IV Development of Monetary Instruments and Financial Markets
- Jean-Pierre Briffaut, George Iden, Peter Hayward, Tonny Lybek, Hassanali Mehran, Piero Ugolini, and Stephen Swaray
- Published Date:
- October 1998
In the early stages of economic development, central banks typically rely on direct instruments of monetary policy, notably credit controls and controls on interest rates. With these instruments, they attempt to control directly the balance sheets of commercial banks. When countries move to a market-based system, central banks rely on indirect instruments to influence the level of bank reserves through financial markets. The main indirect instruments are reserve requirements, lending facilities such as a rediscount facility or a Lombard facility, and open market operations. With indirect instruments, central banks influence the levels of bank reserves by buying and selling securities, particularly government or central bank securities. In the beginning stages, before financial markets are active and deep, it is generally necessary to rely on “open market–type” instruments, such as auctions of treasury bills. Later, when a secondary market develops, central banks can buy and sell securities either outright or through the use of repurchase (repo) and reverse repurchase (reverse repo) agreements.9
The countries of sub-Saharan Africa have made some progress in developing their instruments of monetary policy and their financial markets. Most of the countries in the study have liberalized interest rates and are shifting from direct to indirect instruments of monetary policy.
In Table 3, the countries have been classified into three groups according to the stage of development of their instruments of monetary policy and of their markets for government or central bank securities. More detailed information on each of these countries is provided in Appendix I, Tables A5, A6, and A7.
|Group I||Group II1||Group III|
In this group, some countries are more advanced than others.
In this group, some countries are more advanced than others.
Group I Countries
Countries in Group I continue to rely primarily on direct instruments of monetary policy, either credit or interest rate controls or both. Their financial markets are small and underdeveloped. Essentially, there is no active primary or secondary market for government securities in these countries. Interest rates, which tend to be somewhat regulated, are often negative in real terms.
The main challenges facing Group I countries are privatizing commercial banks, fully liberalizing interest rates, and developing a primary market for treasury or central bank bills with which to conduct open market–type operations. The broad challenge is to free markets of controls and to substitute market processes for administrative solutions. In this regard, central banks will need to develop market-type auctions for issuing government or central bank bills and for allocating refinance credit to banks. Also, central banks in these countries need to gradually develop the capacity to gather, monitor, analyze, and project important information, including especially bank reserves, credit, and broad money. In allowing markets to begin functioning, central banks will need to develop the capacity to regulate and supervise banks.
In this group, Mozambique has recently liberalized interest rates—an important step in the transition to indirect instruments. Also, the Bank of Mozambique reduced the reserve requirement to 15 percent from 25 percent in early 1996 and to 12 percent in 1997. This will help reduce the spread between bank deposit and lending rates. As a way of absorbing the liquidity from these reductions in the reserve requirement, the authorities have begun issuing treasury and central bank bills. However, the primary market—including, in particular, auctions—still needs to be developed. While the Bank of Mozambique is developing its indirect instruments, it continues to use bank-by-bank credit ceilings in a “belts and braces” approach to monetary policy implementation.
Ethiopia, in contrast, has introduced treasury bill auctions, but its financial sector is dominated by a government-owned commercial bank, which accounts for about 80 percent of total banking sector assets. In view of the lack of a level playing field owing to the quasi-monopoly position of the bank, it is very difficult to foster competition and interbank market activities and, ultimately, full implementation of indirect instruments of monetary policy.
Group II Countries
Group II countries have made good progress in developing indirect instruments of monetary policy, and there is some limited secondary market activity in government securities. They have liberalized financial markets, and interest rates are free of controls. Some of them also have stock markets. This group is very diverse and includes members of the WAEMU and the CAEMC.
