Resilience and Growth in the Small States of the Pacific
Chapter

Chapter 12. Monetary Policy Transmission Mechanisms in Pacific Island Countries

Author(s):
Hoe Khor, Roger Kronenberg, and Patrizia Tumbarello
Published Date:
August 2016
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Author(s)
Yongzheng Yang, Matt Davies, Shengzu Wang, Jonathan Dunn and Yiqun Wu 

The global financial crisis tested the effectiveness of monetary policy transmission mechanisms in Pacific island countries (PICs).1 At the onset of the crisis, monetary policy remained tight in a number of these countries, reflecting the overriding priority of protecting foreign reserves and keeping inflation under control in the wake of the global food and fuel price shocks. However, as the effects of the crisis intensified, central banks began to loosen policy to maintain a flow of credit to productive sectors and ease pressures on existing borrowers, with an explicit objective of lowering interest rates. The policy stance was eased by lowering policy rates (Fiji, Samoa), ceasing the sale of government and central bank paper to the market (Samoa, Tonga), lowering reserve requirements (Fiji, Tonga, Vanuatu), and devaluing or depreciating exchange rates (Fiji, the Solomon Islands). Despite these efforts, reductions of lending rates by banks have been limited and the growth of private credit has been anemic in some countries. The sluggish response raised a key question about the effectiveness of monetary policy transmission mechanisms in PICs.

PICs are susceptible to external shocks, and effective monetary policy is vital to maintaining macroeconomic stability. As most countries in the region maintain fixed exchange rate regimes, the burden of addressing the impact of exogenous shocks falls most heavily on monetary and fiscal policies. Because of limited capital flows, monetary policy enjoys a certain degree of freedom despite fixed exchange rate regimes. However, if monetary policy transmission is indeed muted, and the prospects for improvement in the short term limited, effective macroeconomic management will require an appropriate mix of monetary, fiscal, and exchange rate policies. In particular, monetary policy should be closely coordinated with fiscal policy to achieve the desired impact. Fixed exchange rate regimes should not preclude some flexibility to increase the role of the exchange rate in absorbing external shocks and to provide additional freedom for monetary policy.

This chapter assesses monetary policy transmission mechanisms in PICs and explores options for an appropriate mix of macroeconomic policies. We review the main objectives of monetary policy and how it is conducted in PICs, and provide an empirical assessment of monetary policy transmission mechanisms, focusing on the responses of market interest rates and private sector credit growth to policy rates (or their proxies). We then examine the structural constraints on monetary policy transmission and identify areas of reform that could foster long-term financial market development. This is followed by a discussion on the role of monetary and fiscal policy coordination, and exchange rate flexibility. We close with some policy implications.

Monetary Policy Objectives and Operations

Monetary policy in most PICs aims primarily to maintain international reserves in the context of fixed exchange rates (Table 12.1). The small, open economies of the region are subject to frequent internal and external shocks, and adequate foreign reserves are essential to weathering them. A fixed exchange rate provides a nominal anchor, and many in the region believe that exchange rate movements have limited effect on exports, which tend to be dominated by commodities. Yet tourism and other industries do seem to respond strongly to exchange rate movements, as evidenced by Fiji’s tourism boom following the 20 percent devaluation of the Fiji dollar in April 2009. There is also a concern that more flexible exchange rates would create considerable volatility in currencies and domestic prices, given relatively small foreign exchange markets.

Table 12.1Monetary Policy Frameworks in Pacific Island Countries
CountryMonetary ObjectivesMain Monetary InstrumentsExchange Rate Regime
FijiPromote monetary stability and a sound financial structure; foster credit and exchange conditions conducive to orderly and balanced economic development.Open market operations; discount windows; policy ratePegged to a basket
Papua New GuineaAchieve and maintain price stability and financial system stability, and promote macroeconomic stability and economic growth.Open market operations; policy rate; cash reserve requirementDe facto crawl-like arrangement (effective April 2014)
SamoaPromote sustainable real economic growth by maintaining price stability and international reserves viability.Open market operations; discount rate; reserve requirementsPegged to a basket within a ±2 percent band (New Zealand dollar, Australian dollar, U.S. dollar, euro)
Solomon IslandsAchieve and maintain domestic price stability, foster and maintain a stable financial system, and support the general economic policies of the government.Open market operations; short-term securities (Bokolo bills) issued by the central bank; cash reserve requirementPegged to a basket
TongaMaintain internal and external monetary stability; promote a sound and efficient financial system; support macroeconomic stability and economic growth.Open market operations; statutory reserve deposit; credit ceilingsPegged to a basket within horizontal bands
VanuatuMaintain low and stable inflation rate and maintain a sufficient level of official foreign exchange reserves.Statutory reserve deposit; Open market operations; rediscount rateDe facto other managed arrangement
Source: Authors’ compilation.
Source: Authors’ compilation.

With narrow export bases and the need to import most manufactured goods, food, and fuel, PIC trade balances are generally in deficit.2 Although most countries enjoy a surplus in their services and income accounts due to tourism and remittances, current account deficits are often very high (Figure 12.1). Capital inflows—both private and official—that are needed to offset the current account deficits are volatile. Monetary policy therefore needs to be vigilant to contain import demand. Speculative capital inflows are not a significant issue in PICs at the moment, but could become one given ample global liquidity.

