Financial Liberalization and Money Demand in Asean Countries
Implications for Monetary Policy
  • 1, International Monetary Fund

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This paper examines the impact of financial market development and liberalization on money demand behavior in Indonesia, Malaysia, Singapore, and Thailand since the early 1980s. The empirical results indicate continuing instability in the interaction of money growth, economic activity, and inflation. Rapid growth and ongoing changes in financial markets suggest that policy needs to be guided by a wider set of monetary and real sector indicators of inflationary pressures. The feasibility of alternative policy frameworks--including nominal exchange rate targets, and inflation targets--is discussed in the context of the substantial and sustained increase in foreign capital inflows.


This paper examines the impact of financial market development and liberalization on money demand behavior in Indonesia, Malaysia, Singapore, and Thailand since the early 1980s. The empirical results indicate continuing instability in the interaction of money growth, economic activity, and inflation. Rapid growth and ongoing changes in financial markets suggest that policy needs to be guided by a wider set of monetary and real sector indicators of inflationary pressures. The feasibility of alternative policy frameworks--including nominal exchange rate targets, and inflation targets--is discussed in the context of the substantial and sustained increase in foreign capital inflows.


Monetary developments in Indonesia, Malaysia, Singapore, and Thailand—the ASEAN-4—since the early 1980s have to be assessed in the context of remarkably successful economic performance that has contributed to the rapid development of domestic financial markets. The extent of financial liberalization—interest rate deregulation and greater competition in banking markets, as well as the liberalization of restrictions on cross-border capital flows—has been considerably greater than in many other developing countries. A priori, it would be surprising if these structural changes in financial markets and the associated rapid growth did not affect the relation between money, economic activity and inflation. In many industrial countries that went through substantial episodes of financial deregulation and financial innovation during the early and mid-1980s, there were significant shifts in the orientation of monetary policies. Several countries found it difficult to retain intermediate targets and moved more toward explicit targets for final objectives, typically inflation.

This paper examines the extent that the financial market changes in the ASEAN-4 countries has affected money demand behavior and seeks to draw the implications for monetary policy. The core of the paper assesses whether money demand equations are relatively stable and predictable—an important prerequisite for operating a policy framework centered around monetary targets. The results of this exercise caution against excessive reliance on monetary aggregates to gauge monetary conditions. Similar to the experience of many industrial countries, ongoing changes in financial markets suggest that policy actions need to be based on a wider set of monetary and real sector indicators. Although not directly stemming from the empirical work here, the paper also discusses—in the context of increasing integration of financial markets and substantial foreign capital inflows—the feasibility of alternative policy frameworks, including nominal exchange rate targets and inflation targets.

The paper is organized as follows. Section II outlines some of the major changes in financial markets and briefly discusses how monetary policy frameworks have evolved away from a strict adherence to monetary targets. Section III present the estimates of money demand equations for each of the ASEAN-4 countries, while Section IV discusses both the direct policy implications of our findings and offers some concluding remarks on the main alternative policy frameworks.

II. Financial Liberalization and Monetary Policy

A. The Impact of Financial Liberalization on Money Demand

Measures to promote competition among financial institutions will generally tend to lower transactions costs, and technological advances such as the introduction of automatic teller machines and credit cards may cause money demand to respond more rapidly to interest rate changes thereby increasing the interest elasticity of money demand. More generally, measures that promote financial market development could result in the introduction and deepening of markets for new and more attractive assets such as money market paper, stocks and bonds, and may cause gradual portfolio shifts away from monetary assets, possibly reducing the predictability of money demand. In practice, a failure to allow for changes in money demand following financial reform could result in monetary policy that is tighter or looser than planned before the reforms are implemented.

The conventional money demand equation expresses the demand for real money balances (M/P) as a function of a scale variable, usually the level of real income (Y), and an opportunity cost variable, usually the rate of interest on an alternative asset (i):


where ϵ is an error term representing money demand shocks. Instability of this error term will weaken the relationship between money holdings and, income and interest rates. The potential instability in money demand will affect the coefficients, mainly b, and c, but also the intercept term a.