In general, the countries of Group II are placing increased emphasis on indirect instruments, including the use of open market–type operations. However, they have generally not yet developed full-fledged secondary markets or full open market operations involving buying and selling government or central bank securities as a means of exercising close control over bank reserves. These countries are in the process of developing repo operations for short-term monetary management. They are also developing systems to organize activity in the secondary market and to provide underlying support for the primary market. Most of them are considering the creation of a primary dealer system. With this system, some of the most active dealers are invited to become primary dealers, with special responsibilities and privileges. One of the main responsibilities of primary dealers is to make a market for government or central bank securities and to participate on a regular basis in the primary auctions for these securities.
Most of the countries in Group II are in transition from a paper-based system of government or central bank securities to an electronic book-entry system; others have already shifted to a book-entry system (Malawi and Zambia). The book-entry system holds the potential to simplify and greatly speed up trading and to facilitate secondary market activities. In this regard, improvements in the payments systems become crucial, so that clearing and settlement can be made fast and reliable.
The experiences of Ghana, Tanzania, Uganda, and Zimbabwe are representative of the more advanced countries of Group II. In Ghana, the transition to an indirect system of monetary control was gradual. In 1989, as a first step, the banking system was improved and banking supervision was strengthened. Gradually, the reserve requirement was also strengthened, and open market–type operations were begun. Interest rates were liberalized, and credit controls were lifted. A stock market was established. Currently, money market financial instruments or securities are traded through weekly auctions at the Bank of Ghana. Auctions are open to banks, discount houses, and selected brokerage firms. However, the secondary market for government and Bank of Ghana securities remains very thin. Some work has gone into the development of repo operations, including drafting of a master repurchase agreement, but so far the Bank of Ghana does not actively use them.
A contributing factor to the lack of activity in Ghana's secondary market is the relatively high liquid asset requirement (35 percent of deposits), which creates a captive market for government securities. However, with real interest rates relatively high at present, the liquid asset requirement may no longer be needed to induce banks to hold government securities.
A primary dealer system has recently been established; however, the primary dealers are not formally obligated to make a market for securities, which is crucial to the development of the secondary market. Also, at this stage, primary dealers are paid a subsidy for selling treasury bills to the public, which is not a usual feature of a well-functioning primary dealer system. In addition, the Bank of Ghana has made considerable progress in developing a book-entry system for treasury bills.
Ghana has put in place many of the building blocks needed for an active and efficient money market. Nevertheless, money markets are still rudimentary. Also, interest rates on auctioned government and central bank instruments tend to remain constant over long periods. Thus, interest rates frequently do not convey much useful information about market conditions. In the absence of active secondary markets, the Bank of Ghana controls the money base primarily by adjusting the net amount of treasury and central bank bills issued each week.
Since the early 1990s, Tanzania has made good progress in liberalizing interest rates and making the transition from direct to indirect instruments of monetary policy. Interest rates have been fully liberalized, and the Bank of Tanzania uses a variety of indirect instruments of monetary policy. In particular, it conducts regular auctions of treasury bills (182–364 days) and occasionally auctions its own bills. It maintains a reserve requirement of 10 percent of deposits, including foreign currency deposits, and a liquid asset requirement of 20 percent of deposits. As yet, the secondary market for government securities has not developed, which severely constrains open market operations. Tanzania is planning to adopt a book-entry system for government securities and to develop a primary dealer system or some other approach to organizing the secondary market.
In Uganda, the level and structure of interest rates were administered by the Bank of Uganda until 1992. Real interest rates were negative during much of the 1980s, but in 1992 Uganda liberalized interest rates and began shifting from direct to indirect instruments of monetary policy. Since April 1992, the Bank of Uganda has relied on treasury bills as an instrument of monetary policy, with weekly auctions, using a multiple-price method (see also Sharer and others, 1995, especially Section VI). It regularly publishes auction announcements and results, as well as the rediscount rate, the bank rate, and the weighted-average lending rate in the very thin interbank money market. Recently, it modified its reserve requirement to allow averaging over a two-week maintenance period to enable banks to improve their liquidity management. A rediscount facility is also available, with the rediscount rate tied to a moving average of the yield on 91-day bills plus a margin.