Figure 12.1Current Account Balance

(Percent of GDP)

Sources: IMF World Economic Outlook database; and IMF staff estimates.

Maintaining price stability is a key objective in PICs, and some place similar emphasis on financial sector stability. While managing aggregate demand is the main focus in maintaining price stability, movements in world commodity prices and domestic supply conditions, mainly in agriculture, often play a dominant role in determining inflation outcomes in PICs. This highlights the importance of monetary policy not only in mitigating the direct impact of exogenous shocks, but also in preventing their second-round effects on inflation with support of other policies (for example, through restraint on public sector wage bills). Information and analysis of these effects are often lacking. Policymakers therefore have to make decisions with the knowledge that monetary policy actions to influence domestic demand often have a limited impact on headline inflation—and that the longer-term impact of monetary policy actions is subject to considerable uncertainty. The role of monetary policy in maintaining financial sector stability is mainly reflected in combating high inflation and nonperforming loans by avoiding excessive money and credit expansion. Other policy tools that central banks use to ensure financial sector stability are prudential regulation and supervision.3

Most central banks in the region explicitly include promotion of economic growth in their monetary policy objectives. Indeed, most react to threats to growth by loosening monetary policy, as shown during the global financial crisis. It is widely recognized that with a small and narrow base of domestic production, the effects of monetary policy on domestic supply are generally weak (tourism is probably an exception), and credit growth often translates largely into raising import demand with limited pass-through into the domestic economy. Thus, the effectiveness of monetary policy in managing domestic supply and aggregate demand is often diminished by the limited capacity of domestic industries and large external leakages.

As in any other region, it is difficult for PICs to achieve these multiple objectives using monetary policy alone even if transmission is strong. This difficulty was made abundantly clear during the 2007–08 global food and fuel crisis. To arrest rapid depletion of foreign reserves as import costs rose and to prevent inflation from getting out of control, countries needed to tighten monetary policy. Yet doing this would have exacerbated falling liquidity and rising production costs in these economies. The limitation of monetary policy was also evident at the onset of the global financial crisis. Despite declining external demand for exports (including tourism) and falling growth, some PICs were reluctant to ease monetary policy, as inflation remained high (Figure 12.2) and international reserves were low. Exchange rate depreciation—which was not considered an option for most PICs because of their fixed exchange rates—would have helped cushion the demand shock and contain import growth. But it would also have had an adverse effect on inflation.4 Fiscal expansion—again not a viable option for some countries that entered the crisis with high public debt—would also have exacerbated inflation pressure, though it could at least have been targeted at those most affected by the crisis. The point here is that in many circumstances monetary policy cannot achieve one objective—for example, stimulating growth—without undermining other objectives, such as controlling inflation and preserving reserves.

Figure 12.2Consumer Price Inflation

(Percent)

Sources: IMF World Economic Outlook database; and IMF staff estimates.

All six PICs covered in this chapter conduct their monetary policy through various money-targeting frameworks (described in Table 12.1). Central banks in the region typically target some broad money aggregates such as M2 to ensure adequate credit growth and healthy foreign reserves. Policy instruments for achieving money targets include policy rates, open market operations, central bank discount windows, reserve requirements, moral suasion, and, sometimes, administrative measures such as interest rate/spread and credit controls. PICs are trying to move away from administrative measures to market-based instruments, and making these instruments more effective in the broad macroeconomic policy context is a major challenge. This is discussed in the following section.

Empirical Evidence on Monetary Pass-Through

Interest rate movements are used as the main indicator to gauge the effectiveness of monetary policy transmission in PICs. As noted earlier, the lack of response of market interest rates to central bank policy changes during the global financial crisis was a major source of frustration among policymakers. It was hoped that changes in policy rates would translate into commensurate movements in the lending and deposit rates of commercial banks, resulting in increased credit to the private sector, thereby boosting economic activity. Against this backdrop, our assessment of monetary policy transmission begins with a look at the role of policy rates.

The pass-through of policy rates to commercial bank interest rates appears to be indeed low, though this varies across PICs (Figure 12.3). In Papua New Guinea, Samoa, and Vanuatu, commercial banks’ deposit and lending rates do seem to respond to changes in policy rates, but this response is barely discernible in Fiji, the Solomon Islands, and Tonga. The low response in the latter countries is hardly surprising as their policy rates do not change very often, indicating either an inactive interest rate policy or the presence of some other policy measures that may have been taken as substitutes for interest rate policies. Indeed, in Fiji in 2009, the central bank lowered lending rates by setting an interest rate ceiling at the level prevailing at the end of 2008 and by imposing an allowable interest rate spread of 4 percent. While interest rate spreads have fallen somewhat in Fiji and Vanuatu, they have not changed much or have even increased in other PICs. It is worth noting that interest rate spreads in PICs are broadly comparable to those observed in Caribbean countries, and their recent developments have followed a similar path (PFTAC 2010).5

Figure 12.3Interest Rates and Their Spreads in Pacific Island Countries

Sources: Country authorities; IMF, Monetary and Financial Statistics; and IMF staff calculations.

