VIII Case Studies

Bernard Laurens
Published Date:
December 2005
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Part II describes the experiences of a dozen countries or groupings of countries that have introduced and used money market operations for the conduct of monetary policy. Included are small countries with limited scope for developing diversified markets, some of which have been able to set up effective monetary policy frameworks, and larger countries which were still in the process of establishing a strong market infrastructure to address weaknesses in policy implementation.

The countries or grouping of countries are from Africa (Democratic Republic of the Congo, The Gambia, Uganda, and Zambia), Asia (Tonga and Vanuatu), the Western Hemisphere (Eastern Caribbean Currency Union), the Middle East (Egypt and Tunisia), and Europe (Kyrgyz Republic, Malta, and Ukraine). They were selected because of their relevance to the study and because information was available from technical assistance reports of the Monetary and Financial Systems Department (MFD), reports from the Financial Sector Assessment Program (FSAP), and other Fund publications and papers such as Occasional Papers and Staff Reports.

The review of the country experiences is based on an analysis of developments during time periods that vary from one country to another. It seeks to depict the current status of monetary instruments in the various countries, although in some instances, further progress may have been achieved since the completion of the study. In addition, the paper uses a uniform terminology with regard to monetary instruments, and this may not always match the terminology adopted by the individual countries themselves. The terminology used is consistent with the definitions provided in the Glossary.

Democratic Republic of the Congo1


For a number of years, the financial system in the Democratic Republic of the Congo (DRC) has operated in a climate of uncertainty due to political instability and fiscal mismanagement, further complicated by limited resources. This has resulted in major dysfunctions and evident weaknesses. In particular, the financial system became irrelevant in mobilizing savings and providing credit to the economy. In the context of a Staff Monitored Program (SMP) covering June 2001–March 2002, and of the subsequent Poverty Reduction Growth Facility (PRGF), the authorities have started to implement wide-ranging reforms with the assistance of the Fund’s technical assistance program. In particular, a new law for the central bank was passed enshrining its independence and a new banking law was passed. In addition, the Central Bank of the Congo (BCC) has taken measures to remedy its weaknesses and help create conditions that will pave the way for a revival of financial intermediation.

Despite the significant progress made in macroeconomic stabilization, financial intermediation has not yet resumed in the DRC, reflecting continued low public confidence in the banking system. Several years of hyperinflation and a free fall of the exchange rate have undermined confidence in the Congo franc (CGF). Consequently, the banking sector, which forms the bulk of the formal financial sector, has played a limited role in the economy since the late 1980s or early 1990s, with the total assets of the banking sector at less than 5 percent of GDP at the end of 2002 (Table 8.1). It may take some time before confidence in the currency returns and the banking sector resumes a significant role.

Table 8.1.Democratic Republic of the Congo: Financial System Structure(as of December 2002)
Number of InstitutionsTotal Assets (Percent of GDP)
Commercial banks145
Nonbank financial institutions5Not available
Microfinance institutions27Not available
Source: Central Bank of the Congo.
Source: Central Bank of the Congo.

The rate of financial penetration is very low. The DRC, with a population of about 55 million, has only 35,000 bank accounts, of which almost half are held by businesses. The settlement of transactions that go through the banking system is limited due to the prevalence of the informal sector, which operates mostly in cash—the result is that CGF bank deposits represent only 22 percent of the money supply in Congo francs. The contribution of the banking system to money creation is marginal, and for the most part, the activity of commercial banks is circumscribed to collecting government taxes, paying government expenditures, and opening letters of credit for the financing of exports. Since the commercial banks grant little or no credit to the private sector, money creation has taken place mainly through the issuance of BCC currency.

Due to past hyperinflation, there remains a strong preference for foreign exchange as a vehicle for savings and for the settlement of large transactions. The former is also a consequence of currency instability in the past, and the latter is also due to the absence of large-denomination bank notes in local currency in a context of the virtual nonexistence of a payment system other than cash. The dollarization of the economy is reflected in the balance sheets of banks, two-thirds of which are in foreign currencies.

Financial intermediation has also suffered from weaknesses in policy implementation at the BCC. For years, the BCC has been hampered by inadequate operational autonomy and limited resources. Moreover, the low level of financial intermediation has made the use of conventional monetary policy instruments more difficult. This has resulted in major dysfunctions and evident weaknesses which have seriously limited the capacity of the commercial banks to provide financial services. In particular, the BCC has occasionally prevented banks from using their free reserves to obtain currency, resulting in nonfungibility between the components of base money. In turn, currency rationing and the associated nonfungibility of base money has resulted in the discounting of CGF deposits in commercial banks, with CGF bank deposits trading against CGF currency at a discount (“décote”). In the past the use of currency rationing had been prompted by the apparent inability of the BCC to produce sufficient amounts of bank notes. However, more recently, it appears that the BCC has relied on currency rationing as a substitute for conventional liquidity mop-ping-up operations which the low level of financial intermediation makes difficult or costly to undertake.

The Central Bank of the Congo

With the support of Fund technical assistance, progress has been made in strengthening the BCC’s institutional capacity. During 2002, key financial legislation was enacted which reflects international best practices and provides a sound framework for strengthening the DRC’s financial sector. In particular, a new law for the central bank was enacted that provides for its independence, and a new banking law has established sound bank licensing, liquidation, and supervisory frameworks.

Good progress was also made in strengthening the BCC’s operational capacity. In particular, the BCC put in place key components of a framework to program currency issues; the net income position of the BCC was consolidated in the government position; and a Consultative Group on Monetary Policy was created to strengthen policy design and implementation. At the same time, the BCC adjusted interest rates to bring them in line with downward price developments, while keeping them positive in real terms.

However, the long-standing problem of the nonfungibility between the components of base money has remained. In practice, the BCC has not been able to guarantee the convertibility to currency of the banks’ free reserves, and the rate of the discount (décote) has been very volatile and at times high (up to 40 percent) in response to changes in the balance between the supply and demand for bank money.

The BCC has been unable to rely on conventional monetary instruments due to the low level of financial intermediation, and it has frequently resorted to the practice of rationing currency. Furthermore, some of the monetary instruments used by the BCC to regulate overall liquidity in the system have caused distortions or have been costly. Until the end of 2002, certificates of deposits (CDs) had been used to “buy” currency from the market.2 However, as their remuneration was brought in line with inflation, the demand for these CDs evaporated, since they no longer incorporated the implicit cost of the décote. BCC operations on the décote market were used to replace CDs, with the BCC receiving CGF notes against CGF bank money.3 These operations proved costly, and they resulted in an increase of banks’ reserves with the BCC and a correlative increase in the rate of the décote. The rate of the décote dropped in July 2002, as the BCC started to “liquify” banks’ reserves. Recourse to décote operations in September–October 2002 lead again to a sharp increase in the décote rate. Finally, although issuing currency would have been less costly than décote operations, the BCC indicated that it lacked the foreign exchange to pay the related expenses. In addition, currency issues could have created additional demand for foreign exchange, while the décote operations resulted in an injection of bank money which could only be used for the payment of taxes. Therefore, currency issues would have had to be supplemented with sterilization operations, and one cannot rule out that the two operations combined could have generated costs in line with those of the décote operations.

Monetary Policy in the Context of Low Financial Intermediation

The Problem

Given that the discount (décote) has inhibited the operations of the financial system, the return to the fungibility of base money is a necessary initial condition for developing financial intermediation in the DRC. In particular, the nonfungibility of base money has had adverse consequences at the micro level on financial intermediation. Commercial banks need to make a distinction between customer deposits made in cash (cash deposits) and customer deposits resulting from transfers through the payment system (bank money deposits), the counterpart of which consists of reserves with the BCC. Therefore, three payment instruments in local currency circulate in the DRC: currency, cash deposits, and bank money deposits. While currency and cash deposits are traded at par (provided that the former are placed with a solvent bank), at times, bank money deposits are traded at a discount as compared with currency or cash deposits. The level of the décote varies depending on the supply (payments in bank money made by the BCC) and demand for bank money deposits (capacity of taxpayers to settle their taxes in bank money).

The nonfungibility of base money has also had adverse consequences on financial intermediation at the macro level. First, it has acted as a barrier to the provision by the commercial banks of payment services—for instance, checks are not accepted unless the beneficiary is willing to take the risk of having to pay the décote to obtain currency. Moreover, it is a barrier to banks’ provision of credit to the economy. Currency is now the principal medium of settlement for economic transactions. The inaccessibility of banks’ free reserves imposes an additional liquidity constraint because commercial banks cannot guarantee at all times or upon request the availability of currency to the beneficiary of a loan, even if they have free reserves with the BCC. In this context, arbitrage activity between cash and bank money may become a lucrative business.

In the Congolese context, the activities of the financial system are limited to the provision of payment services. The bulk of CGF transactions that are intermediated by the financial system are related to government receipts and expenditures. Therefore, any imbalance between supply and demand of CGF banknotes reflects imbalances in the public sector which are not covered by the issuance of banknotes by the BCC, hence the décote.4 Indeed, with a balanced budget for the public sector, the BCC should not need to have recourse to the rationing of currency. The BCC should be in a position to meet all payments requested by the government. However, the BCC has had to resort to currency issues to meet essential government expenditures, and it has not issued currency to meet the demands of commercial banks, with the result that free reserves at the BCC have accumulated (reinforcing the nonfungibility of base money and the décote).

The imbalances in the public sector originate from three sources. First, some payments executed by the BCC on behalf of the government are not reflected in the budget. Second, not all the operating losses of the BCC are accounted for in the budget in a timely manner. Finally, financial institutions that participate in the collection of taxes have retained part of the government’s revenues to cover expenditures, and these are not recorded in the budget. The weaknesses in the information systems at the BCC, in the financial institutions, and in the public sector have prevented an assessment of the size of these outflows.

Establishing the Initial Conditions

A revival of financial intermediation is critical to the success of the reform agenda currently being implemented by the authorities. In particular, financial intermediation is necessary to release some of the constraints the BCC faces in implementing monetary policy, especially with regard to the control of overall liquidity conditions in the economy. More broadly, the banking system needs to support the private sector so that it becomes the engine of growth.

For banks to increase their role in payment systems, the décote must be eliminated. This is a necessary condition for smooth operation of the payment systems among solvent banks. It is also a necessary (but not a sufficient) precondition for resuming money creation (i.e., provision of credit to the private sector) in local currency.

Corrective measures implemented by the authorities in November 2002 did result in the virtual elimination of the décote. In order to prevent its reappearance in the future, the BCC needs to provide bank notes on demand to the banks that have positive reserve balances. As the BCC discontinues reliance on the rationing of currency, it will need to rely on a monetary instrument to sterilize any injection of liquidity into the system that is inconsistent with the monetary program. The introduction in late 2002 of BCC short-term bills has provided the BCC with such a monetary instrument (Box 8.1).

Under the current policy framework, where fiscal consolidation is one of the cornerstones of the program, strict adherence to the monthly treasury cash flow plan should prevent the buildup of imbalances in the system. This is particularly important because, at least until financial intermediation has deepened, the ability of monetary policy to compensate in a timely fashion for fiscal imbalances, even temporary ones, may be limited. Therefore, the execution of the cash plan at the ministry of finance needs to be closely coordinated with the liquidity forecasting exercise undertaken by the BCC. This is particularly important given the potential for excess liquidity to result in downward pressures on the exchange rate and upward pressures on inflation due to the high level of the pass-through.

A more thorough identification and quantification of the causes of the imbalances in the public sector will facilitate the coordination of monetary and fiscal policies by allowing the monetary and fiscal authorities to identify early on in the process potential deviations from the monetary program and by putting them in a position to decide on corrective measures in a timely and coordinated fashion. Consequently, actions have been taken to rehabilitate the accounts of the BCC in order to better assess its financial position; to strengthen banking supervision in order to assess potential sources of outflows through the financial institutions that participate in collection of public sector revenues; and to strengthen public accounting procedures to enable the ministry of finance to more effectively monitor the government’s account on the books of the BCC.

Box 8.1.Democratic Republic of the Congo: Monetary Policy Instruments

Reserve requirements

Set at 2 percent of local currency–and foreign currency–denominated deposits, they are held in local currency. This instrument has had limited impact in the past given the low level of deposits and the size of banks’ free reserves. Making foreign currency deposits subject to reserve requirements would help constrain currency substitution by reducing the bias against local currency deposits.

Standing facilities

  • Liquidity-providing: Commercial banks may obtain rediscount credit or emergency funding from the BCC against trade bills as collateral. However, in view of the low quality of trade bills, the BCC is considering restricting collateral accepted at the standing facilities to foreign exchange (i.e., short-term foreign exchange swaps).

  • Liquidity-absorbing: This facility involves short-term BCC bills issued on demand to banks and direct investors. BCC bills offer a competitive rate of remuneration which takes into account interest rates on the dollar and inflationary expectations.

The return to the fungibility of base money will result in an increase of deposits for transactions purposes, allowing the banks to resume their participation in money creation. In such a context, the BCC will be able to use the range of refinancing instruments already at its disposal. In particular, within the target for base money provided for in the monetary program, the BCC will be able to supply banks with reserves through short-term foreign exchange swaps.

Restoring the fungibility between the components of base money will involve shifting from the currency programming framework currently in place to a base money programming framework. In order to expand the current monetary programming framework, the BCC will need to strengthen the lines of communication among the various operational BCC directorates, and between the BCC and the ministry of finance. Such a framework will allow the BCC to analyze the autonomous sources of demand and supply of base money, and to decide which discretionary monetary operations to use to keep base money in line with assumptions in the monetary program. Such a framework can also be utilized for ex post analysis of actual flows, enabling the BCC to understand past trends and decide on appropriate corrective actions.

Financial Intermediation and Dollarization

Past macroeconomic instability and weak BCC policies have not only marginalized the banking sector but have also led to multiple forms of dollarization in the DRC (Box 8.2). Bank deposits represent only about 2 percent of GDP, and 80 percent of these are denominated in foreign currencies.5 Total bank reserves of CGFs with the BCC exceeded the level of loans in CGFs, and bank money in CGFs is for the most part used for operations on behalf of the government. Transactions in the economy are also highly dollarized: they are either executed in dollars or indexed to the dollar. Accordingly, any excess supply of local currency has a direct inflationary impact due to the limited demand for local currency and the high pass-through of exchange rate changes into prices (i.e., such excess supply results in additional demand for foreign exchange in the market).

Box 8.2.Democratic Republic of the Congo: Forms of Dollarization

Dollarization may be partial (the local currency is the legal tender but financial or real transactions can be denominated in dollars) or total (another currency—typically but not necessarily the U.S. dollar—is the predominant or exclusive legal tender). Within partial dollarization one can distinguish the following:

  • payments dollarization (or currency substitution), use of foreign currency for transaction purposes;

  • financial dollarization (or asset substitution), residents’ holding of financial assets or liabilities in foreign currency; and

  • real dollarization, indexing, formally or de facto, of local prices and wages to a foreign currency.

While data on residents’ holdings of foreign currency is not always available, dollarization can be assessed by analyzing the balance sheets of domestic banks, comparing the ratio of onshore foreign currency deposits to total onshore deposits. Loan dollarization reflects deposit dollarization but is often less intense because of banks’ holdings of large liquid dollar assets. Loan dollarization is generally lower than deposit dollarization because banks often hold sizable liquid correspondent accounts or sovereign assets abroad.

Source: Gulde and others, 2004.

Dollarization of deposits has occurred mostly through unremunerated foreign currency–denominated demand deposits. These deposits reflect a reluctance to hold balances in domestic currency for transaction purposes because of high inflation, rather than interest rate arbitrage. As they are converted into CGFs, they can be utilized to settle transactions.

With limited financial intermediation, dollarization of large transactions is also encouraged by the low purchasing value of CGF banknotes. This is because the face value of banknotes in CGF has not been adjusted to reflect the evolution of prices in the economy. For instance, the note with the highest face value (CGF 100) is equivalent to less than US$0.30. When this note was introduced in 1998, it was worth as much as US$70.

As financial intermediation develops, increased dollarization could mean additional costs and risks for the financial system. First, dollarization reduces the seignorage base that is associated with the issuance of domestic currency. Second, there is evidence that dollarized financial systems are increasingly vulnerable to solvency and liquidity risks when the degree of financial dollarization increases, while real dollarization lags behind. In particular, higher bank loan dollarization could increase the risk that the quality of bank portfolios deteriorates as loans are not necessarily issued to borrowers with foreign exchange income. Dollarization also limits the central bank’s role as lender of last resort in the event of a run on foreign currency deposits, which could destabilize the banking system (including the local currency segment). Therefore, as financial intermediation is developed, it is important to avoid certain actions that might further reinforce dollarization in the DRC and to take measures that support a re-intermediation in local currency.

Monetary policy can affect the degree of financial dollarization through the interest rate spread between currencies. The authorities should, however, resist using interest rates to prop up the exchange rate because such a strategy could generate difficulties in the long run. In particular, it could increase the lending rate for domestic currency and thus encourage dollarization of loans, thereby increasing the vulnerability of the financial sector to sudden exchange rate fluctuations, as explained above. Therefore, monetary policy should continue to be guided by price stability objectives.

In the DRC, as in other low-income countries, most of the deposits in commercial banks are demand deposits maintained primarily for transaction purposes. Therefore, a process of re-intermediation in local currency will need to be supported by the development of an efficient payments and settlement infrastructure for local currency–denominated transactions. In addition, as the DRC consolidates the gains made in stabilizing the macroeconomic framework, the demand for savings instruments in local currency will rise. In such a context, the offering by the BCC of a short-term instrument, as discussed above, will facilitate the process of re-intermediation in local currency by restoring parity between the CGF and the dollar at a given inflation rate and anticipated depreciation in the exchange rate.

The face value of CGF banknotes must be adjusted to better reflect the use of the currency for transaction purposes. Bank notes in denominations larger than those currently in circulation should be introduced as soon as possible to facilitate the use of the CGF in large transactions. At the same time, the BCC must continue to provide banknotes in the smaller denominations that are still in use by a large proportion of the population.

Finally, the ability to find outlets for stable demand deposits and to generate revenue will depend on the environment in which credit activity is carried out. Accordingly, it is essential that the DRC authorities make every effort to build the pillars of sound banking activity by complementing the new banking law with the following measures: (1) completion of bank restructuring; (2) establishment of prudential regulation and bank supervision processes in line with international standards; (3) completion of public enterprise sector reform; (4) creation of a business environment conducive to the development of an efficient private sector; and (5) promotion of an appropriate legal framework governing contracts and efficient judicial administration.

Conclusions and Lessons

The following conclusions and lessons can be derived from the experience of the Democratic Republic of the Congo:

  • Despite the significant progress made in macroeconomic stabilization, the economy and the financial system continue to be heavily dollarized. Furthermore, financial intermediation has not resumed, and the commercial banks continue to play a limited role in the payment system and in providing credit to the economy. Consequently, the conduct of monetary policy has been difficult, and fiscal discipline has been key to stabilization of the macroeconomic framework.

  • The BCC is discontinuing its reliance on the rationing of currency as a monetary policy instrument. Although this has resulted in the nonfungibility between the components of base money, it is a necessary initial condition for monetary policy to become a relevant exercise.

  • As the BCC discontinues its reliance on the rationing of currency, it will need to rely on monetary instruments to sterilize any injection of liquidity into the system that is inconsistent with the monetary program.

  • Although the BCC started offering short-term bills to the banks to adjust overall liquidity in the system, until financial intermediation has deepened, the ability of monetary policy to compensate for even temporary fiscal imbalances in a timely fashion may be limited. Therefore, the execution of the cash plan at the ministry of finance needs to be closely coordinated with the liquidity forecasting exercise undertaken by the BCC.

  • Further progress in centralizing all the operations of the public sector into the budget would facilitate the conduct of monetary policy, as would enhancing the quality of financial data. Progress in these areas, particularly by facilitating a timely identification of public sector outflows by source, will enhance the coordination of monetary and fiscal policies and facilitate systemic liquidity management by the BCC.

Eastern Caribbean Currency Union (ECCU)1

Path Toward Regional Monetary Integration

The successful road toward monetary integration among Eastern Caribbean countries comprised several different stages that are relevant to this study. During the British colonial era, notes issued by foreign commercial financial institutions circulated along with coins from the United Kingdom. Between 1910 and 1920, three different Boards of Commissioners of Currency started issuing currency in Trinidad and Tobago, Barbados, and British Guyana, respectively. In 1946, a unified decimal currency system was adopted based on the West Indian dollar, and in 1950, the British Caribbean Currency Board (BCCB) was established, which had the prerogative to issue notes and coins at an exchange parity of 4.8 West Indian dollars to one pound sterling.

After Trinidad and Tobago and British Guyana exited the BCCB (in 1962 and 1965, respectively), it was replaced in 1965 by the Eastern Caribbean Currency Authority (ECCA), and the West Indian dollar was replaced by the Eastern Caribbean dollar at the same parity.2 Following the pound sterling devaluation of 1967 and Barbados’s departure from the ECCA in 1972—to establish its own central bank—the ECCA headquarters was moved to St. Kitts. The foreign exchange coverage, originally set at 70 percent, was reduced to 60 percent in 1975. The ECCA later shifted the link of the Eastern Caribbean dollar from the pound to the U.S. dollar and assumed a more ambitious and expansive role by becoming a cosignatory for establishing the Multilateral Clearing Facility in the Caribbean Community and Common Market (CARICOM), which replaced the existing bilateral clearing agreement in 1973.

The Eastern Caribbean Central Bank (ECCB) replaced the ECCA in 1983. The move followed the launch of the Organization of Eastern Caribbean States (OECS) with the 1981 Treaty of Basseterre which institutionalized political and economic cooperation among the Caribbean territories.3 The Eastern Caribbean dollar, the common currency shared by OECS countries, was pegged to the British pound at EC$4.80=£1 from 1950 to 1976, and since then to the U.S. dollar at the market cross-rate of EC$2.70=US$1. The recent experience of the peg system shows an unaltered parity of the exchange rate and a fully self-supported convertibility where member countries have pooled all their foreign reserves.

Monetary Policy Environment

Institutional Framework

The quasi-currency board promotes stability through a strong foreign exchange position that backs the currency issued. The backing ratio is detailed as external assets net of commercial bank foreign currency deposits with the ECCB, divided by demand liabilities. This implies, in practice, a limit on domestic assets of 40 percent of Eastern Caribbean dollar–denominated demand liabilities. However, the minimum level of pooled reserves can be no lower than 60 percent of its demand liabilities, which consists of reserve money—bank reserves and currency. The backing ratio has evolved from 82.1 percent in 1990 to 97.1 in 2003.

Participating governments maintain accounts with the central bank through which transactions are effected with other governments and with regional and international organizations. Member countries have unrestricted access to the common reserve pool and the ECCB can only issue the common currency against foreign exchange, with bank notes coded according to the country to which they are issued. Given the currency issued by each member, the ECCB, in its capacity as fiscal agent, can allocate profits to the member governments accordingly and can impute reserves for each of them as the sum of currency in circulation and its net claims on the government and the commercial banks in each of the member countries.

The ECCB was established by the Eastern Caribbean Central Bank Agreement Act of 1983, which defines the power and scope of the ECCB. The Uniform Banking Act of 1993 specifies the operational framework for financial institutions.

The Articles of Agreement allow the ECCB to provide credit to member countries to assist them with seasonal credit needs (temporary advances) and to service the members’ “special deposit” loans—reserve requirements which reached EC$30.8 million at the end of 1998. In addition, the ECCB provides credit in the form of holdings of treasury bills, holdings of government securities, and holdings of corporate bonds, with maturities not exceeding 91 days, 15 years, and 10 years, respectively.

The monetary council and the board of directors are the two separate bodies in charge of governing the ECCB. The former, which is the most important decision-making authority for the ECCB, comprises the governor, chairman, and deputy governor—who are appointed by the monetary council—and one representative director for each member state. The chairmanship rotates every year. The monetary council meets at least three times a year to set the main guidelines for monetary policy. The 10 members of the board of directors meet five times a year. The board is in charge of administering the bank and taking care of international economic relations.

As in other currency boards, the central bank authorities acknowledge that the main device available to them for achieving price stability is to uphold the credibility of the fixed exchange rate regime. In this regard, the bank is also responsible for regulating money and credit, strengthening credit and exchange conditions, and fostering a robust financial structure aiming at regional growth and economic development. In this vein, member countries are able to smooth differences (i.e., risk-pool) in the timing of inflows into the reserve pool arising from the different composition of member countries’ exports. In addition, they are able to achieve economies of scale in central bank operations by smoothing out overhead costs.

