Abstract
This Selected Issues paper focuses on the European Monetary Union and the monetary policy framework in Iceland. It concludes that in terms of an exchange rate regime, the two most realistic options for Iceland are to continue with the existing arrangement or adopt a unilateral peg to the euro. However, it is argued that both options entail the need for enhancing the independence of the central bank, which will require reforming the Central Bank of Iceland Act. The paper also discusses a Scandinavian forecasting model for inflation in Iceland.
IV. DEVELOPMENT OF MONETARY POLICY INSTRUMENTS1
68. Changes in monetary policy instruments and increasing independence of the central bank have helped develop money markets and improve macroeconomic management. This chapter discusses the development of monetary policy instruments, with an emphasis on changes that have occurred in 1998. These changes did not affect the overall framework of monetary policy, but are intended to assist in achieving policy objectives while facilitating financial sector development. The chapter begins with a brief discussion of the Central Bank of Iceland’s role in the financial market and in the conduct of monetary policy.
A. The Central Bank of Iceland
69. The Central Bank of Iceland, Seðlabanki Islands, was established in 1961. Previously, central bank functions were carried out by the National Bank of Iceland (Landsbanki Íslands), at that time a fully state-owned commercial bank. The Board of Directors is elected by the Parliament for a term of four years and the Governors of the Bank are appointed by the Minister of Commerce and Banking. The Central Bank of Iceland performs all traditional central banking functions, including the conduct of monetary policy, and the management of the country’s foreign exchange reserves. Its balance sheet at the end of 1998 is shown in the Statistical Appendix. The Bank also acts as the borrowing agent for the Republic of Iceland in the international capital markets. Prior to the formation of the new Financial Supervisory Authority on January 1, 1999, responsibility for the supervision of financial institutions had been held by the Bank Inspectorate in the Central Bank.
70. The Treasury and several government institutions have bank accounts with the Central Bank, which acts as banker, economic adviser and fiscal agent for the government. The Treasury had unlimited access to a short-term overdraft facility with the Central Bank until 1992 when an agreement on Central Bank credit accommodation was reached between the Central Bank and the Minister of Finance that terminated this facility, requiring the Treasury to meet all its borrowing needs in the financial market. In addition, the Treasury began to sell its bills and bonds at regular auctions conducted by the National Debt Management Agency. As a consequence, yields on Treasuries are market driven rather than decided by the government.
71. Monetary policy is conducted through market operations primarily in the money market and the interbank market for foreign exchange. The primary objective is price stability. The Central Bank has decisive influence, subject to government approval, in the formulation of the exchange rate policy. The exchange rate of the krona is determined in an interbank market. The Central Bank will use its instruments in the interbank market to keep the trade weighted exchange rate within a fluctuation band of ± 6 percent from a central rate. The degree of independence of the Central Bank of Iceland depends on the criterion used for measurement; Chapter I discusses this issue in more detail.
72. The Central Bank of Iceland has played a major role in the development of financial markets in Iceland. It established the Iceland Stock Exchange in cooperation with banks and securities houses and had supported the Exchange in various ways until it was able to cover its operational costs. The Bank has acted as a market-maker on the Exchange for long and short-term government securities, which has speeded up the development of both bond and money markets. In connection with this task the Bank has sometimes run into conflicts between the conduct of monetary policy on one hand and the need to have a liquid market for government securities on the other. This is particularly true for the bond market. At times the Bank invested considerable amounts in long-term bonds so as to steer long-term interest rates to levels it deemed appropriate. The Central Bank ceased its operations as a market maker for Treasury bonds and Treasury notes in early 1996 but still acts as a market maker for Treasury bills.
73. The Central Bank conducts active business with commercial and savings banks, being a lender of last resort, a clearing agent for checks and provider of liquidity. During the last decade banks’ direct access to central bank accommodation has been reduced. The Central Bank imposes a reserve requirement on all commercial and savings banks, at the present amounting to 1.5 or 4.0 percent of total disposable funds, depending on maturity.