In the ASEAN-4, financial liberalization since the mid-1970s has included the deregulation of deposit rates, and the introduction or deepening of alternative monetary instruments, bonds, and equities (Table 1). The liberalization of interest rates has been the most important feature of financial reform in the ASEAN-4 countries. With the exception of Singapore, real interest rates were sometimes negative before the reform, as in other previously financially “repressed” economies. In Indonesia, after the 1983 reform, time deposit rates more than doubled and real interest rates remained positive, even during subsequent high inflation years. In Malaysia, deposit rates increased following the 1978 liberalization, ending the era of financial repression. Nominal and real rates increased markedly between 1988 and 1993, raising the money market-LIBOR differential, and inducing the inflows of foreign capital. In Singapore, the liberalization of interest rates was complete by 1975, and the extremely open nature of the economy made it difficult for the government to pursue an independent monetary policy. The relatively low levels of both the nominal and real rates in Singapore during most of the 1980s were reflective of U.S. interest rate trends. In Thailand, despite financial repression until the mid-1980s real rates moved to positive levels from the early-1980s onward as inflation subsided. Until the 1989 liberalization measures, however, time deposit rates in Thailand moved in discrete steps as deposit rates were controlled by the authorities.

Table 1.

The ASEAN-4: Financial Liberalization

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Generally, in the ASEAN-4 the liberalization of interest rates preceded the development of money and bond markets, although the money markets developed much faster than the bond markets. With the exception of Thailand, short-term money markets in the ASEAN-4 developed rapidly, soon after the liberalization of interest rates. In Thailand, the money market, comprising mostly repos, started to develop in 1979, a full decade before the liberalization of deposit interest rates.

The development of the ASEAN-4 bond markets has been hampered by strong government fiscal positions in Malaysia, Singapore, and Thailand, the “balanced-budget” rule in Indonesia, and until recently, restrictions on corporate bond issues, and the absence of bond rating agencies. In Indonesia, bond market development has also been hindered by the paucity of institutional investors. While still small, the Malaysian corporate bond market has grown since the establishment of a credit rating agency in 1990. The Singapore bond market is the largest in the region, but is dominated by foreign bonds—about 98 percent of the capitalization are Asian Dollar bonds. In Thailand, corporate bond issuance was severely restricted until 1992, but has since grown with the establishment of a credit rating agency and the Bond Dealers Club.2

The development of the equity markets in the ASEAN-4 has been rapid, and has closely tracked their impressive overall economic performance. The stock market in Malaysia has a long history, dating back over a hundred years, and the market capitalization relative to GDP is the highest among the ASEAN-4. The stock exchange of Singapore was established in 1973, when it was formally delinked from the exchange in Malaysia, and has grown rapidly since that time and is now comparable in size to the major stock markets in the world. The Thai stock exchange—established in 1974—experienced only modest growth initially but grew rapidly in the mid-1980s. In Indonesia, since the early 1990s, the improvement in market infrastructure and the greater supervision and regulation by Bappepam and the Jakarta Stock Exchange have aided the growth of the equity market, with market capitalization increasing from $81 million in 1986 to $67 billion at the end of 1995.

The financial market reforms and financial developments described above may change the velocity of broad money—in principle, in either direction.3 Reforms that increase the number of banks, and spur institutional and technological advances such as credit cards, and electronic transfers of deposits or cash machines, can raise the velocity of broad and narrow money, as these developments make it easier to convert money into money substitutes. However, as noted by Bordo and Jonung (1990), in many developing countries, the velocity of broad money may decline over time because of the increasing monetization of the economy or financial deepening. Furthermore, there can be shifts between the various categories of money. As interest rates are liberalized on time deposits, private agents may shift their assets from currency and demand deposits to time deposits, raising the velocity of narrow money, but lowering the velocity of broad money.

For the ASEAN-4 countries, with the exception of Singapore, there has been a marked secular decline in the velocity of broad money (Chart 1). In Singapore, broad money velocity has declined since 1985, which is somewhat surprising, given the fall in both nominal and real time deposit rates, and the boom in the Singapore Stock Exchange. The velocity of narrow money has been considerably more volatile, particularly in Indonesia and Thailand, although, except in Malaysia, there has not been a trend decline in the velocity of narrow money.

Chart 1.
Chart 1.