The ECCB’s monetary operations are guided by a monetary program that involves setting up explicit operational ceilings through the allocation of a global limit to members in proportion to each government’s share of total regional recurrent revenue. Although this limit has not been enshrined in the legislation, it is well defined by the ECCB for its own operations. It is calculated in terms of the monthly average of the monetary liabilities of the previous year. The actual credit available is the amount of the allocation net of all outstanding balances and arrears.

Fostering Fiscal Discipline

The ECCB has designed a set of specific policy rules in order to foster the fiscal prudence and policy coordination that are needed for participation in a monetary union pegged to another currency. First, the ECCB is helping the governments to institutionalize financial programming as a tool for fiscal management. Second, in 1995, the ECCB created a two-tranche fiscal reserve facility. The first tranche is funded with portions of the profits that the ECCB distributes annually and that governments deposit, at their discretion, in facility accounts at the central bank. These resources are freely accessed by governments. The use of the second tranche of this facility has to be approved by the monetary council because these resources were conceived as savings to be used only as a last resort and/or to help deal with natural disasters.

In addition, against the background of the deteriorating budgetary positions and uncertain economic prospects of ECCU members, the ECCB has designed a set of policy guidelines in the form of fiscal benchmarks to ensure long-term sustainability, along the lines of those instituted for the monetary unions in Europe and in West and Central Africa. These include such benchmarks as a government current account surplus of 4–6 percent of GDP, an overall government budget deficit of no more than 3 percent of GDP, total central government debt outstanding of no more than 60 percent of GDP, and debt service payments of no more than 15 percent of current revenue. However, to be fully effective, this framework would need to be considered binding by the national authorities and enforcement mechanisms to ensure compliance would need to be put in place. Indeed, recently several members of the ECCU have been confronted with serious fiscal crises.

Monetary Policy Instruments and Issues

The ECCB Articles of Agreement instruct the central bank to extend, discretionally, credit to any participating member under specific conditions. The sum of the maximum amounts that the central bank can lend, including outstanding balances on “special deposit loans” typically exceeds the 40 percent global limit on domestic assets. The ECCB Articles also authorize the ECCB to use discount and rediscount rates, as well as differential rates and ceilings for various classes of transactions (Box 8.3). The monetary council regularly reviews the operations of monetary instruments.

In addition to reserve requirements, the ECCB conducts conventional monetary policy through standing facilities. In this regard, the ECCB is allowed to employ discount and rediscount rates, establish differential rates and ceilings for various classes of transactions, determine priority areas for credit distribution in cooperation with member governments, and establish a schedule of reserve requirements (including marginal required reserves) that can vary with the type of deposit.

Bank interest rates are unregulated. However, a minimum savings deposit rate was established in January 1985, in order to encourage small savers.4 At the same time, the ECCB started to remunerate bankers’ U.S. dollar deposits at internationally competitive rates, with the aim of encouraging commercial banks to invest foreign currency in the area. In addition, and in order to discourage deposit outflows, the ECCB allows bankers’ deposits to be exchanged at the official exchange rate.

Although the ECCB has emergency powers to intervene in the event of a systemic problem, there is no lender-of-last-resort facility (LOLR) at the ECCB. With a majority share of foreign-owned banks and given the low exposure to international systemic crises that could undermine the system as a result of external shocks, the need to enact a LOLR facility has not been a priority, and there is no explicit system of deposit insurance.

Box 8.3.Eastern Caribbean Central Bank: Monetary Policy Instruments

Reserve requirements

Since the ECCB’s inception, there has been a reserve requirement of 6 percent on all deposits. Before March 1994, commercial banks were instructed to maintain reserves based on the average deposits during the four preceding weeks and to hold the reserves for four consecutive weeks. After March 1994, ECCB adopted weekly maintenance periods, with reserves based on average weekly deposits and held for one week. All reserves are held in EC dollars and they are not remunerated.

Standing facilities

  • Rediscount window: In place since 1988, it works as an incentive for banks to invest in government securities.

  • Discount rate: Last altered in October 2001, this rate is intended to influence banks’ lending rates and thereby economic activity. Nevertheless, the discount rate is not used by banks because it is higher than the rediscount rate for treasury bills.

Before March 1994, commercial banks were obliged to hold in reserve for four consecutive weeks 6 percent of the average of all deposits during the four preceding weeks. After March 1994, the ECCB implemented weekly reserve requirements, with reserves of 6 percent of average weekly deposits held for one week. Although credit ceilings were never used, right after its inception, as noted previously, the ECCB encouraged banks to invest foreign currency within the region by remunerating them at internationally competitive interest rates, and it allows deposits to be exchanged upon demand at the official cross-rate to discourage capital outflows.

In the mid-1980s, the ECCB established an interbank market in an effort to assist the commercial banks in managing their liquidity and to facilitate the lending and borrowing of available reserve balances between commercial banks in a timely and cost-effective manner. The ECCB performed the role of broker and guaranteed the funds; interest rates were fixed. In October 2001, the ECCB introduced changes to the arrangements governing the interbank market. Under the new arrangement, a Bulletin Board Service, facilitated by the central bank, replaces the ECCB’s brokerage service. This service can be used by the commercial banks on a daily basis to advertise funds available for lending and to source funds for borrowing. Commercial banks negotiate on a bilateral basis for the use of excess funds in the banking system and set the terms and conditions of each loan without the intervention of the ECCB. In the conduct of interbank transactions, commercial banks can either enter into informal unsecured agreements, or can choose to enter into secured arrangements, whether by offering collateral or by repurchase agreements.

The rediscount window for treasury bills established in 1988 under the existing country limits induces trading of government securities, thereby supporting this secondary market. Taking into account its commitment to a high foreign exchange backing ratio, the bank discounts the bills obtained under the existing credit lines to members and uses the window to build up its portfolio of domestic treasury bills. The discount rate is a policy rate which has become somewhat meaningless today. Although originally designed to influence bank lending rates and economic activity, the discount rate usually serves an announcement function, given that it has been infrequently changed and that it is not tailored to be an effective monetary instrument. Consequently, given the monetary council’s decision to set the discount rate at a higher level than the rediscount rate for treasury bills, banks are not usually interested in this use of the discount window.

Structural Factors and Financial Market Infrastructure

The financial system of the Eastern Caribbean states has been dominated by commercial banks (Table 8.2). Among the approximately 43 banks in existence in June 2002, 9 were domestic with 23 percent share of assets, 30 were foreign-owned, and 4 were government controlled. Seven foreign-owned banks, with headquarters in Canada, Trinidad and Tobago, France, and the United Kingdom, accounted for more than 50 percent of the total assets of banks and other deposit-taking institutions. In the financial sectors of Antigua and Barbuda, Dominica, Grenada, St. Lucia, and St. Vincent and the Grenadines, foreign banks enjoyed a majority share ranging from 50 to 90 percent. Private domestic banks controlled a majority share of assets only in Anguilla. In Montserrat, the state-owned bank had a majority share, while in St. Kitts and Nevis, the national banks and foreign banks controlled the same share of assets.

Table 8.2.Eastern Caribbean Currency Union: Financial System Structure(as of June 2002)
NumberAssets (millions of EC$)Percent of Total Assets
Institutional investors122n.a.n.a.
Insurance companies
Life and retirement35n.a.n.a.
Composite companies12n.a.n.a.
National insurance funds61,176.98.9
Other nonbanks107969.77.3
Total financial system2781,3229100
Source: Eastern Caribbean Central Bank.
Source: Eastern Caribbean Central Bank.

On October 19, 2001, the East Caribbean Securities Exchange (ECSE) was officially launched to provide member states with a regional trading market for primary and secondary securities—both equity and government and private debt securities. Supported by electronic trading and remote access and regulated by a uniform Securities Act of 2001, the exchange comprises 47 owners of which the ECCB is the largest. Only seven companies were listed by the end of 2004, and secondary trading volumes have been low. Notwithstanding the limited scope for active debt management provided by the currency board, the possibility of opening up the ECSE to other countries in the region would enable replacing foreign currency–denominated debt with domestic debt, thereby ameliorating external vulnerability.

Although the institutional framework for a regional financial market has been established, financial markets are still segmented by country. With low volumes of intra-ECCU financial transactions (apart from trade financing), there has been no tendency for interest rates to converge. At the same time, net holdings of bank assets by other banks in the ECCU are low, reflecting that most transactions are trade related. Finally, there is little cross-country holding of government securities among ECCU members.

The banking system is well developed and exhibits a ratio of deposits to GDP in excess of 145 percent. Even so, some government-controlled banks are facing harsh conditions and operating under increasing stress, and the level of non-performing loans—as a percentage of total loans—hovered around 14 percent in March 2002.

Conclusions and Lessons

The following conclusions and lessons can be derived from the experience of the Eastern Caribbean countries:

  • Despite the turbulence that affected the international financial arena in the last decades, the monetary stability in the Eastern Caribbean countries provides an example of successful and longstanding monetary cooperation.

  • The monetary and exchange arrangements have served the region well, fostering confidence through stable domestic prices anchored in a peg to the U.S. dollar.

  • The monetary framework of the ECCU imposes strict limits on the ability of the central bank to extend credit to member countries, and has thereby contributed to price, exchange, and financial stability. On the other hand, fiscal virtue remains a precondition to secure the success of the ECCU, and the absence of mechanisms to ensure compliance with fiscal benchmarks has undermined the effectiveness of the framework in fostering fiscal discipline.

  • Efforts to expand monetary cooperation through the integration of national money and capital markets paves the way toward an even more robust economic union, by allowing a move from the current segmentation of financial markets to an eventual consolidation into a single, regional, financial space.


Path to the Adoption of Money Market Operations

Until the early 1990s, Egypt’s banking system was highly controlled, and the financial system was characterized by a high degree of governmental planning and control. The Central Bank of Egypt (CBE) maintained interest rate and credit controls on the banking system. Banks were subject to specific credit limits, and public enterprises received loans on preferential terms. Highly negative real rates of return on domestic savings deposits contributed to a heavily dollarized economy. By 1990-91, slightly more than half of all deposits were denominated in foreign currency. Banks were subject to a relatively high reserve requirement of 25 percent on domestic currency liabilities and a somewhat lower rate of 15 percent on foreign currency deposits, which encouraged foreign currency holdings. Government deficits were largely financed by the CBE, which thereby accumulated a large stock of unmarketable government securities with a low interest rate.

Faced with high inflation, fiscal imbalances, and weak economic performance, the authorities began an economic reform program in early 1991 which was designed to enhance market forces in financial markets and in monetary policy implementation. An auction for 91-day treasury bills was introduced in January 1991, with auctions of 6-month and 12-month bills introduced within the following 15 months. At the same time, bank lending and deposit rates were liberalized, and within the next two years, credit ceilings on bank lending were removed. The reserve requirements were reduced to 15 percent (from 25 percent) on domestic currency deposits and to 10 percent (from 15 percent) on foreign currency deposits. In addition, CBE lending to banks was tightened by the introduction of a penalty rate on such lending of 2 percent over the most recent treasury bill auction rate. The reform program also included introduction of prudential regulations for banks and strengthened bank supervision. In addition, some banks were recapitalized and the preferential lending schemes were eliminated, which reinforced market forces in the allocation of credit.

The reform program, including fiscal and monetary reforms, led to a number of positive effects: inflation dropped dramatically, real interest rates became positive, and the share of foreign currency deposits in broad money declined significantly as confidence increased. The comprehensive package of reforms resulted in a turnaround in perceptions of the Egyptian economy, contributing to sizable and persistent capital inflows.2

Monetary Policy Environment

Institutional Environment and Monetary Policy Framework

During the 1990s, the primary objective of the CBE with respect to monetary policy was to “ensure the stability of the Egyptian currency.” In practice, this meant fixing the nominal exchange rate of the Egyptian pound (£E) with respect to the U.S. dollar, a policy that succeeded in reducing the inflation rate from around 20 percent to the low single digits for a sustained period. However, excessive credit growth during the late 1990s, combined with external imbalances, precipitated a series of devaluations (in the context of an exchange rate band system) starting in 2001. These were followed by a move to a more flexible exchange rate regime in 2003.3

In parallel to its move away from giving priority to the exchange rate as the nominal anchor, the CBE is preparing to implement an inflation targeting framework, which should be in place in the medium term. During the transition period, the CBE has adopted an implicit inflation targeting regime, with M2D (M2 domestic) used as an intermediate target. In addition, the CBE has established a monetary policy committee (MPC) that consists of nine members: the governor and his two deputies, and six members chosen on the basis of their expertise in monetary economics and financial intermediation. The conduct of monetary policy is vested with the MPC.

The government enacted a revised banking law in 2003 (the Law on the Central Bank and the Banking and Monetary System), which specified that the objective of monetary policy was to “achieve price stability […] in the framework of the Government’s general economic policy.” The current presence on the CBE’s board of directors of three members representing the ministries of finance, planning, and foreign trade may dilute the central bank’s independence somewhat, but they are only three individuals out of a total board membership of 15. The CBE is independent in terms of instruments and the numerical representation of targets, and the targets themselves should be jointly agreed upon by the central bank and the government.

Financial Market Infrastructure

Egypt has some 57 banks (Table 8.3), although the commercial banking sector is dominated by four state-owned banks. The latter account for slightly more than half of total commercial bank assets and a somewhat higher share of deposits because they have a relatively large deposit base.4 The dominance of the state in the banking system has been and continues to be a significant impediment to the role of market forces in the intermediation of funds and the allocation of credit.

Table 8.3.Egypt: Financial System Structure(as of June 2004)
NumberAssets (millions of £E)Percent of Total Assets
Domestic (private and joint venture)35232,74534.7
Foreign (branches of foreign banks)1436,8415.5
Institutional investors1
Insurance companies2018,6142.8
Pension funds261714,1992.1
Collective investment schemes3152,6690.4
Money market mutual funds361,1700.2
Source: Central Bank of Egypt.

The equity market capitalization (market value of shares) amounted to £E172 billion or 36.4 percent of GDP at the end of June 2004.

Refers to private funds supervised by EISA.

Actually in business.

Source: Central Bank of Egypt.

The equity market capitalization (market value of shares) amounted to £E172 billion or 36.4 percent of GDP at the end of June 2004.

Refers to private funds supervised by EISA.

Actually in business.

Approximately 14 banks engage in an active interbank money market. These banks account for about 85 percent of the market. Generally, the interbank loans are not collateralized, although there is an active repo (repurchase agreement) market among banks as well. The interbank interest rate is volatile and reacts strongly to changes in excess reserves, in contrast to the interest rate on treasury bills, which is very sticky and often goes for long periods with very little movement.

Treasury bills are auctioned regularly—weekly for 91-day bills, nearly weekly for 182-day bills, and occasionally for one-year bills. The mode is a variable priced auction in which the bidders pay the price that they successfully bid. The treasury bills are mainly held by commercial banks and by the CBE. The auctions are conducted by the CBE on behalf of the ministry of finance (MOF). The results are reported in the newspaper, with the reported yield as the weighted average of the successful bids. Interest rates in these auctions have at times shown very limited variability. Moreover, the rates in the treasury bill market generally do not appear to reflect movements in rates in the interbank market. Since the move to a more flexible foreign exchange regime in early 2003, treasury bill rates have been much more flexible, and by May 2003, they had moved up to the 12–13 percent range, in line with rates in the interbank market.5

The MOF sporadically issues fixed-rate bonds. Outstanding maturities include 3-, 7-, and 10-year bonds. There is a legal limit of £E15 billion on new outstanding bonds that are nontaxable. Bonds can be traded over the stock exchange, but volumes are light. The secondary market for government securities is relatively shallow. Bonds must be traded on the stock exchange. The introduction of an electronic book entry system for treasury bills in June 2002 appears to have encouraged secondary market development. In addition, in July 2004, the CBE started a primary dealers systems, with 13 banks approved to operate as primary dealers. A unit has been set up in the MOF to consider primary dealer applications from banks. Primary dealers that are banks are expected to be regulated by the CBE, with nonbank primary dealers regulated by the Capital Market Authority.

Box 8.4.Egypt: Monetary Policy Instruments

Reserve requirements

Set at 14 percent for Egyptian pound (£E) deposits and 10 percent for foreign currency deposits (with maturities of less than three years in the first case only). Reserves on domestic deposits are not remunerated; those on foreign currency deposits are remunerated at LIBOR (London interbank offered rate). Use of treasury bills to satisfy the reserve requirement was discontinued in March 2003. Vault cash does not count toward required reserves. Reserve averaging is permissible over a two-week maintenance period.

Standing facilities

  • Discount window: only occasionally used, in part because of its high cost to banks.

  • Overnight repo facility: accessible by all banks at most once during any week and within a £E 100 million ceiling; the rate charged is the discount rate.

Money market instruments

  • Central bank deposit auctions were introduced in September 2002 as open market–type operations. They may be announced on any weekday and in practice occur about three times a week, although the frequency varies. Fixed volume auctions are offered. Discretion is used in determining the maturity of auctions, although generally longer maturities are offered when there is a greater need to absorb liquidity. In particular, maturities were increased from one and two weeks initially, to four weeks, then three months and six months, in response to increased need to absorb liquidity.

  • Treasury bill auctions: The Central Bank of Egypt (CBE) can ask the ministry of finance (MOF) to issue treasury bills in excess of its needs and to deposit the proceeds in an account with the CBE; however, this technique is rarely used.

  • Repo operations: The CBE uses repos to provide temporary liquidity to banks, with treasury bills as collateral. Duration ranges from 1 to 14 days.

  • Reverse repo operations: The CBE uses reverse repos to absorb liquidity from banks, with treasury bills as collateral. Reserve repos were introduced in 2004, and they are gradually replacing CBE deposit auctions.

Regarding the foreign exchange market, in conjunction with the move to a more flexible exchange rate already mentioned, the CBE began allowing a subset of banks to trade foreign exchange on an informal, voluntary basis. An interbank convention on foreign exchange trading was adopted and ratified by banks in 2004. It is expected that this formalization of the foreign exchange interbank market will help minimize the risk of a resurgence of a large parallel market spread and its attendant effects on confidence.

Monetary Policy Instruments

As shown in Box 8.4, the CBE has a number of money market instruments. It has not used explicitly administrative measures for almost a decade. The discount window is available for use by each bank to discount treasury bills up until maturity without any limitations; banks use it only occasionally, in part because of the relatively high cost. Repo operations, which were first introduced in 1993, have been used extensively by the CBE to inject liquidity in a flexible way (the short maturity of the repos has enabled the CBE to reduce liquidity quickly by simply waiting for outstanding repos to mature). In order to deal with a situation of liquidity surplus in the system, in September 2002, the CBE introduced deposit auctions. This was an important addition to the CBE’s set of monetary instruments, because it previously had essentially no instrument to withdraw liquidity. In 2004 the CBE started absorbing liquidity with reverse repos based on treasury bills as collateral. Furthermore, in view of the volatility of the interbank overnight rate, the Monetary Policy Unit of the CBE is exploring the possibility of introducing a corridor for interbank market rates, and work is also underway on refined methods for assessing the stance and effectiveness of monetary policy.

Conclusions and Lessons

The main lessons from Egypt’s experience with reliance on money market operations for the conduct of monetary policy are the following:

  • Past attempts to manage interest and exchange rates have limited the scope for reliance on money market operations for the implementation of monetary policy. The move to a flexible exchange rate regime in 2003, which led to interest rate flexibility, has allowed greater reliance to be placed on money market operations.

  • Similarly, the planned privatization of one of the big four public sector banks is expected to increase the effectiveness of money market operations for the implementation of monetary policy, because the measure will enhance the market orientation of Egypt’s financial sector.

  • The CBE was able to gradually modernize and strengthen its instruments, in particular to address the challenges to liquidity management arising from liquidity surplus in the system. The CBE first introduced deposit auctions, and subsequently supplemented those operations with reverse repo operations.

The Gambia1


Reliance on money market instruments to conduct monetary policy was introduced in The Gambia in the mid-1980s, following the serious economic imbalances that resulted from the directed lending policies started in the mid-1970s.2 By 1985, the Gambian Cooperative and Development Bank (GCDB), which had been established to implement the directed lending policies, was faced with a mounting number of non-performing loans which, coupled with insufficient collection efforts and inadequate provisioning, created a continuous need for financing from the Central Bank of The Gambia (CBG). The development model pursued by the government of using policies and institutions to provide directed and subsidized credit to preferred sectors became unsustainable.

In June 1985, The Gambia began implementing a comprehensive adjustment program (the Economic Recovery Program, ERP) which included reforms in the financial sector that encompassed both institutional and policy reforms. Institutional reforms were directed mainly at restructuring the GCDB and resolving the issue of its non-performing loans. Policy reforms were aimed at liberalizing the financial sector with the purpose of promoting the development of a more competitive banking system and efficient financial markets.

One of the first steps in the reform process was to pass the Central Bank of The Gambia Act (CBG Act) and the Financial Institutions Act. The CBG Act was designed to strengthen the role and authority of the CBG so as to improve its ability to formulate and implement independent monetary policy and to regulate and supervise the financial system. With this mandate, the CBG began the process of moving from administrative measures to money market operations to conduct monetary policy. By May 1986, all interest rates were freed and the CBG began to rely more on the primary sales of treasury bills as its main instrument of liquidity management.

To further improve liquidity management, by September 1990, the CBG started issuing its own bills, the CBG bills, with characteristics identical to those of the treasury bills and issued using auctions that were similar in format. The CBG also introduced a rediscount window to provide financing to banks. In 1992 a uniform unremunerated reserve requirement was introduced for all Gambian financial institutions. Since 1992, the CBG has made no further significant changes to its monetary policy instruments. It still continues to rely primarily on primary sales of treasury and CBG bills as the main instruments of monetary policy. However, the experience of The Gambia during 2002–03 with reliance on money market operations was mixed. Weak internal controls in the CBG, combined with a poor conduct of monetary policy and insufficient authority over interest rate policy in the face of large fiscal slippages, led to a continuous decline in the effectiveness of money market operations during this period. Monetary policy targets were missed frequently and excessive money supply drove up inflation and caused a slump in the local currency on the foreign exchange market. The loss of confidence in the CBG’s conduct of monetary policy aggravated the deterioration in the monetary environment. In the beginning of 2003, the CBG had to increase its reliance on reserve requirements (by significantly increasing the minimum requirements) in order to curb excessive growth in reserve money, and interest rates were increased gradually from 15 percent in July 2002 to 31 percent in August 2003.

Monetary Policy Environment

Institutional Framework

Although the basic objective of the CBG Act was to strengthen the role and authority of the CBG in the formulation and implementation of monetary policy, the institutional framework for the conduct of monetary policy in The Gambia is still not clearly defined. The objectives of, and roles and responsibilities for, monetary policy are blurred. The CBG Act sets out the principal objectives of the central bank as: (1) to regulate the issue, supply, availability, and international exchange of money; (2) to promote monetary stability; and (3) to promote a sound financial structure and credit and exchange conditions conducive to the orderly and balanced economic development of the country. There is no established priority among these objectives other than an implied order of importance based on the order in which they are stated. Furthermore, the law does not ensure the autonomy of the CBG because the minister can override CBG policy, forcing the CBG to carry out the policy of the minister without requiring any disclosure or placing any time limit on the override authority. In addition, the law requires many of the CBG’s monetary policy decisions to be referred to the minister for approval. In addition, there has been a lack of internal controls in CBG operations, especially in its foreign exchange operations. Currently, the CBG does not have any formal investment guidelines or policies governing its foreign exchange operations and does not have a robust segregation between front and back office functions. In this regard, the use of outright sales and purchases of foreign currencies to monitor overall liquidity in the system has been problematic. In summary, it is clear that the CBG lacks full autonomy and is therefore not sufficiently well positioned to conduct monetary policy effectively.

Monetary Framework

Among the three objectives outlined in the CBG Act, the CBG has chosen price stability to be the principal operational objective of monetary policy, tempered by its aim also to support the broad policy goals of strengthening the external balance and promoting economic activity. To achieve price stability, the CBG conducts monetary policy within a reserve money framework. Net domestic assets of the CBG, together with net foreign assets and net claims on government, are the central benchmarks that guide the conduct of monetary policy.

The long-term liquidity targets of the CBG necessary to achieve its objective are in place and are currently derived in the context of the Poverty Reduction Growth Facility (PRGF). However, the forward-looking, short-term liquidity forecasting framework is undeveloped, and its development would require improved coordination between the CBG and the ministry of finance, together with substantial improvements in the ministry’s internal reporting system. Although the CBG takes the exchange rate into account in its monetary policy decision making, its stabilization does not appear to be an important monetary policy objective.

