Primary Bill Market Operations

A first step in developing market-based instruments of monetary control in countries with underdeveloped financial markets has frequently been primary issues of treasury bills and/or central bank bills, supported by a restructuring of central bank rediscount windows to allow a greater role for market forces. Commercial banks are often already required to hold treasury bills to meet liquid asset requirements, and, therefore, issues of such paper, which involve less risk than longer-term securities, are a convenient starting point. Issues of central bank securities have been considered useful in some circumstances, because of the potentially greater freedom for the central bank to tailor issues of its own papers to achieve monetary objectives. Although the net budgetary and monetary impact from using central bank rather than treasury paper would in principle be similar, the payment of interest by the central bank on its own debt could affect its profit and loss position, and this could have a monetary effect depending upon the legal and technical arrangements to distribute central bank profits and cover losses, if any.⁷ In those countries where central bank refinance has been a major source of credit to the banking systems, auctions of the refinance credit have been used to introduce market forces into the allocation procedures. Unlike auctions of bills, however, auctions of credit involve issues of moral hazard and adverse selection, and hence require a careful design to limit these problems as well as measures to reduce the extent of reliance on central bank refinance.⁸ It is generally desirable to move quickly away from a situation of significant central bank refinance.

The role of security issues as instruments of monetary control is illustrated in Appendix I, using financial flow and balance sheet equations.⁹ Essentially, the technique is to sell a net volume of securities (e.g., treasury bills or central bank bills) outside the central bank in order to meet an objective for banks’ excess cash reserves. This objective is the short-run operating target of monetary operations. The net volume to be sold is determined on the basis of monetary policy objectives and a forecast of the supply of reserves, compared with the estimate of the banking systems’ demand for reserves. Given these forecasts, the net sales of securities can be targeted to tighten, ease, or maintain the liquidity situation (i.e., raise, lower, or maintain the level of interest rates).

For the central bank to implement the new monetary policy operating framework, a monetary programming procedure must be established to carry out the projections and determine the volume of bills to be sold. The type of operational framework that may need to be developed for determining the regular auction amounts and the volume of money market intervention to be undertaken by the central bank between auctions are illustrated in Table 2.2.

Table 2.2

Framework for Regular Forecasting and Daily Monitoring of Cash Positions

Table 2.2

Framework for Regular Forecasting and Daily Monitoring of Cash Positions

Variable	Regular Forecast for Auction	For Money Market Intervention
Commercial banks’ required cash balances	Based on projected growth of monetary aggregates developed by central bank as part of macroeconomic policy framework and analysis of seasonal pattern in deposits of commercial banks.	Monitoring unit to prepare assessment of progress under the cash reserve ratios and discuss with banks the level of their desired precautionary cash balances.
Foreign exchange	Based on projections of the balance of payments developed by the central bank and analysis of seasonal pattern in payment flows and intervention by the central bank.	Actual intervention by the central bank to be communicated daily to the monitoring unit. Forecast based on two-day delay in settling international transactions.
Currency outside banks	Based on currency demand estimates; seasonal patterns; and statistical forecasting techniques.	The currency issue to be notified daily to the monitoring unit.
Government accounts	Forecasts of regular receipts and payments, such as customs duties, and wage and social security payments to be prepared by the relevant government departments. General Accountant to notify of large irregular payments expected during forecast period. List of securities outstanding with amounts and maturity dates and notification of new issues with dates and amounts to be made available to the public.	Actual receipts and payments through government accounts to be notified to the monitoring unit. Request forecasts and information from government departments.
Maturing central bank bonds and assistance	Lists of bonds and assistance outstanding with amounts and maturity dates.	Actual repayments to be notified to the monitoring unit.
Central bank current transactions	Central bank staff to prepare weekly forecasts.	Actual payments and receipts to be communicated to the monitoring unit.
Other central bank current accounts	—	Actual balances in accounts to be communicated to the monitoring unit.

View Table

Table 2.2

Framework for Regular Forecasting and Daily Monitoring of Cash Positions

Variable	Regular Forecast for Auction	For Money Market Intervention
Commercial banks’ required cash balances	Based on projected growth of monetary aggregates developed by central bank as part of macroeconomic policy framework and analysis of seasonal pattern in deposits of commercial banks.	Monitoring unit to prepare assessment of progress under the cash reserve ratios and discuss with banks the level of their desired precautionary cash balances.
Foreign exchange	Based on projections of the balance of payments developed by the central bank and analysis of seasonal pattern in payment flows and intervention by the central bank.	Actual intervention by the central bank to be communicated daily to the monitoring unit. Forecast based on two-day delay in settling international transactions.
Currency outside banks	Based on currency demand estimates; seasonal patterns; and statistical forecasting techniques.	The currency issue to be notified daily to the monitoring unit.
Government accounts	Forecasts of regular receipts and payments, such as customs duties, and wage and social security payments to be prepared by the relevant government departments. General Accountant to notify of large irregular payments expected during forecast period. List of securities outstanding with amounts and maturity dates and notification of new issues with dates and amounts to be made available to the public.	Actual receipts and payments through government accounts to be notified to the monitoring unit. Request forecasts and information from government departments.
Maturing central bank bonds and assistance	Lists of bonds and assistance outstanding with amounts and maturity dates.	Actual repayments to be notified to the monitoring unit.
Central bank current transactions	Central bank staff to prepare weekly forecasts.	Actual payments and receipts to be communicated to the monitoring unit.
Other central bank current accounts	—	Actual balances in accounts to be communicated to the monitoring unit.

Selling techniques for primary bill issues range from “free” auctions to fixed-price tenders. Under “free” auctions, the ministry of finance or, typically, the central bank acting as the agent of the ministry announces the volume of bills to be sold and asks for competitive bids. Interest rates would be allowed to adjust to sell the quantity of bills tendered, and, hence, achieve the targeted stock of reserves. Bills are allocated starting with the highest bid price and moving to the next highest until the tender is fully sold. The auction produces a range of interest rates, with the highest rate determined by the marginal bid that exhausts the tender—known as the “cutoff” or “striking” rate. Bills could be allocated either at the cutoff rate or at the price bid by each successful bidder. Under a fixed-price tender, the central bank sets the interest rate on bills and accepts the volume demanded at that rate, typically during a fixed subscription period. Thus in contrast to the “free auction,” the interest rate is determined in the short run, and quantities are allowed to vary. The interest rate in a fixed-price tender may be varied from one tender to the next to exercise the desired quantitative control.

