V Agenda for Action to Enhance Monetary Policy Effectiveness

Bernard Laurens
Published Date:
December 2005
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This section discusses broad guidelines for addressing the obstacles to reliance on money market instruments which are drawn from this review of country experiences. The case studies (which are included in Part II) confirm that there is no single way to proceed with reforms, but they also suggest some broad guidelines that may be useful to policymakers in all countries who are designing an agenda for action to enhance monetary policy effectiveness. For countries with a potential for market diversification, the objective is full dependence on open market operations for the liquidity management function of monetary policy. For countries that cannot expect to establish diversified financial markets, the objective is to reach a stage where they can rely on a combination of open market–type operations and rules-based instruments, with the latter still playing an important role in liquidity management.

Curtailing Fiscal Dominance

The chances for a successful reliance on money market operations are dependent on the establishment of a sound financial relationship between the central bank and the government. For countries with a history of fiscal dominance, the main challenges during the transition to reliance on money market operations relate to curtailing the ability of the government to rely on the direct credit of the central bank.1 In the case of countries with shallow markets, the central bank has continued to act as banker to the government. This has frequently involved the provision of direct credit from the central bank to finance the budget deficit. In a number of countries, the central bank has been unable to control its balance sheet because of excessive reliance by the government on the credit of the central bank, which has led to injections of liquidity into the system which the central bank could not absorb through money market operations due to the limited development of markets. In such cases, the central bank’s only options are administrative measures or moral suasion to limit the adverse effects of these operations on its balance sheet.2 Therefore, until the government is able to fund its operations in the market, the coordination of monetary and fiscal policy should rely on a joint exercise between the central bank and the treasury aimed at setting a binding limit on the ability of the government to obtain funds from the central bank.

Participation in a monetary union, particularly for small countries, can help the coordination of monetary and fiscal policy but does not guarantee fiscal discipline.3 First, in any monetary union, fiscal virtue is critical to mitigate the risk of an undesirable policy mix between member countries’ decentralized fiscal policies and the union’s centralized monetary stance. Therefore, monetary unions lead naturally to arrangements that foster fiscal discipline and policy coordination, such as fiscal convergence benchmarks. Second, in small countries, the central bank may have special human and technical resources to develop an institutional capacity for advising member countries’ fiscal authorities or for developing and monitoring the fiscal convergence benchmarks, both of which facilitate the coordination of fiscal and monetary policy. However, a monetary union does not guarantee the achievement of a sustainable fiscal policy. Key to the effectiveness of any framework is the willingness and ability of members to abide by its requirements (Box 5.1).4

Box 5.1.Fostering Fiscal Discipline in the Eastern Caribbean Currency Union

In the Eastern Caribbean Currency Union (ECCU), the central bank was instrumental in helping the governments institutionalize a framework to coordinate monetary and fiscal policy. Furthermore, against the background of deteriorating budgetary positions and uncertain economic prospects for ECCU members, the Eastern Caribbean Central Bank has designed a set of policy rules in the form of fiscal benchmarks to ensure the ECCB’s long-term sustainability, similar to those instituted in the monetary unions in Europe and West and Central Africa. However, the effectiveness of the benchmarks will not be ensured until they are considered by national authorities to be binding and enforcement mechanisms are in place to ensure compliance.

Market-based funding of the government, however, does not necessarily eliminate the potential for fiscal dominance.5 In particular, large sales of government securities to finance a fiscal deficit may lead to rising interest rates, which in turn may result in pressure to reduce the volume of securities issued and instead to monetize the fiscal deficit. To overcome these difficulties, governments should institute programs of fiscal control. Reduced deficit levels not only ease the strains between the monetary and fiscal authorities but also reduce the need for the central bank to monetize the fiscal deficit and thereby enhance the chances for successful monetary policy.

In addition, early in the development of a government securities market, it may not be feasible to completely eliminate direct central bank credit to the government. Maintenance of an overdraft facility also may be warranted until the government has gained sufficient confidence in running a public debt program and until the market has reached an adequate degree of maturity. Any such overdraft facility should be properly designed, however: it should be remunerated at a market rate, and limits should be established to ensure that it operates as a “safety valve” rather than as a permanent source of funding. During this intermediate period, it is desirable to maintain close communication between the monetary and fiscal authorities about policy formulation as well as to establish formal channels for balanced coordination, including appropriate safeguards to ensure that fiscal policy does not dominate the conduct of monetary policy. Balanced coordination between monetary and fiscal policies can be improved by the establishment of coordination committees, which provide a means for policymakers to learn about one another’s objectives and operating procedures and to help build consensus on how to conduct macro policies in a market-friendly manner. Such channels for communication are likely to be necessary until such time when fiscal policy is responsive to market discipline.6