At present, however, Uganda has no repo facility and essentially no secondary market for government securities. In April 1997, the government in conjunction with the Bank of Uganda moved from order- to bearer-type treasury bill certificates to promote the transferability and marketability of the treasury bill instrument. However, buyers view the bearer certificate as too risky and subject to fraud, which runs contrary to one of the objectives of improving transferability and thus promoting secondary trading of the instrument. A book-entry system, developed by the IMF's MAE Department, is being considered to address the issue of payment and settlement of government securities.10
Recently, the Bank of Uganda began issuing (occasionally) its own bills to enhance short-term liquidity management, but the experience has been mixed. There have been five issues since February 1997, and all have been undersubscribed. Authorities attribute the weak demand in part to the short notice given to banks. In addition, the Bank of Uganda does not discount its own bills.
Zimbabwe's monetary instruments are also among the most developed of Group II countries. In particular, the country relies entirely on indirect instruments, and its open market operations include some transactions in the secondary market. It has a relatively well developed interbank market and an active stock exchange. Some of the current issues or challenges facing Zimbabwe include introducing repo and reverse repo operations for more refined liquidity management. Also, Zimbabwe is introducing a system of primary dealers, comprising the former discount houses and the banks, and is implementing a book-entry system.
Zambia's experience is interesting from the point of view of a smaller country in the region. It has managed to make considerable progress in developing monetary management capacity by increasingly relying on market mechanisms, despite its small size. The Bank of Zambia conducts weekly auctions of treasury bills and auctions repos and Bank of Zambia term deposits. In July 1994, it established a special sterilization account for the proceeds of treasury bills sold for monetary policy purposes. The Bank of Zambia maintains a relatively high liquidity requirement, although recently it has come down to 38.5 percent of liabilities from 43.5 percent. The secondary market for treasury bills is still small and relatively inactive. An automated book-entry system, however, was introduced in August 1997. Some work has gone into developing a primary dealer system; however, selection of an appropriate group of dealers has proved to be difficult, in part because of political considerations.
Countries in the WAEMU, which were formerly French colonies, have not made much progress with indirect instruments; the same applies for the CAEMC countries. The countries in each group share a common currency, the CFA franc, which is pegged to the French franc. Monetary policy is conducted by the BCEAO and the BEAC at the regional level. Because of the exchange regime, there is little room for the two regional central banks to exercise any type of independent monetary policy—monetary policy is determined by the exchange rate policy. During 1989–93, the BCEAO and the BEAC shifted from direct to indirect instruments of monetary policy. Currently, they rely primarily on operations in the money market and reserve requirements to control money and credit. By having a regional interbank market for central bank securities and refinance credit, these two banks have a number of advantages that would not be possible for some of the smaller members individually. In particular, the regional financial market increases the number of potential participants, making competitive conditions possible. However, the banking system continues to suffer from chronic excess liquidity in part because of the easy access of banks to the standing facilities. In turn, because of the excess liquidity, banks have little incentive to become active in the interbank market. There is mutual excess liquidity, which is not used because of a lack of demand for credit. (For more detail, see Clément and others, 1996, especially Annex III.)
Group III Countries
Only two countries are in Group III: Kenya and South Africa. Kenya embarked on financial liberalization and conversion to indirect instruments during the late 1980s. In 1991, it abandoned credit ceilings and liberalized interest rates. However, Kenya's progress was interrupted by a period of relatively high inflation. Although inflation has since come down, there is still not much demand for longer-term government securities. Moreover, government debt accumulated from the 1980s contributes to high real interest rates. However, the Central Bank of Kenya has shifted completely from direct to indirect instruments of monetary policy. Even so, there is still very little activity in, or development of, the secondary market for government securities. The authorities are also at the stage of adopting some system of primary dealers, while government securities have been dematerialized and a book-entry system introduced. In July 1997, the Central Bank of Kenya introduced a two-way repo operation, and it and several commercial banks have signed a master repurchase agreement.