Econometric analysis confirms that interest rate pass-through in PICs is generally low (see Annex 12.1). Based on an autoregressive distributed lags model using monthly data over 2001–10, the estimated long-term interest rate pass-through—defined as the percentage point change in commercial banks’ lending rates divided by the percentage point change in central bank policy rates—ranges from 0.1 in Vanuatu to 0.5 in Samoa (Figure 12.4).6 Although it is not surprising that the pass-through in PICs is lower than in larger countries in Asia and the Pacific, its absolute levels indicate limited influence of central bank policy rates over commercial bank lending rates in some PICs.7 The analysis also shows that Papua New Guinea and Samoa have much higher pass-through than Fiji, Tonga, and Vanuatu. This is primarily because policy rates in Papua New Guinea and Samoa are more directly linked to money market rates (rates on central bank securities and government paper), and are more actively used to signal the policy stance, as measured by the frequency of change in policy rates (see Figure 12.3).8 This highlights the importance of a well-developed money market through which policy rates can directly affect liquidity.

Figure 12.4Long-Term Interest Rate Pass-Through

Source: IMF staff calculations.

Note: Data not available for the Solomon Islands.

Compared with interest rate pass-through, the response of private sector credit to policy rate changes is more significant. A similar econometric analysis (see Annex 12.1) shows that for each percentage point change in policy rates, the growth of private sector credit responds by a change of 4–5 percentage points in Fiji, Papua New Guinea, and Vanuatu, 1½ percentage points in Tonga, and only half a percentage point in Samoa (Figure 12.5). Such large variation may reflect different underlying economic circumstances (data could also be an issue). In Samoa, the limited response of credit growth could result from higher interest rate pass-through. This is because competition forces commercial banks to lower lending rates, but they are reluctant to increase lending when responding to lower policy rates, perhaps due to limited low-risk lending opportunities. In Fiji and Vanuatu, on the other hand, commercial banks respond primarily by increasing credit rather than lowering lending rates, whereas banks in Papua New Guinea seem to respond by both reducing lending rates and increasing credit. In Tonga, both interest rate and credit responses are relatively weak. One possible reason that credit is generally more responsive than lending rates is that banks target risk-adjusted returns on their lending. For example, when funding costs are reduced as a result of policy easing, banks may be more willing to extend credit to customers with higher credit risk without lowering interest rates.9

Figure 12.5Private Credit Long-Term Pass-Through

(Percent)

Source: IMF staff estimates.

Monetary policy transmission appears to have been even weaker during the global financial crisis than these long-term responses would suggest. Not only has the interest rate pass-through been generally low, but the response of private sector credit appears to have deviated from its long-term behavior. As panel 1 of Figure 12.6 shows, despite the easing of the policy stance, growth of private sector credit slowed sharply in the wake of the global financial crisis—and even turned negative in the Solomon Islands and Tonga in 2009. Slow credit growth was also reflected in the rising levels of excess reserves held by commercial banks and their falling loan-to-deposit ratios in some PICs. Nevertheless, the rising level of excess reserves and falling loan-to-deposit ratios do indicate that monetary policy in PICs achieved the important objective of ensuring sufficient liquidity when economic activity is weak.

Figure 12.6Credit and Liquidity Indicators

The poor interest and credit responses to monetary policy during the global financial crisis seem to reflect the weak state of regional economies as well as the broader international environment. The sharp slowdown in economic growth undoubtedly reduced opportunities for profitable investments. On the supply side, even though central banks signaled an easing of the monetary policy stance, commercial banks were reluctant to lower lending rates or increase lending. This appears to have been the case even in Samoa, where long-term interest pass-though is relatively high (Pongsaparn 2010). The global financial crisis made banks more risk averse, resulting in tighter lending standards. This occurred even though most banks in the region (mostly owned by Australian parent banks) weathered the crisis well.10 Other factors also played a role. In Tonga, slower credit expansion was a reaction to high nonperforming loans arising from a previous lending boom. In Fiji, exchange restrictions and intensified price controls in the wake of the crisis may have dampened the appetite for new investment and hence demand for credit. On the other hand, Vanuatu’s strong credit expansion in 2008 and 2009 resulted from BRED Bank opening a branch there and the ensuing competition in the banking sector.

Developments in real interest rates may have also dampened credit demand during the crisis. As world food and fuel prices began to retreat in the second half of 2008, inflation rates fell quickly in most PICs, leading to sharp, sustained increases in real lending rates in most countries (Figure 12.7).11 The sharp fall in Fiji’s real lending rates in 2009–10 reflected the one-off increases of domestic prices following the April 2009 devaluation. Overall, real borrowing costs for business increased considerably during the crisis, and this likely contributed to the slow credit growth.

Figure 12.7Real Lending Rate

(Percent)

Sources: IMF, Information Notice System database; and IMF staff calculations.