Finally, in day-to-day policy implementation, government cash management and central bank liquidity management should be closely integrated. Indeed, early in the process of developing a market-based strategy for funding the fiscal deficit, markets may be thin, with few maturities and with most of those concentrated at the short end. This can constrain the use of fiscal and monetary policy in different areas of the market—the central bank typically interacts with the short end of the market, and the fiscal authorities typically raise funds on the long end. This makes it crucial that government cash management is closely coordinated with the central bank liquidity management exercise.7 When markets deepen and become more liquid, it becomes feasible to consider separating the two activities.8

Dealing with a Structural Liquidity Surplus

In shallow markets, reliance on money market instruments is facilitated when the central bank conducts the bulk of its market operations in the form of liquidity-providing operations.9 This reduces the scope for collusion or overshooting, even when the central bank’s money market operations are not yet fully effective, because the banking system needs to borrow from the central bank. Therefore, in the short term, the central bank can achieve a particular liquidity objective and still control the interest rate at which it lends to the system, for instance, by using a volume tender. However, when the central bank needs to withdraw liquidity from the system through a market-based instrument, it may not be able to achieve its quantitative objective at a preset interest rate, as it would with use of a volume auction, because the banks have multiple choices for asset allocation. The central bank would need to rely on interest rate auctions to ensure that it withdraws the desired amount of liquidity from the system and would thus face the risk that auction interest rates, and thereafter market rates, may overshoot.

The central bank can rely on rules-based instruments in the early stages of market development to force banks to borrow from the central bank.10 This can be achieved by using reserve requirements to create a liquidity shortage in the system.11 However, reserve requirements need to be designed in a way that limits the potential for market distortions; in particular, the required reserves (in the form of deposits with the central bank) should be remunerated at a rate that is in line with market rates, particularly if the reserve ratio is high. In the early stages of interbank market development, banks may be allowed to satisfy reserve requirements by holding securities issued by the central bank for monetary policy purposes.12 This creates a captive market for such securities (which would be issued to mop up excess liquidity) and thereby facilitates the introduction of auctions for the sale of the securities, in turn fostering market development (Box 5.2).

Whichever framework is adopted, the costs associated with sterilization operations, which reflect the cost of conducting monetary policy in this particular macroeconomic context, are ultimately a fiscal problem. The central bank can use a variety of operating procedures to borrow funds from the market. In some cases, the government allows the central bank to issue government securities, with the proceeds blocked in an account at the central bank, which means that the cost of mopping up liquidity is borne directly by the government. The central bank may also issue its own securities or accept deposits from the banks; in both cases, related costs are borne by the central bank. However, those costs may exceed the profitability of the central bank and may even lead to large losses for the central bank. In such cases, it is crucial to have arrangements in place to ensure that any central bank losses are passed on to the government in a timely manner. Otherwise, there is the potential for profitability considerations to take precedence over monetary policy considerations, for example, if the central bank were to limit its sterilization operations to preserve its profitability. There are various arrangements to ensure that sterilization costs exceeding the profitability of the central bank are reflected in the fiscal accounts. These include issuing government securities for monetary policy purposes, providing compensation from the budget to the central bank to cover any sterilization costs borne by the central bank, or ensuring that the losses incurred by the central bank are compensated by a fiscal surplus, in order to balance a consolidated budget for the central bank and the government.13

Box 5.2.Measures to Limit the Distortionary Effects of Rules-Based Instruments

Weak market infrastructure can obstruct the use of money market instruments in various ways. With a limited number of participants, cartels or collusion may prevent markets from reflecting the true equilibrium conditions that would be observed in a market with wider participation. In addition, moral suasion exercised on public banks may weaken competition and undermine market determination of interest rates. Finally, in shallow markets, large-scale sterilization operations in response to capital inflows may put upward pressure on market interest rates, in turn creating incentives for further capital inflows.

To limit the distortionary effects of rules-based instruments, the central bank needs to minimize its burden on the banking system and its impact on the allocation of resources. Required reserves should be remunerated, particularly if the reserve ratio is high, and the remuneration rate should be in line with market rates and consistent with the other central bank policy rates (see Table 4.1). A system in which reserve requirements can be satisfied, at least in part, by holding securities issued by the central bank for monetary policy purposes is a superior alternative to a system in which reserve requirements can be satisfied only by holding deposits with the central bank. Indeed, such a mechanism, by creating a captive market for the securities, helps support the use of money market instruments to conduct monetary policy and thereby fosters market development.

Establishing Efficient Money Markets

An efficient interbank market in which banks can trade short-term instruments is a prerequisite for reliance on money market instruments. The first consideration is the appropriate number of market participants needed to ensure market efficiency. While there is no firm evidence, the experience gathered in the case studies suggests that interbank markets with as few as four or five participants can be efficient, provided none of them dominates the market.14 Indeed, more than the number of participants, what most promotes competition is that participants are discouraged from setting prices above the prevailing rates. The reason is that, in perfectly competitive markets, if they did not adhere to prevailing rates, other participants could enter the market quickly and find it profitable. In this context, measures to increase the effectiveness of the interbank market involve removing barriers to entry. Privatizing state-owned banks can also help eliminate market segmentation, and opening access to foreign banks can help upgrade banking skills. In the case of small countries with shared economic interests, participation in a currency union can help reach the critical size needed for markets to emerge.