South Africa, in addition to liberalizing its financial markets and developing indirect instruments of monetary policy, relies heavily on open market operations and has a well-developed secondary market for government securities. In particular, financial markets are active and modern in South Africa, providing a strong basis for conducting open market operations. South Africa is the leading member of the Common Monetary Area and plays a key role in determining monetary policy in the region.11 Johannesburg is a major regional financial center, and its stock exchange is relatively active and sophisticated. The South African Reserve Bank uses a range of indirect monetary instruments, which it continues to add to and refine. In particular, since early March 1998, it has used repo operations much more actively than in the past, when legal uncertainties hindered their use. In addition, South Africa is introducing a modern, large-value gross settlement system as a means of improving the payments system. In March 1998, the South African Reserve Bank replaced its rediscount facility with a marginal or Lombard-type facility that offers overnight credit at penalty rates.
Obstacles to Transition to Indirect Monetary Instruments and Market Development
Practically all of the countries of sub-Saharan Africa now want to adopt indirect instruments of monetary policy and develop their financial markets. What then is preventing or slowing their progress? The obstacles are many and varied. In some countries, they include the small size of financial markets, the limited number of commercial banks, and the absence of fully commercial behavior by commercial banks—in part because of continued state ownership and control. In addition, in many of the countries, banks have relatively large portfolios of nonperforming loans. These loans contribute to the segmentation of the market, because healthy banks are unwilling to lend to weak ones. Moreover, inadequate information on banks, because of poor accounting, exacerbates such problems. These factors, and the long delays by the authorities in dealing with insolvent banks, create in many sub-Saharan African countries the suspicion, though sometimes erroneously, that all banks other than the reputable foreign ones are to some extent in financial difficulties.
Lack of Interbank Market
Largely as a result of the obstacles described, and the risk associated with lending to insolvent banks, interbank market activities in sub-Saharan Africa are very thin and confined to a few, mostly foreign, banks. While interbank market activities are essential for the development of capital markets in these countries, overnight and weekly interbank interest rates are also better indicators of short-term market conditions than are daily movements in bank reserves. Without an active interbank market, most of the countries are heavily handicapped in their short-term monetary policy intervention.
Lack of Securities Portfolio
In many sub-Saharan African countries, government deficits either are not now under control, or were not under control sometime in the past, thereby leaving a large stock of government debt. Typically, large fiscal deficits have to be financed by the central bank, which for some of these countries is the only alternative because markets for government securities are undeveloped. The monetization of these deficits leads to inflation, which in itself is an obstacle to the development of markets for debt instruments. Even if fiscal policy is now prudent and inflation is under control, the large stock of government debt acquired in the past contributes to high real interest rates.
Because of such issues as large fiscal deficits or the unlimited access of banks to lending facilities, the financial systems in many of these countries suffer from excess liquidity, and central banks face common obstacles in sterilizing such liquidity. One such obstacle is that central banks may not have an adequate portfolio of government securities with which to perform open market operations in order to absorb the liquidity. Acquiring a suitable portfolio of government securities for this purpose requires coordination and support from the ministry of finance, which may be difficult to achieve because of political considerations. Another common strategy for absorbing liquidity is for the central bank to issue its own securities or for the central bank to offer a deposit facility to banks. This strategy can, however, be costly to the central bank and can threaten its financial stability. In principle, therefore, government should stand ready to back the central bank in its monetary operations, but in practice sub-Saharan African governments are reluctant to do so because they look on the central bank as a source of revenue rather than as a drain on the budget.
