VII The Central Banking Institution in an Extremely Open Economy

Charles Collyns
Published Date:
March 1983
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This section considers central banking institutions in countries with market-oriented economies, open to both trade and capital flows. As discussed in Section III, it may be very difficult in such countries to exert a strong influence on domestic interest rates or credit conditions. Moreover, successful export-led growth depends on foreign confidence in the continuation of the liberal trade and payments system and in the establishment of a stable monetary environment. To maintain such confidence, the central banking institution must be financially prudent; it must hold reserves, or at least have access to credit, sufficient to cover normal fluctuations in demand for domestic currency, and aim to restrict its own extension of credit to the increase in demand for its own liabilities. To provide some guarantee of such behavior, the central banking institution may be statutorily bound by restrictions on its fiduciary issue and on its lending to government.

A common feature of economies open to trade and capital flows is that the financial sector is an important focus of growth, often being a major source of foreign exchange earnings. As noted in Section III, success in this field requires the central banking institution to play a carefully judged regulatory role, designed to enhance confidence without stifling initiative. This active role contrasts with the more passive conduct of monetary policy.

Examples of central banking institutions in an open economy are provided by Singapore, Hong Kong, Kuwait, Saudi Arabia, and the United Arab Emirates. In Singapore, the fiduciary powers of the central banking institutions have been deliberately restricted but the regulatory powers of these institutions are extensive. In Hong Kong, the monetary authorities have limited powers and financial success has been achieved through almost unfettered entrepreneurship. Finally, in the oil exporting Gulf states, the strong fiscal position has led to a shift in responsibilities between the central banking institution and the government.

Singapore and Hong Kong

Since gaining independence, Singapore has combined an export-oriented development policy with fiscal conservatism and a stable political environment. Barriers to trade and to capital flows have been progressively removed; by 1978 exchange controls had been completely dismantled. Singapore has grown into a major financial center, and is now the largest external currency center in Asia. There are two main central banking institutions, the Board of Commissioners of Currency and the Monetary Authority of Singapore, set up in 1967 and 1970, respectively; proposed legislation that would bring the former under the auspices of the latter has yet to be enacted. The Board of Commissioners of Currency operates as a strict currency board, controlling the issue of the Singapore dollar subject to holding at least 100 percent foreign exchange reserve cover. The Monetary Authority of Singapore is responsible for the bulk of the central banking functions and has a wide range of supervisory and regulatory powers. Recently, however, the task of managing the country's foreign exchange portfolio has been transferred to a separate body, the Singapore Investment Corporation, which is intended to provide a more aggressive approach to foreign investment.

The monetary operations of the Monetary Authority of Singapore consist largely of recycling funds deposited by the Government into the commercial banking system through the rediscounting of bills and open market operations. In the past, the Monetary Authority of Singapore attempted to influence domestic credit conditions in line with macroeconomic policy objectives. This policy was bolstered by regulations intended to keep domestic and offshore markets distinct. Since 1975, domestic deposit and lending rates have been freely determined in the market and have followed the Singapore interbank rate, which in turn has followed the Asian dollar rate and, hence, world financial conditions. The Monetary Authority of Singapore has, for the most part, kept the rediscount and the treasury bill rates in line with these market rates, recognizing that a policy aimed at setting independent interest rates could not be sustained for long, given the ready domestic access allowed to international capital markets. After a period in which the Monetary Authority of Singapore attempted to steer domestic monetary aggregates along a target path, the current policy seeks to stabilize the exchange value of the Singapore dollar. This strategy is believed to be a more effective means to control inflation in a highly open economy, and is conducted through swap operations in the foreign exchange market.

The regulatory functions of the Monetary Authority of Singapore are directed at the promotion of the Singapore financial system. Entry into this system is limited by tiered licensing, which allows less than half of registered banks to conduct the full range of banking operations; other banks hold “restricted” or “offshore” licenses. The Monetary Authority of Singapore imposes a series of liquidity requirements on banks and finance houses, issues directives guiding their lending operations, and controls their nonbanking activities. It has also been instrumental in encouraging the development and diversification of the Asian dollar market. Not only are offshore operations released from liquidity requirements and eligible for considerable tax benefits, but, in addition, the Monetary Authority has been fully involved in setting up offshore markets for bonds, certificates of deposit, and commercial paper.

The experience of Singapore may be contrasted with that of Hong Kong. The economy of Hong Kong is very similar to Singapore's, but the former's colonial administration has been much less involved in financial affairs. Indeed, in Hong Kong, currency issue is performed by the two foremost commercial banks, the Hong Kong and Shanghai Bank and the Chartered Bank, which also act as lender of last resort, serve as banker to the government, and administer the interbank clearance mechanism. The range of functions entrusted to public institutions is limited and divided. The Commissioners of Banking and of Deposit-Taking Companies undertake the licensing, supervision, and regulation of banks and deposit-taking companies, respectively. The Secretary for Monetary Affairs takes responsibility for the management of official assets and liabilities, for the issue of coinage, for foreign exchange operations, and for relations with international monetary institutions.