Real exchange rate appreciation during the crisis may have also contributed to weak credit demand, as all PICs except Papua New Guinea maintain a pegged exchange rate. Although there were some movements over time, nominal effective exchange rates at the end of 2010 for most PICs remained roughly at their 2005 levels (Fiji and the Solomon Islands were the exceptions, as shown in Figure 12.8). Higher inflation than in trading partners, largely reflecting the pass-through to domestic markets of higher world food and fuel prices, led to real exchange rate appreciation during the global financial crisis in five of the six PICs covered in this chapter (Fiji was the exception). In the Solomon Islands, the real exchange rate was on an appreciating trend well before world prices began to rise (Figure 12.9). The decline in world prices since mid-2008 did not bring real exchange rates back to their precrisis levels. The monetary easing to boost economic activity has therefore not been supported by real exchange rate movements, with the exception of Fiji. Its April 2009 devaluation led to a sharp real depreciation of the Fiji dollar since the second quarter of that year, which boosted tourism amid weak overall economic activity.

Figure 12.8Nominal Effective Exchange Rate

(Percent)

Source: IMF, Information Notice System database.

Figure 12.9Real Effective Exchange Rate

(Percent)

Source: IMF, Information Notice System database.

Most PICs eased fiscal policy during the crisis to support economic activity. Vanuatu kept the policy stance neutral and the Solomon Islands tightened, while Fiji, Papua New Guinea, Samoa, and Tonga loosened fiscal policy in 2009, and Tonga and Samoa continued to loosen in 2010 (largely due to post-tsunami reconstruction in the latter; Figure 12.10). At least part of the fiscal expansion was financed domestically, but given weak private sector activity, there was little risk of crowding out and hence the fiscal expansion most likely did not contribute to slow private sector credit growth.

Figure 12.10Fiscal Balance

(Percent of GDP)

Source: IMF staff estimates.

Macroeconomic policy developments during the global financial crisis highlight the limitations of monetary policy in economic stabilization without the support of other macroeconomic policies. To be sure, the crisis experience does not prove that monetary policy easing was totally ineffective. One could argue that even though interest and credit responses appear to be weak, the credit situation facing the private sector could have been worse had there been no policy action. Nevertheless, the experience does suggest inconsistency between exchange rate and monetary policies, which is difficult to avoid when a fixed exchange rate regime is faced with an adverse terms-of-trade shock such as rising international prices.

Constraints on Monetary Policy Transmission

At the broadest level, the effectiveness of monetary policy transmission depends on the macroeco-nomic policy framework it operates in. In particular, since most PICs have a fixed exchange rate regime one way or another, monetary policy is subordinate to the maintenance of the exchange rate regime. However, because of limited capital flows across their borders, monetary policy does enjoy a certain degree of autonomy. Namely, higher domestic interest rates in response to monetary policy may not attract rapid capital inflows and bring interest rates back to where they were, thereby largely avoiding increased liquidity and inflation pressures. It is not clear, however, how some private transfers, particularly remittances, respond to domestic interest rates. The literature suggests that remittances respond mainly to the needs of families in migrants’ home countries rather than to returns on investments or exchange rates (Chami and others 2008). Nevertheless, given large remittance volumes in some PICs (Australia and New Zealand Governments 2010), their response to interest rates and exchange rates could make a major difference to domestic liquidity and, hence, the effectiveness of monetary policy transmission.12

Underdeveloped domestic financial markets appear to be the main constraints on monetary policy transmission in PICs. Measured by the ratio of broad money (M2) to GDP, domestic money markets are quite shallow and on average compare unfavorably with Caribbean countries (Figure 12.11).13 Collateralized interbank lending is not widely available, and secondary markets for government and central bank paper are virtually nonexistent. Markets for commercial paper, corporate bonds, and foreign exchange products are also underdeveloped, while equity markets are in their infancy.14 This not only affects interest rate and credit pass-through, but also all other channels of monetary policy transmission, particularly those through asset prices and exchange rates.15

Figure 12.11Pacific Islands: Broad Money, 2005–14 Average

(Percent of GDP)

Sources: IMF International Financial Statistics database; and IMF staff calculations.

Note: Small Caribbean islands are Antigua and Barbuda, Dominica, Grenada, St. Kitts and Nevis, St. Lucia, St. Vincent and the Grenadines, and Trinidad and Tobago. The definition for emerging market and developing economies accords with the IMF’s World Economic Outlook database.

Lack of vigorous competition in the domestic banking sector may also be partly responsible for the weak monetary policy transmission. Reflecting the small size of domestic markets, only a few commercial banks operate in each of the PICs (Table 12.2). These banks, together with provident funds and a few insurance companies, are also major players in domestic money and credit markets. Provident funds account for a large share of total domestic financial assets in PICs. Because opportunities for long-term investment and restrictions on overseas investment are lacking, provident funds often hold large volumes of their assets in bank deposits and government paper. Given their size, actions by provident funds often have a large influence on domestic liquidity and hence on the effectiveness of monetary policy transmission (Box 12.1).