Inefficient Payments System
In most of sub-Saharan Africa, the inefficient payments system represents a major impediment to same-day, or short-term, settlement among investors and hence reduces the liquidity of the securities. In addition, the large float generated by inefficiencies in the payments system, coupled with the lack of an active interbank market, forces commercial banks to hold large excess reserves in their current accounts with the central bank in order to avoid the stiff penalties for noncompliance with the daily clearing settlement. The existence of a large and erratic float is one of the major impediments to the transmission of monetary policy signals (see Ugolini, 1996).
Absence of an Automated Book-Entry System
An automated book-entry system is becoming essential in those sub-Saharan African countries that have large volumes of securities to auction or roll over on a continuous basis. Such a system facilitates the collection of statistics and information on the ownership, maturities, payments, and movements of securities. In addition, it greatly facilitates secondary market activities. In several countries that do not have such a system, IMF missions have encouraged its introduction to facilitate fully collateralized interbank market activities as well as quick settlement of delivery-versus-payment activities in the securities market (Kenya, Malawi, Uganda, Zambia, and Zimbabwe). Through this system, commercial banks will be more willing to engage in interbank market activities with other banks, independently of their solvency status, as long as banks have securities to offer as collateral. An automated book-entry system also reduces the risk of loss or theft and, ultimately, generates savings by eliminating the cost of printing high-quality securities certificates and of moving bills from place to place.
Reserve Requirement and Liquid Asset Ratios
Some of the countries in the region stipulate high reserve requirements, such as Angola (40 percent of deposits), and high liquid asset requirements, such as Ghana (35 percent of deposits). The former operates as an implicit tax, adding to the spreads between deposit and lending rates and thereby retarding investment. Reserve requirements, while contributing profits to the central bank, raise the costs of financial intermediation and thus contribute to financial disintermediation. This often results in the growth of the “informal” financial sector, which is typically large in these countries.
High liquid asset requirements are frequently adopted to create or strengthen the demand for government debt. However, such regulations tend to segment the market and retard the development of the secondary market for treasury bills by creating a captive market for securities. Moreover, in the face of high real interest rates on government securities, liquid asset requirements become inoperative because commercial banks will willingly invest in government debt anyway. This development crowds out the private sector, eroding investment and hence growth. Ultimately, liquid asset requirements should not be used as a monetary policy tool. Indeed, their usefulness is somewhat justified only as a prudential requirement at the very early stages of development of a supervisory framework in the financial sector.
Absence of a Primary Dealer System
It is easier to establish an active secondary market for government and central bank securities if a primary dealer system is in place. There are common obstacles to establishing a primary dealer system in sub-Saharan African countries. The main one, which is political, involves choosing the financial institutions that are the strongest and most active in the market for government and central bank securities. Local financial institutions are not frequently in this select group because they tend to be less well capitalized and are overburdened with relatively large portfolios of nonperforming loans. In addition, investors may not trust the smaller, local institutions with transactions. The authorities thus often face a political dilemma in deciding on the composition of the primary dealer group.
Box 2.Main Recommendations on Development of Monetary Operations and Financial Markets
Supporting actions and conditions. Create a level playing field in the financial sector. Eliminate the monopoly of large government-owned banks, restructure and recapitalize banks, deal with bad loans, and strengthen banking supervision. The need for these supportive conditions may require a number of concomitant reforms and a gradual “belts and braces” approach to the transition to full reliance on indirect instruments.
Financial markets. Liberalize financial markets. Interest rates should be market-determined and free of controls. There should be no controls on bank lending and deposit rates. Interest rates on treasury bills and central bank bills should be determined in the market.
Reserve requirements. Cash reserve requirements should be uniform to facilitate liquidity projections, and banks should be allowed to meet the requirement on an average basis during the maintenance period. Reserves should not be used as the sole instruments of monetary operations, but should be used only to adjust to trends and patterns. They should be kept low so as not to increase spreads between lending and borrowing rates. (In the short run, the appropriate level depends on monetary conditions and the range of monetary instruments that are available.) Where reserve requirements cannot be kept low, consideration should be given to remunerating them. In parallel, noncompliance with the requirement should be subject to penalty at an applicable rate that is the highest in the market.
