earnings, valuation gains and losses from exchange rate movements, and so on.
The double entry accounting principles underlying the survey require that assets equal liabilities—net foreign assets plus domestic assets (or domestic credit) equal money and quasi-money or liquidity, which are liabilities of the monetary authorities or deposit money banks (that is, NFA + DC = L). This framework contains no behavioral assumptions and is therefore valid regardless of the economic system or policy mix; an advantage that, combined with the reliability and timely availability of monetary data, also makes the monetary accounts a useful instrument to monitor programs.
For this accounting identity to become a useful economic tool, a behavioral relationship—a stable demand for money—is introduced; the result is an equation that can be employed to balance aggregate demand with available resources. One of the first tasks in designing credit policy is to estimate demand equations both for real money and real quasi-money (which includes, for instance, savings deposits). Typically, these equations include, inter alia, variables for real income and the opportunity cost of holding money—the interest rate on bonds and/or the expected inflation rate less the interest rate paid on quasi-money. With the parameter estimates from this equation plus targets for inflation and output, as well as for projections for interest rates and inflationary expectations, the increase in nominal demand for liquidity is forecast. There are many difficulties involved in making these projections, especially when the economy is experiencing significant institutional or economic changes. Nevertheless, some judgment must be reached—not only for this variable but others as well—if economic policies are to be formulated.
|Net foreign assets1||50||30|
|Net claims on government/public sector||50||70|
|Claims on private sector||150||200|
|Liquidity (money and quasi-money)||250||300|
For our purposes, the change in net foreign assets is equivalent to the balance of payments deficit.
For our purposes, the change in net foreign assets is equivalent to the balance of payments deficit.
If domestic credit exceeds the amount of money demanded, a balance of payments deficit—a loss of net foreign assets—may ensue. In the short run, however, an excess supply of money does more than produce a deficit. Excess liquidity could also increase domestic inflation and, given excess capacity, raise real growth, while a tightening of credit policy could, in the short run, lower domestic inflation, real growth, and employment. The specific effects on output, employment, prices, and the balance of payments depend, of course, on the economy’s structure and situation, as well as other policies, such as the exchange rate. In the table, the weighted average growth rate of nominal money and quasi-money is assumed to be 20 per cent. Were domestic credit to rise above the target level (say to 300), then some combination of lower net foreign assets (20)—implying a larger balance of payments deficit—and higher liquidity (320) would result.
The planned change in net foreign assets during the program period depends not only on the domestic response to policy changes but also on external conditions, and on receipts and payments that are exogenous during the program period—debt service, noncompressible imports, and capital inflows associated with ongoing investment. Export forecasts are based on projections of demand in trading partner countries, expected price developments on a commodity-by-commodity basis, and the estimates of the exportable surplus, which includes the effects of policies to stimulate supply. Similarly, import projections are based on forecasts of global inflation, domestic output growth, relative price developments, excess liquidity in the financial system, and project implementation. Some items, such as transportation and merchandise insurance, may be related to trade flows, while others, such as tourism and direct investment, may be estimated separately. Debt service projections use data on amortization and interest payments plus a forecast of international interest rates for floating-interest-rate debt. Many developing countries have exchange control regulations, employ debt management policies, or have limited access to international capital markets that simplify the projection of capital flows. In countries with a well-developed financial system that is integrated into the global market, interest rate differentials and expected exchange rate movements also influence these flows, making the balance of payments even more sensitive to domestic policy.
With agreement on the overall balance of payments target, the net foreign assets entry is also determined. (This target may not be equivalent to the change in net foreign assets defined in the monetary survey because the latter includes banking system flows of a medium-term to long-term maturity, which are customarily treated as part of the capital account in the balance of payments.) In the table, a balance of payments deficit of 20 million domestic currency units has been envisaged. When exchange rates are fixed, it is straightforward to go from the overall balance of payments deficit to the net foreign asset target in domestic currency. For example, at an exchange rate of two domestic currency units per U.S. dollar, the balance of payments deficit would be US$10 million.
The level of domestic credit consistent with the targeted change in net foreign assets and the projected demand for liquidity is obtained by subtracting net foreign assets from liquidity(DC = L – NFA), and with appropriate seasonal adjustments, quarterly ceilings are also obtained. Naturally, the appropriateness of deriving a domestic credit target as a residual depends on how accurately the targets for net foreign assets and liquidity reflect the economy’s structure and prospective developments. Hence, an understanding of the economy’s behavioral relationships and their linkages to financial flows is necessary to ensure that the policy package is properly designed. In addition, because of the balance sheet properties of the monetary accounts, movements in exchange rates alter domestic credit by changing the domestic currency value of net foreign assets; therefore, when reporting to the Fund under an arrangement, adjustments are made in order to insulate domestic credit from unanticipated movements in exchange rates.
The permissible increase in domestic credit is also allocated between the private and public sectors. The public sector’s fiscal deficit under the program can be financed from either foreign or domestic sources. Foreign financing obviously has implications for debt management and the overall balance of payments target, as well as for domestic borrowing. The mix of domestic financing—borrowing by selling debt instruments to domestic nonbank holders and credit from the banking system—has different implications for domestic interest rates and the credit available to the private sector. The domestic credit requirements of the public sector are derived by subtracting foreign and domestic nonbank financing from its overall deficit. Usually a subceiling on net credit to the public sector is set by adding this flow figure to the initial stock; the remaining domestic credit is allocated to the private sector. If this amount of credit is insufficient to finance the projected activity of the private sector, measures to reduce the public sector’s recourse to the banking system would be needed. The subceiling on credit to the public sector is especially important since larger-than-programmed credit use, resulting from a greater-than-targeted fiscal deficit, is often the reason domestic credit ceilings are breached.
Monetary authorities have differing degrees of control over the domestic credit of the banking system. In some countries, they can control it directly through ceilings assigned to deposit money banks. Where the relationship between liquidity and banking system reserves (known as the money multiplier) is stable and where the ability of deposit money banks to borrow and lend externally is limited, they can control bank credit indirectly by limiting reserve growth or increasing reserve requirements. However, even though stable, the money multiplier can still fluctuate unexpectedly and commercial banks may still be able to lend and borrow abroad to some extent and, thereby, weaken the monetary authorities’ control over total domestic credit. In such cases, the authorities may prefer to have a ceiling set on the domestic credit of the central bank, which they can more readily control. Such a ceiling reduces the risk that it would be accidentally exceeded; however, because the linkage from central bank credit to banking system credit is less stable, the attainment of program targets may be more problematic.
As has been suggested, credit ceilings in Fund-supported programs are a quantitative limit to ensure that the domestic credit extended, plus the monetary implications of the balance of payments target, will match the expansion in liquidity demand. These ceilings are thus an instrument used to safeguard the economy against financial disequilibria that could undo the adjustment achieved through budgetary, exchange rate, incomes, and pricing policies. What happens when a breach of a credit ceiling occurs? The immediate consequence is an interruption in the member’s right to draw on the Fund resources made available to support the adjustment program. This does not mean, however, that the program has collapsed and the standby or extended arrangement is canceled. Rather, the first order of business is to determine why the ceiling was exceeded. The Fund is well aware that there are numerous uncertainties in designing a financial program and that a reversible shock may have temporarily caused the credit ceiling to be exceeded. In such cases, a waiver of that particular ceiling is normally granted. However, if the deviation indicates a more fundamental problem with the program’s design or implementation, then either the program will have to be modified or an entirely new financial program will be negotiated before access to Fund resources can be resumed.
G. Russell Kincaid