Table 12.2Structure of the Banking Sector in PICs, 2000–14
Number of Commercial Banks
2000200520092014
Fiji5556
Papua New Guinea6444
Samoa3444
Solomon Islands3334
Tonga3334
Vanuatu4344
Sources: Central banks; and IMF staff reports.Note: PICs = Pacific island countries.
Sources: Central banks; and IMF staff reports.Note: PICs = Pacific island countries.

Domestic financial markets require continued reforms to reduce risk to investors, who see broader country risk and economic risk as high in PICs (PFTAC 2010). Such risks find their way into higher interest rates and impede the expansion and deepening of financial markets, as investors require higher returns. While some risk factors (vulnerability to cyclones, for example) are beyond the control of governments, much can be done to improve market infrastructure for financial development. In many PICs, measures could include establishing credit reporting bureaus, secured transactions laws, and collateral registries. Moreover, the enforcement of credit contracts needs to be strengthened to ensure reliable and rapid resolution of defaults, bankruptcies, and disputes.

Box 12.1.Provident Funds in Pacific Island Countries

Provident funds are the largest financial sector institutions in Pacific island countries (PICs) and account for the bulk of private savings in many of them. Provident fund assets average 36 percent of total banking sector assets and reach over 60 percent in Fiji (Figure 12.1.1). These assets are normally held in a mixture of long-term investments, government paper, and bank deposits. Very few funds hold assets overseas, in part due to concerns over the impact this may have on official reserve positions.

Provident funds complicate the transmission of monetary policy in a number of ways:

  • Deposit rates—Because provident funds often control much of the liquidity in the banking system, banks compete vigorously for their deposits, which are often made available in lumpy amounts. This can drive up the cost of funding for banks even when there is ample liquidity in the system, thereby frustrating central bank attempts to ease monetary policy.
  • Lending rates—Provident funds are significant sources of private sector credit in some PICs. This can diminish the influence of monetary policy on credit growth and aggregate demand, as actions designed to tighten the credit environment have limited impact on the credit made available by provident funds.
  • Dampening price signals—Provident funds can come under pressure to provide finance at lower than true market rates if they are government owned and represent a key source of domestic finance for the budget deficit. Some funds also have considerable lending to quasi-government bodies and state-owned enterprises, and this lending is not always on a fully commercial basis.

Some central banks have taken action to moderate the impact of provident funds on the domestic money market. For instance, the Reserve Bank of Vanuatu placed a temporary ceiling on deposit rates when provident fund offerings began pushing up interest rates as it was trying to loosen policies.

Provident funds are likely to continue to complicate monetary policy transmission in PICs. While markets are still relatively shallow and investment opportunities limited, provident funds are likely to remain one of the main providers of liquidity to the banking system. There are, however, a number of measures that could increase their sensitivity to market interest rates and therefore strengthen the transmission of monetary policy. These include ensuring open and transparent price auctions for the deposits that the funds place in the banking system, holding market-based variable-rate auctions for government securities, increasing the range of financial products available to provident funds for investment, and, contingent on the external position, allowing greater levels of investment overseas.

Figure 12.1.1Ratio of Provident Fund Assets to Total Banking Assets

(Percent)

Source: IMF staff compilations based on official websites.

Note: 2011 data for Vanuatu, 2012 data for Tonga, and 2013 data for other countries.

Policy consistency can also help market development and strengthen signals for monetary policy transmission, as market expectations can play an important role in monetary policy transmission. Central bank independence, policy consistency, and effective communication help build expectations in line with policy intentions. For instance, when fiscal and monetary policies are moving in the same direction, it increases the credibility of monetary policy and the strength of transmission. In contrast, if the fiscal policy stance does not support a monetary easing it is likely to mute the effect on market interest rates or result in interest rates moving in unintended directions. Similarly, restrictions and controls on interest rates inconsistent with market conditions are unlikely to help long-term monetary policy transmission as market players see greater uncertainty and risk to their future activities.

Macroeconomic Policy Coordination

The ultimate objective of macroeconomic policies is to achieve high economic growth and low and stable inflation. But, as noted earlier, it is difficult to rely on a single policy to accomplish this objective, be it fiscal, monetary, or exchange rate policy. Given the rather weak transmission of monetary policy in PICs, it is particularly important that it is employed in a macroeconomic policy framework in which all policies are geared toward the same objectives.

Despite fixed exchange rate regimes in most PICs, exchange rate policy can still be useful in economic stabilization. Under a flexible regime, the exchange rate itself is the first absorber of external shocks. Although a fixed exchange rate regime precludes such an automatic role, some flexibility—either through a one-off devaluation when facing a negative external shock or permitting the exchange rate to move within a narrow band—could still have significant stabilizing effects. Fiji, for instance, devalued its dollar when its balance of payments was under considerable pressure, as foreign reserves were running very low. The devaluation helped rebuild reserves quickly, with few second-round effects on inflation. One could argue that had Fiji relied on monetary tightening alone, the domestic price level would have had to fall substantially to restore the external balance, possibly with significant output losses. More generally, Wood (2010) argues that greater downward exchange rate flexibility could be expected to have favorable impacts on competitiveness over the medium to longer term, though it may not be able to counter a recession-induced decline in exports in the short term. Similarly, when a country faces increasing capital inflows, such as Papua New Guinea experienced during 2010–11 as a result of a large liquefied natural gas project, upward exchange rate flexibility would help reduce inflation pressure.