The development of the interbank market may be inhibited if banks are reluctant to deal with one another because of credit risk or because of a reluctance to reveal their commercial interests. These obstacles can be addressed in the short run by developing the use of collateral (such as government securities) or organizing clearing of interbank transactions on the books of the central bank (provided appropriate arrangements are in place to cover counterparts’ risk) in order to ensure that settlements will be honored when interbank loans mature.15 More fundamentally, concerns about the financial soundness of interbank market participants underscore the need for actions to strengthen their financial positions. In particular, banks must restructure their balance sheets by dealing with problem loans, diversifying their portfolios, and assessing risks more effectively.16

Strengthening Financial Market Infrastructure

To enhance monetary policy transparency and accountability, price stability should be the main objective of monetary policy.17 To do this efficiently requires setting up an institutionalized, transparent mechanism for resolving divergences between monetary and fiscal policies, including placing explicit and binding limits on the amount of credit that the central bank can grant to the government; ensuring that the central bank has the means to manage the level of liquidity in the banking system; and protecting the central bank from undertaking quasi-fiscal activities that may erode its autonomy.

Central bank autonomy and transparency is being increasingly recognized not only as an aspect of good governance, but also as a means for promoting the credibility needed to formulate and implement monetary policy.18 Greater transparency is an incentive for the monetary authorities to be more rigorous in the formulation of strategies and the choice of instruments. Transparency and the timely flow of information are also crucial for the development, stability, and soundness of the financial system. They also help promote efficient markets because information about trading interests, trading volumes, and prices are central to price discovery. Disclosure of the central bank’s liquidity forecasts can also help the banking sector form expectations about the overall liquidity situation. This can facilitate financial institutions’ liquidity management and contribute to stabilizing liquidity conditions, thus enhancing market stability and development.19

An efficient financial sector infrastructure is vital to the smooth transmission of monetary policy actions.20 The payment systems and the accounting and auditing systems are essential parts of that infrastructure. An efficient payment system facilitates the smooth operation of markets by ensuring that transactions are settled in a timely and reliable manner, while an efficient accounting and auditing system ensures that transactions are recorded appropriately and accurately, which is crucial for providing credible and timely information that allows markets to make sound decisions. More specific to monetary policy implementation, weak payment systems or central bank accounting frameworks can greatly complicate the implementation of a liquidity management and forecasting framework and, ultimately, jeopardize the central bank’s ability to control its balance sheet.

Fiscal dominance also includes the central bank providing subsidized funds to priority sectors and conducting foreign exchange transactions at non-market-clearing levels. Such activities should be discontinued in the early stage of financial reforms.

In the Democratic Republic of the Congo, the central bank resorted to a rationing of currency; in Tonga, it resorted to bank-by-bank credit ceilings and moral suasion.

Participation in a monetary union entails loss of monetary policy independence and of the exchange rate as a mechanism to adjust to shocks. However, those losses may not be significant for small open economies whose freedom to pursue an independent monetary policy is restricted by the limited relevance of the exchange rate. Therefore, the benefits of monetary union participation in fostering fiscal discipline may be more important (Fasano, 2003).

Analysis of the cost and benefits of a monetary union needs to take into account factors outside the scope of this paper, including patterns of trade, correlations of economic growth, and political and institutional considerations.

See Sundararajan, Dattels, and Blommestein (1997) and World Bank (2001) for a survey of best practices regarding market-based public debt management frameworks.

See Appendix III for a review of liquidity management and forecasting.

It is agreed that a liquidity surplus does not hamper monetary policy transmission in deep markets.

See Appendix IV for a review of country experiences with a liquidity surplus.

When using reserve requirements for liquidity management, it is advisable to avoid frequent changes in the level of the ratio because of the potentially disruptive effects, particularly in shallow markets or when the distribution of excess reserves among banks is uneven.

As evidenced by the country experiences presented in Appendix III, other rules-based measures may be used, such as mandatory deposits with the central bank or switching government deposits from the commercial banks to the central bank.

While such a framework is a second-best solution, it can serve until a stronger one is set up.

These findings for small countries are corroborated by a study by the Group of Ten (2001) on the consequences of financial sector consolidation in large countries.

See Hoelscher and Quintyn (2003) for a discussion on the effect on monetary policy of weak banking systems.

Desirable transparency practices are set out in the IMF’s Code of Good Practices on Transparency in Monetary and Financial Policies.

See World Bank (2001) for details.

Effective coordination between the financial supervisor and the monetary authorities is critical to underpin market development.

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