B. Monetary Policy Framework and Instruments
74. Current central bank legislation stipulates several goals for monetary policy. However, price stability has become through consensus the primary objective of monetary policy. This goal is to be achieved by maintaining a stable exchange rate as an intermediate target. In December 1989, the exchange rate of the krona was fixed against a basket of currencies in order to establish a nominal anchor. The Bank does not target base money or money supply aggregates in monetary management as the ability to control these variables is limited and their link to the exchange rate and prices is uncertain. The Bank has in this period placed emphasis on managing interest rates in order to achieve a stable exchange rate. Combined with a program of fiscal consolidation and wage restraint, the exchange rate anchor has succeeded in reducing inflation, which for a long time far exceeded the OECD average, to low single digits in recent years. In July 1997, the Central Bank passed its role as a market maker in the interbank foreign exchange market to several credit institutions. Therefore, market forces have become increasingly important determinants of the exchange rate, although the Central Bank is equipped to intervene through market operations. The currency basket is composed of 16 currencies, weighted in terms of the respective country’s share in trade of goods and services. The basket is revised once a year based on the composition of the previous year’s trade. Since 1989 the exchange rate has been devalued twice, first in the wake of the turbulence in international currency markets in late 1992, which led to a significant deterioration in Iceland’s terms of trade, and then in mid-1993 in response to a prospective deterioration of the real economy resulting from a sharp reduction in allowable fish catches for conservation reasons. Since mid-1993, the exchange rate has fluctuated very modestly around its central rate. In September 1995 the fluctuation band was widened from ±2.25% to ± 6%.
75. The chief operating targets of monetary policy are short-term interest rates. The main instruments used to implement policy are: bond and money market operations, central bank credit facilities for financial institutions, central bank interest rates, intervention in the foreign exchange market, reserve requirements and a minimum liquidity ratio. The Central Bank sets its own interest rates independently but the use of some of its instruments is subject to Government consent.
Money market transactions
76. The central bank influences short-term interest rates through its transactions in the money market, specifically the market for Treasury bills. The Bank places non-competitive bids at auctions of Treasury bills and offers two-way prices on the secondary market for such bills. This market is the most important channel for the Bank in terms of traded volume, both for outright purchases of Treasury bills and for the sale of such bills. The deposit money banks (DMBs) make use of this market to adjust their most liquid reserves and to maximize their earnings on liquidity. The central bank offers the DMBs reverse repos of Treasury bills at predetermined interest rates. Also available to the DMBs are certain central bank notes, but usually these play a negligible role. The Bank would only make the notes attractive if for some reason Treasury bills were to lose their importance for the conduct of monetary policy. The above-mentioned transactions of the central bank are seen as a way of influencing interest rates, but at the same time the Bank is either providing or absorbing liquidity. The Bank does not make a clear distinction between these two roles. By monitoring several monetary aggregates, the Bank makes its decisions about its bid and offer yields in the secondary market. Changes in the yields are often based on a judgement that the direction of the flow of liquidity should change.
Limits on discount and other credit facilities
77. The central bank provides the economy with liquidity through (a) the purchase of foreign exchange, (b) the purchase of Treasury bills and government bonds, and (c) by granting financial institutions some access to central bank financing. The last channel includes limited discount facilities at low interest rates and repurchase agreements (repos) at predetermined interest rates which are slightly higher than the discount rate. Treasury bills are the most common instrument in repos with the DMBs. There is no formal limit. The maturity in each case is 14 days. The central bank has also granted limited repo facilities to securities houses which have assumed the role of market-makers in government bonds, in which case such bonds serve as the underlying securities and the maturity is 30 days. The central bank provides no privileged credit for private or public borrowers. Until 1985, however, the Bank applied preferential rates when rediscounting loans which the banks had granted to certain business sectors.