Macroeconomic Performance

Economic performance in The Gambia has been mixed since the introduction of money market operations for the conduct of monetary policy. While GDP growth has been predominantly strong and inflation moderate, there have been significant slippages in the implementation of the budget, which has led the government to continue to borrow heavily from the domestic banking and public enterprise sectors to finance its fiscal deficit. The fiscal deficit (excluding grants) has varied between 3½ percent of GDP and 8¾ percent over the years. The fiscal slippages have necessitated increased recourse to government domestic financing, which has raised the stock of domestic debt to about 33 percent of GDP. Due to the rapid expansion in credit to the government, the treasury bill rates have remained high, varying between 12½ percent and 15 percent, although recently they have increased to 24 percent. Lending rates have also been consistently in excess of 25 percent.

On the external front, the external current account deficit, excluding official transfers, has also remained high over the period, averaging around 11.8 percent of GDP. Partly as a result of this, the Gambian currency (the dalasi) has been depreciating—by 12 and 27 percent in 2001 and 2002, respectively, in U.S. dollar terms (end-of-period rates).

Inflation performance, just like overall economic performance, has been mixed. Inflation fell in 1994 to 1.7 percent but increased subsequently to almost 7 percent on average, following an instance of political instability. After the return to constitutional government, inflation moderated once more, reaching 1 percent by the end of 2000. In 2002, however, inflationary pressures again developed, with inflation in that year averaging 8.6 percent (compared to 4.5 percent in 2001 and 0.9 percent in 2000), and with end-of-period inflation reaching 13 percent (compared to 8.1 percent in 2001 and 0.2 percent in 2000). In addition, the consumer price index in The Gambia may understate actual inflation because it is based on outdated weights stemming from a 1976 household survey among the low-income Banjul population. That inflation may be understated is also indicated by the strong growth of broad money and reserve money of more than 20 percent on average over the past four years, and the depreciation of the dalasi by about 50 percent in SDR and U.S. dollar terms.

The persistent weak fiscal performance has been the main source of pressure on monetary aggregates and on interest rates. In 2002, broad money rose by 35 percent, compared to a target of 13 percent. Some 24 percentage points of that increase in broad money stemmed from a mushrooming in credit extension to the private sector, apparently associated with speculation in real estate and foreign exchange. This excessive credit growth was sustained by a rise in reserve money of 34 percent, a substantial proportion of which appears to have resulted from liquidity injections by the CBG associated with foreign exchange losses.3 Corrective action by the CBG was late and initially inadequate: the treasury bill rate was raised gradually from 15 percent in June 2002 to 25 percent in June 2003, while minimum reserve requirements were extended to include foreign currency deposits and increased from 14 percent to 16 percent in April 2003. However, broad money growth failed to slow down, and annual growth reached 52 percent, while private sector credit more than doubled in the year ending June 2003. In July, the CBG further increased minimum reserve requirements to 18 percent and, in August, it raised the treasury bill rate to 31 percent. Clearly, the CBG has been facing a difficult macroeconomic environment within which to implement monetary policy, particularly on account of weak fiscal performances.

Structure of the Financial System

By every indicator, the financial system of The Gambia is small and underdeveloped.4 It comprises the Central Bank of The Gambia (CBG), 6 commercial banks, 11 insurance companies, 52 Village Savings and Credit Associations (VISACAs), and numerous microcredit institutions. There are also 11 foreign exchange bureaus operating under license from the CBG and an active unofficial market.

The banking sector overwhelmingly dominates the financial system,5 although it is small in both absolute and relative terms. Total banking sector assets are equivalent to about 40 percent of GDP. Total loans, however, are equivalent to only 9 percent of GDP (Table 8.4). All banks in The Gambia are now virtually privately owned.6

Table 8.4.The Gambia: Banking System Structure(as of 2001)
Millions of DalasisMillions of U.S. DollarsPercent of GDP
Total assets2,90317247
Total loans7504412
Total deposits1,86411030
Sources: Central Bank of The Gambia (CBG) and IMF staff estimates.
Sources: Central Bank of The Gambia (CBG) and IMF staff estimates.

The banking system is highly concentrated, with the largest bank in the country dominating the market both in terms of deposits (52 percent) and of loans extended (38 percent). The top three banks account for 86 percent of the market in terms of loans and 95 percent in terms of deposits. The balance sheet structure of Gambian banks reflects the highly embedded credit risk in the economy, a preference for liquid, low-risk assets, and the intermediation of official and private transfers. As of June 2002, loans accounted for less than one-fourth of banks’ total assets, reportedly reflecting primarily the dearth of bankable projects and creditors’ inability to exercise their rights. The largest portion of bank assets—about one-third—was placed in treasury bills. As a result, liquidity in the banking system as a whole is high, even though there are significant bank-to-bank variations.

The banking sector has been very profitable, with average after-tax profits at about 4.6 percent of assets at the end of 2001. The high level of profitability derived by banks from treasury bill holdings has so far provided no incentives to reduce rates or spreads for private lending.

All banks have significant open foreign exchange positions, with long positions ranging from 20 percent to 53 percent of their capital. In the existing environment, with the domestic currency depreciating, the returns on investments in foreign currency are a sizable source of the banks’ income. It also means, however, that the banks are vulnerable to unexpected exchange rate movements. Moreover, the banks are exposed to adverse movements in exchange rates through their impact on the credit risk of their borrowers.

Market Infrastructure

Interbank Money Market

Six banks dominate the money market in The Gambia. A dalasi interbank market does not exist in the real sense of the term, except for a few ad hoc interbank transactions. The banks invest their excess funds in treasury bills, and despite a 3 percent margin between the treasury bill rate and the CBG refinance rate, banks seldom deal with one another, and they prefer to use the CBG’s refinance facility despite its high cost. The participation of nonbank public institutions, particularly social security funds, in treasury bill auctions has increased, but total investments are still insignificant, and purchased bills are almost without exception held until maturity.

Competition in the money market is very limited. First, the demand for short-term funds is limited and the number of potential participants is very small. Second, most activities in the short-term market are centered on trade, primarily re-exports. As a result, all banks are on the same side of the market in that they are all influenced by the same seasonal, cyclical, or external factors. The structure of the banking system and the uniform effects of seasonal, cyclical, or external events on all participants are also the main reasons for the lack of an interbank market.

The Foreign Exchange Market

Like the interbank money market, the interbank market for foreign exchange has played a limited role in distributing foreign exchange in the economy. The structure of the foreign exchange market in The Gambia consists of the central bank, commercial banks, exchange bureaus, and moneychangers.7 While the central bank and the commercial banks handle mainly large transactions, involving international financial transactions, exchange bureaus deal mainly in cash. Large traders who use these exchange bureaus to acquire foreign exchange directly from the public often directly “own” the latter. Partly as a result of the prevalence of cash transactions on the foreign exchange market, specifically for the re-export trade and large bank charges, the exchange bureaus have become the preferred depository or source of foreign exchange.

The foreign exchange market is completely liberalized, and since 2001, commercial banks have been allowed to accept foreign currency deposits. CBG maintains exposure limits for banks and exchange bureaus for prudential purposes. Any amount above the limit must be offered for sale within seven days of the weekly meeting of the foreign currency review committee, which is chaired by the CBG and includes representatives of the commercial banks and the foreign exchange bureaus. Banks and exchange bureaus would normally be expected to submit their bids for purchases and sales together with the desired exchange rate, at the weekly meeting of the official market participants. In practice, there is more demand than supply of foreign currency, since all market participants prefer to buy foreign exchange at the same time at the interbank rate and there is therefore an absence of selling activity. In this context, the interbank market resembles more of an auction system. As in the interbank money market, banks and exchange bureaus prefer to deal directly with the CBG.

CBG’s foreign exchange transactions have not been subject, however, to suitable internal controls and have helped undermine the effectiveness of using outright purchases and sales of foreign currencies as an instrument to influence overall liquidity conditions. As mentioned above, a major part of liquidity injections in 2002 stemmed from losses that the CBG incurred by conducting foreign exchange transactions.

Government and Central Bank Debt Market

The CBG issues treasury bills on behalf of the government for purposes of financing the deficit. Treasury bills are auctioned at 91-, 182-, and 364-day maturities—with the latter (one-year) maturity being a recent innovation. Bills are auctioned as a block, with bidders choosing the maturity desired. The CBG auctions treasury bills at a uniform price and, because of the prevailing climate of excess liquidity, accepts all bids. The amount of bills outstanding as at the end of 2001 was D2 billion, of which over 50 percent were 91-day bills, although the share of 182-day bills has been increasing. Commercial banks hold just over 50 percent of all treasury bills outstanding. The secondary market is modest and primarily consists of the rediscount facility at the CBG and its sales of rediscounted bills.

The CBG also issues its own bills with 91-day and 182-day maturities, of which the latter (three-month) bills account for the vast majority. Central bank bills are the same as treasury bills except for the issuer. The bulk of central bank bills are owned by commercial banks. There is no organized securities market in The Gambia.

Monetary Policy Instruments

The CBG has essentially three instruments to manage banking system liquidity: (1) primary market sales of treasury and central bank bills and secondary market sales of treasury bills from its own portfolio and at its own discretion to absorb liquidity; (2) a rediscount window, which is a standing facility, used at the initiative of banks and nonbanks; and (3) reserve requirements, which are been used increasingly actively (Box 8.5). Due to current liquidity conditions, most operations exist to absorb liquidity and are carried out through primary sales of treasury and central bank bills, while rediscount operations and secondary sales of treasury bills are quite limited. Banks are also subject to a liquid asset ratio, which currently does not represent a constraint and is primarily used as a prudential instrument. In effect, primary sales of treasury and central bank bills represent the main monetary policy instrument in The Gambia.

Box 8.5.The Gambia: Monetary Policy Instruments

Liquid asset ratio

Set at 30 percent of deposits. Eligible assets mostly include treasury and central bank bills.

Reserve requirements

Set at 18 percent of deposits, in the form of unremunerated deposits with CBG.

Standing facilities

Rediscount window: Allows banks to obtain funds on demand against accepted collateral (treasury and central bank bills). No limit to access, as long as bank complies with liquid asset ratio. Rate applied is sets above treasury bill rate (currently 300 basis points).

Money market instruments

  • Primary market sales of treasury and central bank bills: Issued using uniform price auction in maturities of 91, 182, and 364 days; issued on a fortnightly basis. This is the main discretionary instrument of liquidity management.

  • Secondary sales of treasury bills: Consist of sales of rediscounted bills; used to absorb liquidity from market in between primary market sales of securities.

The amount of bills issued in the primary market at any given time (usually a combination of both treasury and central bank bills) reflects both maturing bills (to be rolled over) and an extra amount for monetary policy purposes. The extra amount is placed into a special account—the “sterilized account”—at the CBG. The special account is, in principle, blocked so that inflows to it are sterilized. In practice, however, the treasury draws on this account as funds are needed. These treasury withdrawals have been seriously undermining the CBG’s monetary policy actions, but the CBG has insufficient autonomy to stop the process, which from the treasury’s point of view, is required by the high fiscal deficit. The CBG also does not have the resources to pay interest on a large amount of its own bills. Occasionally, the CBG uses sales of treasury bills from its own portfolio as an instrument to absorb liquidity in between auctions. But as indicated, this portfolio is small, thereby limiting the effectiveness of secondary market sales of treasury bills as an instrument of monetary policy.

The CBG maintains a standing facility—the rediscount window—through which banks, at their discretion, can obtain cash for their bill holdings from the CBG. These discounts are without limit as long as a bank holds bills above the minimum liquid asset ratio. Under these operations, the ownership of the collateral is transferred to the central bank for its whole residual maturity. Financing, therefore, is granted for a period corresponding to the maturity of the underlying collateral. The interest rate charged is the rediscount rate, which is set at 3 points above the treasury bill rate (see below).

In June 1998, reserve requirements were unified across deposits and were set at a rate of 14 percent of total deposits. In 2003, the CBG reverted to the use of reserve requirements as an active policy device. During the first half of 2003, reserve requirements were gradually increased to 18 percent and were extended to include foreign currency deposits.

Interest Rates

The treasury bill rate is the key interest rate in The Gambia, because most other interest rates are linked to it. This rate varied little up to 1998 but since then rose from 12.5 percent to 14 percent in 1999 and further to 23 percent before mid-2003. The treasury bill rate was increased further to 26 percent in July 2003 and then to 31 percent in August 2003. As noted, the rediscount rate is set at 3 percentage points above the treasury bill rate. The CBG’s secondary market rate for selling bills is 1 percentage point below the treasury bill rate. The “bank rate”—the rate for lending to parastatals and for emergency loans—is 2 percentage points below the treasury bill rate.

The spread between lending and deposit rates has also remained unchanged at about 13–14 percentage points, which is even higher than in other countries in the region. The high spreads can be explained by a combination of factors, including the high credit risk inherent in the economy, the inefficient legal and institutional framework, the oligopolistic nature of the banking system, and its small size.

The CBG is concerned about the level of nominal and real interest rates. The current high rates, in addition to putting pressure on the budget, also hamper economic activity and may pose a severe threat to the banking system, given that the only borrowers willing to pay such high real interest rates are usually very risky ones. However, this must be balanced against the CBG’s commitment to keeping inflation low.

Conclusions and Lessons

The following conclusions and lessons can be derived from the experience of The Gambia with reliance on money market instruments:

  • Following financial sector reforms of the early 1990s, inflation performance in The Gambia was encouraging, suggesting that progress in the implementation of monetary policy can still be achieved in small, underdeveloped, and concentrated financial systems with the use of very simple money market operations—mainly primary sales of treasury and central bank bills, a refinance window, and occasional secondary market sales of treasury bills.

  • These strong performances occurred, however, against the background of an increased buildup of domestic debt and persistently high interest rates (including treasury bill rates), as a result of continued sales of sizable amounts of treasury and CBG bills in pursuit of a tight monetary policy stance. Since most interest rates are linked to the treasury bill rate, all interest rates have remained high in real terms, which has posed a significant challenge to monetary policy.

  • More recently, weak internal controls in the CBG, combined with a weak monetary policy and insufficient authority over interest rate policy in the face of large fiscal slippages, have led to a continuous decline in the effectiveness of money market instruments for the conduct of monetary policy.

Finally, the experience of The Gambia shows that expansionary fiscal policy constitutes a setback to effective monetary policy and to sustaining low inflation in the context of shallow markets.

Kyrgyz Republic1

Monetary Policy Environment

Background and Motivation for Adopting Money Market Instruments

At the time of independence in 1991, the Kyrgyz Republic had a planned economy modeled after that of the former Soviet Union. The National Bank of the Kyrgyz Republic (NBKR) allocated credit according to the financial plan among banks and sectors. Interest rates were controlled, and the currency was the Russian ruble.

Market-related reforms were introduced beginning in 1992-93. In May 1993, the Kyrgyz Republic was among the first republics of the former Soviet Union to introduce its own currency, the som. Market reforms were introduced to improve efficiency and included the removal of controls on interest rates. A reserve requirement system and credit auctions were introduced in 1992 and 1993, respectively, to manage overall liquidity in the system, and by mid-1994 virtually all of the refinancing was being auctioned. Treasury bill auctions were introduced in 1993, although most of the domestic credit for the government was financed by the NBKR.

As the interbank market developed, banks began to rely on it for their liquidity needs, and the NBKR began phasing out the credit auctions, which were stopped completely in January 1997. NBKR subsequently introduced a Lombard facility and an emergency credit facility. In 1997, repos were introduced. In 2000, central bank bills were introduced as an instrument of monetary policy, and the NBKR began holding weekly auctions. Also that year, the NBKR introduced foreign exchange swaps, and these have at times been used extensively as a monetary tool since then.2 In 2001, the reserve requirement was reduced from 20 percent to 10 percent.

Framework for Monetary Policy Implementation

The primary objective of the NBKR, as defined in the Law on the National Bank of the Kyrgyz Republic of 1992 (and confirmed in a new law adopted in 1997) is to maintain price stability. The NBKR was granted operational independence by that legislation. Specifically, all government agencies are prohibited from interfering with issues under the jurisdiction of the NBKR, including monetary policy implementation.

In the Kyrgyz Republic, monetary policy is implemented in the context of a managed floating exchange regime with no preannounced path for the exchange rate, and the NBKR intervenes in the market to smooth fluctuations in the value of the som and to meet international reserve targets. The Kyrgyz Republic accepted Article VIII in March 1995, thus permitting exchange rate convertibility for current transactions. However, it retains controls on capital transactions.

The NBKR uses broad money, including foreign currency deposits, as its intermediate target and the monetary base as its operational target. The monetary aggregates are targeted on a quarterly basis, while the weekly operations target is excess reserves in the banking system.

Macroeconomic Performance

The Kyrgyz Republic is relatively small, with a population of about 5 million. Total GDP in 2001 was approximately US$1.5 billion, and per capita GDP was about US$300 per year. The Kyrgyz Republic’s macroeconomic performance has been strong in recent years. Like other countries of the former Soviet Union, following its independence, the Kyrgyz Republic suffered a period of high inflation and falling output. Inflation was over 2,000 percent in 1992 and about 1,000 percent in 1993. However, the Kyrgyz Republic stands out as one of the pioneers of economic reform, and since 1994, inflation has been on a downward trend, with the exception of the inflationary shock from the Russian financial crisis of 1998. The inflation rate has declined significantly since 1999. The 12-month inflation rate fell to 3.7 percent in 2001, from 9.6 percent in 2000 and 39.9 percent in 1999, mainly reflecting appropriately tight monetary and fiscal policies. The fiscal adjustment in 2001 was impressive, with the deficit falling from 9.2 percent of GDP in 2000 to 5.0 percent in 2001. The current account deficit declined to 1.0 percent of GDP in 2001, from 5.7 percent in 2000 (versus 15.0 percent in 1999). The real GDP growth rate was approximately 5.5 percent per year in 2000 and 2001.

Structure of the Financial System

The financial sector is dominated by a banking sector with weak penetration. At the end of 2001, the total assets of the banking system were equivalent to only about 7 percent of GDP (Table 8.5). Banks in the Kyrgyz Republic have shown a limited capacity to attract deposits, and lending is geared to the short term, owing to underdeveloped credit skills and low confidence in the banking system. Banking sector problems have arisen frequently since 1993, when solvency problems first emerged after the NBKR tightened monetary policy to control inflation. In 1995, regulations were introduced that require on-site inspections and provisioning for doubtful loans; this led to the revelation that about half of all commercial banks had negative net worth and that about 60 percent of the banking sector’s loans were considered unrecoverable.

Table 8.5.Kyrgyz Republic: Financial System Structure(as of July 2002)
Number of InstitutionsAssets (millions of soms)
Commercial banks195,897
Assets to GDP (percent)7.4
Deposits to GDP (percent)3.5
Special credit10
institutions of
which KAFC1,005
Credit unions357311
companies of which Stateowned
Source: National Bank of the Kyrgyz Republic (NBKR) and Ministry of Finance.
Source: National Bank of the Kyrgyz Republic (NBKR) and Ministry of Finance.

In late 1995, a comprehensive financial sector reform program was introduced to liquidate and restructure insolvent banks and improve the legislative and regulatory framework. The program incorporated a wide range of measures, including a new central bank law, a banking law, a bankruptcy law, and a mandatory chart of accounts for all banks. By mid-1998, these reforms led to improvements in bank intermediation, including the emergence of a small core of healthy banks. Nevertheless, weaknesses remained, including insufficient and poorly enforced bank regulation and supervision, which is due in part to weaknesses in financial reporting by banks.

The economy and the banking system were hit by the Russian crisis of 1998, both directly and indirectly through the subsequent devaluation of the som, the collapse of one of the largest industrial conglomerates, and the bankruptcy of two of the country’s largest banks. The Russian crisis also revealed gaps in institutional capacity and corporate governance, delays in the development of financial and legal infrastructures, deficiencies in banking supervision, and the lack of banking services.

As of July 2002, 19 commercial banks were operating in the Kyrgyz Republic, including several subsidiaries of foreign banks. The NBKR is encouraging consolidation of these banks. During 1999 and 2000, banks experienced substantial declines in asset quality. However, during the following year, gross non-performing loans as a percentage of total loans stabilized at about 13 percent (about 5 percent net of provisions), bank capitalization increased substantially, and banks generally returned to profitability. Two banks, accounting for approximately 14 percent of total bank assets, are state-owned, and the remainder are privately owned. The banking sector is not highly concentrated, with the three largest banks accounting for only about 31 percent of total bank loans.

The volume of funds intermediated by the commercial banking sector remains limited. Banks lend funds in both national and foreign currency, primarily to a few enterprises in the industrial and services sectors. There is an acute shortage of basic financial services, including depository and payment services and credit for the majority of the population. Services are especially limited or nonexistent in rural areas.

The Basel standards on capital adequacy were adopted in June 1995, and new regulations passed in December 1998 increased the capital requirements for establishing a new bank. The NBKR, which is responsible for banking supervision, has had difficulties with regulatory enforcement. At least some of the problems arise because of weaknesses in the judicial system which result in pressure being brought to bear on the courts by vested interests. Other weaknesses can be traced to accounting problems and to the need to improve the legislation covering bankruptcy and liquidation. There has been some recent progress. For example, in 2002 a new law was enacted that requires the courts to accept the balance sheets of commercial banks as certified by the NBKR in bankruptcy cases.

The capital market in the Kyrgyz Republic is at an early stage of development and is not a significant source of funds. The Kyrgyz Stock Exchange (KSE) opened in May 1995, but market capitalization has grown slowly, from the equivalent of US$4 million at the end of 1999 to US$33 million in May 2001 (2¼ percent of 2001 GDP).

The market for government debt securities is underdeveloped. The treasury bill market contracted sharply after the Russian crisis in 1998, with the volume of treasury bills held by commercial banks falling from approximately som 490 million in June 1998, to som 86 million in June 1999. Confidence in government securities has suffered from the government’s failure to always pay promptly when debt matures. In addition, the market for government debt soured a few years ago when a bond issued by a government entity failed, and the government did not stand behind the bond. The market has begun to recover, with banks’ holdings of treasury bills increasing to som 255 million in mid-2001 and to som 460 million in June 2002, but this was still equivalent to only 0.5 percent of estimated 2002 GDP. In December 2002, with the regularization of financial relations between the NBKR and the ministry of finance, an additional som 850 million of treasury bills were issued. In addition, all non-interest-bearing securities held by the NBKR were restructured according to an IMF technical assistance mission’s recommendations.

Box 8.6.Kyrgyz Republic: Monetary Policy Instruments

Reserve requirements

Set at 10 percent of all deposit balances, except domestic interbank deposits. Requirements are the same for domestic and foreign currency deposits, and reserves for foreign currency deposits are held in domestic currency. They are computed over a two-week period, and reserve averaging is permitted. They are remunerated based on the weighted average deposit rate for each bank.

Standing facilities

NBKR maintains a noncollateralized overnight lending facility for banks. Lending must meet reserve requirements, and it stands at a penalty rate of 1.2 times the average rate at the previous auction for the 28-day NBKR bills. Risk for the NBKR is minimized by the manner in which the facility for selling NBKR bills is operated. NBKR funds are added to a bank’s account as the last transaction of one day and withdrawn as the first transaction the following day.

Money market operations

  • NBKR bills are auctioned weekly, on a very limited basis. Treasury bills are also auctioned weekly. Both auctions are at a variable price.

  • Repo and outright transactions in government securities are conducted on a limited basis, due to the limited quantities of government and central bank securities. The NBKR’s portfolio includes som 2.38 billion in nonmarketable debt, in accordance with the law “On Restructuring the Government’s Debt to the NBKR” and which the NBKR used in reverse repo transactions for monetary purposes.

  • Spot and especially swap operations in the foreign exchange market are frequently used for monetary purposes.

  • Government deposits with the NBKR have been varied for liquidity purposes, because of limited quantities of securities for conventional open market operations.

Monetary Policy Instruments

The NBKR uses money market instruments and has developed several such instruments to manage liquidity (see Box 8.6). In part because of the thin markets for government and NBKR securities, the NBKR relies heavily on foreign exchange spot and swap transactions as instruments of monetary policy. The NBKR’s other instruments are reserve requirements, weekly auctions of NBKR bills, and repo operations. In addition, the NBKR has a noncollateralized overnight lending facility for banks. In order to sterilize a recent inflow of foreign exchange, the government increased its deposits with the NBKR in view of the limited potential for conventional open market operations.

The NBKR has not developed its liquidity projections and does not forecast liquidity on a daily basis. One of the main weaknesses is the absence of adequate short-term projections for the government’s cash flow. Consequently, interbank interest rates can sometimes be particularly volatile and can exhibit seasonal patterns.3 The NBKR does not attempt to maintain an interest rate corridor for rates in the interbank market. In addition, income averaging for the reserve requirement scheme is insufficient to stabilize interbank rates.