In introducing primary bill auctions, a concern expressed by central banks about a “free” auction is that it may result in excessive volatility in interest rates, while the concern with a fixed-price tender is that it may risk a “bias to delay” in adjusting interest rates. Central banks have thus adopted different selling procedures that seek to avoid excessive interest rate volatility while allowing flexibility in interest rate adjustment. In some cases, bills are auctioned, but no tender volume is announced in advance. Usually the ministry of finance or the central bank exercises its discretion in accepting or rejecting bids, depending on its quantitative or interest rate objectives. The decision not to announce the tender amount can thus give the authorities added flexibility, although at the cost of reducing information to market participants. In some other cases, bills are auctioned and tender volumes announced in advance, and a permissible range is announced for acceptable bids; the range is usually based on the interest rate set at the previous auction. In some countries the central bank or other financial institutions underwrite the bill issue at interest rates indicated by and agreed with the ministry of finance. Another procedure is for the ministry of finance or the central bank to preannounce an initial auction amount, but to vary it once bids are received in order to achieve interest rate objectives. The central bank may also decide to reject all bids if they are not considered satisfactory. The increased flexibility provided by these various techniques can help overcome initial concerns about a loss of control over interest rates when implementing new monetary control and debt management procedures.

Central Bank Facilities

In addition to issuing primary bills, the central bank may need to intervene to manage short-term fluctuations in liquidity.¹⁰ For example, unanticipated deposit withdrawals into cash may be such as to create a reserve shortage and force commercial banks to borrow from the central bank. If not offset by the central bank, the resulting reserve shortages or surpluses could result in excessive volatility in interest rates, complicate banks’ compliance with legal reserve requirements, and interfere with the functioning of the payment system.

Under a strict monetary base control system or regimes that allow for period averaging when determining compliance with compulsory reserve requirements, it is conceivable that banks’ precautionary reserve holdings would remove the need for frequent money market interventions by the central bank.¹¹ Nevertheless, most central banks have facilities for day-to-day money market operations, and the arrangements for such facilities have varied depending on local circumstances and the stage of development of the domestic money market.

Central banks have frequently set penalty interest rates (discount or bank rate) at which they are willing to lend to commercial banks, usually against collateral.¹² A loan window provides a facility only to eliminate reserve shortages, and has sometimes been combined with a deposit facility at the central bank to help manage surpluses in liquidity; the European Central Bank has such a facility. The loan window rate has sometimes come to be viewed as the indicative rate for all interest rates, thus inhibiting their market determination. Some countries have sought to mitigate this concern by providing graduated access to the loan window at progressively higher penalty rates.¹³ A few countries with underdeveloped financial markets have found it useful for the central bank to preannounce its willingness to buy or sell bills at posted interest rates close to those determined in the last primary auction. Such procedures, however, can interfere with monetary control objectives and the development of secondary markets. To reduce these risks, central banks have widened the margins between their preannounced buying and selling rates for bills.

In view of the drawbacks of the above-mentioned techniques, the generally preferred procedure for short-term liquidity management is for the central bank to take the initiative on the quantity of intervention and leave the interest rates to the market. The central bank could participate in the interbank market or conduct auctions of its money market intervention instruments, including outright sales and purchases of specified securities, repurchase agreements, foreign exchange swaps, and rediscounts.¹⁴ By restricting these auctions to a few key money market participants, the day-to-day auctions can be implemented more flexibly than the general auctions of primary bills.¹⁵ Various techniques can be used to help identify the need for and the volume of such auctions.¹⁶

Transitional Considerations in Moving to a Market-Based System

The introduction of more market-based monetary controls raises a number of transitional issues. The transition to full reliance on indirect monetary controls may take time, because experience and confidence in the new system has to be gained by the central bank and the private sector, and new institutional arrangements may have to be established to ensure effective monetary control and competitive market mechanisms. A phased approach to reform may, therefore, be appropriate. If the initial financial system is highly regulated, however, with each regulation supporting the other, it may be difficult to implement a gradual, effective reform. In such cases, a major one-step change in the monetary operations system supported by a critical mass of concomitant reforms of institutions and structures may be unavoidable.

An indirect, market-based approach relies on reasonable efficiency in the monetary transmission mechanism; however, prolonged periods of financial repression usually weaken this mechanism. First, repressed financial systems usually lack competition. While a monopolistic structure may not necessarily interfere with monetary control, it could result in a sluggish response of deposit and lending rates to monetary policy initiatives, inhibit the development of new instruments and markets, and result in an inefficient allocation of resources. The removal of direct controls can itself reduce incentives for monopolistic pricing arrangements by increasing the areas where competition is possible.

Second, repressed financial systems often feature a high incidence of lack of credit discipline and loan delinquency, or arrangements where borrowers or banks expect to have their deficit covered by the government. Such features undermine the role of markets in the allocation of credit. The financial reforms can also bring to the fore weaknesses in bank solvency and in the supervisory arrangements, and can have widespread effects on the viability of borrowers. For example, as the direct controls on interest rates and credit are relaxed, some borrowers that previously had access to directed credit may no longer be viable, and loans will have to be provisioned and written off. Strengthening bankruptcy laws, implementing legal procedures for loan recovery, increasing attention to the quality of bank balance sheets through improved bank supervision, and carrying out bank closures and restructuring may have to accompany the reforms of monetary control procedures. This aspect of reforms is further discussed in Chapter 4.

Third, the effective use of issues of government or central bank securities to manage liquidity will require elimination of captive markets for government securities and the liberalization of interest rates on these securities. These developments could have a direct budgetary impact and call for appropriate institutional arrangements to coordinate monetary and public debt management. But they could also improve the capacity to finance the fiscal deficit, because of the scope for the development of markets in government debt instruments and improved overall savings mobilization. Moreover, under financial repression the actual fiscal burden is often hidden by the below market rates of interest on government debt. These “hidden” deficits still impose a financial burden on the economy, including through low savings mobilization, inefficient allocation of credit, and capital flight.¹⁷

Fourth, the transition to indirect monetary controls also raises questions about the selection of appropriate monetary target variables and the interpretation of monetary indicators more generally as guides to policy. Relationships between money and credit and final objectives that existed during the prereform phase may become less reliable following financial reform. The introduction of new instruments may shift the interest sensitivity of money demand. A liberalization of interest rates on bank deposits may result in broad money becoming less sensitive to changes in the general level of interest rates. The removal of credit ceilings that constrain portfolio allocation can result in portfolio shifts, and the liberalization of interest rates can reduce cash holdings by the public.