Official monetary policy in Hong Kong was purely laissez-faire until the financial crisis in 1978. This crisis followed excessively rapid credit creation by the banking cartel, leading to a collapse in the value of the Hong Kong dollar. Since then, the Commissioner of Banking and the Secretary for Monetary Affairs together have attempted to restrain the growth of domestic credit. Their influence has been exerted primarily through moral suasion that encourages domestic interest rates to follow world levels more closely, in combination with closer supervision of financial operations. Neither open market operations nor discount rate manipulation are available in the absence of either government securities or central bank lending.

In Hong Kong, in strong contrast to Singapore, the monetary authorities have never been much involved in the promotion of the financial system. Even so, the financial development of Hong Kong has proceeded at a rapid pace. It is therefore interesting to observe the recent reorganization in Singapore, where the Monetary Authority is to take a less prominent part in guiding the evolution of the financial system and in supervising foreign branch banks.

Kuwait, Saudi Arabia, and the United Arab Emirates

The economies of Kuwait, Saudi Arabia, and the United Arab Emirates fall into a distinctly different category of open economy than those of Hong Kong or Singapore. They are dominated by exports of oil, which provide the countries with considerable world market power to influence their terms of trade. A basic feature of their rapid development over the last decade has been the rapidly increasing deployment of government oil revenues into domestic investment. Financial sectors have grown with the accumulation of financial wealth and the rising requirements for internal financial intermediation, and have been encouraged by governments seeking focuses for diversification. Access to world capital markets is effectively good: there are few restrictions on financial flows, while the substantial stocks of both financial assets and oil reserves imply that marginal shifts in net lending cannot much affect these countries' aggregate net worth or threaten their credit rating.

Kuwait and the United Arab Emirates both have Central Banks; Saudi Arabia, a Monetary Agency. These monetary authorities are legally entrusted with the issue of currency, the roles of banker to commercial banks and government, the regulation and promotion of the banking system, and the execution of monetary policy.

Of these roles, banking regulation is crucial to the development of these countries as financial centers, especially as all three countries are intent on local ownership and management of their financial institutions. In the United Arab Emirates, the Central Bank has only recently displaced a currency board, endowed with little regulatory power, following a banking crisis arising from rapid financial expansion and speculation against the domestic currency. This new institution has applied a minimum restriction on the capitalization of domestic commercial banks, and has required banks to accumulate out of their profits a reserve fund, the value of which should be at least 50 percent of capital. Commercial banks must provide the Central Bank with extensive information on their operations and establish proper auditing facilities. The government intends to establish a separate Credit Risk Bureau charged with monitoring local lending to support this supervision. Kuwait and Saudi Arabia have also taken steps to strengthen monitoring and enforcement procedures. A particular problem now being faced in all three countries is set by the money changers, whose activities have extended beyond their eponymous role but have hitherto been unregulated. The authorities are taking steps to restrict licensing, to limit the range of activities undertaken, and to establish proper monitoring facilities; but whether such controls can be effective in a traditionally informal business sector remains to be proven.

In all three countries, the role of banker to the government is relatively limited. Given the substantial budgetary surpluses, governments have not required loans from their bankers; rather, they must determine the allocation of their accumulated financial resources between central bank deposits and other uses. In the United Arab Emirates, deposits with the monetary authority claimed a particularly small percentage of government assets in the past, although this proportion has now risen to around 50 percent following the establishment of the Central Bank, as the individual emirates hold considerable foreign assets on their own account. In Saudi Arabia, government financial resources are recycled into the domestic economy via the five government-owned, specialized credit institutions which provide long-term credit to priority sectors at highly concessional rates; the amount of this credit is, in fact, about double the total of commercial bank funds made available to the private sector. The Saudi Arabian Monetary Agency itself receives government deposits intended for investment abroad. In Kuwait, government funds reach the domestic economy at concessional rates both via three specialized banks and via the combined intermediation of the Central Bank of Kuwait and commercial banks—the Central Bank provides cheap rediscounting facilities to subsidize commercial bank lending, and is itself financed by government deposits and subsidies.

In these countries, monetary policy has attempted to influence domestic financial conditions. The Central Bank of Kuwait is empowered to limit the lending rates of domestic banks and has imposed low ceilings relative to those rates obtaining elsewhere and to uncontrolled deposit rates. This action is consistent with Islamic law, which prohibits interest payments, and also reflects a desire to encourage local investment. Narrow, even negative, spreads between savings, deposit, and lending rates are feasible for commercial banks receiving a high proportion of deposits as non interest-bearing demand deposits and having access to low-cost central bank credit. Saudi Arabia and the United Arab Emirates both impose ceilings on some deposit rates of interest. Given the minimal controls on capital mobility, these policies have led domestic wealth holders to invest a substantial portion of their portfolios offshore, as well as in foreign currency-denominated deposits with domestic banks bearing internationally competitive returns. In consequence, domestic monetary aggregates do not fully reflect the total money balances held by residents.

An implication of these arrangements is that the governments of these countries have more influence on domestic credit conditions than do the monetary authorities. It is up to the government to decide how much to deposit with the monetary authorities and the extent of credit subsidies; these decisions determine how far the monetary authorities and other specialized institutions can expand domestic credit and at what price. In addition, the government domestic budget deficit, that is, government revenue from domestic sources less government domestic expenditure, is the main source of increase in privately held wealth.19 To the extent that this wealth is placed in domestic bank deposits rather than being spent on imports or deposited abroad, it provides the commercial banks with funds to expand their own credit.

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