Liquid asset requirement. Lower the high asset requirement in many sub-Saharan African countries because this is typically a prudential requirement. Therefore, in the medium to long term, appropriate prudential requirements may be needed to replace the liquid asset requirement.
Open market–type operations. These operations are conducted at the initiative of the central bank (open market operations) and differ from those conducted at the initiative of the banks (standing facility; see below). With respect to the former, there should be an active primary market for treasury or central bank bills, with regularly scheduled auctions that are run professionally and transparently. Central banks should have the capacity to conduct outright purchases and sales of securities to adjust flows of liquidity and repo (and reverse repo) operations for fine-tuning short-term operations. The central bank should also have a portfolio of high-quality securities with which to conduct reverse repo operations or to sell directly in the market to mop up liquidity when needed.
Standing facility for banks. The central bank needs to maintain a collateralized short-term lending facility for banks at the banks' initiative, such as an overnight Lombard facility. The terms should be higher than in the treasury bill market or the interbank market. Banks would thus have the incentive to participate first in the interbank market and would have less opportunity to make risk-free profits by borrowing from the central bank to invest in treasury or central bank bills.
Reserve money programming. The central bank should also be able to monitor and project banks' reserves and the main factors influencing reserves. As a corollary, it should be able to coordinate its various instruments of monetary policy to achieve specific targets for bank reserves.
Development of secondary market for government securities. In general, the ultimate stage involves full-scale development of the secondary market for government securities. Development at this stage usually involves adopting a primary dealer system to facilitate market-making and to ensure that there will be adequate demand for government or central bank securities in the primary market. An automated book-entry system could also greatly facilitate and enhance delivery versus payment, interbank market activities, and open market operations (of the central bank). However, it may not be feasible to develop an active secondary market, in which case the central bank could be prepared to conduct open market–type operations through repos and reverse repos, rather than through outright purchases and sales. An active repo and collateralized interbank market can be an effective substitute for a secondary market and may be possible to develop at a lower cost.
Large Interest Rate Spreads
Most of the factors that impede the full use of indirect instruments of monetary policy and the development of interbank market activities also contribute to the large spread between deposit and lending rates offered by commercial banks in sub-Saharan Africa.
The spread is the result of the quasi-monopolistic role played by large banks, mostly government-owned, that are burdened with nonperforming loans and other operating inefficiencies. If the implicit cost of holding large unremunerated cash reserves and excess reserves for clearing and payments is added to this cost, and if one considers the risks involved in lending to borrowers with limited collateral, the courts' inefficiency in collecting nonperforming loans, and, ultimately, the profit margin of the investors, it is not surprising that the spread between deposit and lending rates is often very large. These spreads can be between 10 and 25 percentage points depending on the country. Typically, the large spreads make domestic instruments very expensive, and hence unattractive, and discourage financial intermediation and savings.
Lack of Communication and Information
Too little communication between the central bank and commercial banks—which is more of a problem in less developed systems—is an obstacle to effective policy development and implementation. In most sub-Saharan African countries, the monetary authorities do not send clear signals about the monetary policy direction of the country, and commercial banks are, at times, confused by the policies of the central bank. Although there is usually a bankers' association that can aid communication, the association may be divided between the stronger banks—often the foreign banks—and the weaker domestic banks, which tend to be isolated and less vocal. There is also often a dearth of information available to the public, such as on interest rates and volumes in markets.
Areas for Further Reform
For sub-Saharan African countries to make the ultimate transition to indirect instruments and to develop financial markets, they must make progress on a number of fronts simultaneously: get fiscal policy under control, restructure banks so that essentially all banks have adequate capital, acquire the means to mop up excess liquidity, and modernize the payments system (see Box 2, page 21).