Interest rates
78. Financial institutions can freely set all their interest rates. However, the central bank determines the so-called penalty interest rates on overdue payments according to a formula specified by law. There are no indications that interest rates are set by an agreement among financial institutions; such collusion is strictly forbidden by law. The large market share of a small number of banks may nevertheless have led to oligopolistic behaviour in the setting of bank rates.
Foreign exchange operations
79. The central bank may intervene in the foreign exchange market by buying or selling kronur so as to prevent the exchange rate from moving too far from the central rate. Since the fixed exchange rate policy was adopted, foreign exchange reserves have been adequate to maintain the exchange rate at the desired level. Government foreign borrowing has sometimes been helpful in supporting the reserve position, but is not used in any systematic way to regulate official reserves. The Central Bank follows a policy of maintaining reserves at three months’ value of merchandise imports, at a minimum. Iceland presently has a quota of SDR 85.3 million in the Fund. Since 1962, the Central Bank has been a party to an agreement between the Nordic central banks which consists of an exchange of credit lines, allowing each of the banks to draw on the others on a short-term basis in times of temporary foreign reserve shortage. According to the current agreement the Central Bank of Iceland can draw up to 200 million euro. In addition, the Central Bank has access to secured interbank lines for a total amount of US$275 million and unsecured interbank lines with a number of international banks. Existing credit facilities total $600–800 million.
Reserve requirements
80. Deposit money banks are subject to reserve requirements that can be fulfilled only via deposits in blocked accounts with the central bank. The base for the reserve requirement includes not only deposits but also DMBs’ bond issuance and other domestic liabilities. Since November 1993 the required reserve ratio has been lower for time deposits and outstanding bonds than for other liabilities. Prior to that no differentiation was made with regard to the type of liabilities. Marginal reserve ratios were applied in the 1960s and 1970s, but they have no relevance except when the (average) reserve ratio is being raised. Reserve ratios have been reduced sharply over the last decade at the same time as access to central bank financing by banks and the Treasury has also been reduced. Deposits on the required reserve account with the central bank have always been remunerated. There had also been a minimum liquidity ratio until March 1998, which was temporarily restored in February 1999. It is a secondary requirement that is fulfilled by holdings of cash, Treasury bills and free reserves as measured by an average during each month.
81. The development of monetary instruments has been gradual, but has moved toward arrangements that will improve financial markets. Credit ceilings were applied in the 1970s and early 1980s. Since the early 1980s, the Central Bank has not used direct or indirect quantitative controls on lending. The Bank’s instruments and facilities were mostly based on arrangements put in place in 1987 when the Bank began a gradual lowering of reserve requirements. However, a liquidity ratio was introduced and then raised to offset the declining reserve requirements. The liquidity ratio also served to induce the deposit money banks to hold treasury bills and other government paper as these assets could be used to satisfy the liquidity requirement. At the same time, the Central Bank began engaging in repurchase transactions in treasury bills with deposit banks as well as transacting in treasury bills on the Stock Exchange. These measures resulted from the Bank’s desire to support the development of the securities market and establish repo transactions in Iceland. Nonetheless, the arrangements were unnecessarily complicated in that they provided many routes for deposit money banks to secure liquidity from the Central Bank. This liberal access hampered the development of the interbank market for kronur as commercial and savings banks took advantage of the repo facility rather than approach each other for liquidity. Furthermore, the liquidity ratio gradually became ineffective as an instrument as deposit bank holdings of marketable securities rose. Many of the recent changes to monetary instruments, especially those in 1998, were intended to address these shortcomings.