The expenditure-switching effects of exchange rate policy can be powerful in PICs. Even though real exchange rate depreciation through devaluation may have a limited impact on the supply of domestic goods, tourism seems to respond well to real exchange rate movements. Moreover, imports, which often consist of a high proportion of manufactured goods, tend to be more elastic, and devaluations can quickly reduce import demand. At the same time, because of high dependency on imports, devaluations can put considerable upward pressure on domestic prices, rendering policymakers reluctant to take such actions. However, an increase in the price of imports is a necessary part of expenditure-switching adjustment, a key reason why the exchange rate can be effective in monetary policy transmission.16 A critical step in preventing second-round effects of higher import prices, as Fiji took in 2009, is to have supportive monetary and fiscal policies to stamp out further inflation pressure.

Fiscal policy is particularly important in maintaining macroeconomic stability in PICs. As discussed earlier, a core objective of monetary policy under the mostly fixed exchange rate regimes in PICs is to protect foreign reserves by keeping inflation in line with the levels of major trading partners. But they can only achieve this if fiscal policy is prudent and aimed at keeping aggregate demand at an appropriate level. Moreover, when countries need to stimulate domestic demand, such as when an external shock weakens domestic economic activity, fiscal policy is more powerful under a fixed exchange rate regime. To take advantage of it, countries need to build adequate fiscal space during good times to serve as a policy buffer during bad times.

A prudent fiscal policy can also help ensure adequate credit to the private sector and promote long-term growth and stability. It is now less common for governments to borrow directly from central banks, which, in turn, finance such borrowing by printing money. Unless private activity is depressed, even a fiscal expansion financed in a noninflationary manner (by issuing government paper, for example) will ultimately require a tightening of credit to the private sector to keep overall inflationary pressure under control. This is particularly important in PICs, as public sectors tend to be large and government borrowing can crowd out the private sector, undermining the objective in the region of private sector–led growth.

At an operational level, fiscal, and monetary authorities need to coordinate closely to maintain appropriate liquidity. While central bank operations should aim to maintain money supply at a level consistent with inflation objectives, fiscal authorities should provide central banks with forecasts of borrowing needs to ensure the availability of adequate liquidity. At the same time, there is considerable scope for PIC central banks to strengthen monetary projections and liquidity forecasts. Such projections can be challenging, however, given frequent exogenous shocks in the region. Actions by the large provident funds also have a significant effect on domestic liquidity, as noted earlier.

Experience in the region demonstrates the importance of prudent fiscal policy in maintaining price stability and promoting growth. Figure 12.12 shows that smaller fiscal deficits and lower public debt are generally associated with lower inflation among PICs and Caribbean countries. Moreover, inflation seems to vary less in countries with lower inflation, generating greater certainty for economic agents, as the smaller bubbles in Figure 12.12 show. Similarly, both lower fiscal deficits and public debt appear to be associated with higher economic growth.

Figure 12.12Fiscal Balance and Inflation, 2005–09

Source: IMF staff estimates.

Note: Blue bubbles indicate the following Caribbean countries: The Bahamas, Dominica, Grenada, Haiti, Jamaica, and Panama. PNG = Papua New Guinea. Bubble size indicates standard deviation of inflation.

Summary and Policy Implications

Recent experience in the global financial crisis highlighted the weakness of monetary policy transmission in PICs. In particular, interest rate pass-through—a channel to lower borrowing costs to boost economic activity—seems quite limited in some countries. On the other hand, the credit channel of monetary policy transmission appears to be stronger in some countries. That said, weak interest rate pass-through should not be interpreted as the total ineffectiveness of monetary policy in influencing commercial interest rates. This is because other factors could also offset the effects of monetary policy on commercial interest rates and credit growth.17

Nevertheless, cross-country variations in pass-through suggest that policy rates are poorly connected to money markets in some PICs. The inactive use of policy rates weakens their signaling effects and exacerbates the problem. Relatively weak monetary policy transmission through the interest rate channel is therefore unsurprising, especially given the region’s shallow money markets. During the global financial crisis, monetary easing in PICs was not supported by real exchange rate movements because domestic inflation was higher than in trading partners, and nominal exchange rate adjustments were avoided due to concerns about rapid inflation pass-through. This diminished the power of monetary policy to stimulate economic activity.

Development of the domestic financial markets should focus on strengthening monetary policy transmission in PICs. Measured by standard indicators, such as the ratio of broad money to GDP and the availability of financial products, domestic financial markets in PICs are relatively shallow compared with Caribbean countries. A deeper financial market would strengthen monetary policy transmission, not only through interest rate and credit channels, but also through other channels that are now likely very weak, such as those through asset prices and balance sheets that are effective only in sophisticated financial markets.