Market Infrastructure

The NBKR’s development and use of money market instruments is particularly constrained by shallow financial markets. In addition to the relatively small size of the stock of government securities (approximately 5 percent of GDP), one of the main reasons for the thin market in government securities is that the bulk of domestic public debt is held by the NBKR in the form of non-interest-bearing securities with no specified maturity. As of mid-2001, non-NBKR investors held government securities amounting to only about 0.8 percent of GDP, while the NBKR held government securities amounting to approximately 4 percent of GDP.4 The market for NBKR bills is even shallower than the market for government securities, with the outstanding stock of NBKR bills amounting to approximately som 16 million, or less than 0.1 percent of GDP.

Although steps have been taken to increase the amount of treasury bills in the system, the thin market for these bills has contributed to a scarcity of suitable collateral, both for NBKR lending operations and for the interbank market, and has constrained the NBKR’s use of repo operations (and reverse repo operations) as an instrument of monetary policy. In addition, the segmentation of the interbank market, caused in part by the presence of weak banks, has interfered with the proper distribution of liquidity injections among banks. The Kyrgyz Republic is also highly dollarized, with approximately 60 percent of deposits in foreign currency. Finally, currency holdings somewhat exceed deposits, reflecting a low, though somewhat improving, level of trust in banks.

Channels of Transmission of Monetary Policy

The two main channels through which monetary policy changes are transmitted are foreign exchange market adjustments and the availability and cost of credit. Buying foreign exchange or engaging in swap operations tends to increase domestic liquidity. Also, because the Kyrgyz Republic has a flexible exchange rate system, an expansive monetary policy would tend to depreciate the som, stimulating exports and retarding imports. A contractionary policy would have the reverse effects. The effects would also be felt through the banking system: an expansionary policy would increase the level of excess reserves, putting downward pressure on the interbank interest rate and reducing the cost of lending. There would also be effects on the level of credit as a result of changes in the availability of credit.

Conclusions and Lessons

The main lessons from the Kyrgyz Republic’s experience with reliance on money market operations for the conduct of monetary policy are the following:

  • Money market operations have been conducted in the context of a shortage of securities and conventional collateral by means of foreign exchange operations, especially foreign exchange swaps. More recently, the authorities have taken steps to increase the quantity of treasury bills through phased securitizing of government debt held by the NBKR.

  • Monetary policy implementation has been hindered by weak liquidity projections, in part because of undeveloped projections of governmental budgetary flows.

  • The small stock of marketable government and central bank securities and the resulting thin markets have retarded the NBKR’s development of open market operations and have limited collateralized lending, including repo and reverse repo operations. However, authorities have taken steps gradually to increase the stock of marketable government securities.


Path to Reliance on Money Market Instruments

Malta’s gradual process of financial liberalization started in 1990 and was to be fully completed upon accession to the European Union (EU) in 2004. Policy measures included elimination of price controls, liberalization of interest rates, lifting of capital controls, introduction of market-based monetary policy instruments, and reduction of the government’s involvement in the financial sector. At the outset, interest rates were controlled and rigid. Nominal rates had hardly changed over nearly three decades. The Central Bank of Malta’s (CBM’s) only monetary policy instruments were interest rate controls and liquidity requirements. All deposit money banks were state-owned, which severely reduced the scope for competition. Financial markets were nonexistent. No interbank borrowing took place, and there was no real market for government securities and the few other instruments. The banking sector was very liquid as a result of balance of payments surpluses.

Financial market liberalization preceded capital account liberalization. The reforms of the heavily regulated financial system commenced in a favorable economic environment, with large levels of international reserves, low inflation, and a low level of public debt. The first steps taken by the CBM between 1990 and 1994 included tying bank lending rates to the CBM’s discount rate, eliminating preferential lending arrangements (except for mortgage rates which remained in effect for social reasons until April 2000), and removing ceilings for bank deposit rates (but at the same time setting minimum rates for savings deposits). Trading of government stocks and equities commenced on the Malta Stock Exchange (MSE) in 1992. Treasury bill rates, which had formerly been administered, were determined by auctions. A new banking act was approved that brought banking legislation in line with EU practice. The amended CBM Act empowered the CBM with more authority to carry out monetary policy, but fell short of providing it with full independence.

Capital account liberalization commenced in the early 1990s and was subsequently extended, and Malta took further steps to liberalize and develop the financial system. The government reduced its equity participation in the banking system, holding only a 25 percent stake in one commercial bank by 1999. Lending and deposit rates were gradually liberalized. Remuneration of banks’ excess reserves was eliminated, and reserve requirements were made more flexible by allowing reserve averaging and lengthening the maintenance period. The weekly trading sessions for government securities on the MSE were replaced by daily sessions. Treasury bill auctions were conducted regularly, and longer maturities were introduced. On the foreign exchange market, the CBM started to quote exchange rates on a real-time basis in 1995. It introduced foreign exchange swaps as an additional tool.

Monetary Policy Environment

Institutional Framework

The newly amended CBM Act, effective October 1, 2002, assigns the CBM the primary objective of maintaining price stability. Before the amendment, the act assigned the CBM multiple objectives, but the CBM interpreted its mandate to maintain price stability by using the exchange rate as the nominal anchor. The amendments, all in line with requirements for EU membership, also strengthened the legal and operational independence of the CBM and explicitly prohibited central bank financing of public sector deficits.

The governor of the CBM is solely responsible for decisions on monetary policy. The governor is advised by the newly established monetary policy advisory council. The governor and deputy governor are appointed by the president of Malta, on advice of the prime minister, for a period of five years and are eligible for reappointment. Together with three other directors, they comprise the board of directors. The other three directors are appointed by the prime minister for a period of five years and are also eligible for reappointment.

Monetary Framework

The CBM operates monetary policy within the framework of an exchange rate peg. The Maltese lira (Lm) has been pegged to a currency basket since 1972. The weights of the three currencies currently in the basket (euro, U.S. dollar, and pound sterling) reflect Malta’s external trade pattern. The lira was devalued only once, after the European Exchange Rate Mechanism (ERM) crisis in 1992. The exchange rate peg has contributed to moderate inflation in Malta. Since 1996, inflation averaged 2.6 percent, close to the rate in the currency basket countries.

The CBM’s flexibility in conducting monetary policy is also constrained by a required minimum reserve cover for CBM liabilities. Specifically, under the CBM Act, the CBM is obliged to maintain foreign exchange reserves at a minimum of 60 percent of the CBM’s liabilities (monetary base plus other deposit liabilities). The CBM’s stock of official reserves has over many years fully covered the monetary base and recently increased due to the balance of payments surplus (143 percent at the end of 2002). Official reserves in terms of broad money stood at 29 percent at the end of 2002 and covered about nine months of imports.

Macroeconomic Performance

Malta’s economy is highly dependent on a few sectors, such as tourism and manufacturing, and is therefore heavily influenced by external developments. Malta is a small island, with a population of 395,000 and a GDP per capita of over US$9,200 (one of the highest among the EU accession countries). Tourism accounts for about 30 percent of GDP and manufacturing for about 25 percent. Electronic products make up 75 percent of manufactured exports. The government’s involvement in the economy remains high, notwithstanding the ongoing reform strategy of reducing the government’s stake in enterprises. Public administration and state-owned enterprises account for about 23 percent of GDP and employ about one-third of Malta’s workforce.

Strong growth in deposits, combined with a slowdown in credit expansion, caused a rapid build-up of liquidity in the banking system since 2001. The growth in deposits accelerated to annual rates exceeding 10 percent due to widening interest rate spreads over the basket currencies, the weak performances of equity markets, the lack of alternative investment vehicles in Malta, and a tax amnesty in 2002 that encouraged some capital to flow back to Malta. On the other hand, a sluggish economy markedly weakened the demand for credit, especially within the private sector, to growth rates below 3 percent in 2002 (compared with more than 10 percent in each of the previous four years).

Structure of the Financial System

The banking sector is by far the largest segment in Malta’s financial sector (Table 8.6). Malta has never experienced any banking crises. The banking sector consists of a domestic and an international component which operate independently of one another. The domestic component is highly concentrated, comprising only four banks. Two of these are roughly the same size, and they dominate the system, accounting for more than 90 percent of domestic system assets and similar shares of the deposit and loan markets for residents. The two large banks also dominate the insurance and securities industries, through subsidiaries and affiliates in these sectors. Government involvement in the banking system has been significantly curtailed. The international component consists of nine international banks and one offshore bank that deals with nonresidents in foreign currency. With one exception, the international banks consist of branches and subsidiaries of Austrian and Turkish banks, which have established offices in Malta mainly for tax purposes. They have no significant links to the domestic banking system. The last offshore bank was to relinquish its offshore status at the end of 2003.

Table 8.6.Malta: Financial System Structure(as of end 2002)
NumberAssets (millions of Lm)Percent of Total AssetsPercent of GDP
Deposit money banks53,91158.0232.1
International banks92,56938.1152.5
Off-shore banks12663.915.8
Insurance companies1212513.814.9
Source: Central Bank of Malta and Malta Financial Services Authority.

Since three insurance companies are composite companies, the subtotals of life and nonlife companies do not add up to the total insurance companies. Data for assets are end-2001.

Source: Central Bank of Malta and Malta Financial Services Authority.

Since three insurance companies are composite companies, the subtotals of life and nonlife companies do not add up to the total insurance companies. Data for assets are end-2001.

The level of financial intermediation in Malta is relatively high: M2 exceeds 150 percent of GDP, and credit extended to the private sector exceeds 90 percent. This is largely the result of many years of stability in the banking system, which has not experienced any major crises or economic/financial shocks.

The Maltese banking system is healthy but exposed to the country’s narrow economic base. Bank loan portfolios are highly concentrated. Loans to the tourism, retail trade, manufacturing, ship repair/shipbuilding, and construction sectors are the most important, along with loans to households. Lending to non-residents is insignificant, and more than 95 percent of lending to residents is denominated in Maltese lira.

Market Infrastructure

Maltese Lira Money Markets

Turnover in Maltese lira money markets is very low due to the excess liquidity in the banking system and the small number of banks. Money markets consist of an unsecured cash market and a treasury bill market. There are no interbank repo or sell/buy-back markets and no other instruments such as commercial paper or certificates of deposits. In the past, the lack of legislation that recognizes netting in times of bankruptcy has prevented the development of a repo market, but new legislation was put in place since 2003.

Interbank lending is unsecured and has been dormant since 2001. Turnover in 2002 was only 6 percent of GDP, less than half of the already low turnover in 2001. All four banks have credit lines with each other, and these are typically reviewed on an annual basis. Deals are arranged over the telephone. The CBM monitors interbank exposures by requiring banks to report their deals. Interbank transactions are highest for the one-week maturity bracket.

Interbank interest rates are closely aligned with the CBM Central Intervention Rate. They have exhibited hardly any volatility because all banks tend to be on the same side of the market. In September 2002, the CBM launched the weekly fixing of two interbank rates, MIBOR (Malta Interbank Offered Rate) and MIBID (Malta Interbank Bid Rate), in the following tenors: overnight, 1 week, 1 month, 2 months, 3 months, 6 months, 9 months, and 1 year. The rates have so far been purely indicative, because no trades have been conducted. Nevertheless, the fixing should prove useful once liquidity conditions change and it can be conducted on a daily basis.

The Maltese treasury holds weekly auctions for treasury bills with a 91-day maturity. Auctions are held even when the government has no borrowing requirement in order to maintain some liquidity in the treasury bill market and set a yield curve. Treasury bills with other maturities (1 to 12 months) are held less frequently. The CBM does not participate in primary auctions. At the beginning of 2003, there were 15 issues of treasury bills outstanding, with remaining maturities from 4 to 164 days and a total value of Lm 219 million. The treasury has a threshold of Lm 300 million in treasury bills that it can issue without parliamentary approval.

The vast majority of treasury bills (about 87 percent) are held by banks. The minimum bidding volume in the primary auctions was raised to Lm 20,000 in 2002, in line with the authorities’ policy to focus on the wholesale market. Due to the high excess liquidity in the banking system and the small number of investment vehicles, banks tend to hold treasury bills until maturity. The turnover on the secondary market for treasury bills is therefore very low, at 7.2 percent of GDP in 2002. Most treasury bill transactions are with the CBM (43 percent), which quotes bid and offer prices. Treasury bills are not dematerialized (but dematerialization is planned), and trading is over the counter and unregulated.

In the government securities (treasury bills and government bonds) market, the CBM aims to ensure liquidity and install investor confidence (in particular for retail investors), and thereby to contribute to orderly conditions and stability. To achieve these objectives, the CBM quotes bid and offer prices based on yields with a yield spread of 5 basis points for wholesale transactions and 10 basis points for retail transactions. The CBM cannot bid in the primary market but serves as a buyer for any investor who would like to receive proceeds before maturity date. The CBM then makes the purchased bills available for sale.

The CBM’s pricing role in the government securities market appears to cause confusion among some market participants. Even though the CBM follows the prices established at the primary auctions and carefully observes market transactions and adjusts its prices accordingly, the pricing pattern has been surprisingly steady. This has created a perception among some market participants of an attempt to stabilize the government securities prices. Such suggestions could call into question how solid the yield curve is beyond the range of active treasury bill maturities.

Government Stock Market

Secondary market trading in government securities is very thin. Government stocks are traded on the MSE. Trading volumes shrunk significantly in 2002, to only 2.4 percent of GDP. Given the build-up of liquidity in the banking system, the poor performance of equity markets, and widening spreads between Maltese and foreign government bond yields in recent years, new issues of government securities have been heavily oversubscribed, and investors have been reluctant to trade them afterward in the secondary market. Also undermining secondary market liquidity has been the highly fragmented nature of debt stock (36 bonds outstanding at the end of 2002), the participation of the governmental Sinking Funds in the government debt market, and the previously mentioned pricing role of the CBM in government securities.

Foreign Exchange Markets

The most active financial market in Malta is the foreign exchange market, with a turnover of 167 percent of GDP in 2002. However, given the openness of the Maltese economy, this turnover rate is still relatively low. More than 95 percent of all transactions are spot. As in most countries, forward contracts typically have maturities between 3 and 12 months. Transactions between banks and the public account for about two-thirds of all foreign exchange operations, and transactions between foreign exchange bureaus and the public account for about 4 percent. Most banks are close to the regulatory limit for open foreign currency positions and therefore pass on any additional open foreign exchange positions to the CBM. Bid-ask spreads between credit institutions have narrowed to about 0.37 percent, compared to 0.25 percent for transactions with the CBM. A wider bid-ask spread for government and parastatals of 0.5 percent (compared to 0.25 percent for banks) provides some incentive for them to deal with banks. However, when the size of their transactions is too large, they directly deal with the CBM.

Monetary Policy Instruments

Auctions of Term Deposits and Repurchase Agreements

The CBM’s main monetary policy instruments for steering short-term interest rates are auctions of term deposits and repurchase agreements with securities. Depending on the liquidity situation of the banking system, every Friday the CBM conducts either of those two operations (Box 8.7). They have a 14-day maturity and are settled on the same day. Auctions are at variable rates, with each bank having to pay its successful bidding rate (i.e., American-style auction). However, the rates are within a narrow corridor of 5 basis points above the CBM central intervention rate for repos and 5 basis points below the central intervention rate for term deposits. The CBM honors all bids in this corridor, except when it views the bidding amount as clearly inconsistent with its liquidity forecast. Its liquidity management approach is therefore accommodating. In 2001, when Malta experienced a balance of payments deficit, the CBM predominantly conducted liquidity-injecting operations. With the turnaround of the balance of payments situation, the CBM has conducted only liquidity-absorbing auctions of term deposits. Typically, three out of the four eligible counterparts participate in the operations.

Securities that can be used for repurchase agreements are government bonds and treasury bills, but the CBM Act also allows acceptance of other eligible assets. In practice, the CBM requires the use of government bonds unless a bank does not have enough government bonds in its portfolio. In such cases, treasury bills may be used, in certificate form, provided that the actual transfer of ownership is effected on the same day. The only risk-control measures are initial margins of 2 percent. However, the CBM plans to introduce valuation haircuts and variation margins similar to those used by the European Central Bank. As noted previously, until the passage of new legislation in 2003, the lack of legislation recognizing netting in times of bankruptcy prevented development of an interbank repo market.

Standing Facilities

The CBM’s standing facilities create a 350-basis-point corridor for the overnight money market rate. The lower boundary is set by the CBM’s overnight deposit facility. This facility is available to deposit money banks upon request at the end of the day. Maltese banks frequently use the overnight deposit facility at the end of the reserve period. This is the result of the limited options for using short-term liquidity given the smallness of the financial system and the fact that most banks are on the same side of the market. Deposits with the deposit facility averaged Lm 10.5 million per month during 2001–02. This compared to about Lm 125 million of required reserves on average.

Box 8.7.Malta: Monetary Policy Instruments

Reserve requirements

Set at 4 percent of deposits, and remunerated at a fixed rate of 2.7 percent (cash in vault is not counted as eligible asset). Averaging provisions apply. CMB may impose penalties for noncompliance of up to 5 percentage points above CBM’s rate applied to its overnight standing lending facility.

Standing facilities

An overnight deposit facility is combined with an overnight lending facility (“standby loan”) to form a corridor of 350 basis points for interbank market rates. A pool of collateral for the lending facility is pledged in advance in favor of the CBM, allowing the lending facility to be activated automatically to cover end-of-day overdrafts.

Money market instruments

  • Auctions of term deposits: Conducted regularly (weekly), with 14 days maturity, using multiple-rate interest rate tenders. Main discretionary instrument in situation of excess liquidity.

  • Repo operations: Conducted regularly (weekly), using multiple-rate interest rate tenders. Acceptable securities include treasury bills and bonds. Main instrument when the system is short of liquidity.

The CBM’s overnight lending facility sets the upper limit for overnight money market rates. It is available upon request by banks or can be used automatically when the settlement account is overdrawn at the end of the day. For that purpose, banks have pledged a pool of securities to the CBM. The marginal lending facility has been used only occasionally (in four separate months over the past 2½ years), with borrowing averaging Lm 2.6 million per month, lower than deposits with the CBM.

Reserve Requirements

Banks operating in Malta are required to hold 4 percent of deposits and other liabilities with the CBM. Required reserves are remunerated at a fixed rate of 2.7 percent. Required reserves have to be held in the currency that is used as the accounting base of the bank.2 Vault cash is not counted as an eligible asset. Required reserves are calculated based on the average of the end-of-month balance of the two months proceeding the maintenance period, and full averaging over the holding period is allowed. Reserve shortfalls used to be given a fixed penalty rate of 8 percent. Under the amended CBM Act, the CBM may impose a penalty of up to 5 percentage points above its marginal lending rate.

Foreign Exchange Operations

The CBM maintains the peg to the currency basket by standing ready to buy and sell (spot) the basket currencies in the market and by maintaining an appropriate interest rate spread to reflect the risk premium. The CBM quotes real-time exchange rates for spot and forward trades and stands ready for spot transactions in the three currencies of the basket. The bid-ask spread for spot deals is 0.25 percent, and for forward deals, is 0.25 percent plus the premium or discount depending on the interest rate differential.

Conclusions and Lessons

The following conclusions and lessons can be derived from Malta’s experience with reliance on money market instruments:

  • Low inflation rates have been the result of a successful pegging of the currency and a consensus about the importance of the peg to achieving price stability. The lack of CBM independence (until the 2002 CBM Act amendments), including the possibility of financing fiscal deficits through the CBM and the assignment of multiple objectives through the CBM Act, was not misused. Capital controls, which were recently lifted, also facilitated maintenance of the peg.

  • The sequencing—first liberalizing financial markets, later eliminating capital controls—has helped to avoid any currency or banking crises. However, the approach has been very gradual, stretching over more than a decade.

  • The combination of weekly auctions of term deposits or repos, standing facilities at penalty rates, and reserve averaging have allowed effective liquidity management. However, trading activity in the money market has remained low, due to excess liquidity of the banking system and the small size of the market.

  • Certain institutional elements impede market development:

    • CBM’s operations in the government securities markets may have led to the perception that it still seeks to manage interest rates across the yield curve. Such suggestions could call into question how solid the yield curve is beyond the range of active treasury bill maturities.

    • Dematerializing treasury bills would encourage the development of a repo market.

    • Impediments to the use of repos have just been eliminated and should help to build up a repo market.

    • Public debt management could be used more effectively to help develop more liquid securities markets, for example, through the reduction in the fragmentation in the debt stock.

  • The privatization of the deposit money banks—in particular, the sale of one large bank to a foreign owner—has increased the degree of competition. Nevertheless, interest rate volatility has been minimal.


Adoption and Reversal of Reliance on Money Market Operations

Shortly after it was established in 1989, Tonga’s central bank (the National Reserve Bank of Tonga, or NRBT) shifted from administrative measures to money market instruments to conduct monetary policy. However, when confronted with rapid credit growth in 1994 and 1995, the NRBT had to resort to administrative measures owing to its inability to support the financial costs involved in a tightening of monetary policy.

During the first half of 1990s, the NRBT gradually shifted reliance from administrative measures to money market instruments to conduct monetary policy: interest rate controls were progressively phased out and fully liberalized in 1991, and credit controls, mainly in the form of a maximum loan-to-deposit ratio, were eliminated in 1993. Concomitantly, the NRBT introduced three new policy instruments: non-interest-rate-bearing reserve requirements (at 5 percent of banks’ deposits); issuance of NRBT notes on weekly basis;2 and a refinance standing facility.

At the same time, the NRBT allowed the entry into the market of two foreign commercial banks, with a view to increasing competition. Commercial bank credit to the private sector increased significantly during 1993–95, and international reserves declined markedly, calling for a tightening of monetary policy.

The attempt to tighten monetary policy in 1995 revealed the weak financial position of the NRBT. The NRBT lacked revenues and had no financial support from the government, and it would need to issue significant amounts of notes to tighten overall liquidity conditions, which would have resulted in large operating losses. Several factors were responsible for the NRBT’s weak financial condition, including the following. At the creation of the NRBT, currency in circulation was covered by claims on the government, which did not yield a return. Also, the amount of paid-up capital was very limited, and substantial resources were absorbed in the construction of a new headquarters building.3 Ultimately, the NRBT resorted to higher reserve requirements (the ratio was raised from 5 percent to 10 percent in 1995) and moral suasion to dampen credit growth. In 1998, the NRBT was forced to discontinue issuing the more expensive three-month central bank bills (at 5.5 percent).4 In 1998–99, in addition to informal credit ceilings, the NRBT raised the reserve requirement ratio further from 10 percent to 12 percent, increased the NRBT’s minimum lending rate (MLR) from 7 percent to 9 percent, and imposed a 30 percent deposit cash margin on all new loans with the exception of export and tourism sector loans. Subsequently, the growth of credit was contained and official reserves stabilized in 1999, allowing the removal of the 30 percent cash margin. However, in response to a loss of official reserves, the reserve requirement ratio was raised from 12 percent to 15 percent, and the MLR was further increased to 12 percent in 2000.5

During the course of 2000, faced with higher reserve requirements, banks reduced their holdings of NRBT bills to fund an expansion of credit, which in turn resulted in pressures on international reserves. Eventually, the NRBT had to impose formal credit ceilings, which have since remained the main monetary policy instrument in Tonga. Concomitantly, the NBRT discontinued the issuance of NBRT notes because of the financial cost associated with their placement.

Monetary Policy Environment

Institutional Framework

In Tonga, monetary policy is implemented in the context of a pegged arrangement with a horizontal band, whereby the value of the pa’anga is determined based on a weighted basket of currencies comprising the Australian dollar, the Japanese yen, the New Zealand dollar, and the U.S. dollar.6 The exchange rate is managed on a day-to-day basis by the NRBT on the basis of the movement of the basket of currencies. With foreign exchange control regulations, Tonga is in a position to maintain some monetary policy independence.

The monetary objectives of the NRBT are defined as promoting monetary stability and the soundness of the financial system and fostering conditions for economic development. The NRBT aims to keep inflation low and gross foreign reserves equivalent to or greater than three months of total imports. In addition, the NRBT recognizes that exchange stability is essential for price stability in Tonga, given the high pass-through of the exchange rate to the price level, which reflects that more than half of the items on the CPI basket are imported goods.