Not only can the monetary relationships shift, but the controllability of certain aggregates may become more difficult following financial reform. In a liberal environment, the impact of a change in interest rates on broad money and credit will depend on the response of financial institutions in adjusting their rates, and on the portfolio responses of individuals and firms. Initially there is likely to be a good deal of uncertainty about these responses. A range of indicators, including the exchange rate, inflation, and asset prices, as well as various monetary and credit aggregates, therefore, may need to be examined to assess monetary conditions. It may also become more difficult to formulate monetary and credit targets that can act as benchmarks in macroeconomic adjustment programs when structural changes are occurring in the financial system. Nevertheless, quantitative monetary or credit targets often remain a central element in macroeconomic policy formulation.¹⁸

As part of a more gradualist approach to reform, interest rates could be set free in stages, for example, by gradually widening the permissible ranges for deposit and lending rates, or by steadily adjusting minimum deposit rates and maximum lending rates, freeing up commercial bank lending and deposit rates from official interference, or removing credit subceilings. The traditional instruments—reserve requirements and rediscount windows—could be deployed initially to manage bank reserves and thereby the credit-creating capacity of the banking system, while phasing out credit ceilings on banks. Market-based instruments of monetary policy would be introduced as the reforms proceed, to manage interest rates and credit more flexibly. The eventual elimination of direct controls would require that the indirect instruments of monetary policy be already functioning in parallel. By this stage, progress should also have been made on developing a money market and a more competitive financial system.

The particular phasing of reforms would depend upon the institutional circumstances. For example, if reserve requirements are already at high levels, and are nonremunerative, it would be undesirable to increase them further; market-based instruments of greater flexibility should be developed at an early stage in the reform process. If the major source of liquidity and credit creation is preferential refinance credit, the initial focus should be on reducing such credit and applying market interest rates to remaining credit facilities—for example, by auctioning the credit. The parallel development of interbank markets and secondary markets and the supporting payment system may need to be encouraged through appropriate reforms.

Developing Market-Based Procedures of Monetary Control in Nine Developing Countries

This section reviews the use of market-based procedures of monetary control in nine developing countries—Argentina, Brazil, Indonesia, Kenya, Malaysia, Mexico, the Philippines, Sri Lanka, and Thailand—all of which have reduced or abolished the use of direct controls on interest rates and credit, and increased reliance on market-based monetary control. Some of the countries, including Argentina, Brazil, and Indonesia, have for a number of years operated market-based instruments of monetary control, although direct regulations of interest rates and credit have been retained or reintroduced to a certain degree. Other countries have undertaken quite determined reductions in direct controls more recently.

Reforming Monetary Instruments

The approaches to market-based procedures for monetary control followed by these countries are summarized in Table 2.3. Appendix II provides more detailed information on the approaches to monetary control. The main conclusions emerging from the country experiences are:

Table 2.3.

Development of Market-Based Procedures for Monetary Control in Nine Developing Countries

Table 2.3.

Development of Market-Based Procedures for Monetary Control in Nine Developing Countries

Country	Primary Issues of Securities and Other Market-Based Instruments	Targets of Security Issues	Instruments of Daily Money Market Management	Other Monetary Instruments and Controls	Intermediate and Short-Term Operating Targets
Argentina (July 85-March 91)	Weekly auctions of participation in government papers in the form of central bank bills.	Volumes sold to meet quantity objectives; however, volume targets overridden to limit volatility in interest rates.	Repurchase/reverse repurchases, foreign exchange swaps at interest rates set by the central bank.	Interest rate regulations. Quotas on nonregulated rate deposits, acceptances and swaps. Subsidized refinance facilities. Reserve requirements varied actively.	Intermediate: Monetary aggregates; at times the exchange rate. Short term: Interest rates on central bank bills or debt sales.
Brazil	Weekly auctions of central bank bills (and treasury bills, but mainly for budgetary finance).	Volumes preannounced to control money market liquidity; discounts market determined. Prior to 1986, central bank intervened in the treasury bill auctions when bids were unacceptable.	Volumes preannounced to control money market liquidity; discounts market determined. Prior to 1986, central bank intervened in the treasury bill auctions when bids were unacceptable.	Selective credit controls; subsidized facilities.	Intermediate: Monetary aggregates; real interest rates. Short term: Base money, overnight interest rates.
Indonesia	Auctions of central bank bills. The frequency of auctions has varied between daily and weekly.	Prior to 1987, cutoff interest rate in the auctions determined consistent with exchange rate objective; subsequently a greater focus on liquidity conditions and interest rates increasingly market determined.	Repurchase agreements and daily auctions of central bank bills. Passive central bank accommodation at posted interest rates discontinued, July 1987.	Subsidized refinance facilities. Transfers of government deposits. Limits on borrowing abroad.	Intermediate: Monetary aggregates and monetary base. Short term: Exchange rate, interest rate.
Kenya	Weekly auction of treasury bills.	Mainly government finance purposes; monetary objectives targeted 1993- mid-1994.	Foreign exchange intervention; open market operations in treasury bills.	Reserve requirements varied actively.	Intermediate: Monetary aggregates; at times exchange rate. Short term: Reserve money; net domestic assets of the central bank.
Malaysia	Weekly auctions of treasury bills.	Government finance purposes.	Discount window, outright sales and purchases of government securities, repurchase/ reverse repurchases, foreign exchange swaps, recycling of government deposits.	Selective credit and interest rate controls; reserve requirements varied actively; subsidized refinance facilities.	Intermediate: Broad monetary aggregates. Short term: Interbank interest rates.
Mexico	Weekly auctions of treasury certificates.	Budgetary and monetary objectives. Interest rates freely determined, central bank may intervene to moderate interest rate movements.	Outright sales and purchases and repurchase/reverse repurchases. Weekly auctions of fixed deposits and placements from the central bank.	Reserve requirements and liquid asset ratios (credit ceilings removed in 1988/89).	Intermediate: Exchange rate; growth of central bank credit. Short term: Interest rates.
Philippines	Weekly auctions of treasury bills, issues of central bank bills.	Tender volumes decided based on budgetary needs and increasingly monetary objectives; interest rates determined within a range based on previous auction rate.	Repurchase/reverse repurchases, foreign exchange swaps.	Reserve requirements varied actively.	Intermediate: Base money. Short term: Money market liquidity, interest rates, exchange rate.
Sri Lanka	Weekly or more frequent auctions of treasury bills; auctions of central bank securities.	Volumes of treasury bills based on budgetary, needs cutoff interest rate set by central bank. Sales of central bank securities based on monetary objectives.	Repurchase/reverse repurchases, foreign exchange swaps. Secondary window for sale and purchase of treasury bills.	Reserve requirements varied actively. Indicative bank by bank credit ceilings. Subsidized refinance facilities.	Intermediate: Base money. Short term: Central bank net domestic assets.
Thailand	Weekly auctions of treasury bills; central bank bonds.	Sales of treasury bills for budgetary purposes and to meet liquid asset requirements; sales of central bank bonds for monetary purposes.	Repurchase/reverse repurchases, using government bonds; discount window; forward exchange swaps.	Interest rate ceilings gradually eliminated. Subsidized refinance facilities. Guidance on commercial bank lending. Limits on lending spreads.	Intermediate: Multiple monetary and credit aggregates. Short term: Interest rates, money market liquidity.