Better market infrastructure is critical to stronger monetary transmission. In many PICs, specific measures could include establishing credit reporting bureaus, secured transactions laws, and collateral registries. Countries need to strengthen the enforcement of credit contracts to ensure reliable and rapid resolution of defaults, bankruptcies, and disputes. And as market infrastructure improves, they can accelerate the development of financial products, such as commercial paper, corporate bonds, equities, and foreign exchange products.

While focusing on the development of domestic financial markets in the long term, policymakers need to expand the use of their toolkit in macroeconomic management. The ultimate objective of monetary policy—and those of other macroeconomic policies—is to achieve low and stable inflation and high economic growth. Achieving this, along with intermediate objectives such as protecting foreign reserves, calls for using all macroeconomic tools available and closely coordinating them, especially when monetary policy transmission is weak.

Exchange rate policy remains powerful for macroeconomic stabilization in PICs. Fixed exchange rates have provided a useful nominal anchor and policymakers should recognize this benefit. However, some exchange rate flexibility (that is, a band around a central rate) would help countries absorb the impact of frequent external shocks in the region. Monetary and fiscal policy adjustment without the support of exchange rate flexibility would require larger changes in domestic prices to restore external balances and could result in larger output losses. This flexibility could be extended to one-off devaluations of the central parity when inconsistent fiscal and monetary policies have made the fixed exchange rate untenable at its set level. Of course, each country should examine such considerations carefully for their feasibility and appropriateness.

Prudent fiscal policy is vital to macroeconomic stability in PICs. To maintain a credible fixed exchange rate, fiscal policy must ensure that government spending does not lead to higher inflation than in trading partners. Even when governments finance spending in a noninflationary manner, they still need to be mindful of crowding out private sector credit. Experience in PICs and the Caribbean shows that prudent fiscal policy pays off: lower fiscal deficits and lower public debt seem to be associated with lower average inflation and higher GDP growth. Moreover, lower fiscal deficits and lower public debt are associated with lower variability of inflation.

Annex 12.1. Estimating Interest Rate and Credit Pass-Through

We used an autoregressive distributed lags (ADL) model to estimate interest rate and credit pass-through. The model postulates the relationship between the policy rate and lending (deposit) rate as follows:

where lt= lending rate;

  • mt = time trend
  • pt= policy rate
  • εt = error term
  • α = parameters to be estimated

The long-term interest pass-through is measured by (α2 + α4)/(1 – α3).

Empirical studies use this type of ADL model widely to compare interest rate pass-through across countries (Cottarelli and Kourelis 1994; Moazzami 1999; Espinosa-Vega and Rebucci 2003; Guimarães-Filho and Ruiz-Arranz 2009; Pongsaparn 2010). Vector autoregression (VAR) is another popular model for the analysis of monetary policy transmission. However, the multivariable-VAR approach requires much more information and determination of the optimal lag length for each variable. Moreover, a VAR model with long lag structures would reduce estimation efficiency in small samples. The two-variable ADL model used here can be reparameterized as a VAR-type error-correction model without altering the estimated residuals.

The ADL model for estimating credit pass-through follows a similar structure by essentially replacing the lending rate with credit growth in equation (12.1.1).

Data used for the estimation were compiled from various internal IMF sources, which are often supplied by country authorities. For easy reference, the sources are as follows:

Fiji

Deposit rate (savings deposit rate): IMF, International Financial Statistics (IFS) database.

Lending rate (maximum commercial bank lending rate): IMF, IFS database.

Policy rate (bank rate, end of period): IMF, IFS database.

Private sector credit (monthly): IMF, Monetary and Financial Statistics database.

Private sector credit (annual): IMF staff estimates.

Excess reserves: IMF staff estimates.

Loan-to-deposit ratio: IMF, Monetary and Financial Statistics database.

Overall fiscal balance: IMF staff estimates.

Total government debt: IMF staff estimates.

Papua New Guinea

Deposit rate (weighted average): Country authority.

Lending rate (weighted average): Country authority.

Policy rate (bank rate, end of period): Country authority.

Private sector credit (monthly): Country authority.

Private sector credit (annual): IMF staff estimates.

Excess reserves: Country authority and IMF staff estimates.

Loan-to-deposit ratio: Country authority and IMF staff estimates.

Overall fiscal balance: IMF staff estimates.

Total government debt: IMF staff estimates.

Samoa

Deposit rate (weighted average): Central Bank of Samoa.

Lending rate (weighted average): Central Bank of Samoa.

Policy rate (bank rate, end of period): Central Bank of Samoa.

Private sector credit (monthly): Central Bank of Samoa.

Private sector credit (annual): IMF staff estimates.

Excess reserves: Central Bank of Samoa.

Loan-to-deposit ratio: Central Bank of Samoa.

Overall fiscal balance: IMF staff estimates.

Total government debt: IMF staff estimates.

Solomon Islands

Deposit rate: Central Bank of Solomon Islands.

Lending rate: Central Bank of Solomon Islands.

Private sector credit (monthly): Central Bank of Solomon Islands.

Private sector credit (annual): IMF staff estimates.

Excess reserves: Central Bank of Solomon Islands and IMF staff estimates.