The NRBT pursues these objectives in close consultation with the government. Most changes in monetary and exchange rate operations require approval of the executive branch of government, making the NRBT subject to political pressures.7 In particular, the exchange rate has not always reflected the economic fundamentals because there are political pressures to prevent the depreciation of the pa’anga to contain inflation. At times, pressure to prevent a currency depreciation has come from corporations with foreign debt denominated in U.S. dollars. Furthermore, the limited operational autonomy of the NRBT has at times resulted in direct central bank lending to the government, in particular as it is called to buy any unsold portion of the government securities offered to investors in order to finance the budget. The interest rates on government bonds are based on the yields curve of deposit rates in the market, adjusted for tax-exemption and risk premium. The associated reserve money creation has contributed to excess liquidity, given the limited policy instruments at the disposal of the NRBT to sterilize excess liquidity in the system.

Macroeconomic Performance

Although real GDP growth temporarily strengthened to 6.5 percent in 1999–2000, it slowed to only 0.5 percent in 2000–01 and was estimated at 1.6 percent in 2001–02. The contraction of the economy occurred because of a decline in the level of activity in the agricultural sector. An increase in the current account deficit to 8.1 percent of GDP in 2000–01 led foreign reserves to fall to the level of 1.75 months of imports, which was about half the level in 1998–99. During 2000–01, the pa’anga depreciated against the U.S. dollar by a total amount of 20.8 percent, which consisted of normal basket movements of 6.8 percent and the remainder due to adjustments by the NRBT. Because more than 50 percent of the CPI basket is based on imported commodities, the inflation rate increased from 5.3 percent in 1999–2000 to 7 percent in 2000–01, and to 10.4 percent in 2001–02.

The sharp depreciation of the pa’anga against the U.S. dollar was necessary to dampen foreign reserve losses in the wake of fiscal and monetary expansion in 2000–01. Because Tonga has had no flexible monetary policy instruments, exchange rate movements have sometimes helped to affect aggregate demand through the impact of import prices on real income. However, the use of exchange rate adjustments as a monetary policy instrument is not necessarily effective because depreciation can easily lead to further inflation.

Structure of the Financial System and Market

Tonga’s financial sector is composed of five institutions: the NRBT, three commercial banks, and one state-owned development bank (Table 8.7). Until 1993, only two banks operated in Tonga, including a state-owned development bank established to promote rural development by investing resources obtained mainly from external borrowing. One of the commercial banks established in 1993 was a branch of a foreign bank; the other was a locally incorporated bank. A small insurance sector completes the financial sector.

Table 8.7.Tonga: Financial System Structure(as of 2001)
Assets (millions of pa’anga)Percent of Total AssetsPercent of GDPNumber of Institutions
Commercial banks200.481.672.33
State-owned development bank45.118.416.31
Insurance companiesn.a.n.a.n.a.6
Sources: Tonga authorities and Fund staff estimates.
Sources: Tonga authorities and Fund staff estimates.

Monetary Policy Instruments

In conducting monetary policy, the NRBT attempts to monitor the net domestic assets of the banking system. Limiting domestic credit expansion is considered essential to dampen the demand for imports and prevent a deterioration of international reserves. Following the unsuccessful attempt to rely on open market operations, the NRBT now relies on a combination of credit ceilings and reserve requirements to achieve its intermediate objectives (Box 8.8).

In a context of a structural excess of liquidity, the short-term liquidity facility does not play any operational role, and the NBRT has not had a discretionary instrument to absorb excess liquidity since it discontinued issuing NBRT notes in 2001. Changes in reserve requirement ratios have been used to influence the demand by the financial system for central bank reserves above the clearing balance needed for settlement purposes. They were instrumental in mopping up structural excess liquidity that built up in relation to direct NBRT credit to the government.

Following a period during which the NRBT relied on moral suasion to monitor the growth of bank credit, in 2002 the NRBT introduced formal individual credit ceilings on the commercial banks and the state-owned development bank.8 The recourse to credit ceilings became necessary due to the absence of effective money market instruments to regulate overall liquidity in the banking system. In particular, issuing NBRT notes was no longer a viable option, given the high costs involved and the weak financial position of the NBRT. Meanwhile, rapid credit growth has highlighted the limited effectiveness of administrative measures and the need to restore conditions for using money market operations.

Box 8.8.Tonga: Monetary Policy Instruments

Credit ceilings

These are imposed on the net domestic assets of each individual bank, within a global ceiling on net domestic assets of the banking system. Credit ceilings are set quarterly by the NRBT, and they have been the main monetary policy instrument in Tonga since 2000.

Reserve requirements

These were introduced in 1993. They are not remunerated. The ratio was raised from 5 percent to 10 percent in 1995, to 12 percent in 1998, and to 15 percent in 2000.

Standing facilities

Short-term liquidity facility: This allows the banks to borrow from the NRBT for a short term (normally for less than a month), using government bonds or the NRBT notes to the NRBT as collateral. The discount rate charged by the NRBT on these short-term loans is 17 percent per year during the first 10 days, and 19 percent thereafter, as of August 2002.

Money market instruments

Central bank bills: NRBT bills were introduced in the mid-1990s; they were discontinued in 2001 owing to the high cost to the NBRT associated with their placement. The NBRT bills were replaced by treasury bills, and the associated costs are thus now financed by the government budget.

Channels of Transmission of Monetary Policy

The credit ceilings have been the main monetary policy instrument since 2000 due to the NRBT’s inability to support the financial costs associated with money market operations for liquidity management.9 The weak financial position of the NRBT stems from high interest payments and administrative expenses.

The NRBT experienced the most significance losses during 1996–98, associated with the issuance of NRBT notes. In those years, interest payments rose from 46.8 percent of operating income in 1996, to a peak of 63.9 percent in 1997, and to 55.3 percent in 1998. Administrative expenses also represented a large share of operating income over the previous eight years. Those expenses rose from 27.9 percent of operating income in 1995, to 47.7 percent in 1997, and to 42.3 percent in 1998. More recently, administrative expenses dominated the other items of the NRBT’s operating expenditure, rising to 46.8 percent of operating income in 1999, compared with 38.9 percent in the case of interest payments.10

Interest rates do not play a significant role in monetary operations in Tonga because the NRBT has taken the stance since 2001 that it cannot afford to conduct open market operations. The interest rates charged on government bonds have not reflected the movement of inflation, and recently have been far below the inflation rate. One important implication is that interest rate policy has failed to support the government’s more flexible exchange rate policy, and consequently excess demand has continued and foreign reserves have declined. The NRBT is required to buy any unsold portion of government bonds, with the result that it must issue reserve money to finance government operations. This has contributed to inflation and to a loss of foreign reserves.

Conclusions and Lessons

Tonga’s experience illustrates that, when the central bank is in a weak financial position, reliance on money market operations faces difficult challenges:

  • In the absence of budgetary support, the central bank was unable to absorb excess liquidity and therefore relied on financial repression to conduct monetary policy.

  • The NRBT resorted to bank-by-bank credit ceilings because of its inability to support the costs associated with money market operations.

  • Although recently the government has been a net creditor to the banking system, political interference in the conduct of monetary policy has at times weakened the effectiveness of monetary policy when the central bank has had to finance the government and public enterprises by issuing reserve money, which has eventually led to further inflation.

  • With the central bank unable to rely on money market operations, the depreciation of the currency may have helped to reduce aggregate demand and prevent foreign reserve losses, but at the expense of raising inflation.


Path to Reliance on Money Market Operations

Throughout the 1970s and until the mid-1980s, Tunisia’s monetary policy relied on credit and exchange and capital controls. Credit controls involved bank-by-bank credit ceilings, interest rate controls, and mandatory requirements for banks to channel credit to strategic sectors. Exchange and capital controls were used to ensure that domestic savings would be used to finance domestic investments rather than the acquisition of foreign assets. These policies led to macroeconomic imbalances and the emergence of serious problems in the banking system, as the system for controlling and funneling credit to strategic sectors proved increasingly inefficient. In the mid-1980s, the authorities responded with the implementation of wide-ranging stabilization and structural reforms. Key objectives of the reforms were to reduce direct government intervention, strengthen the role of market forces in the allocation of financial resources, improve the capacity of financial institutions to mobilize domestic savings, and enhance competition among banks and strengthen their financial soundness.

The initial phase of financial reforms (1987–93) culminated with the completion of current account convertibility (Table 8.8). Liberalization of lending rates was initiated early in the process and followed a gradual path; the requirement of prior approval for granting bank loans was eliminated, and the regulatory constraints imposed on the balance sheet of commercial banks were relaxed. Concomitantly, comprehensive prudential bank regulations were introduced. Early in the reform process, the Central Bank of Tunisia (BCT) modernized its monetary policy framework: the role of the rediscount window was reduced, and reliance on money market operations to conduct monetary policy was gradually enhanced. At the time Tunisia accepted the obligations of Article VIII of the Fund’s Articles of Agreement in January 1993, lending rates had been almost completely liberalized, the prudential framework for the banking system had been significantly strengthened in line with the recommendations of the Basel Committee on Banking Supervision, and progress had been made in liberalizing the trade regime. However, capital controls were pervasive; banks were still subject to mandatory lending requirements to priority sectors and to limitations on their ability to undertake foreign currency-denominated transactions. The authorities intend to eventually adopt a floating exchange rate regime.

Table 8.8.Tunisia: Adoption of Money Market Operations
YearMonetary SectorFinancial SectorExternal Sector
1987Liberalization of deposit and lending rates begins.Introduction of comprehensive bank prudential regulations.
1988Rediscount operations limited to priority sector loans. Money market operations are started.BCT prior approval for granting bank loans is eliminated.
1989Reserve requirements are reactivated.Introduction of treasury bill auctions.Creation of money market in foreign exchange.
1991Relaxation of mandatory bank holdings of government securities.
1992Interest rate ceiling set at money market monthly average rate (TMM) plus 3 percentage points. Reduction in scope of preferential credit rates.Strengthening of prudential regulations for the banking sector.
1993Adoption of new auditing standards for the financial statements of banks.Article VIII accepted.
1994New banking law sets framework for a more market-oriented system. Audits of commercial banks completed; restructuring plans implemented. Introduction of negotiable treasury bills.Creation of interbank foreign exchange market.
1996Lifting of all lending rates controls. Elimination of mandatory lending requirements to priority sectors.
1997BCT intervention in money market becomes main monetary instrument.Privatization of Banque du Sud.Forward covers introduced. Maximum buying/selling spread for spot transactions eliminated.

Strengthening of prudential norms for the banking sector.
2000Merger of Banque de Dévelopement Économique (BDET) and Banque Nationale de Développement (BNDT) and merger with Société Tunisienne de Banque (STB).
2001Efforts to strengthen liquidity forecasting framework. Three-month reserve repos introduced.Enactment of new banking law. Introduction of liquidity ratio.
2002Amendment of the reserve. requirements systemPrivatization of Union Internationale de Banque (UIB)
2003Introduction of open market operations (OMOs).Framework for repos is introduced.
Source: IMF Country Report No. 02/120 and Central Bank of Tunisia (BCT).
Source: IMF Country Report No. 02/120 and Central Bank of Tunisia (BCT).

Following current account convertibility, greater emphasis was placed on shifting to greater reliance on money market operations to conduct monetary policy (1994–present). Soon after the completion of current account convertibility, the authorities introduced a spot interbank foreign exchange market (1994). Following the lifting of all restrictions on lending rates and the elimination of mandatory lending requirements to priority sectors (late 1996), intervention in the money market became the main monetary instrument of the BCT (early 1997). The implementation of a plan to restructure non-performing loans (NPLs) to public enterprises resulted in a strengthening of the financial structure of the banks (allowing the minimum capital adequacy ratio to be raised from 5 percent to 8 percent). Gradually, banks were allowed greater freedom in undertaking foreign currency operations. In parallel, the stock market was modernized, thus allowing corporations to diversify their funding sources and encouraging the public to invest in the market.2 Trade liberalization continued, in particular through the negotiation of a free trade agreement with the European Union. Finally, efforts were made to modernize the institutional and operational framework for public debt management.

Environment for Monetary Policy Conduct

Institutional Framework

The primary objectives of the BCT as defined in its charter include preserving the value of the currency and supporting the economic policies of the government. The latter objective has motivated the implementation of an activist monetary policy aimed at supporting the development needs of Tunisia. Until late 1996, commercial banks were subject to mandatory lending requirements to priority sectors and lending rates were regulated. Following the lifting of these controls, interventions in the money market became the main monetary instrument, but BCT’s policies continued to encourage lending to certain sectors until October 2002, and short-term interest rates exhibited remarkable stability, at least until the end of 2000.3

A statutory limit on the amount of government securities the BCT can hold for monetary policy purposes may have encouraged reliance on private paper in the conduct of monetary policy, including bank claims on strategic sectors, thus reinforcing credit policy considerations in the conduct of monetary policy.4 Such a limit may also have placed a constraint on the ability of the BCT to conduct open market operations with government securities.

Monetary Framework and Macroeconomic Policies

During the past decade or so, monetary policy in Tunisia has been implemented in the context of a managed floating exchange regime whereby the BCT intervenes in the market with a view to maintaining a stable real exchange rate against a basket of currencies weighted according to the country’s main trading partners and competitors. This policy amounted to a constant real exchange rate rule according to which the authorities adjusted periodically the nominal exchange rate so as to maintain the real exchange rate constant. This approach allowed the main exporting sectors to record good performances. In the most recent period, in guiding its exchange rate policy, the BCT has also begun to take into account a broader set of indicators to gauge the competitive position of producers.

At the same time, extensive restrictions on capital inflows and outflows were aimed at ensuring that domestic funds financed domestic investments.5 This policy allowed the BCT to pursue an independent monetary policy which has been very prudent over the period: the BCT focused on setting the target rate of expansion in credit to the economy around the rate of nominal GDP growth. The objectives set by the authorities were met over the last decade or so: credit to the economy has been broadly in line with domestic demand, and the authorities have shown their willingness to tighten monetary policy in order to moderate domestic demand when necessary.

Fiscal management was also significantly strengthened over the past decade: the consolidated central government budget deficit declined from 6 percent of GDP in 1991 to 2.4 percent in 2001. This adjustment was sustained even during the periods when private demand was growing quickly, during the periods 1991–93 and 1997–99. Public debt has been stable at about 60 percent of GDP since the mid-1990s.

The conjunction of constant real exchange rate targeting with very prudent monetary and fiscal policies, restricted capital flows, and comprehensive structural improvements has resulted in successful macroeconomic performance. In particular, inflation declined from over 5 percent in the early 1990s to 1.9 percent in 2001; real GDP and real export growth averaged 4.8 percent and 7.4 percent during the last decade.

Structural Factors

Tunisia’s financial system is dominated by the banking sector, in which state ownership continues to be extensive (Table 8.9). The state has majority positions in three of the largest commercial banks, in a newly created bank specializing in microfinance, in the largest insurance company, and in two specialized insurance companies. It also operates the social security institutions that dominate the provision of retirement benefits and has 50 percent participations in the development banks. A comprehensive program for modernization and restructuring of the banking sector began in 1997. It has involved the privatization of several commercial banks and the merger of several development banks and their transformation into full-fledged commercial banks.6 The other components of the financial system have grown significantly but remain small compared with the banking sector.

Table 8.9.Tunisia: Financial System Structure(as of December 2003)
Assets (millions of dinars)Percent of Total AssetsPercent of GDP
Commercial banks23,41575.172.8
of which state-controlled10,63434.133.0
Development banks9873.23.1
Offshore banks1,7655.75.5
Nonbank financial institutions (NBFIs)11,2033.93.7
Insurance companies 21,3004.14.0
Pension funds 22,5008.07.7
Source: Tunisian authorities.

NBFIs include leasing and factoring companies and merchant banks.

As of the end of 2000.

Source: Tunisian authorities.

NBFIs include leasing and factoring companies and merchant banks.

As of the end of 2000.

Despite measures to encourage financing from the securities markets and alternative sources of funding, bank credit continues to be the predominant source of external finance for Tunisian enterprises. Consequently, the level of private sector indebtedness is very high. Moreover, corporate debt is predominantly short-term, and long-term credits are indexed to short-term money market rates, making the cash flow position of borrowers highly sensitive to changes in the level of interest rates.7

Tunisia’s strong macroeconomic performances contrast with the relatively weak financial position of the banking system: NPLs are high (NPLs net of provisions accounted for 15.1 percent of total loans at the end of 2003) and stress tests show a large exposure to credit risk.8 While no empirical evidence is available, one could argue that the credit policy considerations in monetary policy conduct may have delayed the development of the credit culture. The resulting sub-standard allocation of credit to the economy may have led to higher credit risk and NPLs. The longstanding involvement of the government in the financial sector may have contributed to a lack of efficiency and distortions in credit allocation.

Market Infrastructure

The money market, which is composed of the interbank market and markets for certificates of deposits, commercial paper, and treasury bills, remains shallow. In particular, turnover in the interbank market has been low and volatile, mainly as a result of banks’ easy access to liquidity from the BCT, as mentioned above, as well as the rigidity of interest rates.

Starting in 1989, the government began to reduce reliance on captive sources of funding. However, the lack of a firm commitment to market funding of the budget and weak institutional arrangements for public debt management have resulted in only limited success for the auctions, which at times had to be postponed, and have left a shallow secondary market. In order to confront financing requirements that could not be met through securities issues, on several occasions the Treasury resumed reliance on captive funding sources. In turn, the limited and uncertain supply of securities has been a deterrent to secondary market trading because it has encouraged investors to hold the securities until maturity. Secondary market trading is also hindered by weak commitment on the part of the primary dealers to promote market development, accounting rules that do not require valuation of securities at market value, and a long delay in the settlement and delivery of securities (four days). However, the introduction in 2003 of a legal framework for repo transactions should encourage market development.9

Channels of Transmission of Monetary Policy

Most deposit and lending rates in Tunisia are (de facto) indexed to the money market rate. Therefore, changes in official interest rates are reflected quickly in other interest rates throughout the financial system. Given that bank credit continues to be the predominant source of external finance for Tunisian enterprises, the transmission of monetary policy through the interest rate channel is potentially strong, in that changes in official interest rates can quickly alter the cash-flow positions of borrowers by altering the average cost of borrowing through the re-pricing of banks’ loans.

This responsiveness may have generated some reluctance on the part of the monetary authorities to make interest rate changes. It is worth noting that interest rates in Tunisia have shown very limited volatility during the past ten years, although it must also be added that inflation has remained low during this time.

This state of affairs suggests that the BCT has not relied on interest rate signals to regulate overall monetary conditions or to respond to shocks. Instead, monetary policy has affected aggregate demand by altering the quantity or availability of credit. In this context, the direct involvement of the government in the loan market (through the development banks and the public commercial banks) may have been instrumental in the conduct of monetary policy in a context in which interest rates were not, or could not be, actively used.

Monetary Policy Instruments

The BCT has developed a comprehensive set of rules and money market instruments to manage banking system liquidity (Box 8.9). The weekly seven-day tender for repurchase operations is the main discretionary instrument. It is supplemented by standing facilities which allow banks, at their own initiative, to obtain or place liquidity at the official intervention rates (but at penalty rates compared to those reflecting market conditions) and by nonremunerated reserve requirements. The combination of the weekly tender for repurchase operations with the standing facilities creates a corridor for money market rates.

Typically, the Tunisian banking system has an aggregate liquidity deficit and is reliant on refinancing from the BCT. This is due to the liquidity-absorbing effect of autonomous factors of liquidity generated by banknotes in circulation, and the liquidity-absorbing effect of reserve requirements. In this environment, the BCT acts as a supplier of liquidity (through the standing facilities and the discretionary monetary operations) and thus steers money market interest rates. However, at times the system has experienced a structural liquidity surplus owing to large capital inflows. While the BCT has the appropriate instruments to deal with excess liquidity (in particular, deposit auctions), it has complicated monetary policy implementation because of the multiple objectives of the central bank.10

Weekly seven-day tenders for repurchase operations are the main discretionary instrument for liquidity management. Until June 2004, participating banks bid the amount of money they wished to transact at the fixed interest rate specified in advance by the BCT (fixed-rate auction). In June 2004, the BCT began using a multiple rate auction system, whereby banks bid for the amount and the rate and the BCT charges the rates offered. In the event that bids received from participating banks exceed the volume of liquidity the BCT is prepared to provide, the BCT proceeds to a pro rata allotment of the individual bank’s bids, depending on the ratio between total bids and total liquidity to be allotted.

Given the shallowness of the interbank market, the BCT has not been in a position to receive signals on the level of market rates. Furthermore, given the room for independent monetary policy, the BCT could have deviated from monetary and foreign exchange conditions in foreign financial markets. However, BCT’s interest rate policy (in particular, the policy decisions regarding the official intervention rate) has been cautious: deviations from conditions in foreign financial markets have been avoided, and domestic interest rates have been kept positive in real terms.

Until recently, BCT’s readiness to systematically meet bank requests under its standing facilities, combined with a narrow corridor for interbank market rates, prevented the development of the interbank market. The credit policy considerations in the conduct of monetary policy also prevented market development.11 In addition, weak capacity to carry out liquidity forecasts made it difficult for the BCT to take an active stance in managing overall liquidity in the system. In particular, the volume of credit auctioned to the banks in the seven-day tender for repurchase operations (volume tender) was determined by a prediction of banks’ expected demand rather than by monetary policy considerations. Therefore, if the demand of credit was overestimated, the remaining liquidity was left unsold. Conversely, if the demand for credit was underestimated, the credit was pro-rated to the banks on the basis of their respective bids. Banks in need of additional BCT credit had recourse to the refinance standing facilities and could obtain additional liquidity.

Reserve requirements have not been used actively for liquidity management purposes. Averaging provisions over a one-month period with regard to compliance allowed credit institutions to smooth out daily liquidity fluctuations (i.e., those arising from the fluctuation in the autonomous factors of liquidity).

The de facto reliance on the standing facilities to manage overall liquidity in the system led to the dominant position of the BCT in the interbank market. In particular, the narrow corridor for interbank market rates has resulted in limited incentives for interbank trading and has inhibited the development of liquidity management skills in the banks.

Conclusions and Lessons

The main lessons from Tunisia’s experience with reliance on money market operations to conduct monetary policy are the following:

  • In the context of a predetermined exchange rate, monetary policy independence was retained through the maintenance of capital controls. The targeting of a rate of expansion in credit to the economy provided the anchor for price expectations.

  • The use of monetary policy to encourage lending to all sectors regarded as central to Tunisia’s development strategy, together with limited progress in modernizing public debt management, delayed reliance on open market operations. However, the BCT has been able to ensure an adequate provision of credit to the strategic sectors of the economy without jeopardizing price stability.

  • The BCT retained control over the main components of its balance sheet. However, rationing rather than competitive mechanisms were used for base money allocation.

  • The structural liquidity deficit of the banking system has facilitated reliance on rationing for liquidity management, including the ability to target multiple objectives (i.e., price and quantities).

  • Although capital controls allowed the conduct of an independent monetary policy, interest rate management has been cautious.

  • State ownership in the financial system may have facilitated achieving credit objectives. However, the high number of NPLs in a context of high growth suggests that this policy mix may have amplified credit risks for the banking system.

  • From an operational perspective, reliance on money market operations for monetary policy conduct calls for development of the money and government securities markets and for strengthened liquidity forecasting arrangements.

  • As Tunisia moves toward greater exchange rate flexibility and toward capital account liberalization, greater interest rate flexibility will be needed. In this context, money market operations (i.e., open market operations) for the allocation of base money will need to be further developed. The BCT has already started moving in this direction.12

Box 8.9.Tunisia: Monetary Policy Instruments

Reserve requirements

These are calculated as monthly averages. They must amount to 2 percent of domestic currency-denominated sight and term deposits and similar instruments (i.e., certificates of deposits) with an initial maturity below three months; 1 percent for term deposit and similar instruments with initial maturity between three months and less than two years; and 0 percent for term deposits and similar instruments of two years or more. They are not remunerated, and they are not actively used as a monetary policy instrument.

Standing facilities

  • One- to seven-day reverse repurchase operations: Bank may request liquidity against delivery of collateral at a premium over the official intervention rate (+ 100 basis points). Accepted collateral includes treasury bills and banks’ claims on priority and other sectors.

  • End-of-day (overnight) settlement operations: Banks may request liquidity against delivery of collateral or place liquidity at the official intervention rate plus/minus a spread. Accepted collateral includes treasury bills and banks’ claims on priority and other sectors.

Money market operations

  • Weekly seven-day tender for repurchase operations: The BCT invites bids for seven-day repurchase operations. The BCT decides on the amount to be injected, and the bids are allocated using a multiple price auction (as of June 2004). Accepted collateral includes treasury bills and bank claims on corporations that are deemed to be financially sound.