82. Changes in the relationship between the Central Bank and the Treasury have also helped develop financial markets. Before 1992, the Treasury only sold bills on tap at a price decided by the Ministry of Finance. The Treasury started auctioning T-bills in 1992, and now regularly sells Treasury bills, Treasury notes and Government savings bonds at auctions. In the past, the Treasury also had unlimited access to a short-term overdraft facility with the Central Bank. Consequently, the Central Bank had a rather limited ability to influence short-term interest rates of commercial banks and savings banks. Following the 1992 agreement on Central Bank credit accommodation between the Government and the Central Bank, the Treasury meets all its borrowing needs in the financial market. As a result of this agreement, a significant money market has developed in only few years, the largest financial market in Iceland in terms of turnover. Interest rates on government securities are fully set by the market, and they now play a bigger role in the determination of general domestic interest rates. Through market operations, the ability of the central bank to influence short-term interest rates has been strengthened.
C. Recent Changes in Instruments
83. In first half of 1998, the Central Bank of Iceland made significant changes to its monetary policy instruments, in line with the decisions taken for the European Central Bank. The reform of monetary policy instruments was not intended to have impact on the monetary policy framework. The Bank’s main instrument remains short-term, now fourteen day, money market interest rates which it controls by setting the yields in its repurchase transactions. The Bank’s intermediate target remains keeping the exchange rate within the announced fluctuation margins while price stability remains the overall objective. These changes did not imply any alteration of the monetary stance as instrument rates were left unchanged. The main objectives of the reform in the instruments of monetary policy include the following:
equalize the operating conditions of credit institutions in the domestic market and harmonize their access to facilities at the Bank. The coverage and availability of the Central Bank instruments and facilities had been largely confined to deposit money banks. Yet, the financial market has changed dramatically over the last decade with new credit institutions emerging. The change in instruments was intended to ensure uniformity of treatment of different institutions and financial instruments.
create operating conditions for domestic credit institutions similar to those prevailing in the European Economic Area. The changes in the monetary policy instruments were guided by the ECB’s plans for instruments and facilities to the extent that they had been spelled out when the changes were implemented.
simplify the instruments and enhance the Central Bank discretion in carrying out monetary policy.
to stimulate the development of the money market, especially the interbank market and the secondary market for government securities.
Overview of the recent changes:
84. On March 1, 1998, the following changes to monetary instruments took effect;
The secondary liquidity requirement (liquidity ratio) was replaced with weekly auctions of such agreements.
The maturity of repurchase agreements was extended from 10 to 14 days and weekly auctions replaced tap-availability. The number of securities eligible as collateral in repos was expanded to include all government guaranteed securities registered on the Stock Exchange. Central Bank CDS will continue to qualify as well.
The tap-sale of 45 day Central Bank CDS was abolished but the Central Bank reserved the option to auction 14 days CDS on the weekly auction when it wishes to reduce liquidity. CDS of 90-day maturity will continue to be available on tap.
An overnight facility was established in the Central Bank for credit institutions subject to reserve requirements. The same securities can serve as collateral for overnight loans as in repurchase agreements.
85. The second phase of the changes became effective on May 21, 1998 when the following changes were implemented;
The reserve base was expanded, both in terms of coverage of institutions and types of liabilities.
The discount quota of deposit money banks was abolished.
The foreign currency accounts of deposit banks at the Central Bank were closed.
86. The two most significant changes were the abolition of the liquidity requirement and the revision of regulations governing reserve requirements. The liquidity requirement had been introduced to offset declining reserve requirements and induce banks to hold government paper (Table 13). However, only deposit money banks were subject to the liquidity requirement and it was difficult to see how it could be applied to other credit institutions. In addition, the liquidity requirement had a distortionary impact on price formation for government paper as short-term and long-term government paper was not treated in the same manner.
Required Reserve and Liquidity Ratios
Abolished on March 1, 1998. Reinstated on March 21, 1999.
The second ratio is for bonds and time deposits with maturities of at least one year.