View Table

Table 2.3.

Development of Market-Based Procedures for Monetary Control in Nine Developing Countries

Country	Primary Issues of Securities and Other Market-Based Instruments	Targets of Security Issues	Instruments of Daily Money Market Management	Other Monetary Instruments and Controls	Intermediate and Short-Term Operating Targets
Argentina (July 85-March 91)	Weekly auctions of participation in government papers in the form of central bank bills.	Volumes sold to meet quantity objectives; however, volume targets overridden to limit volatility in interest rates.	Repurchase/reverse repurchases, foreign exchange swaps at interest rates set by the central bank.	Interest rate regulations. Quotas on nonregulated rate deposits, acceptances and swaps. Subsidized refinance facilities. Reserve requirements varied actively.	Intermediate: Monetary aggregates; at times the exchange rate. Short term: Interest rates on central bank bills or debt sales.
Brazil	Weekly auctions of central bank bills (and treasury bills, but mainly for budgetary finance).	Volumes preannounced to control money market liquidity; discounts market determined. Prior to 1986, central bank intervened in the treasury bill auctions when bids were unacceptable.	Volumes preannounced to control money market liquidity; discounts market determined. Prior to 1986, central bank intervened in the treasury bill auctions when bids were unacceptable.	Selective credit controls; subsidized facilities.	Intermediate: Monetary aggregates; real interest rates. Short term: Base money, overnight interest rates.
Indonesia	Auctions of central bank bills. The frequency of auctions has varied between daily and weekly.	Prior to 1987, cutoff interest rate in the auctions determined consistent with exchange rate objective; subsequently a greater focus on liquidity conditions and interest rates increasingly market determined.	Repurchase agreements and daily auctions of central bank bills. Passive central bank accommodation at posted interest rates discontinued, July 1987.	Subsidized refinance facilities. Transfers of government deposits. Limits on borrowing abroad.	Intermediate: Monetary aggregates and monetary base. Short term: Exchange rate, interest rate.
Kenya	Weekly auction of treasury bills.	Mainly government finance purposes; monetary objectives targeted 1993- mid-1994.	Foreign exchange intervention; open market operations in treasury bills.	Reserve requirements varied actively.	Intermediate: Monetary aggregates; at times exchange rate. Short term: Reserve money; net domestic assets of the central bank.
Malaysia	Weekly auctions of treasury bills.	Government finance purposes.	Discount window, outright sales and purchases of government securities, repurchase/ reverse repurchases, foreign exchange swaps, recycling of government deposits.	Selective credit and interest rate controls; reserve requirements varied actively; subsidized refinance facilities.	Intermediate: Broad monetary aggregates. Short term: Interbank interest rates.
Mexico	Weekly auctions of treasury certificates.	Budgetary and monetary objectives. Interest rates freely determined, central bank may intervene to moderate interest rate movements.	Outright sales and purchases and repurchase/reverse repurchases. Weekly auctions of fixed deposits and placements from the central bank.	Reserve requirements and liquid asset ratios (credit ceilings removed in 1988/89).	Intermediate: Exchange rate; growth of central bank credit. Short term: Interest rates.
Philippines	Weekly auctions of treasury bills, issues of central bank bills.	Tender volumes decided based on budgetary needs and increasingly monetary objectives; interest rates determined within a range based on previous auction rate.	Repurchase/reverse repurchases, foreign exchange swaps.	Reserve requirements varied actively.	Intermediate: Base money. Short term: Money market liquidity, interest rates, exchange rate.
Sri Lanka	Weekly or more frequent auctions of treasury bills; auctions of central bank securities.	Volumes of treasury bills based on budgetary, needs cutoff interest rate set by central bank. Sales of central bank securities based on monetary objectives.	Repurchase/reverse repurchases, foreign exchange swaps. Secondary window for sale and purchase of treasury bills.	Reserve requirements varied actively. Indicative bank by bank credit ceilings. Subsidized refinance facilities.	Intermediate: Base money. Short term: Central bank net domestic assets.
Thailand	Weekly auctions of treasury bills; central bank bonds.	Sales of treasury bills for budgetary purposes and to meet liquid asset requirements; sales of central bank bonds for monetary purposes.	Repurchase/reverse repurchases, using government bonds; discount window; forward exchange swaps.	Interest rate ceilings gradually eliminated. Subsidized refinance facilities. Guidance on commercial bank lending. Limits on lending spreads.	Intermediate: Multiple monetary and credit aggregates. Short term: Interest rates, money market liquidity.

(1) Market-based approaches to monetary control have usually been adopted in the context of progressive modifications of existing monetary instruments. Most of the countries continued to rely to a greater or lesser extent on reserve requirements, liquid asset ratios, and subsidized refinance facilities while increasing the reliance on market-based procedures for monetary and interest rate control. Also, although interest rate controls were relaxed significantly, they were not eliminated completely in a few cases, partly because of concern over the competitiveness of the banking system.¹⁹ Although specific credit ceilings were eliminated, guidance on lending was retained in some cases. Countries further along in the reform process, however, have been able to abandon the direct forms of control and to rely on indirect procedures.

(2) Nearly all of the countries surveyed made use of regular auctions—either for central bank or treasury bills—as part of a market-development, debt-management, or monetary-control strategy. Under these auctions, the public submits bids indicating the volume demanded and the bid price to the central bank for treasury/central bank bills on auction. The type of instrument used and the frequency of the auction varied. Typically, the papers used for monetary control through auctions have been short term, with maturities from 7 days to 12 months. In some cases, an inflationary environment has put downward pressure on maturities (Argentina, Mexico, the Philippines, and Sri Lanka). Auctions have normally been held weekly, although the frequency has varied and even daily auctions have been held in one country (Indonesia). Mexico has also held weekly auctions of central bank offers to place or accept deposits to supplement the auctions of treasury bills. Some countries (Mexico and the Philippines) have instituted formal limitations on the cutoff yield in the auctions, in order to promote orderly bidding and to avoid large short-run fluctuations in interest rates. In some countries, participation in the auctions has been formally restricted to financial institutions (Indonesia) or appointed dealers in the papers in question (Mexico and the Philippines). Appointed dealers have sometimes been obliged to make secondary markets in these papers (Philippines).