  • Deposit auctions: When the banking system as a whole is overly liquid, deposit auctions are used instead of credit auctions to mop up excess liquidity. Bids are ranked and accepted according to the rate that is proposed (interest rate auction); they cannot exceed that of the weekly seven-day tender for repo operations.

  • Three-month reverse repurchase operations: the BCT invites bids for three-month reverse repurchase operations. Accepted collateral is limited to treasury bills only.


Adoption of Money Market Operations

Uganda has been relying on money market operations since the beginning of economic reforms in the late 1980s. Critical elements of the reform efforts included a substantial withdrawal of government from commercial activities and the elimination of controls on prices, interest rates, and bank credit. Similar reform efforts were also brought to bear on the trade and exchange regimes, culminating in current account convertibility in 1993 and liberalization of the capital account in 1997.

Overall macroeconomic performance has been robust, with economic growth in excess of 6 percent over the last decade. Inflation has been substantially reduced from the double-digit figures of the early 1990s, to less than 4 percent on average between 1999 and 2003. The large inflow of donor funding resulted in the buildup of significant import cover (up to six months of imports of goods and nonfactor services), and this substantially reduced the size of the emerging budget deficits and related government borrowing. Donor support and prudent macroeconomic policies both contributed to these sustained high rates of economic growth and low inflation.

Reliance on money market operations has not been without challenges, especially given Uganda’s underdeveloped financial market and the need for substantial sterilization operations to address the liquidity implications of the release of donor funds. Another challenge for the Uganda authorities has been pressure for the real exchange rate to appreciate consequent on the large external inflows. Specifcially, Uganda has a floating exchange rate, and the large donor inflows have often generated pressures for an appreciation of the Uganda shilling, which complicates exchange rate policy as the authorities are concerned about the implications for competitiveness and the ability to adjust to other shocks. Additional pressures are generated on domestic liquidity as the government spends the donor funds. Unlike many developing countries, Uganda’s monetary policy operations have not been subjected to undue fiscal dominance, thanks to donor assistance for budgetary operations. Treasury bill operations have been primarily for liquidity management.

Institutional Framework for Monetary Policy

The Ugandan Constitution stipulates that the Bank of Uganda (BOU) promote and maintain the stability of the value of the currency and, in addition, encourage and promote economic development through effective and efficient operation of a credit system. The BOU Statute states that the objectives of the central bank are to maintain monetary stability and external reserves, as well as to participate in Uganda’s economic growth and development programs. At the same time, the BOU believes the overriding objective of monetary policy is to contain annual inflation at below 5 percent while maintaining a flexible exchange rate that is responsive to changes in Uganda’s terms of trade.

Structure of Financial Sector

Although the BOU has managed to attain its main policy objective (low and stable inflation), it operates in the context of a low level of monetization and a shallow financial market. Cash constitutes about one-quarter of broad money, which is only about 15 percent of GDP, and assets of the financial system are only about 30 percent of GDP.

The financial sector is dominated by commercial banks. As of December 2003, there were 15 commercial banks, of which 11 were foreign banks, 7 nonbank credit institutions, 9 securities firms and finance companies, 19 insurance companies, 2 pension funds, and 83 microfinance institutions and credit unions (Table 8.10). Commercial banks accounted for slightly over 80 percent of total system assets, while other financial institutions played only a minor role. The banking sector is characterized by a large share of foreign ownership and high loan and deposit concentration, with the four largest banks in the system (one previously state-owned), accounting for about 70 percent of total sector assets, 63 percent of total loans, and 71 percent of total deposits.

Table 8.10.Uganda: Financial System Structure(as of December 2003)
Assets (billions of shillings)Percent of Total AssetsNumber of InstitutionsPercent of GDP
Commercial banks2,99083.51522.6
Nonbank credit institutions1444.071.1
Insurance companies1153.2190.8
Pension funds2938.222.5
Microfinance and credit unions401.1830.3
Source: Bank of Uganda.
Source: Bank of Uganda.

The increase in treasury bill issues at times has exerted upward pressure on interest rates and added to the already strong disincentives to private sector lending development.3 The rise in interest rates, as well as the volume of treasury bill issues, implied an increase in the interest payments on treasury bills, adding to budgetary costs. In fiscal year 2000-01, interest costs accounted for 5.4 percent of budgetary revenues. Although still small relative to GDP, interest costs increased from 0.15 percent of GDP in 1999 to 0.89 percent of GDP in 2002.

Monetary Policy Implementation and Instruments

To achieve its objectives, the BOU has set a monetary program that is consistent with the economy’s overall macroeconomic framework. Uganda has introduced major changes in its monetary policy framework in order to contain the excessive volatility in interest rates that resulted from liquidity management operations, particularly in 2000 and 2001. These operations were conducted mainly through a mixture of foreign exchange interventions and treasury bill auctions, with the latter bearing the greater part of the burden during the early stages. The volatility in interest rates abated due to the BOU’s increased reliance on short-term instruments for day-to-day liquidity management (repos) and the use of a judicious mix of treasury bill auctions and foreign exchange interventions for sterilization operations. In practice, the BOU’s money market interventions now seek a gradual rather than abrupt attainment of the reserve money path determined by the monetary program. The new monetary policy framework has entailed changes in the use of various instruments. In addition to the reserve money target, the BOU monitors a broad range of variables.

The large capital inflows associated with donor assistance have called for large-scale sterilization operations in the form of outright sales of foreign exchange and treasury bill auctions. Foreign exchange sales have tended to appreciate the exchange rate, thereby adversely affecting the country’s competitiveness. In addition, volatility in the exchange rate has caused exporters and importers to speculate on the value of the shilling.

Foreign inflows have, on occasion, slowed the depreciation of the real exchange rate, thereby impairing the scope for adjusting to terms of trade shocks in order to safeguard export competitiveness. Initially, the BOU responded by reducing its foreign exchange sales to the market in order to allow the exchange rate to depreciate in response to the terms of trade shock and shifted the burden of liquidity absorption to treasury bills. Subsequently, the BOU shifted the burden somewhat toward more foreign exchange sales in the policy mix for sterilization operations.

Structural Excess Liquidity Problem

As noted above, sustained capital inflows have at times complicated the BOU’s conduct of monetary and exchange rate policies. On the monetary front, the challenge for the BOU has been to preserve its inflation objective by neutralizing the effects of the government-injected liquidity as donor funds are released into the system. This has been done through sterilization operations which at times have resulted in interest rate volatility due to weaknesses in the monetary management framework and the shallow money market.

While it lasted, the volatility of interest rates undermined the BOU’s capacity to signal a clear and consistent policy stance. For example, the BOU’s two policy rates—the rediscount rate and the bank rate which are both set at a margin over the treasury bill rates—became ineffective as monetary policy signals, because they reflected the volatility of treasury bill rates.4 The rediscount rate has become the policy rate the BOU uses to signal its desired monetary policy stance.

Interest rate volatility also undermined the BOU’s ability to extract meaningful information on monetary conditions from the market. Both the monetary authorities and the financial system lacked a benchmark interest rate to which returns on loans and other financial assets could be linked and from which liquidity overhangs could be gauged.

Interest rate volatility, which was caused by the large fluctuation of bank reserves, had implications for the conduct of monetary policy.5 In particular, the sharp movements in bank reserves meant that the excess funds were not lendable and therefore posed little threat of transmission through the credit channel of monetary policy. This has allowed the BOU some flexibility in conducting sterilization operations, while at the same time preventing it from becoming too complacent about the potential surge in credit and its inflationary consequences.

Swings in bank reserves stem from factors that are endogenous and exogenous to the interventions of the central bank. On the one hand, the limited development of the financial markets has made it difficult for banks to manage liquidity effectively. The bunching of capital inflows—which are dependent on disbursements related to projects implemented by nongovernmental organizations (NGOs) and on government investment expenditures—results in the sporadic conversion of large sums of foreign exchange into shillings and sporadic exchange rate volatility.

Monetary Policy Transmission

In general, high credit risk, combined with inefficiencies in the banking and payment systems and poor physical infrastructure, impedes monetary policy transmission and the supply of credit to the private sector, particularly in rural areas such as Uganda. Money and securities markets are highly illiquid, owing to the lack of creditworthy counterparts in the financial system. Under such circumstances, commercial bank liquidity and interest rates become volatile, reflecting both the size and bunching of foreign currency inflows and outflows and the weaknesses in the management of liquidity. When this situation occurs, the interest rate and credit channels of monetary policy do not function as well as might be expected in a more well developed financial market. With the elimination of financial repression and improvement in the liquidity management framework in Uganda, the signaling role of interest rates has been restored and changes in policy rates are increasingly transmitted to the entire spectrum of interest rates and the entire yield curve.

Small as it is, credit to the private sector is of some significance to prime corporate borrowers and may also influence the transmission of monetary policy, though to what degree remains an empirical issue. Repos have become the instrument of choice for day-to-day liquidity management, with a judicious mix of foreign exchange operations and treasury bill issues addressing the sterilization needs.

Monetary Policy Instruments

Since the initiation of reforms, the BOU shifted to a combination of rules-based instruments and money market operations to conduct monetary policy (Box 8.10). The monetary policy instruments at its disposal include reserve requirements, standing facilities (rediscount window for treasury bills, a refinance standing facility), and discretionary and money market operations (treasury bills, repurchase agreements, and foreign exchange sales). In addition, the BOU has been a significant participant in the foreign exchange markets, in conjunction with its need to undertake sterilization operations as part of the conduct of monetary policy. In practice, the BOU has relied on a mix of treasury bill issuance and foreign exchange sales for its sterilization operations.

The BOU has developed a liquidity management plan which separates the management of short-term “temporary” and long-term “structural” liquidity resulting from government domestic expenditures financed through foreign donor inflows. The BOU uses repos for fine-tuning “temporary” liquidity variations and a mix of foreign exchange sales and net treasury bill issuance to sterilize structural liquidity, with clear signaling of sterilization and intervention actions in the foreign exchange market. Overall, these actions have resulted in lower volatility of interest rates and have helped anchor market expectations.

Conclusions and Lessons

The following conclusions and lessons can be derived from the experience of Uganda with implementation of monetary policy:

  • Fiscal dominance has not been a problem in Uganda, mainly because of sources of foreign financing. Treasury bills are solely for liquidity management. In this context, prudent macroeconomic policies have enabled Uganda to control inflation.

  • Financial liberalization, increased confidence in the banking system, and improved liquidity management practices have enhanced the signaling capabilities of interest and exchange rates.

  • Notwithstanding ongoing challenges, the BOU has stayed the course on money market instruments. There has been no tendency for policy reversals. Uganda’s experience demonstrates that a combination of rules-based instruments and money market operations can be effective even under conditions of limited market development, provided supporting policies are in place.

  • Over time, self-liquidating repo transactions can help to counter seasonal and short-term swings in liquidity, and repos are now being more actively used to deal with day-to-day liquidity management, while treasury bill issues and foreign exchange operations are used for sterilization operations.

  • The BOU has responded to the potential for interest rate volatility with a mechanical adherence to a base money path by smoothing its liquidity management operations in a manner that does not amplify interest rate volatility. Greater emphasis on sterilization through sales of foreign exchange (thus lower net treasury bill issuance) has allowed a steadier execution of the base money program.

  • Uganda’s experience also illustrates the importance of the central bank communicating clearly with the market. At times, market volatility refelcted uncertainties in the perceptions by the market of the intentions of the central bank. Conversely, during periods when there was clarity, market stability increased. The shallowness of the market may have amplified the response of the market to shocks.

Box 8.10.Uganda: Monetary Policy Instruments

Reserve requirements

Reserve requirements are set at 10 percent for demand deposits and 9 percent for term and savings deposits, with a two-week maintenance period. They are not remunerated and are held in domestic currency for both local and foreign currency deposits. Reserve averaging is permitted up to 50 percent of the required reserves.

Standing facilities

  • Rediscount window for treasury bills: For bills with remaining maturity of 91 days or less. The rediscount rate is now the policy rate that is fixed by the BOU to signal its desired monetary policy stance. The rediscount rate is based on four primary market observations of the 91-day treasury bill auction rate plus a policy margin.

  • Automatic borrowing window: Accessible at the discretion of banks up to 5 percent of required reserves and up to five days. Collateral includes only treasury bills with remaining maturity of 91 days or less. The interest rate is equal to the rediscount rate plus a 1 percent margin.

Money market instruments

  • Weekly treasury bill auctions: Issued solely for monetary policy purposes with the costs accounted for in the government’s annual budget. Bills are issued with maturities of 91, 182, 273, and 364 days.

  • Repos: Repos are decided based on liquidity conditions and are used for fine-tuning operations.

  • Sales of foreign exchange: Sales of foreign exchange are being used in tandem with treasury bill auctions for sterilization purposes.


Path to Reliance on Money Market Operations

The introduction of money market operations to conduct monetary policy in Ukraine followed the move to replace the karbovanets with Ukraine’s permanent currency, the hyrvnia (HRV), in 1996. Due to the political importance attached to the monetary conversion, the authorities made a concerted effort to ensure its success. In particular, great significance was attached to the stability of the exchange rate in the period preceding the announcement of the conversion. In effect, this gave the National Bank of Ukraine (NBU) the political mandate for tight financial policies during 1996.

With this mandate, the NBU began a process of financial liberalization, including the gradual introduction of money market operations to conduct monetary policy and the phasing out of directed credit and bank-by-bank credit ceilings. The main monetary instruments that were introduced at these beginning stages were reserve requirements, a variety of money market operations, and a limited standing facility. The political mandate for tight policies, the resulting fiscal adjustment, and growing activity in the nascent domestic treasury bill market allowed the NBU to limit its credit expansion to the government. It also reduced pressures on the commercial banks to provide directed credits. As a consequence of these developments, the exchange rate remained broadly stable throughout the year, and in September 1996, Ukraine introduced its new currency.

Ukraine’s progress toward financial liberalization was disrupted by the financial crises that hit many Asian economies during the second half of 1997 and hit Russia in mid-1998. The reversal of investor sentiment and the ensuing capital outflows put monetary policy under pressure. In 1998, when the Russian crisis broke, the confidence of domestic and foreign investors in Ukraine was weakened, and in particular, demand for Ukrainian government debt collapsed. A significant depreciation of the hryvnia followed, and a vicious cycle emerged of flight from government securities and rising real interest rates. With reduced access to international and domestic creditors, the government once again relied heavily on borrowing from the NBU to finance the budget deficit and to service public debt. This borrowing was in the form of NBU purchases of government securities in the primary market for treasury bills.

Starting in 2000, Ukraine managed to recover substantially from the Russian crisis and to achieve significant growth in its own economy. However, the government securities market was slow to recover following the rescheduling of government debt in 1998. Furthermore, the low level of treasury bills outstanding limited the scope for reliance on some of the money market instruments that the NBU had developed.

Monetary Policy Environment

Institutional Framework

The NBU’s responsibilities for the formulation and conduct of monetary policy are defined by the constitution, passed in 1996, and the Law of Ukraine on the National Bank of Ukraine (NBU law), passed in 1999. According to the NBU law, the central bank’s primary objective is to ensure the stability of the Ukrainian monetary unit. The NBU law also requires the bank to support other government economic and financial objectives, such as promoting macroeconomic stability, economic growth, and employment, under the condition that this support does not create a conflict with the primary objective of the NBU.

In pursuing the goal of stability of the monetary unit of Ukraine, the NBU has chosen to target the nominal exchange rate rather than reserve money.2 In granting operational responsibility to the NBU for the conduct of monetary policy, the law authorizes the NBU to use a range of specified monetary policy instruments and to take other measures as necessary to achieve its objective.

Macroeconomic Performance

The onset of the Russian crisis disrupted the good macroeconomic performances recorded in the mid-1990s: gross international reserves fell sharply, and the sharp depreciation of the hryvnia during this period led to an upturn in inflation. However, fiscal policies were restrained, and, subsequently, macroeconomic balance was restored. The currency was allowed to float in 1999, and since 2000 the monetary policy framework has been characterized by a de facto fixed exchange rate against the U.S. dollar. Ukraine’s macroeconomic performance since 1996 has gone through periods of stability, interspersed with crises, reflecting in part the poor policy environment and in part, adverse economic shocks. Fiscal and monetary policies have been inconsistent, and Ukraine’s initial defense of its exchange rate in mid-1998 proved counterproductive. However, the country achieved significant economic progress and access to international markets was regained with the Eurobond issues in 2003 and 2004.

Structure of the Financial System

The Ukrainian financial system is small and concentrated in commercial banking. Assets in Ukraine’s 158 active banks amounted to 40 percent of GDP at the end of 2003 (Table 8.11). The other financial sub-sector of significance is insurance, where premiums account for about 2.0 percent of GDP in 2002. Other financial institutions such as pension funds, credit unions, and leasing companies together account for less than 1 percent of GDP.

Table 8.11.Ukraine: Financial System Structure
Number of banks152157158
Total assets (millions of hryvnia, HRV)47,20467,774104,873
In percent of GDP23.431.139.7
Number of insurance companies328338357
Total assets3,0075,3009,030
Premium revenue (millions of HRV)3,0314,4429,135
Number of investment and mutual funds362
Total assets (millions of HRV)
Number of pension funds152347
Total assets (millions of HRV)6055
Number of credit unions>400>450
Total assets (millions of HRV)5090
Sources: National Bank of Ukraine (NBU) and Ukraine Ministry of Finance.
Sources: National Bank of Ukraine (NBU) and Ukraine Ministry of Finance.

The banking system is composed mainly of a large number of private banks, and concentration is low by international standards. The ten largest banks held 54 percent of assets as of December 2003. There are two wholly owned state banks, which together account for about 10 percent of total bank assets. Foreign involvement in the sector has been relatively modest, particularly in comparison to other countries in Central and Eastern Europe. Besides the seven wholly owned foreign banks, there are another 13 banks that are partly foreign, which together account for 16 percent of total bank assets.

The growth of banking aggregates between 1998 and 2003 was remarkably high. The rapid rise in deposits reflected macroeconomic stability, increased public confidence in the banking system, and a significantly reduced use of cash relative to bank money. However, per capita bank deposits in Ukraine are still far lower than in comparable countries. Credit expansion has been even faster than the expansion in deposits, as the ratio of stock of credits to stock of deposits rose from 103.7 percent in 1999 to 115.2 percent in 2003.3

The long period of economic instability promoted dollarization, but in the more stable recent conditions, dollarization of deposits has fallen much faster than the dollarization of loans. At the end of 2003, 32 percent of deposits and 38 percent of bank loans were denominated in foreign currencies, compared to 44 percent and 45 percent, respectively, at the end of 1999. The wide differentials between hryvnia and foreign currency interest rates, coupled with a stable exchange rate, made loans in dollars seem very attractive to borrowers.4

Money Market Infrastructure

The Government Domestic Debt Market

The market for Ukrainian government domestic securities is thin and fragmented, and the volume of securities suitable for secondary market trading is small. About two-thirds of domestic government securities are restructured bills which are held by the NBU. Furthermore, the small stock is fragmented into large numbers of issues with different maturity dates, and most issues are small in size,5 making secondary trading difficult. Turnover in the secondary market has been small and volatile despite a well-functioning online automatic quotation and trading system (called “PFTS”) and adequate depository facilities offered by NBU.

The Interbank Money Market

The interbank market in Ukraine has been characterized by high volatility of hryvnia interbank rates.6 Furthermore, interbank lending has been concentrated in short maturities, and the market is segmented. These deficiencies have weakened the monetary transmission mechanism. In particular, a number of commercial banks have maintained substantial excess reserves.

Over the years, the poor functioning of the interbank market has been related to credit risk, in a context where there has been limited amounts of securities to be used in repurchase transactions or as collateral.7 In addition, neither did the NBU intervene actively to offset fully exogenous liquidity shocks, nor did the NBU standing facilities serve effectively to limit interbank interest rate fluctuations, in part because many banks lacked eligible collateral and the NBU imposed limits on the use of these facilities. Finally, some problems in the interbank market have emerged due to unanticipated effects of the successful introduction of the single treasury account and delays in establishing the proper coordination of liquidity management between the monetary and fiscal authorities.

Monetary Policy Implementation and Instruments

After independence in 1991 and up until 1996, monetary policy in Ukraine relied on administrative measures designed to provide credit to preferred sectors of the economy at subsidized interest rates as well as to provide liquidity to finance the government’s substantial budget deficits. The commonly used instruments were directed credit, refinance credit, interest rate controls, and bank-by-bank credit ceilings. During this period, the economy performed poorly: inflation was consistently in triple digits or more (by 1993, it was 10,000 percent), and output was continuously contracting—the cumulative decline in reported GDP is estimated at more than 50 percent through 1996.8

In 1996, Ukraine introduced its own permanent currency. The importance attached to a successful introduction of the hryvnia resulted in a substantial easing of pressure for directed lending by commercial banks and the NBU. Moreover, demand for refinancing credit in 1996 was very moderate as banks exhibited caution in their general lending activity to the nongovernmental sector, in part because of their own fragile state. Instead, banks preferred to maintain large holdings of unremunerated excess reserves.

In parallel, the NBU began the process of financial liberalization, including the gradual introduction of money market operations to conduct monetary policy and the phasing out of directed credit and bank-by-bank credit ceilings. Concurrently, basic market infrastructure, including a treasury bill market, was developed to facilitate reliance on money market operations to conduct monetary policy. At the end of the process, the NBU could rely on a combination of rules-based instruments (reserve requirements) and money market operations to manage longer-term trends in liquidity (Box 8.11).9

The NBU also had the option to use open market operations, involving the buying and selling of treasury bills in the secondary market and repurchase (repo) or reverse repo operations, but it did not frequently use such money market operations.10 The NBU’s toolkit has also included standing facilities, and the interest rates for these facilities have been set administratively by the NBU. Finally, the NBU has intervened in the foreign exchange market, and this eventually became its main instrument of monetary policy.

Reflecting the generally good performance of the budget and the rapid expansion of the treasury bill market, the NBU was able to effectively regulate liquidity and conduct monetary policy during 1996 and part of 1997. Policy was tightened at the beginning of 1996, through increases in the required reserve ratios for both domestic and foreign currency deposits, in an effort to quickly reduce excess reserves at commercial banks. This action was followed by tight credit policies, with the NBU restricted refinancing by limiting both the number of auctions and the use of its refinance standing facility and with periodic NBU sterilization operations to offset its frequent net purchases in the exchange market. The NBU maintained its relatively tight credit policy during the first nine months of 1997, and strong participation of nonresidents in the treasury bill market allowed the budget to be financed without recourse to borrowing from the NBU.

Box 8.11.Ukraine: Monetary Policy Instruments

Reserve requirements

Reserve requirements used to be set at differentiated rates depending on maturity and currency denomination. Effective October 1, 2004, demand deposits became subject to an 8 percent reserve requirement and time deposits to a 7 percent requirement (both domestic and foreign currency deposits). Reserves must be held in domestic currency over an averaging period of one month. As of August 2004, banks are required to maintain a daily minimum balance of 70 percent of required reserves (earlier 60 percent minimum and before that full averaging was allowed). The NBU has been lowering the reserve requirement in line with the reduction in inflation.

Standing facility

  • Discount rate: The discount rate serves as (de jure) benchmark interest rate for money market participants set by the NBU to benchmark the cost of money. As such, it is the lowest of the NBU’s lending rates, but no transactions are carried out at that rate.

  • Deposit facility: Interest rates are fixed by the NBU. Only banks that do not borrow from the NBU can use the deposit facility. Maturity ranges are 2–7 days, 8–21 days, and 22–30 days.

Money market instruments

  • Refinancing facilities: Three types of regular refinancing facilities are available to commercial banks: secured overnight loans, unsecured overnight loans, and refinancing up to 365 days. Collateral accepted by the NBU is limited to government securities for the overnight credit, but a broader list of collateral is accepted for loans in other maturities. To use these facilities, banks must meet specific conditions relating to capital and solvency and must have a good track record of loan repayment to the NBU. The use of these facilities is limited, and stricter criteria are applied for unsecured overnight credit than other credit. The total amount of refinancing cannot exceed a certain percentage of the commercial bank’s paid up capital. Interest rates on refinancing loans cannot be lower than the NBU’s discount rate. The interest rates on overnight loans are set by the NBU, while loans on other maturities are provided with price or quantity tenders. Effective March 2004, the NBU set the rates daily depending on the liquidity conditions in the market and differentiating the interest rate on secured and unsecured overnight loans.

  • NBU’s Certificate of Deposits (CDs): CDs with maturities from 1 to 180 days can be auctioned to commercial banks to mop up excess liquidity in the system. Interest rates on CDs are set by the NBU. CDs can be traded in the secondary market and be used as collateral in the interbank market.