Velocity of Monetary Aggregates

Citation: IMF Working Papers 1997, 036; 10.5089/9781451845419.001.A001

B. The Evolving Monetary Policy Framework

Financial liberalization can affect the choice of targets of monetary policy and the variables that are monitored by central banks to gauge monetary conditions. In an underdeveloped financial market, interest rates tend to be set by administrative controls, and the central bank usually targets quantity variables such as broad money. Following financial liberalization, the stability of monetary aggregates may be reduced. Central banks presiding over relatively advanced financial markets often resort to monitoring price variables such as exchange and interest rates. In many industrial countries, broad money targets are effectively seen as monitoring ranges, with very few central banks attempting to strictly adhere to monetary targets, or base policy actions on deviations of actual money growth from projected growth.

In each of the ASEAN-4 countries, the role of monetary targets in the conduct of monetary policy has been reduced in recent years. This process took place earliest in the case of Singapore, which since the early 1980s has focused primarily on managing the exchange rate as its principal monetary instrument (previously it monitored a variety of intermediate targets, including the monetary base, interest rates and loan growth, as well as exchange rates).4 However, in recent years it has also been apparent in the other ASEAN-4 countries. In Malaysia, the emphasis of monetary policy shifted during the 1980s from M1 to M2 and then to M3; in recent years, policies have focused more on short-term interest rates although money and credit aggregates are still monitored (Table 2). Similarly, the Bank of Thailand has shifted its policy emphasis from M2 towards commercial bank credit to the private sector and domestic interest rates;5 and Indonesia, while continuing to set money and credit targets and conduct a reserve money programming exercise, has in practice given increased weight to interest rates.

Table 2.

The ASEAN-4: Monetary Policy in the 1990s

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The shift away from formal monetary targeting has been due to several factors. In the case of Singapore—and increasingly a number of other countries as well—it has reflected the growing difficulties in simultaneously seeking to target the exchange rate and monetary aggregates in increasingly open economies.6 But it has also reflected concerns that the demand for money may have become more unstable as financial liberalization has accelerated, and thus a less reliable guide to policy formulation.

The instruments of monetary policy have depended on the maturity and depth of financial and capital markets, and the flexibility of interest rates. There has been greater reliance on open-market operations to affect short-term interest rates as financial markets have developed, and, in general, a move away from achieving broad money targets by limiting bank lending through moral suasion, or through changes in reserve requirements.

Since the 1980s, Indonesia, Malaysia, and Thailand have tried to introduce or to intensify the use of open-market operations (Table 2). The absence in the early 1980s of government debt instruments in these countries meant that the shift to open market operations was accompanied by the issuance of the central banks’ own debt instruments. To date, however, only Indonesia has a short-term paper market of sufficient depth to conduct traditional open market-type operations. Normally, when tightening monetary conditions, Bank Negara Malaysia raises reserve requirements or borrows directly from the interbank market, and the Bank of Thailand sells repos or Bank of Thailand paper.

Singapore’s monetary policy, in contrast, is implemented through foreign exchange operations, with the Monetary Authority of Singapore (MAS) selling foreign exchange for Singapore dollars to achieve a steady appreciation of the nominal exchange rate. Although treasury bills are auctioned and yields are competitively determined, the MAS does not carry out traditional open market operations. Official exchange rate intervention is able to exert a stronger influence on the nominal exchange rate because various regulations, such as limits on bank lending in Singapore dollars, have prevented the Singapore dollar from being widely held by foreigners.

III. Empirical Estimates of Money Demand Equations

The estimation of money demand has a long history, but it is only recently that cointegration techniques have been applied. In conventional money demand equations, such as (1), if M/P, Y, and i, are cointegrated, then in the long-run movements in these variables will be closely related. If some shock drives the long-run relationship between money, real income, and the opportunity cost of money out of equilibrium, there will be a tendency for real money balances to adjust, and for these variables to move together again. Thus the existence of a cointegrating relation means that in the long-run, the economy will return to some stable relationship between money, income, and the opportunity cost of money. Without a proper understanding of the structural parameters of the long-run money demand equation, it is possible that policymakers react to an adverse shock to real income, for example, by an excessive easing of monetary conditions, leading to inflation that is higher than targeted.

