The Central Bank of The Bahamas (CBB) has long relied on direct credit controls and restrictions on capital flows to manage liquidity, as the depth of the domestic credit market was seen as insufficient to support open market operations. But more recently, it has become concerned about the microeconomic distortions resulting from its direct controls and is reconsidering its monetary framework. For this reason, the IMF recently discussed with the CBB a strategy to set the stage for a successful transition toward market-based instruments of liquidity management in an effort to enhance the role of price signals in allocating financial resources.
The Bahamian dollar has been pegged at par with the U.S. dollar since 1973, and keeping an adequate level of international reserves has been a key objective. The CBB is required to have external assets equivalent to at least 50 percent of its demand liabilities. In practice, since 2003, reserves have been targeted at 100 percent of base money or more, well in excess of the statutory limit. The Monetary Policy Committee (the CBB’s monetary policy decision-making body) monitors monetary and bank soundness indicators and takes corrective action if losses of international reserves threaten to put pressure on the exchange rate.
Since the late 1980s, the CBB has been relying on direct credit controls as its main monetary policy instrument, with changes in the discount rate playing a secondary and infrequent role. Credit growth is seen as a key intermediate target given its importance in achieving the Bank’s reserve objective through its effects on domestic demand, which is highly import-intensive. During the most recent episode of credit controls (September 2001–August 2004), the CBB introduced a ceiling on bank loans and advances to the private and public sectors, supported both by moral suasion and existing capital controls.
The current framework has worked reasonably well in achieving policy objectives. From September 2001 to end-2003, aggregate bank credit growth gradually declined to near zero, and international reserves recovered sharply from the low level experienced in the wake of the post-September 11 drop in tourism revenues (see chart). A considerable degree of monetary independence was also evident, with domestic interest rates remaining broadly stable, in contrast to the sharp swings in U.S. rates.
The insulation of domestic interest rates from U.S. rates is largely a consequence of exchange controls, but it also reflects a seeming absence of price competition among banks. Eight clearing banks operate in the domestic commercial banking sector, of which one is government-owned, two are locally owned private banks, and five are subsidiaries or branches of foreign banks. In addition there are 11 nonbank financial institutions of a smaller size. Even in the face of large excess bank liquidity, bank deposit and lending rates have been remarkably stable and banks appear not to compete through interest rates. This may be an unintended consequence of the long-standing reliance on credit controls, which have reduced the scope and incentive for banks to gain market shares by adjusting lending rates.
Toward more market-based regulation
Now, however, the authorities are considering steps to deepen domestic financial markets, including by promoting a secondary market for government bonds, revitalizing the Bahamas International Stock Exchange, and increasing the role of market-based interest rates in signaling the cost of funds. The CBB views the creation of a money market as a component of this reform and is proposing a cautious and gradual liberalization of capital controls. It sees this as a step toward further integrating the country into the global economy, increasing competition in the banking sector, and giving citizens broader investment opportunities. A number of issues will need to be addressed, however, for this strategy to be successful.
Data: Central Bank of The Bahamas.
At present, the supply of domestic short-term financial instruments is limited, and a majority of domestic currency transactions are intermediated through domestic banks. While the CBB auctions government treasury bills, there is a legal ceiling on the amount outstanding. There are almost no secondary market transactions in government securities, as holders tend to keep them in their portfolios until maturity. This is in part because government securities are held by financial institutions to meet their liquid asset ratio requirements and because of a lack of alternative investment choices available to public and private pension funds.
Structural excess bank liquidity and relatively predictable liquidity needs have reduced the scope and need for interbank transactions. Indeed, excess bank reserves sharply increased during 2004 and early 2005, as strong external inflows outpaced the private sector’s capacity to borrow. At the same time, there do not appear to be other institutions in The Bahamas with significant short-term liquidity management needs that might help foster the development of a market for short-term instruments. This situation could prove an obstacle to the development of a vibrant money market that would yield market-based short-term interest rates.
Looking forward, consideration could be given by the CBB to establishing a formal operational target either for the supply of reserve money or for interest rates. For countries with relatively shallow financial markets and capital controls, best practice is for the central bank to signal its intentions by targeting reserve money. Countries tend to adopt interest rate targets at a later stage once domestic financial markets deepen and a market-based vehicle can be developed so that the central bank can signal its interest rate objective.
A possible reform strategy
A transition to more market-based monetary policy instruments is expected to be part of a broader long-term strategy to modernize and open up the financial sector. While this process would need to proceed in a careful and well-sequenced manner, there is scope for the CBB to begin to introduce market-based policy instruments to manage excess bank liquidity. Key considerations include:
•Unremunerated reserve requirements are a tax on the banking sector and raising them should remain an option of last resort.
• Preferable would be instruments that would allow a continuous CBB presence in the money market.
•The CBB will need the capacity to forecast market liquidity.
•The CBB should be able to conduct monetary policy without imposing a financial burden on the central bank and inhibiting its independence.
On this basis, the CBB has available a number of options to develop market-based policy instruments, but each presents challenges:
Issue the CBB’s own paper for open market-type operations. Experience in other countries, however, suggests this approach can result in central bank losses and could eventually require the government to recapitalize the central bank.
Conduct open market operations using treasury bills. A complication with this approach is that, owing to a legal ceiling on the amount outstanding, the supply of these bills may not be adequate to ensure their market liquidity or enable the central bank to acquire a sufficient stock.
Introduce auctions of short-term central bank deposits (to withdraw liquidity) and repurchase/reverse repurchase agreements of government securities (to withdraw or inject liquidity). A key consideration with this approach is that the central bank’s portfolio of marketable securities is fairly small, so consideration could be given to securitizing CBB’s advances to the government as well as its portfolio of government bonds. Under this approach, the maturity of repurchase agreements would be shorter than that of the underlying instrument, which would help clearly differentiate these transactions from government financing.
In all such cases, consideration would also have to be given to the desired structure of the money market. This would include defining the CBB’s counterparties—that is, the institutions with which the CBB would transact on a regular basis (which could include all clearing banks or a restricted set of primary dealers). The CBB’s role as a lender of last resort for its money market counterparties would also need to be reviewed, which could involve a streamlining of its existing standing facilities to ensure that they were solely accessed by counterparts at penalty rates.
This article is based on IMF Country Report No. 05/224, The Bahamas: Selected Issues and Statistical Appendix. Copies are available for $15.00 each from IMF Publication Services. Please see page 332 for ordering details. The full text is also available on the IMF’s website (www.imf.org).