(3) The objectives and procedures for determining auction volumes and interest rates varied across the countries. In Brazil, Malaysia, Sri Lanka, and Thailand the auction volumes of treasury bills have been determined purely by budgetary considerations. Nevertheless, the central bank has intervened in these auctions, to determine the cutoff rate (Sri Lanka), influence money market liquidity, or moderate the movement in interest rates. In some of the other countries, both budgetary and monetary considerations have been taken into account in determining auction volumes. For example, in the Philippines, the tender volumes of treasury bills have been used to sterilize foreign capital inflows.

Central bank securities have been issued for monetary control purposes, either as a supplement to the issues of treasury bills (Brazil, Philippines, Sri Lanka, and Thailand) or as the primary instrument (Argentina and Indonesia).²⁰ The central bank accepts or rejects bids on the basis of a cutoff yield determined to be consistent with their desired operating target for monetary policy. The most widely used operating target has been short-term interest rates. Other operating targets have included various measures of liquidity (Argentina, Brazil, and Mexico) and net domestic assets of the central bank (Sri Lanka and Kenya).

(4) Day-to-day money-market operating procedures have varied among the countries, but in most such operations have taken on increasing importance as instruments of liquidity and interest rate management. The most common instrument has been repurchase and reverse repurchase agreements using government papers (Argentina, Brazil, Malaysia, Mexico, the Philippines, Sri Lanka, and Thailand). Some countries, such as Malaysia (initially), Sri Lanka, and Kenya, have operated a secondary window for the purchase and sale of treasury bills with interest rates set based on those determined at the latest auction rate. These interest rate margins have been varied to encourage secondary sales or purchases, which help to achieve objectives for money market liquidity. Several countries have operated a loan or rediscount window carrying varying degrees of penalty (for example, Kenya); and some countries have used foreign exchange swaps (the Philippines and Argentina). Interest rates on most of these facilities are determined by the central bank. Malaysia and Indonesia have supplemented these facilities by the transfer of government or public enterprise deposits between the central bank and commercial banks as a way of managing money market liquidity. Some countries (most notably Indonesia and the Philippines) have also reformed the central bank’s refinance facilities for priority sector borrowing to, among other things, restrict the financial institutions’ access to central bank credit and to rationalize rediscount facilities.

(5) Countries that have taken the most determined steps toward a market-based monetary control system adopted their intermediate targets for monetary policy sometimes in the context of a modification of their exchange arrangements. Following its financial reform, Indonesia changed from targeting domestic credit of the banking system to targeting base money and broad money. In Malaysia and Sri Lanka, the focus shifted from interest rates to broader monetary aggregates. Also, the Philippines shifted from targeting net domestic assets to targeting base money following the move to a floating exchange rate in late 1984. At different times, the exchange rate has also been used as a key target in some of these countries, including Kenya. Domestic monetary instruments and exchange market intervention have been used to target the rate. The short-term operating targets have most commonly included money market interest rates. In some cases the exchange rate, money market liquidity, and the net domestic assets of the central bank have been used.

(6) In nearly all the countries surveyed, the introduction of market-based instruments was accompanied by measures to foster money and interbank markets, particularly secondary markets in government securities. Country experiences also revealed the complex two-way interactions between choice of monetary instruments and operating procedures, and the characteristics and pace of development of money and securities markets, including the supporting clearing and settlement system for payments. For example, in both the Philippines and Malaysia, the authorities facilitated money market development by adopting market-based instruments. The effectiveness of the instruments was strengthened in turn by the authorities’ efforts to develop money and interbank markets. Their efforts consisted of fostering money market intermediaries, including primary dealer arrangements, rationalizing reserve requirement systems and refinance facilities, and promoting adequate institutional arrangements for coordination of monetary and public debt management.

In some countries, reforms of clearing and settlement systems for payments also helped to strengthen the functioning of money and interbank markets (e.g., Malaysia). Country experiences confirm that aspects of the payment system could play a crucial role in the reform of monetary policy implementation and the pace of development of money markets. For example, lags in the settlement of money and exchange market transactions, accounting rules governing clearing and settlement in central bank books, the level of communications technology, and availability and terms of central bank credit or access to required revenues for settlement purposes are some of the structural elements that influenced the demand for excess reserves and short-term money market conditions.²¹

Importance of Market-Based Procedures as Instruments of Monetary Control

The importance of market-based instruments in seven of the sample countries is examined in the tables in Appendix II.²² These tables attempt to identify the “autonomous sources” of reserve money expansion and the use of market-based and other instruments, including reserve requirements, to offset the expansion.²³ The autonomous sources include the extent to which the domestic financing requirement of the government has to be met by the central bank, the increase in the net foreign assets of the central bank, and central bank autonomous net lending to commercial banks. Instruments used to reduce liquidity include traditional adjustments to reserve requirements or in central bank refinance facilities, and more market-based procedures, including debt sales and money market operations.

Implications of the Use of Indirect Instruments for Monetary and Credit Aggregates

when:

Δ	is the first difference operator;
Y	is nominal GDP;
P	is the consumer price index;
rd	is the domestic deposit rate in the equations for currency and broad money, and the lending rate in the equations for credit to the private sector;
rf	is the foreign interest rate, the euro-dollar rate in London; and
u	is the stochastic error term.

View Table

Δ	is the first difference operator;
Y	is nominal GDP;
P	is the consumer price index;
rd	is the domestic deposit rate in the equations for currency and broad money, and the lending rate in the equations for credit to the private sector;
rf	is the foreign interest rate, the euro-dollar rate in London; and
u	is the stochastic error term.

The regression estimates, reported in the first table in Appendix III, illustrate some of the difficulties of conducting monetary policy in countries with developing financial markets. Although there are some exceptions, the estimated money-and credit-demand equations are generally quite poor. This is particularly the case for the sign and significance of the interest rate responses, with a notable absence of sensitivity of broad money holdings to changes in the domestic interest rate. The response of the demand for currency to interest rates tends to be somewhat more significant. Overall the estimates caution against excessive fine-tuning of monetary operations to meet a specific targeted financial aggregate.