  • Repurchase (repo) and reverse repo operations: Repos and reverse repos can be used to fine-tune liquidity on a day-to-day basis, either to absorb or provide liquidity against government securities (foreign exchange can be accepted in bilateral repos). They may be sold on a bilateral basis or through auctions.

  • Outright purchases or sales of securities: The NBU can conduct outright operations with government securities. Purchases of securities can be conducted on a bilateral basis or through an auction mechanism and sales through an auction mechanism. The NBU holds only restructured debt in its portfolio.

  • Foreign exchange market operations: Foreign exchange operations have been used as a monetary policy instrument to regulate liquidity in the system. In fact, foreign exchange intervention has been the main instrument of liquidity management.

Most nominal interest rates (which by then had been completely freed) began to fall in 1996 as inflation came down sharply. Average commercial bank lending and deposit rates declined following several reductions in the statutory NBU refinance rate during this period. Nongovernmental borrowing did not increase in response to the fall in the commercial bank lending rates, however, because of the cautious lending policies of commercial banks. Indeed, with the yield on three-month treasury bills remaining high, commercial banks found holding treasury bills an attractive alternative to extending loans. It is not clear whether this crowded out lending to the nongovernmental sector, because the commercial banks had previously kept large unremunerated excess reserves. The volume of treasury bills sold increased steadily, reflecting in part the rapid rise in the participation of nonresident investors in the market, particularly in the second half of 1996 and through the third quarter of 1997.

The onset of the financial crisis that hit many Asian economies during August and September 1997 influenced investor perceptions of Ukraine. The foreign exchange and treasury bill markets became increasingly erratic during the fourth quarter of 1997, and investors started withdrawing due to concerns regarding the stability of the exchange rate and Ukraine’s ability to repay. During this period, the NBU sold a considerable amount of foreign reserves to protect the exchange rate. At the end of October, the authorities announced a number of measures to ease pressures in the foreign currency market and to help keep the hryvnia within its band. These included increased interest rates,11 tightened reserve requirements, large-scale open market operations, and measures to enhance the attractiveness of treasury bills (including lowering the cutoff price and shortening their maturity). However, these measures were not sufficient to stem the loss of reserves associated with the decision to maintain the band.

The reversal of investor sentiment and the ensuing capital outflows put monetary policy under considerable pressure. When the crisis broke, the confidence of domestic and foreign investors in Ukraine weakened and, in particular, demand for Ukrainian government debt collapsed. A significant depreciation of the hryvnia followed, and a vicious cycle emerged of flight from government securities and rising real interest rates. With reduced access to international and domestic creditors, the government had to rely on borrowing from the NBU to finance the budget deficit and to service public debt. The flight from government debt and the rising real interest rates eventually led to the rescheduling of about US$5 billion worth of outstanding government securities and a substantial reduction in their net present value.

During 2000-03, monetary policy actions were aimed at maintaining a stable exchange rate against the U.S. dollar and building up external reserves, while keeping monetary expansion in line with the growth and inflation objectives. Reflecting the generally good performance of the external sector during this period, the NBU enhanced its purchases of foreign exchange from the interbank markets. As a result, net international reserves grew from –$0.6 billion at the end of 2000 to $5.1 billion by the end of 2003. Part of the liquidity generated from these purchases remained unsterilized, and consequently, monetary aggregates were expansionary.12 The expansion in monetary aggregates was, however, accommodated by strong growth in real money demand, stemming from the higher-than-expected growth of real GDP, regained confidence, and the phasing out of large amounts of noncash (barter) transactions. Annual inflation fell from 19.2 percent at the end of 1999 to 6.1 percent at the end of 2001, to –0.6 percent at the end of 2002, although it rose to 8.2 percent by the end of 2003. The nominal exchange rate depreciated only marginally, from 5.22 hryvnia to the U.S. dollar at the end of 1999, to 5.30 at the end of 2001, and to 5.32 at the end of both 2002 and 2003.

In line with reduced inflation, the NBU cut its discount rate several times (from 45 percent at the beginning of 2000 to 7 percent at the end of 2003). Similarly, the NBU cut its overnight lending rate from 30 percent to 8 percent by the end of 2003. It also lowered the reserve requirement from 17 percent in 1999 to 7 percent for time deposits and 8 percent for demand deposits (effective October 2004). Because of the reduced cost of funds to the banks and the expansion in liquidity, nominal interest rates for loans in domestic currency to the economy declined from a weighted average of 52 percent in 1999 to 18 percent at the end of 2003. Overall, over the period 2000–03, the NBU was able to maintain the stability of the exchange rate, build up its external reserves, and achieve a decline in inflation.

Conclusions and Lessons

Ukraine’s experience reveals that reliance on money market operations to conduct monetary policy may be complicated by the following factors:

  • Fiscal dominance—monetary policy performed poorly in all those years in which the NBU was used to meet the financing needs of the budget.

  • Poor target choice—the initial defense of the exchange rate at the onset of the Russian crisis, which later proved counterproductive, complicated the successful implementation of monetary policy.

  • Underdeveloped government domestic debt market—the underdeveloped debt and securities market and the absence of a sufficient amount of securities with which to conduct sterilization and collateralized operations effectively rendered many of the money market operations inoperable.

  • Deficiencies in the interbank market arising largely from weaknesses in the banking system, the absence of suitable instruments to use as collateral, and the poor intervention strategy of the NBU—these deficiencies weakened the monetary transmission mechanism and complicated reliance on money market operations to conduct monetary policy.

However, Ukraine was able to effectively conduct monetary policy between 1996 and 1997, and achieved a significant reduction in inflation over that period, largely by the use of simple rules-based and open market–type instruments, including reserve requirements, a Lombard facility, credit auctions, and primary market outright transactions in government securities. Similarly, during 2000–03, the NBU was able to maintain the stability of the exchange rate, build up its external reserves, and achieve a decline in inflation.


Path to Reliance on Money Market Instruments

Since its independence in 1980, monetary management in Vanuatu has remained underdeveloped. In 1988 the Reserve Bank of Vanuatu (RBV) started to impose a reserve requirement on all banks, the so-called Statutory Reserve Deposit (SRD), which requires banks to keep 10 percent of all residents’ local currency (vatu) demand, time, and saving deposits with the RBV. This requirement was primarily for prudential reasons. The RBV also had a lender-of-last-resort facility (the Advance Facility), which was used more often by nonbanks than banks.

Early in 1998, the financial system came under stress when social unrest prompted the government to allow the public to withdraw their retirement savings from the Vanuatu National Provident Fund (VNPF). In response to a sharp rise in liquidity in the financial system, the RBV introduced liquidity asset ratios, the so-called Prescribed Reserve Asset (PRA) requirement. The PRA required banks to hold 16 percent of vatu deposit liabilities in the form of government securities and/or RBV notes. In addition, the RBV raised the base lending rate of the Advance Facility by 5 percentage points, to almost 11 percent, to indicate to the market that it was prepared to defend the vatu exchange rate. The commercial banks followed the RBV’s move and increased their deposit and lending rates.

Because this action was not sufficient to absorb excess liquidity, the RBV also started to issue its own securities, RBV notes. These measures produced positive results: the financial system stabilized, confidence in the vatu recovered, and official reserves were significantly increased. At the end of 1998, the RBV started to phase out the PRA requirement, but still retained the SRD requirement, although its design was modified. The original SRD requirement had been based on all the demand, time, and saving deposits of residents in vatu, but the new SRD also included 50 percent of residents’ demand deposits in foreign currency. At the same time, reserve holdings no longer had to be held in a blocked account at the RBV, and the banks were allowed to meet the reserve requirement on average during the maintenance period.

The introduction of the PRA requirement was intended, not for monetary policy purposes, but rather to facilitate the placement of government bonds by creating a captive market, in a context where the payouts by the VNPF were financed largely through the liquidation of its holdings of government bonds and the issuing of new government bonds. As an instrument of monetary policy, the usefulness of the PRA requirement was limited. A change in the PRA requirement was likely to affect interest rates which, in turn, would influence the demand for credit and, therefore, monetary conditions. However, the quantitative effect of a change in the PRA requirement on interest rates, and subsequently on monetary conditions, was difficult to determine. The quasi-absence of a secondary market in government securities and the shallowness of the financial sector also made it difficult to use the PRA requirement as an effective monetary policy instrument.

At the same time, the RBV became more active in the primary market for RBV notes. The RBV notes have become the most tractable instrument of monetary operations since their introduction in 1998. Two new credit facilities were also introduced: the Rediscount Facility and the Repurchase Facility. These facilities made the Advance Facility superfluous and it was therefore abolished in May 1999. In the meantime, the rediscount rate became the RBV’s benchmark rate.

Monetary Policy Environment

Institutional Framework

The primary objective of the RBV, as explicitly stated in the Reserve Bank Act, is to promote monetary stability. Monetary stability is defined as a stable value of money both at the domestic level (price stability) and at the external level (exchange rate stability).2

The RBV Act specifies that the RBV and the ministry of finance are both monetary institutions. There is a close working relationship between these organizations, which can be characterized as being on equal terms. A representative of the ministry of finance is a member of the board of the RBV; and the RBV is represented on committees advising the government on macroeconomic, monetary, and budget affairs. However, Article 25(h) of the RBV Act gives the minister of finance the power to give directives to the RBV, with which the RBV must comply. Legally, then, the RBV is not an autonomous institution. In practice, however, the RBV has a high degree of autonomy, in particular with regard to the formulation and implementation of monetary policy.3

The government’s fiscal position has sometimes contributed to excess liquidity in the financial system, which in turn has reduced the effectiveness of monetary policy. The government has an advance facility with the RBV, and its continuing resort to this facility in the last few years, due to cash flow problems, has contributed to excess liquidity. In 2003, the advance facility was reduced from 500 million vatu to 400 million. Coordination between monetary and fiscal policies and the relationship between the RBV and the ministry of finance have thus been especially important where financial markets are shallow.

Monetary Framework

In Vanuatu, monetary policy is implemented in the context of a fixed exchange rate regime under which the value of the vatu (VT) is determined on the basis of an undisclosed transactions-weighted (trade and tourism receipts) basket of currencies of Vanuatu’s major trading partners. The RBV quotes rates daily for vatu. Buying and selling rates of vatu against the currencies in the basket are quoted once a day, with margins ranging between 0.25 percent and 0.3 percent around the middle rate. In general, the RBV has not intervened in the foreign exchange market to defend the exchange rate, but it could do so if necessary.

There are no capital controls in Vanuatu and therefore not much room for an independent monetary policy. Within the exchange rate regime, the RBV attempts to guide monetary developments, including domestic credit conditions. The RBV formulates a target for its international reserves (at least six months of imports). In order to maintain official reserves at adequate levels, besides conducting monetary policy, the RBV has issued several guidelines for foreign exchange sales to the banks.4

Macroeconomic Performance

Vanuatu maintained macroeconomic stability with moderate inflation and a GDP growth rate of 4¼ percent during 1991–95. Several shocks, however, resulted in a deterioration of overall macroeconomic performance from 1996 to 2000, with the growth rate declining to 1½ percent. In the mid-1990s, political instability eroded investor confidence.5 Following social unrest in January 1998, the government decided to permit unconditional withdrawals of retirement savings of the VNPF, as noted previously. The payouts by VNPF led to a sharp rise in liquidity in the banking system. Only part of the liquidity was sterilized by the RBV. That decision and the attempt to devalue the vatu fueled devaluation expectations, which caused large capital outflows.6 Because of the VNPF crisis, the official reserves of the RBV decreased dramatically, from the equivalent of around six months of imports to less than three months of imports.

In recent years, the political situation has not been very stable, with frequent changes in the government. Economic growth has not fully recovered. Favorable weather conditions and major public investment boosted growth to 2.5 percent in 2000. However, two cyclones in 2001 resulted in significant crop loss, with real GDP contracting by nearly 2 percent. Inflation remains subdued, increasing from 2½ percent in 2000 to 3½ percent in 2001, largely due to the impact of oil prices on utility and transportation costs.

Structure of the Financial System and Market

Vanuatu’s financial sector includes the RBV, four commercial banks (a government-owned bank, a locally owned bank, a subsidiary of a foreign bank, and a branch of a foreign bank), a number of trust and insurance companies, the VNPF, and several smaller financial institutions. In 2001, a merger reduced the number of commercial banks to four. At present, the largest bank has almost 70 percent of total bank assets. Moreover, one of the remaining four banks is an “exempted bank,” which means that it has a domestic banking license but is not allowed to do business in local currency. Vanuatu also has a prominent offshore financial center (OFC), which in 2001 comprised 36 banks with offshore banking licenses and 16 insurance companies (Table 8.12). Offshore banks are regulated by the International Banking Act of 2002 and are supervised by the RBV, as are domestic banks. Offshore banks are not allowed to accept local deposits from, or make loans to, residents in Vanuatu. Prior to 2003, when the new act came into effect, offshore banks were supervised by the Financial Service Commission. After implementation of the act, offshore banks fell to 24 (as of October 2003), with 10 applicants under review.

Table 8.12.Vanuatu: Financial System Structure(as of end 2001)
Assets (billions of vatu)Percent of Total AssetsNumber of InstitutionsPercent of GDP
Commercial banks43.111.25147.2
of which: state controlled2.70.718.5
Nonbank financial institutions
Offshore banks337.587.9361061.3
Insurance companies0.50.131.6
Pension funds3.10.819.7
Source: Vanuatu authorities.
Source: Vanuatu authorities.

As of the end of December 2001, the total assets of the financial system were about 387.9 billion vatu, equivalent to 1,219.8 percent of GDP (see Table 8.12). If offshore banks are excluded, however, the total asset drops to 50.4 billion vatu, equivalent to 158.5 percent of GDP. Given the restrictions on the ability of the offshore banks to deal in domestic currency and to do business with domestic banks, the commercial banks play a dominant role in the domestic financial system and the offshore banks have no direct impact on the conduct of monetary policy.

The activities of the offshore banks, nevertheless, are likely to have an indirect impact on monetary conditions. The “trust funds” accepted from nonresidents are usually deposited with one of the domestic banks. The banks, in turn, deposit the funds with banks abroad, primarily in their European or Asian offices. However, a small segment leaks into the domestic system, and then becomes part of the money supply. Domestic banks sometimes make loans in foreign currency to residents, mainly for expatriates and local businesses engaged in foreign trading, but the amount of foreign currency loans is small.

Monetary Policy Instruments

The developments during the financial turmoil in 1998 made the RBV aware of the need to strengthen monetary arrangements. Since then, the RBV developed several money market instruments to manage overall liquidity in the system (Box 8.12). Open market operations in RBV notes have been the main discretionary instrument since 1998; they are supplemented by the SRD and two standing facilities.

The SRD requirement applies to all demand, savings, and time deposits of residents in vatu, and to 50 percent of the residents’ demand deposits in foreign currency. The rationale for including only the foreign currency demand deposits is that they are almost entirely held by residents for payments of current transactions in foreign currency (mainly imports), while the time and saving deposits in foreign exchange can be reasonably assumed to be deposited through Vanuatu’s offshore financial center. By including foreign currency deposits in the reserve requirements, the RBV can limit the availability of the banks’ liquidity for private sector lending and reduce excess liquidity. Therefore, the RBV is in a better position to control monetary developments.

Banks are free to choose the currency in which they hold the required reserves, that is, in vatu or the currency in which the deposits are held. However, to date banks have always held the required reserves in vatu.

RBV notes are auctioned through a variable-rate tenders system whereby the allotment interest rate is equal to the interest rate offered by each individual bid. Auctions are held on an irregular basis. The RBV notifies banks and nonbanks of the tender of the notes several days in advance through advertisements in the local newspapers. The decision to issue a given amount of RBV notes to achieve a desired level of the money supply (intermediate target) depends on the reserve money program run by the RBV.

The RBV does not attempt to use the SRD for short-term liquidity management, and the level of the ratio has not been adjusted since 1998. In case of unwarranted high (low) liquidity, the RBV can absorb (inject) liquidity from (into) the financial system through issuing higher (lower) amounts of RBV notes. Under circumstances of very tight liquidity, the RBV might decide not to hold auctions.

Box 8.12.Vanuatu: Monetary Policy Instruments

Reserve requirements

Reserve requirements are calculated as monthly averages and must amount to 10 percent of deposits. The current requirement includes 50 percent of residents’ demand deposits in foreign currency as well as all the demand, time, and saving deposits of residents in vatu. This was the only monetary instrument for about a decade, since it was first instituted in 1988 until 1998.

Standing facilities

  • Discount Facility: Banks can sell (rediscount) treasury bills and/or RBV notes with up to a 90-day maturity to the RBV.

  • Repurchase Facility: Banks sell government bonds and/or RBV notes to the RBV and subsequently buy back the securities at a specified date and price. In the period between the sale and the repurchase of the securities, the RBV provides the bank with temporary liquidity. The discount rate applies to these operations.

Money market operations

RBV notes: The RBV intermittently auctions these RBV notes, which have maturities of 28, 91, 119, and 182 days. RBV notes with maturities of 119 and 182 days were introduced in April 2002. The RBV issues the notes to absorb excess liquidity. Since 1998, monetary policy is mainly conducted by open market operations in RBV notes. (The RBV notes of 119 and 182 days are no longer issued, because competition in the financial sector is low which results in high interest costs for the RBV.)

There is no secondary market in RBV notes in the sense of banks trading among themselves. However, the notes can be and are rediscounted or used in repo transactions with the RBV. Since their introduction, RBV notes have been partially successful in absorbing excess liquidity from the financial system. Due to the ever-increasing liquidity in 1998 and early 1999, the RBV was forced to issue increasing amounts of notes, which were almost all absorbed by the banking system.

The Rediscount and Repurchase Facility can be also used by the RBV as a monetary instrument to affect the total amount of liquidity by setting an upper limit to the credits or by changing the rediscount rate. These facilities are designed to provide liquidity to the banks in the event of temporary liquidity needs. The rediscount facility makes it possible for the banks to sell (rediscount) treasury bills and/or RBV notes with 90 days or less to maturity. Through the repurchase agreements, the RBV offers the possibility for banks to borrow for a short period of time from the RBV using treasury bills and/or RBV notes as collateral.

Channels of Transmission of Monetary Policy

The interest rate applied to borrowing under the Rediscount and Repurchase Facility is the rediscount rate. By making this more or less expensive, the RBV is able to affect liquidity in the financial system. The transmission of monetary policy through the interest rate channel has been successful to only a limited degree in Vanuatu. The main reasons include the high structural liquidity in the financial system and the relatively limited competition among banks. In addition, banks are very cautious in extending new loans. Consequently, banks can sometimes be slow to follow interest rate changes by the RBV.

The first, and for a long time the only, credit facility through which the banks could borrow from the RBV was the Advance Facility, which was established in the 1980s and abolished in 1999, following the establishment of the Rediscount Facility and the Repurchase Facility. The rate charged for borrowing under the facility was the RBV’s official interest rate (the base lending rate). Borrowing under the facility was not encouraged. In fact, the rate incorporated a penalty element to ensure that banks in need of short-term liquidity turned first to the interbank market before seeking funds from the RBV.

During the period when the Advance Facility was in force, banks often had ample liquidity needs, which discouraged them from having recourse to the RBV’s credit facility. Even under the circumstances, the signaling role of the base lending rate remained unimpaired. This was clearly demonstrated during the financial crisis in 1998. After the Advance Facility was abolished on May 1999, the rediscount rate of the Rediscount Facility and the Repurchase Facility became the benchmark rate, and it too incorporates a penalty element, like the Advance Facility’s base lending rate. The RBV uses the rediscount rate as a key variable in monetary operations.

Market Infrastructure and Liquidity Surplus Problem

As described earlier, there is no secondary market in RBV notes. The government security market is also very limited, with virtually no secondary market.7 In general, the absence of secondary markets in government securities and RBV notes has not impinged on the effectiveness of monetary policy because RBV has been in a position to achieve its goals by the combination of the SRD and regular issuance of RBV notes in the primary market. However, the issuance of RBV notes has not always been fully effective in mopping up excess liquidity. For the purpose of risk management or for other reasons, banks with excess liquidity may decide to hold the liquidity rather than invest in RBV notes. So far, the resulting excess liquidity in the system has not been a source of inflation given the investment opportunities in Vanuatu.

Conclusions and Lessons

The main lessons from Vanuatu’s experience with monetary policy implementation are the following:

  • The shallowness of Vanuatu’s interbank market and the small number of banks have inhibited the effectiveness of money market operations. However, the combination of reserve requirements and open market–type operations have in general allowed the monetary authorities to manage overall liquidity conditions satisfactorily.

  • In the context of shallow financial markets, coordination of monetary and fiscal policies is especially important. A good relationship between the central bank and the ministry of finance has fostered such coordination.

  • Absence of secondary markets for government and central bank securities has not prevented effective liquidity management. Auctions of the short-term central bank notes, coupled with averaging provisions for the reserve requirements, proved to be an effective mix of instruments.

  • Excess liquidity in the system has put banks in a situation in which they can decide freely how to use and allocate these resources. However, prudent management on the part of the banks has prevented an expansion of domestic credit and inflationary pressures.


The Path to Reliance on Money Market Operations

Zambia’s path to reliance on money market operations to conduct monetary policy has been similar to that of many other countries in sub-Saharan Africa. Following independence, the Zambian economy was dominated by state enterprises, administered prices, and trade protection. In this environment, the financial sector and monetary policy were geared toward the provision of subsidized credit to the state enterprises. Monetary policy relied on administrative measures and on credit and capital controls—involving credit ceilings, interest rate controls, and exchange controls—in order to channel resources to the preferred state enterprises. After nearly two decades of controls, macroeconomic performance deteriorated sharply and major problems emerged in the financial sector such that by the early 1990s, it was clear that the policy of direct lending and the provision of subsidized credit to preferred sectors had become unsustainable.

At the beginning of 1992, Zambia embarked upon a program of financial liberalization as part of an overall macroeconomic reform program. The first step in the process of financial reform was to free interest rates, which was followed by a freeing of wages and prices. At the same time, a program of privatization was instituted. The external sector was also liberalized in stages between 1992 and 1994, beginning with the dismantling of controls on capital account transactions and followed by gradual, but eventually complete, deregulation of capital controls.

Money market operations were first introduced in 1993, with the implementation of treasury bill auctions, followed in 1995 by daily auctions of credit and deposits to commercial banks. These were soon complemented by the introduction of rediscount facilities and active management of the statutory reserve requirements.

Monetary Policy Environment

Monetary Objectives and Operating Targets

The Bank of Zambia (BoZ) defines price stability as the ultimate objective of monetary policy. In order to achieve this objective, the authorities implement a reserve money program, where commercial banks’ cash balances in the BoZ settlement account (excess reserves) are the operating target and reserve money is the intermediate target. Direct quantity targeting is therefore preferred to an interest rate target, given the difficulty of setting the interest rate consistent with the inflation target and the high volatility of the expected inflation.

The BoZ pursues its objective of price stability in the context of a managed float, with no preannounced path for the exchange rate and with a target for reserve money as the nominal anchor. Quite often, however, the central bank focuses excessively on exchange rate stability (as reflected in frequent foreign exchange auctions and interventions), concentrating less on conventional monetary policy. This attachment to multiple policy goals has at times generated some inconsistencies between the stated objective of price stability and the activities aimed at exchange rate stability.

Structure of the Financial Sector

The financial system in Zambia is small and underdeveloped and operates in the context of a low level of monetization. The ratio of M2 to GDP has been at a level of only about 15–20 percent between 1998 and 2003, compared with an average of about 35 percent for sub-Saharan African countries as a group. The system is dominated by the banking sector whose assets amount to about 90 percent of total financial system assets at the end of 2001 (Table 8.13). In terms of foreign equity participation, about three-fourths of banking system capitalization is foreign. Dollarization is also high: about half of deposits and one-third of loans are in foreign currencies.

The Zambian banking system comprised 15 commercial banks with assets equivalent to about 25 percent of GDP in 2001 (Table 8.13). The largest domestic bank is state-controlled, although it is in the process of being privatized. It holds about one-fifth of the banking system deposits, has the largest branch network, and has the second largest customer base. Four large banks, which are subsidiaries of multinational banks, held 63 percent of assets and 71 percent of loans in 2001. Their market share increased in the late 1990s as a result of a flight to quality following the failure of nine local banks during 1994–98. Other commercial banks are small, with the five smallest banks accounting for less than 1 percent of banking system assets in 2001. The banks participate intensively in investments in government securities and foreign exchange trading, which are their main sources of revenue.