To estimate long-run real money demand relationships, we use the Johansen (1988) Full-Information Maximum-Likelihood procedure. A necessary condition for the existence of a stable long-run relationship is that there is a cointegrating vector containing money, income, and interest rates. The test for this is whether the “maximal-eigenvalue” or “trace-eigenvalue” statistics from the Johansen procedure are above the relevant critical values, in which case we can reject the hypothesis of no cointegration. In principle, there may, of course, be more than one cointegrating vector between these variables. In such cases, given the issue that is of immediate interest, we focus only on the vector that has money on the left hand side (normalized on M/P), although in practice, in all the countries considered here, this problem did not arise. Details of the estimation procedure are provided in Appendix I, and variable definitions and data sources are provided in Appendix II.

A. Results

The estimation results, presented in Table 3, by and large, do not provide strong evidence of stable relationships.7 We find stable demand equations with reasonable coefficients for real narrow and broad money only in Malaysia (and even here, coefficients on key variables are statistically insignificant). Overall, these results suggest that it is difficult to obtain stable real money demand functions using only the conventional determinants—real income, and interest rates. Alternative specifications have not been explored because the focus here is on the relatively narrow question of whether there is a stable relation between money, income and interest rates that could provide the basis for a particular monetary policy framework.8

Table 3--

ASEAN-4: Estimates of Real Money Demand Elasticities

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Note: Estimated by Johansen’s (1988) method, with one lag.All variables except for interest rates are in logarithms.chi-squared tests for statistical significance in parentheses

denotes significant at 5% level


Eigenvalue tests for the null hypothesis that there are no cointegrating vectors. The eigenvalue statistics are adjusted for degrees of freedom (Reimers, 1992).

Critical values for Indonesia, which are inclusive of two dummy variables, are simulated. For the other countries, critical values are from Osterwald-Lenum (1992).

1. Summary of Nominal Money Demand Results

Prior to estimating real money demand, we estimated nominal money demand equations of the form M=α+bY+ci+dP+ϵ to test if the coefficient on the log price level (d) is equal to one. If d is unity (price homogeneity)—a doubling of the price level will double nominal money demand—this would then allow us to estimate the real demand for money. The results are shown in Appendix I. We reject the assumption that d is equal to one for nominal narrow money in Singapore, and nominal broad money in Malaysia, Singapore, and Thailand. However, to estimate real money demand, we impose the restriction that d is one since the rejection could be a result of sample specific factors.9 Over the long-run, it would be unlikely that price illusion exists—rather the rejection most likely reflects ongoing changes in financial markets and money-holding behavior among private sector agents.

2. Real Narrow Money

In Indonesia, Thailand, and Singapore we are unable to find a stable relationship between real narrow money10 and its conventional determinants, real GDP, and an opportunity cost variable—typically the time-deposit rate. This is perhaps not surprising for Indonesia and Thailand, which have experienced substantial financial reform from the 1980s to the present. (In Indonesia, the inclusion of dummy variables to capture the effects of the 1983 and 1988 financial liberalization episodes, does not help in achieving stability.) For Singapore, the freeing of interest rates and other major reforms were almost completed by the beginning of our sample, 1975.11 Thus, the instability of narrow money demand is probably related more to the financial innovations that were common to all international financial centers in the 1980s—the greater use of credit cards, electronic transfers, and the introduction of mutual funds with checking accounts, enabling Singaporeans to economize on narrow money holdings. The difficulty in finding stable money demand functions in a number of industrial countries, such as the United Kingdom, the United States, and Australia over the 1980s and early 1990s is often attributed to similar, albeit more widespread institutional and technological innovations. It is noteworthy that Malaysia, where reforms have been less extensive than in Indonesia and Thailand, and where financial markets are less developed than in Singapore, is the only country among the ASEAN-4 with a stable narrow money demand function.