The tests of stability of the aggregates comparing the full sample (1970-92) with those for a prereform subperiod are reported in the second table in Appendix III.²⁴ In the majority of countries, a greater reliance on indirect approaches to monetary control—and by implication reduced reliance on direct credit and interest rate controls—resuited in instability in the determinants of the demand for credit by the private sector. Structural shifts were not seen in either Indonesia or Thailand, and in part this may have reflected these countries’ more gradual approach to the liberalization of bank credit markets.²⁵ Instability in broad money demand was also evident in Malaysia and Kenya following the reforms. Kenya was the only country that showed instability in currency demand. Although caution needs to be exercised in the assessment of all the monetary indicators during the period of financial reform, the tests suggest that the credit aggregates were the most heavily affected by the reforms, and that the demand for broad money was more heavily influenced than the demand for currency. As a consequence, the objectives of monetary policy and the design of financial programs may need to be refocused, and the central bank is likely to have to examine a broader range of financial indicators, including the developments in the central bank’s balance sheet, during reform periods.

Constraints Imposed by Capital Flows

i_d is the domestic interest; i_f, the foreign interest rate of the same maturity and F_d, the forward discount for that maturity; e^s is the rate of exchange (units of domestic currency in terms of a foreign currency) in the spot exchange market; and e^f, the forward exchange rate on the date of maturity of the interest rate contracts. Thus, where the foreign interest rate and forward exchange rate are predetermined, a country could determine the domestic interest rate or the spot exchange rate, but not both.²⁶

The initial policy response to strong capital inflows with a pegged exchange rate has usually been to conduct sterilized intervention. Such intervention involves quasi fiscal costs, however, and is generally of limited effectiveness since it serves to keep domestic interest rates high, attracting further capital inflows. Pegged exchange rates have also led in some cases to an underestimation of the risks involved in foreign currency borrowing. Thus, as capital account liberalization has progressed, a number of countries have responded to the increase in capital flows by adopting greater exchange rate flexibility, as a way of reducing shorter-term capital inflows that reflect interest rate differentials. In some cases, exchange rate arrangements have evolved in a progressive manner with the degree of flexibility depending on the size of the capital inflow problem. Such arrangements have included exchange rate bands, crawling bands, managed floats, and free floats.

Some countries have followed strong nominal exchange rate anchors, which has required subordinating monetary policy to the maintenance of these anchors and accepting that interest rates be allowed to adjust in response to the capital movements. Such anchors have helped to reduce reversals in capital flows due to uncertainty about the exchange rate. Since the exchange rate instrument is not available to reduce short-term capital inflows, greater attention has been given to the adequacy of prudential standards, including the management of risks associated with potential currency and maturity mismatches in such circumstances.

Some countries have targeted the exchange rate (and hence monetary) policy to maintain competitiveness, and relied on fiscal consolidation to achieve domestic stabilization and to offset the effects of large capital inflows. But because of the limited short-run flexibility of fiscal policy, the authorities have had to rely on other measures to deal with more volatile capital flows, particularly capital controls. Generally, such controls are effective primarily as temporary measures.

Implications for Monetary Instruments

Increased capital mobility will also have a number of operational implications for the design of monetary policy frameworks and the use of different monetary instruments. In the case of fixed or managed floating exchange rate regimes, the external counterpart of money supply may become more volatile, and the demand for domestically defined monetary aggregates may become more sensitive to international interest rate differentials, and may shift as a result of the external liberalization. As a result, it may be more difficult to identify a monetary aggregate with a sufficiently stable behavior that is capable of anticipating the evolution of other nominal variables in the economy. Capital account liberalization, therefore, reinforces the trend toward the adoption of more eclectic monetary frameworks that is frequently a feature of domestic financial sector reforms, and to giving more weight to exchange rates in monetary assessments.²⁷

High capital mobility alters the effectiveness of different monetary instruments in achieving the objectives of monetary policy. On the one hand, instruments that impose a high cost or administrative constraint on the banks—as is the case with credit or interest rate ceilings or high nonremunerated reserve requirements—may be circumvented more easily by disintermediation through the capital account and, therefore, become less effective. On the other hand, monetary instruments that operate on the overall cost of money or credit in financial markets may be transmitted more rapidly to credit and exchange markets and allow the central bank to influence the decisions of financial institutions and markets that operate in its domestic currency, both locally and internationally. The characteristics of the major monetary instruments and the effects of capital mobility are reviewed in Table 2.4.

Table 2.4.

Monetary Instruments and High Capital Mobility

Table 2.4.