Loan-to-deposit ratio: Central Bank of Solomon Islands and IMF staff estimates.

Overall fiscal balance: IMF staff estimates.

Total government debt: IMF staff estimates.

Tonga

Deposit rate (six months): National Reserve Bank of Tonga.

Lending rate (weighted average): National Reserve Bank of Tonga.

Private sector credit (monthly): National Reserve Bank of Tonga.

Private sector credit (annual): IMF staff estimates.

Excess reserves: National Reserve Bank of Tonga and IMF staff estimates.

Loan-to-deposit ratio: National Reserve Bank of Tonga and IMF staff estimates.

Overall fiscal balance: IMF staff estimates.

Total government debt: IMF staff estimates.

Vanuatu

Deposit rate (three months, representative): IMF, IFS database.

Lending rate (commercial advances, representative): IMF, IFS database.

Policy rate (discount rate, end of period): IMF, IFS database.

Private sector credit (monthly): IMF, Monetary and Financial Statistics database.

Private sector credit (annual): IMF staff estimates.

Excess reserves: IMF, Monetary and Financial Statistics database.

Loan-to-deposit ratio: IMF, Monetary and Financial Statistics database.

Overall fiscal balance: IMF staff estimates.

Total government debt: IMF staff estimates.

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This chapter was originally prepared as a paper for the 25th Meeting of South Pacific Central Bank Governors in Wellington, New Zealand, December 2–3, 2010. The authors thank the central bank governors and other participants for their helpful comments. Ray Brooks, Tubagus Feridhanusetyawan, Tarhan Feyzioglu, Simon Gray, Joji Ide, Papa N’Diaye, Runchana Pongsaparn, and Daranee Saeju provided valuable comments on an earlier version, published in Asian-Pacific Economic Literature.

1

The chapter covers the six PICs with their own currencies: Fiji, Papua New Guinea, Samoa, the Solomon Islands, Tonga, and Vanuatu.

2

Papua New Guinea is an exception. Its exports are dominated by minerals and petroleum, and the country’s current account deficit in 2009/10 was driven by large imports of goods and services for the construction of a large liquefied natural gas project.

3

Recent research has highlighted the importance of effective prudential supervision—as well as better regulation—in maintaining financial sector stability. In drawing lessons from the global financial crisis, Viñals and Fiechter (2010) argue that good supervision is “intrusive, skeptical, proactive, comprehensive, adaptive, and conclusive.”

4

Nevertheless, Fiji did decide to devalue its currency by 20 percent in April 2009 to arrest the decline of foreign reserves.

5

PFTAC (2010) also shows that the profitability of PIC banks’ interest operations, based on prudential data, appears to be in line with international norms, though overall profitability is higher than in comparable regions when all sources of bank income (not just interest income) are considered.

6

To the extent that other policy moves accompany policy rate changes, such as changes in reserve requirements, the estimated pass-though would reflect the combined effects of all simultaneous policy changes. This also applies to the estimates of pass-through from policy rates to private sector credit. For Tonga, the repo rate was used as a proxy for the policy rate. Pass-through rates could not be estimated for the Solomon Islands because there were no changes in the policy rate over time.

7

The results for Fiji seem to be consistent with the findings of Jayaraman and Choong (2009) that money supply is the most effective channel of monetary policy transmission. The low interest rate pass-through found here is also consistent with findings for developing economies in other regions. Dabla-Norris and Floerkemeier (2006), for instance, show that the interest channel of monetary policy transmission in Armenia is weak.

8

Given that short-term money market rates are probably more indicative of the monetary policy stance in PICs, it would have been useful to estimate their pass-through to bank lending rates and credit growth. However, data limitations precluded such estimation.

9

An examination of the effective lending rates or distribution of lending rates could shed light on this hypothesis, but data limitations preclude such an analysis.

10

Parent banks in Australia also experienced slower credit growth after the crisis, especially to the corporate sector for similar reasons—tighter credit standards and some corporate deleveraging.

11

Real lending rates were obtained by deflating nominal rates by the headline consumer price index. Ideally, a core inflation index should have been used, but these data are not available.

12

This subject may be worth a separate examination.

13

Of course, in making such comparisons one has to be mindful that, despite their smaller populations, Caribbean countries have high income per capita and are more integrated among themselves and with North American goods and financial markets because of greater geographic proximity.

14

The lack of foreign exchange products is predictable given the fixed exchange rates in most countries.

15

For an overview of various channels of monetary policy transmission, see Bank of England (2010) and Loayza and Schmidt-Hebbel (2002).

16

Jayaraman and Dahalan (2009) show that in Samoa, M1 and exchange rate channels are important in transmitting monetary impulses to output. In its exchange rate assessment of Fiji, IMF (2010) reports that a 1 percent real depreciation leads to a 4 percent increase in gross reserves. This suggests that most of the increase in reserves—excluding the special drawing rights allocation and the repatriation by Fiji National Provident Fund assets—since April 2009 was due to the devaluation.

17

For example, changes in risk premiums, including risk arising from policy interventions such as controls and restrictions, and the availability of investment opportunities.

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