Previous research on the stability of narrow money demand in the ASEAN-4 is limited, but, in general, has had more success in finding stability. The differences between the earlier work and the results reported here can be attributed partly to different sample periods and to differences in specification and estimation techniques but, as explained in more detail in Appendix I, some previous studies have not corrected the test statistics for the small sample size, and may therefore have erroneously rejected the null hypothesis of no cointegration. Using data only up to 1989, Tseng and Corker (1991) found that real narrow money demands were stable for Indonesia, Malaysia, and Singapore, but unstable for Thailand. Using a very different specification, Hataiseree (1994) estimated that real narrow money, real income, and nominal interest rates were cointegrated for Thailand.12 Price and Insukundro (1994) and Arize (1994) found stability for narrow money in Indonesia and Singapore, using somewhat different estimation methods than that adopted here.13

3. Real Broad Money

The estimated real broad money equations are unstable for the ASEAN-4, except for Malaysia (Table 3).14 For Malaysia, the elasticity of real broad money with respect to real income is higher than that for real narrow money, but the opportunity cost semi-elasticity, although reasonable, is statistically insignificant.15 For Indonesia, Malaysia, and Thailand, we use the difference between the call money rate and the return on broad money as the opportunity cost of broad money.16 In Singapore, given the openness of its capital market, we include the foreign return along with the return on broad money. Although the coefficient estimates are all reasonable, we fail to achieve cointegration for Indonesia, Singapore, and Thailand.

It is somewhat surprising that the results for real broad money are not better than those for real narrow money. The freeing of time-deposit rates should mainly cause a shift from one component of broad money to another, from narrow to quasi-money. These instabilities in real broad money demands may, therefore, reflect the growth of money alternatives such as stocks and money market instruments. Equity markets grew very rapidly in the 1980s in Indonesia and Thailand, and firms and individuals in these countries, as a result, may have changed their money holding behavior. In contrast, in Malaysia, the equity market was well entrenched by the beginning of our sample.

Previous research on the stability of real broad money demand in the ASEAN-4 is again limited. However, consistent with our results, the earlier work has had greater difficulty in finding stability for real broad money than for real narrow money. Among the ASEAN-4, using the period up to 1989, Tseng and Corker (1991) found broad money stability only for Indonesia. Hataiseree (1994) and Arize (1994) using specifications and estimation methods different from ours and Tseng and Corker’s, found stability for Thailand and Singapore.

IV. Policy Implications and Conclusions

The empirical results of the previous section, although preliminary, have an important bearing on the feasibility of framing monetary policy around targets for monetary aggregates. Monetary targeting to control inflation depends on the stability and predictability of money demand. Only then can monetary authorities have a reasonable degree of confidence that if actual money growth is above target, there is likely to be upward pressure on prices and consequently some policy actions needed to tighten monetary conditions. If money demand behavior is not predictable, however, monetary authorities face the difficulty of not knowing whether “excess” money growth reflects an underlying shift in the private sector’s desire to hold money balances, or whether the actual money holding is temporarily above what private agents would wish to hold over the long term.

During the 1980s, many industrial countries such as Canada, the United Kingdom, the United States, and a number of countries in continental Europe faced similar policy dilemmas. Following deregulation of financial markets in the late 1970s and early 1980s, a number of these countries experienced rapid growth of financial markets, which was also spurred by continuing advances in underlying transaction technologies. Money demand instability effectively implied that money growth rates were poor predictors of future inflation and output trends.17 The dilemma for policymakers is to decide on how much policy actions should be constrained by pre-announced targets. If money growth rates are not good leading indicators of future inflation, then it may be preferable to abandon them as intermediate targets, or as many industrial countries did, downgrade them as one of a set of variables that policymakers regularly monitor.18

For some of the ASEAN countries that are currently faced with similar uncertainty regarding money growth, there is the potentially difficult judgment to be made about how much emphasis to place on intermediate targets. If money targets are announced, but policy actions are not seen to be based on money growth because specific episodes of “excess” money growth are judged not to indicate inflation pressures, there is a risk that credibility of policies could be undermined. Against this concern, policymakers also have to weigh the reduced effectiveness of policies if money growth and inflation are not closely related. Indeed, as discussed in Section II, a number of countries have reduced the emphasis on strictly adhering to monetary targets.