Monetary Instruments and High Capital Mobility

Monetary Instrument	Main Characteristics	Compatibility and Effectiveness with High Capital Mobility
Reserve requirements with no differentiation between residents/nonresidents, domestic/foreign currency	Aims to achieve a combination of different objectives: (1) influence the commercial bank’s demand for reserves and, therefore, enhance predictability of reserve money demand, and influence the growth of domestic credit; (2) contribute to the stabilization of short-term interest rates through the effect of averaging provisions; (3) sterilize excess liquidity; (4) increase the seigniorage when reserves are not remunerated.	In the case of nonrenumerated required reserves, high capital mobility and the lack of harmonization between regulations may prompt operators to relocate their transactions aboard. In response, some countries reduced or eliminated the ratio. To preserve the effectiveness of the instrument some countries maintain restrictions on the issue of domestic securities abroad by residents and on the issue of securities locally by nonresidents.
Reserve requirements with differentiation between domestic and foreign currency	Used to influence liquidity in domestic and foreign currency and to encourage or discourage deposit taking in local and foreign currency. Impact depends on the level and rate of remuneration of the required reserves. Low or zero reserve requirements in foreign currency deposits are a feature of offshore banking centers.	Applying different ratios on deposits in domestic and foreign currency could serve to influence capital movements. May substitute for reserve requirements differentiated by residency where residents’ holdings of foreign currency deposits are restricted.
Reserve requirements with differentiation between residents and nonresidents	With nonremunerated required reserves, which impose a tax on bank intermediation, higher ratio on nonresident deposits compared to resident deposits discourages capital inflows through bank deposits by lowering remuneration for the depositor.	Has been used by a number of countries to influence capital movements. To be effective in limiting short-term inflows, this instrument would need to be applied comprehensively to all short-term capital inflows.
Deposit requirements on certain capital flows	Through its cost effect, a nonremunerated deposit requirement serves to reduce or increase the interest differential between domestic and international rates. In some cases it may be replaced by the payment of flat fee.	Similar to reserve requirements that differentiate between residents and nonresidents.
Net open position/position limits	Used predominantly as a prudential control when defined as a net foreign currency position.	In some countries open position limits are defined asymmetrically on resident and nonresident transactions and have been changed frequently with the intention of influencing capital flows.
Statutory liquidity ratios	Intended principally as a prudential measure or to influence the allocation of bank assets by imposing the requirement to hold minimum amounts of specified liquid assets as a percentage of specified liabilities. When used as monetary control instrument it affects the allocation of financial assets.	As in prudential measure, helps to manage the risks of short-term capital inflows and potential reversals in such flows.
Minimum (or maximum) portfolio requirements	Intended mainly to affect the allocation of credit rather than overall credit availability. Typically imposes on commercial banks the requirement to hold a minimum or maximum of certain assets (e.g., government securities or loans to priority sectors).	In the case of qualifying assets restricted to domestic assets, it can influence capital flows.
Interest rate controls	Limitation on the ability of commercial banks to determine their lending and for deposit rates. Typically abandoned with the move to indirect monetary controls.	Becomes ineffective with capital account openings because they will be circumvented through capital flows.
Bank-by-bank credit ceilings	Directly limits the domestic counterpart of money supply through a rationing of the total credit provided by commercial banks. Typically abandoned with the move to indirect monetary controls.	Becomes ineffective with capital account openings, because they will be circumvented through capital flows.
Directed credit	Allocates central bank credit to commercial banks mostly to finance priority sectors. Abandoned with move to indirect monetary control.	In the case of qualifying assets restricted to domestic assets, it may influence capital flows.
Bank-by-bank rediscount quotas	Allocates central bank refinance credit among commercial banks, allowing banks to borrow on demand at the central bank. Rediscount quotas usually only available for resident banks.	Increased volatility of money supply due to external actors requires flexibility in central bank’s refinancing operations. The importance of rediscount quotas tends to diminish as the main tool for liquidity management.
Standing facilities	Deposit and lending central bank facilities used at the initiative of commercial banks. Standing facilities usually only available for resident banks.	High capital mobility increases volatility of money supply and requires flexibility in the central bank’s liquidity management. Role of standing facilities tends to diminish as instrument of liquidity management.
Public sector deposits	Given magnitude of daily government flows in and out of banking system, real location of government deposits between the central bank and the commercial banks can be used to offset impact of such flows on short-term liquidity. Public sector deposits usually only available for resident banks.	Given the need for flexibility in interest rate management, allocation mechanism needs to ensure equitable distribution among the competing commercial banks based on a market mechanism.
Open market operations	Monetary operation at the initiative of the central bank involving one of the following transactions: (1) buying or selling assets outright; (2) buying or selling assets (including foreign exchange) under a repurchase agreement; and (3) lending or borrowing against underlying assets as collateral through an auction mechanism. The central bank typically deals only in its local market and with resident banks.	Becomes the preferred monetary instrument as it allows flexibility for timing and amount of the central bank operations, and for managing interest rates.

View Table

Table 2.4.

Monetary Instruments and High Capital Mobility

Monetary Instrument	Main Characteristics	Compatibility and Effectiveness with High Capital Mobility
Reserve requirements with no differentiation between residents/nonresidents, domestic/foreign currency	Aims to achieve a combination of different objectives: (1) influence the commercial bank’s demand for reserves and, therefore, enhance predictability of reserve money demand, and influence the growth of domestic credit; (2) contribute to the stabilization of short-term interest rates through the effect of averaging provisions; (3) sterilize excess liquidity; (4) increase the seigniorage when reserves are not remunerated.	In the case of nonrenumerated required reserves, high capital mobility and the lack of harmonization between regulations may prompt operators to relocate their transactions aboard. In response, some countries reduced or eliminated the ratio. To preserve the effectiveness of the instrument some countries maintain restrictions on the issue of domestic securities abroad by residents and on the issue of securities locally by nonresidents.
Reserve requirements with differentiation between domestic and foreign currency	Used to influence liquidity in domestic and foreign currency and to encourage or discourage deposit taking in local and foreign currency. Impact depends on the level and rate of remuneration of the required reserves. Low or zero reserve requirements in foreign currency deposits are a feature of offshore banking centers.	Applying different ratios on deposits in domestic and foreign currency could serve to influence capital movements. May substitute for reserve requirements differentiated by residency where residents’ holdings of foreign currency deposits are restricted.
Reserve requirements with differentiation between residents and nonresidents	With nonremunerated required reserves, which impose a tax on bank intermediation, higher ratio on nonresident deposits compared to resident deposits discourages capital inflows through bank deposits by lowering remuneration for the depositor.	Has been used by a number of countries to influence capital movements. To be effective in limiting short-term inflows, this instrument would need to be applied comprehensively to all short-term capital inflows.
Deposit requirements on certain capital flows	Through its cost effect, a nonremunerated deposit requirement serves to reduce or increase the interest differential between domestic and international rates. In some cases it may be replaced by the payment of flat fee.	Similar to reserve requirements that differentiate between residents and nonresidents.
Net open position/position limits	Used predominantly as a prudential control when defined as a net foreign currency position.	In some countries open position limits are defined asymmetrically on resident and nonresident transactions and have been changed frequently with the intention of influencing capital flows.
Statutory liquidity ratios	Intended principally as a prudential measure or to influence the allocation of bank assets by imposing the requirement to hold minimum amounts of specified liquid assets as a percentage of specified liabilities. When used as monetary control instrument it affects the allocation of financial assets.	As in prudential measure, helps to manage the risks of short-term capital inflows and potential reversals in such flows.
Minimum (or maximum) portfolio requirements	Intended mainly to affect the allocation of credit rather than overall credit availability. Typically imposes on commercial banks the requirement to hold a minimum or maximum of certain assets (e.g., government securities or loans to priority sectors).	In the case of qualifying assets restricted to domestic assets, it can influence capital flows.
Interest rate controls	Limitation on the ability of commercial banks to determine their lending and for deposit rates. Typically abandoned with the move to indirect monetary controls.	Becomes ineffective with capital account openings because they will be circumvented through capital flows.
Bank-by-bank credit ceilings	Directly limits the domestic counterpart of money supply through a rationing of the total credit provided by commercial banks. Typically abandoned with the move to indirect monetary controls.	Becomes ineffective with capital account openings, because they will be circumvented through capital flows.
Directed credit	Allocates central bank credit to commercial banks mostly to finance priority sectors. Abandoned with move to indirect monetary control.	In the case of qualifying assets restricted to domestic assets, it may influence capital flows.
Bank-by-bank rediscount quotas	Allocates central bank refinance credit among commercial banks, allowing banks to borrow on demand at the central bank. Rediscount quotas usually only available for resident banks.	Increased volatility of money supply due to external actors requires flexibility in central bank’s refinancing operations. The importance of rediscount quotas tends to diminish as the main tool for liquidity management.
Standing facilities	Deposit and lending central bank facilities used at the initiative of commercial banks. Standing facilities usually only available for resident banks.	High capital mobility increases volatility of money supply and requires flexibility in the central bank’s liquidity management. Role of standing facilities tends to diminish as instrument of liquidity management.
Public sector deposits	Given magnitude of daily government flows in and out of banking system, real location of government deposits between the central bank and the commercial banks can be used to offset impact of such flows on short-term liquidity. Public sector deposits usually only available for resident banks.	Given the need for flexibility in interest rate management, allocation mechanism needs to ensure equitable distribution among the competing commercial banks based on a market mechanism.
Open market operations	Monetary operation at the initiative of the central bank involving one of the following transactions: (1) buying or selling assets outright; (2) buying or selling assets (including foreign exchange) under a repurchase agreement; and (3) lending or borrowing against underlying assets as collateral through an auction mechanism. The central bank typically deals only in its local market and with resident banks.	Becomes the preferred monetary instrument as it allows flexibility for timing and amount of the central bank operations, and for managing interest rates.