Table 8.13.Zambia: Financial System Structure(as of December 2001)
Number of InstitutionsIn billions of kwacha (K)Percent of GDP
Nonbank financial institutions
Development and savings banks22531.9
Building societies3370.3
Leasing companies10950.7
Microfinance institutions98
Exchange bureaus45
Other (investment/venture)4
Pension funds175904.5
Insurance companies6960.7
Subtotal: nonbank financial institutions4,53134.6
Sources: Bank of Zambia and Lusaka Stock Exchange.
Sources: Bank of Zambia and Lusaka Stock Exchange.

The nonbank financial sector, which includes two development and savings banks, three building societies, and a handful of leasing companies, is small both in absolute terms and relative to the size of the economy. The stock market is equally small, with stock market capitalization equivalent to about 8 percent of GDP in March 2002.

Market Infrastructure

The money market in Zambia is traditionally concentrated in the overnight maturity segment, although there have been improvements in the longer-term maturity segment, with more active use of loans of 2- to 14-day maturity (term money market). Use of longer-term maturities is, however, sporadic. Total loans amounted to 3.4 trillion kwacha (equivalent to around US$750 million), or 26 percent of GDP, in the first six months of 2002.

The interbank market is usually characterized by excess liquidity. The lack of instruments to manage short-term liquidity, together with insufficient BoZ smoothing operations and a punitive rediscount rate, has induced banks to hold liquid funds in their current account at the BoZ. Banks also use short-term liquidity to be able to buy foreign exchange at very short notice. Operating in a context of excess liquidity means that the BoZ has to constantly withdraw liquidity to meet its operating target (i.e., commercial banks’ current account with the BoZ). This has tended to constrain liquidity management because the BoZ does not have a sufficient amount of government securities to sterilize the excess liquidity.

The overnight interbank money market has also been characterized by significant interest rate volatility, for a variety of reasons including limited windows for funds at the BoZ, a costly rediscount facility, volatile flows of cash between the government and the private sector, and market segmentation.2 The interbank rates also show a high degree of seasonality related to government flows and tax payments, with spikes concentrated at the end of (almost) every month. This seems to indicate a cyclical reduction of available liquidity in the interbank market at the end of each month; as a consequence, a statistically predictable component of the liquidity forecasting exercise might not be adequately taken into consideration.

The interbank market is supplemented with a government securities market (Box 8.13). The primary market is organized by the BoZ, which maintains and processes all transactions relating to these securities through its book entry system. Although the BoZ is supposed to act only as the government debt-issuing agent, it has, in practice, a large degree of flexibility in deciding the terms at which securities are auctioned: it decides the amount of securities to issue and determines the cut-off rate. Up until March 2001, tenders of government securities were managed as uniform-price auctions, in which bidders paid the price of the lowest acceptable bid. Since then, a multiple-price tender system has been in place. Bids at the cut-off price are prorated based on the size of bids. The BoZ’s rather large responsibility in deciding the terms at which securities are auctioned has removed from the government much of the incentive for efficient liquidity forecasting and cash flow management. This in turn has hampered the ability of the BoZ to forecast and fine-tune liquidity in the system.

Box 8.13.Zambia: Government Securities Market

In 1993, as part of a larger program of financial liberalization, the government of Zambia introduced an auction arrangement for pricing and distribution of government securities. The objective of this reform was to enable the government to cover its expenditures in a way that was less distorting than other alternatives (direct advances from the BoZ or distorted taxation) and to enhance the development of financial markets by providing an instrument of collateral, a benchmark interest rate, and a means of managing liquidity.

The market for securities underwent significant changes, including the introduction of a multiple-price format for tender sales and the opening of tenders to corporations and individuals. The range of securities has been expanding over time, with treasury bills issued in maturities of one to nine months, and government bonds issued in maturities of one to two years. Off-tender (noncompetitive) sales of government securities have also been introduced to cater to the small investor who is unable to meet the minimum requirement bid size for the auction. The largest holders of government securities have been banks (around 70 percent), followed by pension funds.

A secondary market for government securities does exists, although it is very thin, and prices are determined by negotiation between interested parties rather than two-way pricemaking.

A secondary market for government securities does exist, although it is very thin because investors—individuals, corporations, or banks—prefer to hold securities until maturity. Commercial banks typically purchase the securities first to meet the liquid asset ratio and, second, as an alternative investment to low-quality private sector lending opportunities. Other investors hold the securities because the interest payment offers sizable revenue.

Channels of Transmission of Monetary Policy

The foregoing analysis of the structure of the financial sector and the existing market infrastructure in Zambia reveals a case in which the traditional monetary transmission mechanisms do not operate as effectively as might be expected under a more developed financial system. While it has been possible to transmit some monetary policy signals through the interest rate channel, via the treasury bill rate, the other channels (credit, exchange rate, and asset prices) have been either very weak or nonexistent.

The most important direct signal the BoZ provides to the market is related to the treasury bill auction, held weekly. The auction rate is the base for the determination of the Bank Rate, which in turn is used by the commercial banks to guide them in setting deposit and lending rates. However, even in this case, bank lending rates, while being flexible upwards in response to movements in the treasury bill rate, are rigid downward, indicating sluggishness in the transmission mechanism of monetary policy. The oligopolistic market structure in the banking sector is the primary root cause of these rigidities.

The interest rate channel, through the money market, has not functioned as strongly as expected. As indicated, the interbank money market in Zambia is characterized by high volatility in interest rates and average excess liquidity. The high volatility in interest rates has been attributed to the limited availability and high cost of BoZ liquidity facilities, volatile flows of cash between the government and the private sector, and market segmentation. In addition, monetary operations as implemented in Zambia do not provide sufficient guidance to the short-term money market about the policy stance of the BoZ. Monetary operations tend to provide policy signals for the three- to four-week maturities and upward, leaving the shortest end of the money market—especially the overnight interbank—to fluctuate wildly, within the range of 10 percent to more than 80 percent. These deficiencies have tended to weaken the interest rate monetary transmission channel.

Monetary Policy Instruments

In light of the limited effectiveness of transmitting monetary policy signals in Zambia through traditional market-based channels, and in light also of the fact that the framework for monetary policy is itself still in transition, the BoZ has had to rely on a combination of rules-based instruments and money market operations to conduct monetary policy. The most important instruments have been reserve requirements (RRs) and a minimum liquid asset ratio (LAR) (Box 8.14). In particular, the RRs have been increased on repeated occasions to adjust structural liquidity imbalances. A wide range of money market instruments have been introduced in order to reduce reliance on the RRs and LAR because use of these instruments require substantial portfolio adjustments, which are not easy to implement at short notice. However, repo operations have only been conducted infrequently as the BoZ does not have enough treasury bills in its portfolio to withdraw the excess liquidity from the market on a regular basis.

Box 8.14.Zambia: Instruments of Monetary Policy

Liquid asset ratio

Banks are required to hold 35 percent (up from 25 percent in 2001) of their kwacha deposits in liquid form (cash and excess reserves with the BoZ or in treasury bills). Averaging provisions over the weekly maintenance period apply.

Reserve requirements

Reserve requirements apply to kwacha and foreign currency deposits and are held as a non-remunerated kwacha and foreign currency deposits with the BoZ. The ratio is subject to frequent changes in response to liquidity developments in the system. (For example, the RR was increased from 8 percent to 11 percent in December 2000, increased to 15 percent in January 2001, lowered to 10.5 percent in March 2001, increased to 12.5 percent in June 2001, increased to 15 percent in December 2001, and increased again to 17.5 percent in December 2002.) There is a seven-day maintenance period, and averaging provisions apply.

Standing facilities

Discount facility: If the market is short of liquidity, banks can rediscount treasury bills at the BoZ with a penalty rate. During a given month, banks are permitted to discount bills by an amount up to 10 percent of their regulatory capital. Above this limit, an additional penalty of 7 percent is applied. Because the overall penalty is usually very high and complex to calculate, banks are reluctant to make use of this facility.

Money market instruments

  • Deposit auction: These are used to absorb excess liquidity. The BoZ may decide to auction (via multiple price tender) deposits to banks. The BoZ retains the right to reject offers that are, in its judgment, not consistent with market fundamentals. The maturity of deposits depends on how long the BoZ estimates the excess liquidity situation will prevail. To date, these auctions usually have been undersubscribed, despite the banks’ excess liquidity.

  • Credit auctions: These provide credit to the banks. In the recent period, this facility has seldom been used, given the structural excess liquidity in the system.

  • Outright sales/purchases of government securities: The BoZ may withdraw or inject liquidity through outright sales or purchases of government securities.

  • Repurchase operations: In 2002, the BoZ started using repurchase (repo) operations (maturity of 2 to 12 weeks) on government securities to withdraw liquidity. Ultimately, repo operations are expected to replace the BoZ term deposit auctions. Repo operations have only been conducted infrequently because the BoZ does not have enough treasury bills in its portfolio to withdraw the excess liquidity from the market on a regular basis. The repo documentation in place also allows the BoZ to conduct reverse repo operations, which could replace the credit auctions.

Conclusions and Lessons

The following conclusions and lessons can be derived from the experience of Zambia with reliance on money market operations to conduct monetary policy:

  • Money market instruments do not seem to have led to a significant reduction in monetary growth, but inflation has been reduced.

  • The effectiveness of monetary transmission mechanisms has been diminished by the oligopolistic market structure coupled with the excess liquidity in the banking system, which have caused rigidities in market rates and prevented the transmission of monetary policy signals.

  • An overall lack of credibility in the financial sector reform process and frequent backtracking have affected market sentiment and created great difficulties in bringing money supply and inflation under tighter control.

  • Money market operations have had limited effectiveness in stabilizing banking system liquidity due to attempts to achieve multiple objectives, which have resulted in inconsistencies between the stated objective of price stability and a de facto objective of exchange rate stability.

  • A long history of hyperinflation in Zambia has given rise to the persistence of inflationary expectations, which have made it difficult to achieve single-digit inflation.

  • The high degree of dollarization has imposed significant constraints on the implementation of monetary policy by creating an environment in which there is large volatility in exchange rates.

Prepared by Bernard Laurens (Deputy Division Chief, Monetary and Financial Systems Department, MFD), based on MFD technical assistance missions of October 2001 and October 2002 (both headed by Bernard Laurens) which took place in the context of the definition and implementation of the PRGF with the DRC. The study covers developments through the end of 2003.

CDs were issued to finance the budget. However, they could be purchased only with cash, thus allowing the BCC, in its capacity as fiscal agent, to “buy” currency from the market which it could use to pay the government’s expenses.

BCC’s operations on the décote market involved purchases of foreign currency or CGF banknotes against payments in CGF bank money at a premium.

“Public sector” encompasses the government budget, the BCC, and other government entities (i.e., commercial banks) that utilize, in one way or another, the payment systems.

At the end of 2001, average foreign currency deposits to total deposits in Africa reached 33.2 percent (see Gulde and others, 2004).

Prepared by Rodolfo Maino (Senior Economist, Monetary and Financial Systems Department, MFD), based on van Beek and others (2000). The study covers developments through 2003.

The ECCA included the Leeward Islands and the Windward Islands with the exception of Grenada, which finally joined in November 1968, after originally establishing a political union with Trinidad and Tobago.

The six member countries and two territories of the ECCB are Anguilla, Antigua and Barbuda, Dominica, Grenada, Montserrat, St. Kitts and Nevis, St. Lucia, and St. Vincent and the Grenadines. With the exception of Anguilla, they are all members of CARICOM.

The minimum savings deposit rate was initially set at 4 percent and lowered to 3 percent in September 2002.

Prepared by George Iden (former Senior Economist, Monetary and Financial Systems Department, MFD), based on MFD work in the context of the Financial Sector Assessment Program (FSAP) for Egypt and the December 2002 Monetary and Exchange Affairs (MAE) technical assistance mission to Egypt on strengthening the institutional framework for implementing monetary policy that was headed by Kal Wajid. The study covers developments through the end of 2004.

For detailed discussion of the Egyptian reforms and their positive effects, see Alexander, Baliño, and Enoch (1995); and Handy and others (1998).

The real effective exchange rate depreciated by over 40 percent between mid-2002 and early 2004.

Plans to privatize these banks have been prepared. In particular, the authorities announced in September 2004 that one of the public sector banks, which was identified, was scheduled to be privatized.

The upward trend in interest rates helped to stabilize the exchange rate, and the premium in the parallel market fell steadily until it had essentially disappeared by October 2004, together with strong current account inflows.

Prepared by Stephen Swaray (Senior Economist, Monetary and Financial Systems Department, MFD), based on MFD work in the context of the December 2001 mission to discuss medium-term technical assistance needs to serve as input into a three-year Technical Cooperation Action Plan (TCAP), and the subsequent April and October 2002 technical assistance missions (both headed by Udaibir Das) on strengthening the central bank and the financial system. The study covers developments through the end of 2003.

The decade between 1975 and 1985 witnessed a decline in real growth, accelerating inflation, and a deteriorating external payments position, in response to a variety of external shocks coupled with the implementation of inappropriate policies. In particular, the government started to intervene actively in the development process through the establishment of financial institutions designed specifically to provide subsidized directed credit to the groundnut sector, the country’s major cash crop. The financial system and monetary policy were relegated to the role of mobilizing the savings of the population and allocating credit to the preferred agricultural sector.

Some of these losses result from seasonal smoothing operations by the CBG coupled with the rapid depreciation in the dalasi exchange rate. In addition, a number of foreign exchange transactions involved extremely wide spreads, implying that the transactions’ counterparties earned large profits at the expense of the CBG.

A small financial system is usually defined by M2 smaller than US$1 billion, which is the size of a small bank in an industrial country. The World Bank Financial Sector Discussion Paper No. 6 lists about 60 such countries—The Gambia among the smallest ones, with M2 only slightly above US$100 million.

Banking system assets account for about 97 percent of total financial sector assets. Of the rest, 2 percent belong to insurance companies and 1 percent to microfinance institutions.

The government’s direct participation in banks is now limited to the 10 percent it holds in one bank. Of the six banks, foreign individuals and companies own at least 70 percent shares in three of them and substantial amounts (30 percent and over) in the others.

Both the banks and the bureaus are licensed by the CBG to deal in foreign exchange and to participate in the foreign exchange market. Moneychangers were licensed starting in 2002. There are also money transfer offices (such as Western Union), which operate without direct transfer of foreign exchange into the country. The bulk of foreign exchange inflows, mainly remittances, have been channeled through Trust Bank, which also serves as an agent for Western Union.

Prepared by George Iden (former Senior Economist, Monetary and Financial Systems Department, MFD), based on MFD work in the context of the July 2001 technical assistance mission on monetary operations that was headed by Greta Mitchell Casselle; MFD work in the context of the Financial Sector Assessment Program (FSAP) for The Kyrgyz Republic. The study covers developments through the end of 2003.

In 2001, for example, the NBKR conducted swap transactions totaling approximately US$38 million, with average maturity of five days.

A change in the NBKR’s procedures for setting interest rates on “overnight” credits, which took effect in March 2002, may have contributed to a subsequent reduction in volatility in interbank rates.

According to an agreement between the NBKR and the ministry of finance, these government securities will be transformed into marketable treasury bills and medium-term government bonds which will gradually be redeemed over a 10-year period. The remuneration on the bonds will be approximately inflation plus 1 percent, and they can be used for repo operations.

Prepared by Andrea Schaechter (Economist, Monetary and Financial Systems Department, MFD), based on MFD work in the context of the Financial Sector Assessment Program (FSAP) for Malta. The study covers developments through the end of 2003.

This policy is relevant for former offshore or international banks that have acquired a license to operate in Malta (rather than only operating from Malta). Holding required reserves in the currency that they use as their accounting base reduces exchange rate risk.

Prepared by Kentaro Iwatsubo (Summer Intern, Monetary and Financial Systems Department, MFD) and George Iden (former Senior Economist, MFD), based on a February 1999 Monetary and Exchange Affairs (MAE) technical assistance mission to Tonga, led by Hidaeki Suzuki, and on IMF Country Report No. 03/37. The study covers developments through the end of 2003.

Initially only 56-day maturity notes were offered at a 4.5 percent interest rate. In 1994, securities with maturities between 28 days and five years were added. More than 90 percent of the securities were acquired by commercial banks.

For a more detailed discussion, see IMF Country Report No. 03/37, p. 5.

The NRBT also stopped issuing one-month NRBT bills (at 3.5 percent) in 2001.

The deposit and lending rates by commercial banks in Tonga have been very sticky; consequently, changes in the MLR hardly affected commercial banks’ behavior.

The pa’anga was pegged to the Australian dollar until 1991. The Asian crisis and the sharp drop in reserves in 1997–98 led the authorities to introduce a 2 percent band in March 1998. In 2000, the band was widened to 5 percent and the Japanese yen was included in the currency basket since Japan became more important as a trading partner.

The NRBT governor is appointed for a period of five years and is eligible for reappointment. Responsibility for policy and affairs lies with the board of directors, which comprises the governor and six other directors appointed by the executive branch.

The NRBT did not specify sanctions for noncompliance with the credit ceilings. The June 2002 experience shows that two banks complied, while the other two did not.

Excess liquidity resulted from credit expansion associated with operations with the government and public enterprises.

In 2002, the government approved a proposal to strengthen the NRBT through a recapitalization, reflecting the cost of monetary policy in the budget for 2002–03 and subsequent years.

Prepared by Bernard Laurens (Deputy Division Chief, Monetary and Financial Systems Department, MFD), based on MFD work in the context of the Financial Sector Assessment Program (FSAP) for Tunisia, and Laurens and Sarr (2003), and a joint MED-MFD Supplement to the Staff Report for the 2003 Article IV Consultation. The study covers developments through October 2004.

Measures were adopted in 2001 requiring all securities issued in Tunisia, regardless of nature, to be registered in book entry format. Furthermore, the management and administration of securities accounts traded on the market can only be carried out by credit institutions. Consequently, authorized intermediaries are subject to the supervision of the BCT and of the Financial Market Board, each in its own area of competence. In the same context, a code grouping all legislation governing mutual investment funds was issued in 2001. Other measures in recent years included easing of conditions for opening stock savings accounts to encourage the public to open such accounts.

IMF Country Report No. 02/119.

BCT’s holdings of government securities are limited to 10 percent of recurrent government revenues.

While the convertibility of the dinar is at a very advanced stage for nonresidents, capital controls for residents are pervasive.

Noteworthy is the privatization of Union Internationale de Banques (UIB) in November 2002, involving the sale of a controlling share to foreign investors.

In a sample of 1,500 enterprises, the average debt-asset ratio exceeds 65 percent, and it reaches 80 percent in the construction sector; two-thirds of corporate debt is short term.

On the positive side, the sector’s profitability is high, and the system is protected from external competition due to extensive capital controls. Furthermore, to help banks improve the financial soundness of their portfolios and to strengthen their financial positions, greater flexibility was introduced in the conditions for writing off doubtful claims, reducing from four to two years the period to allow the write-off of frozen claims.

The legal framework defines a repo as a transaction involving the purchase of securities with transfer of full ownership, at a price agreed at the time of the initial purchase and with the commitment on the part of the seller/buyer to buy back/hand back the securities at a date and price agreed at the time of the initial transaction.

Nondebt-creating capital inflows (mostly foreign direct investment, FDI) were about US$650 million in 2000, about 40 percent of which were from the privatization of public enterprises.

The following changes in the implementation of monetary policy in 2001 led to a more active monetary policy: (1) end-of-day settlement operations are conducted at rates that differ from the official intervention rate (± 1/16 percent); (2) introduction of three-month reverse repo operations; and (3) broadening of the range of collateral for BCT refinancing (treasury bills, claims on priority sectors, and claims on other sectors in equal shares).

Prepared by Obert Nyawata (Senior Economist, Monetary and Financial Systems Department, MFD), on the basis of MFD work in the context of the Financial Sector Assessment Program (FSAP) for Uganda, the technical assistance missions on monetary policy implementation of August 2001 and January 2002 (both headed by Abdessatar Ouanes), and the mission of March 2004 (headed by Stephen Swaray) on monetary policy implementation. The study covers developments through the end of 2003.


Over 50 percent of government’s expenditures has been covered by donor funds.

Outstanding treasury bills rose from less than 2 percent of GDP prior to 1999 to over 5 percent of GDP in 2001, with issuances persistently exceeding redemptions.

Subsequent to a more active use of repos for short-term liquidity management, interest rate volatility declined. The policy changes were introduced in the context of Monetary and Exchange Affairs (MAE) technical assistance to the BOU after an FSAP mission.

Excess reserves have fluctuated between 10 percent and 50 percent of required reserves.

Prepared by Stephen Swaray (Senior Economist, Monetary and Financial Systems Department, MFD), based on MFD work in the context of the Financial Sector Assessment Program (FSAP) to Ukraine, and on MFD technical assistance mission of April 2004 (headed by Inci Ötker-Robe). The study covers developments up to October 2004.

The NBU has been pursuing a nominal exchange rate target to a large extent due to undeveloped monetary transmission mechanisms and unpredictable dynamics of the money demand. The authorities have argued that exchange rate stability was desirable in an open economy like Ukraine since in the short run the exchange rate has a direct impact on inflation.

Commercial bank credit to the economy grew by 62 percent, 41 percent, 48 percent, and 64 percent between 2000 and 2003, respectively, while deposits grew by 47 percent, 32 percent, 43 percent, and 58 percent, respectively.

Interest rate spreads between loans in domestic and foreign currency were 6.9 percent in 2003, 10.5 percent in 2002, 18 percent in 2001, and 21.3 percent in 2000 (December data).

For example, 66 new issues were sold in 2003.

For example, the overnight rate rose from 8.1 percent at the end of May 2001, to 35.1 percent at the end of June 2001. The volatility declined somewhat thereafter, until another spike occurred in November 2003.

As of end 2003, treasury securities amounted to HRV 2.6 billion. Total domestic government securities held outside the central bank amounted to 1.5 percent of the GDP, of which more than 90 percent was held by banks.

Poor economic performance has also reflected unsuccessful fiscal and tax reforms.

Refinancing facilities are subsumed under the heading “money market instruments” because these instruments are at the initiative of the NBU.

The NBU started to use more actively reverse repos and to issue CDs in mid-2004.

The statutory refinance rate was raised three times during October–November 1997, from 16 percent to 35 percent, and 12-month treasury bill yields were increased from 27 percent to 38 percent.

Base money grew by 40.1 percent, 37.4 percent, 33.6 percent, and 30.1 percent, respectively, between 2000 and 2003, while broad money grew by 45.5 percent, 41.9 percent, 41.8 percent, and 46.5 percent, respectively, during the same period.

Prepared by Kentaro Iwatsubo (Summer Intern, Monetary and Financial Systems Department, MFD) and George Iden (former Senior Economist, MFD), based on “20 Years of Central Banking in Vanuatu,” Reserve Bank of Vanuatu; a February 1996 Monetary and Exchange Affairs (MAE) technical assistance mission (headed by George Iden); and on IMF Country Reports No. 02/265 and No. 02/266. The study covers developments through the end of 2003.

As an illustration of its intervention in monetary policy, when the government did not agree with the RBV’s decision to devalue the vatu in 1998, it revoked the decision of the RBV within a few days.

During the financial crisis in 1998, the RBV issued a guideline that it would sell foreign exchange to the banks for current transactions only. In addition, in June 2001, the RBV enforced a regulation that it would sell foreign exchange to the banks in minimal amounts of US$1.0 million per client. In September, the amount was lowered to $250,000.

Following the general election in 1995, the government changed three times in 1996, and continued instability led to the dissolution of parliament in 1997.

In the aftermath of the Asian financial crisis in 1998, several countries such as Papua New Guinea, Fiji, and the Solomon Islands devalued their currencies by 20 percent. Shortly afterward, because of the VNPF crisis, the RBV followed suit. However, the government immediately revoked the RBV decision on the grounds that the devaluation could potentially have a high cost if it were to spark an inflation-wage spiral.

In early 2003, the RBV and the ministry of finance agreed on the issuance of a substantial amount of treasury bills (VT 400 million, of which approximately half were already issued by May 2003). These bills, used as collateral, assisted banks in accessing the credit facilities of the RBV.

Prepared by Marco Arnone (Economist, Monetary and Financial Systems Department, MFD) and Stephen Swaray (Senior Economist, MFD), based on MFD work in the context of the Financial Sector Assessment Program (FSAP) to Zambia, the June and October 2001 technical assistance missions on monetary and financial sector issues (both headed by Thordur Olafsson), and the January and September 2003 technical assistance missions on monetary and foreign exchange operations (both led by Susana Crossa Sosa) The study covers developments through the end of 2003.

For instance, the overnight rate ranged between 7 percent and 130 percent in 2001, and between 9 percent and 80 percent in the first six months of 2002.

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