But moving away from a monetary targets framework raises the question of whether there is an alternative yardstick by which monetary conditions can be assessed. If there is no single variable that can be used as an intermediate target, either because of an unstable relationship with economic activity, or because those that are closely related to the state of the economy cannot be directly influenced by central bank actions, then the assessment of monetary conditions and policy actions will necessarily be based on monitoring a range of indicators. In practice, of course, all central banks monitor a wide set of variables, including some real sector variables that can only be influenced indirectly. The challenge for policymakers is to ensure that, in the absence of an explicit intermediate target, credibility of the central bank’s resolve to maintain low inflation is sustained. When the assessment of monetary conditions is based on a range of indicators, there is always a risk that policy inaction could be seen as a weakening in the anti-inflation stance. While policies must demonstrate consistency, transparency of the monetary policy decision making process is also important to provide more information to market participants about the rationale for policy actions.

It is sometimes argued that if countries cannot pursue money-based disinflation strategies, the operation of monetary policy could be simplified by adopting an exchange rate target. In terms of the decision making process, an exchange target is perhaps the most simple to operate; central banks are only required to maintain a fixed rate either with respect to a basket of trading partner currencies, or vis-à-vis a single major foreign currency. However, the benefits of fixed exchange rates are stongest for countries that lack credibility and have a history of relatively high inflation. In the ASEAN-4, which have maintained macroeconomic stability and relatively low inflation rates, the benefits of a pegged exchange rate in terms of stability must be weighed against other considerations, including the greater difficulties of managing capital inflows and other real shocks. In particular, reduced monetary autonomy weakens the ability to control inflation.

An alternative approach, when there is no suitable intermediate target variable that can be predictably influenced by policy and has a close relationship with inflation, is to target inflation directly. The instruments available to the monetary authorities and the objectives of monetary policy—maintaining low inflation—are exactly similar under both approaches. Indeed when comparing the operation of monetary policy in countries that have explicit inflation targets with those that frame policy decisions around intermediate targets, the difference may be more semantic than economic. Policy objectives are in most cases specified in terms of price stability.

If inflation targeting is not very different from targeting intermediate variables, what then are the benefits of moving toward explicit inflation targets, and with respect to the ASEAN countries, what would be the requirements to pursue this approach? The empirical analysis of money demand behavior in Section III, establishes only that strict adherence to intermediate targets on monetary aggregates may not be desirable in the ASEAN-4 countries, but it does not provide sufficient evidence to determine whether inflation targets would be beneficial and also whether they would be feasible in these countries. To address these issues requires further research on the underlying determinants of inflation and on the variability of inflation. Nevertheless, it is helpful to consider the benefits of inflation targeting in a general context and the key ingredients of this approach.

In countries that have adopted inflation targets, the formulation of explicit medium-term price objectives has helped to fill an important gap following the abandonment of monetary targets, and in some cases exchange rate targets. When monetary policy assessments are based on a range of indicators, or when policy is framed around intermediate targets, there may be a tendency for the policy framework to lack an explicit forward-looking element. Moreover, private agents may find it difficult to gauge the policy stance when actions of the authorities are based on a complex feedback rule. This is essentially a presentational problem that can undermine credibility. Inflation targets help get round this presentational problem by forcing the authorities to base policy actions on their forward-looking assessment of inflation. Furthermore, because central banks find it easier to justify policy actions by making public their assessment of future inflation, this also helps to enhance the credibility of polices.

The adoption of inflation targets is not, however, costless. By definition, forward-looking assessments are subject to wide margins of uncertainty. Forecasting errors in inflation projections typically tend to be relatively large.19 This in effect gives rise to a trade-off between flexibility and credibility. To ensure that targets are met, central banks may define a relatively large inflation target band, but this will not enhance credibility of policies. Thus, with respect to the ASEAN-4 countries, an important prerequisite is to model the inflation process and to examine both the magnitude and the source of forecast errors. If, for example, an economy is subject to frequent supply or structural shocks, actual inflation may deviate significantly from the target range. In such circumstances, it may well be appropriate for monetary authorities not to tighten conditions, but this could result in some loss of credibility. Although the economic structure of the ASEAN-4 countries is diverse, sector specific shocks may still have strong economy-wide effects, and these issues need to be investigated in greater detail to establish the desirability of an explicit inflation targeting approach.

Financial Liberalization and Money Demand in Asean Countries: Implications for Monetary Policy
Author: Mr. Robert Dekle and Mahmood Pradhan