While many countries have reduced, and some have phased out the use of reserve requirements in the context of high capital mobility, some still rely on them to influence the supply and demand in the market for bank reserves (bank deposits with the central bank).²⁸ Nonremunerated reserve requirements, however, impose a tax on the banks subject to the reserve requirements and thus encourage disintermediation to financial institutions and markets that are not subject to the reserve requirements. A number of countries have responded to this potential problem either by remunerating the reserve requirements at a rate fairly close to market rates or by reducing or eliminating the reserve requirement ratio.²⁹ However, some countries have retained selected capital controls—for example, on the issue of certificates of deposits locally by nonresident banks to safeguard the effectiveness of their reserve requirements. The expectation is that by limiting foreign banks’ access to a particular instrument, the extent of disintermediation would also be limited.³⁰

Open market operations play a core role for the purpose of steering interest rates, managing the liquidity situation in the market, and signaling the stance of monetary policy with an open capital account. When capital moves freely, the central bank is able to affect the conditions of both the domestic and external markets in its local currency through open market operations. Standing facilities, rediscount quotas, and public sector deposits are frequently used to support open market operations, particularly to guide interest rate movements, and transmit rapidly and clearly the central bank’s message to market participants. Movements toward capital account convertibility, therefore, have been supported with the adoption of indirect monetary controls.

Use of Discriminatory Reserve Requirements

Differential reserve requirements on short-term borrowing from nonresidents are frequently used to reduce capital inflows, or change the composition of these inflows. Such measures are sometimes referred to as “Chile-type” measures because of their adoption by the Chilean authorities in 1991, although they have a long history of use in other countries, such as in Germany during the 1970s.

Non-interest-bearing reserve requirements raise the cost of borrowing through the instruments subject to the requirements. If r is the nonremunerated reserve requirement, and i_f the nominal foreign interest rate, then the effective cost of foreign borrowing to a resident after the imposition of the reserve requirement, $i_f^e$, becomes:³¹

The implementation of the reserve requirements will thus increase the cost of foreign borrowing to residents (or conversely reduce the return on local investments to foreign investors), and therefore, reduce borrowing from abroad.

Since $i_f^e>i_{f,}$ the imposition of the differential reserve requirement would require either that the short-term domestic interest rate rise $(i_d^{\cdot }>i_d)$ or the forward discount on the currency fall. A drop in the forward discount could come about through a depreciation of the spot exchange rate.³²

After the adjustments in the domestic interest rate (or the exchange rate), interest rates would again be constrained by the covered interest rate parity condition (equation 3). The non-interest-bearing reserve requirement on foreign borrowing would introduce a wedge between the domestic and offshore interest rates, and other things being equal, allow the country to have a higher domestic short-term interest rate with a given exchange rate than otherwise. By allowing for higher domestic short-term interest rates, the non-interest-bearing reserve requirement might also encourage a shift to longer-term borrowing by residents, and, in turn, could influence the composition of inflows. The effect on the composition of inflows would depend, however, on the resulting evolution of interest rates along the yield curve.³³

If the differential reserve requirement is not applied comprehensively to all short-term sources of foreign capital inflows, it may encourage larger short-term inflows through those instruments that are not subject to the requirement. This could result if the general level of short-term domestic interest rates increases with the tightening of monetary policy that accompanies the introduction of the differential reserve requirement, providing, therefore, greater incentives for short-term flows through foreign instruments not subject to the discriminatory requirement.

Various empirical studies have sought to examine the impact of such instruments on capital flows and have generally concluded that they have a temporary effect, but one that can be eroded quite quickly depending on the scope of the controls and the stage of development of financial markets and instruments. Financial derivatives that restructure one type of financial transaction into another have now become an important means of circumventing such regulations, in addition to the more traditional channels for circumvention through instruments not covered by the regulations. Over time, Chile found it necessary to extend progressively the instruments covered by its reserve requirement to all short-term capital inflows in an attempt to avoid circumvention. The effectiveness of the measures in Germany in the 1970s appeared to depend on whether they extended to corporate borrowing.³⁴

Conclusions

An increasing number of developing countries have begun to operate market-based instruments of monetary policy and use these instruments more actively to achieve macroeconomic policy objectives. The decision to introduce more market-based instruments reflects a number of factors, including: a general desire to liberalize markets and to free them from administrative controls that have tended to inhibit the efficient allocation of resources; the ineffectiveness of direct interest rate and credit controls for macroeconomic management in the face of financial innovations, disintermediation, and large private international capital flows; and the inhibiting effect of direct controls on market development, and, hence, on saving mobilization and investment.

The developing countries in the sample examined are in a transitional stage of monetary reform; direct controls have been substantially abandoned but full-fledged open market systems of monetary control have not yet been established. Nevertheless, most countries have developed the instruments and an operational capacity to manage money market interest rates or reserve money growth through indirect, market-based procedures and have relied increasingly on these instruments to effect monetary control. The introduction of more market-based monetary control procedures has required a modification of operating procedures, the development of information systems, and the introduction of new instruments.

The increase in capital mobility has posed a particular challenge for monetary operations in recent years, generating huge flows that have strained the capacity of fledgling money markets. It has also provided additional impetus for the introduction of market-based monetary instruments. Countries have also responded to these flows by adjusting more traditional instruments such as reserve requirements.

The financial sector reforms and the increase in capital flows have implications for the behavior of financial aggregates and thus for the design of monetary control frameworks. The trend has generally been toward the adoption of more eclectic monetary frameworks involving an examination of a broader range of monetary indicators.