Required Reserve and Liquidity Ratios
| Effective | Date | Reserve Ratio | Liquity Ratio 1/ |
|---|---|---|---|
| May 1, | 1990 | 10.0 | 11.0 |
| June 1, | 1990 | 7.0 | 12.0 |
| Nov. 1, | 1991 | 6.0 | 12.0 |
| Jan. 1, | 1992 | 7.0 | 12.0 |
| Nov. 1, | 1992 | 6.0 | 12.0 |
| Dec. 1, | 1992 | 5.0 | 12.0 |
| Nov. 1, | 1993 | 4.0 2.5 2/ | 10.0 |
| Oct. 1, | 1996 | 4.0 2.5 2/ | 12.0 |
| March 1, | 1998 | 4.0 2.5 2/ | 0.0 |
| April 1, | 1998 | 4.0 1.5 2/ | 0.0 |
| March 21, | 1999 | 4.0 1.5 2/ | 1.5 |
Abolished on March 1, 1998. Reinstated on March 21, 1999.
The second ratio is for bonds and time deposits with maturities of at least one year.
Required Reserve and Liquidity Ratios
| Effective | Date | Reserve Ratio | Liquity Ratio 1/ |
|---|---|---|---|
| May 1, | 1990 | 10.0 | 11.0 |
| June 1, | 1990 | 7.0 | 12.0 |
| Nov. 1, | 1991 | 6.0 | 12.0 |
| Jan. 1, | 1992 | 7.0 | 12.0 |
| Nov. 1, | 1992 | 6.0 | 12.0 |
| Dec. 1, | 1992 | 5.0 | 12.0 |
| Nov. 1, | 1993 | 4.0 2.5 2/ | 10.0 |
| Oct. 1, | 1996 | 4.0 2.5 2/ | 12.0 |
| March 1, | 1998 | 4.0 2.5 2/ | 0.0 |
| April 1, | 1998 | 4.0 1.5 2/ | 0.0 |
| March 21, | 1999 | 4.0 1.5 2/ | 1.5 |
Abolished on March 1, 1998. Reinstated on March 21, 1999.
The second ratio is for bonds and time deposits with maturities of at least one year.
87. Reserve requirements were expanded to include more institutions and additional forms of liabilities. To compensate for the expansion of the base, the reserve ratio for longer-term liabilities was lowered. This left the reserve requirement of the deposit taking institutions, already subject to reserve requirements, more or less unchanged. The remuneration of required reserves was also changed from indexed terms to nominal interest rates, leaving the expected nominal yield unchanged. This is in line with the official policy of reducing the scope of indexation in the financial system. Another important change is that institutions subject to reserve requirements will be able to meet their requirements on average during the reserve period instead of the reserves being held in frozen accounts at the Central Bank. This change makes it easier for credit institutions to manage their liquidity and should reduce the volatility of money market rates. The new regulations also allow one institution subject to reserve requirements to fulfil the reserve requirements on behalf of another or other institutions. This provision is intended for the savings banks which have long cooperated in the fulfilment of their liquidity ratio through Icebank Ltd.
88. The main changes to the repurchase facility are twofold. First the tap availability of repurchase contracts was discontinued, and second, the eligible collaterals were expanded to include all government registered securities on the Iceland Stock Exchange. This imposes a significant widening of the eligible collateral as only treasury bills had been eligible previously. In place of daily transactions, the Central Bank will hold weekly auctions of repurchase agreements, with advance notice of whether the auction will involve repurchase or resale agreements. The Bank can vary the auction form between a volume tender to fixed price auctions, the latter being the rule. This new agreement will enhance Central Bank discretion and stimulate interbank market activity. The older arrangement made the Central Bank the hub for intermediation of short-term funds between credit institutions. With the repo window open only once a week the credit institutions are encouraged to enter the interbank market to take-up or place short funds.
89. The establishment of the overnight credit facility at the Central Bank effectively creates a corridor for short-term interbank interest rates by setting an upper limit to their movements, while the interest rate paid on current accounts of credit institutions at the Bank provides the lower limit. These limits prevent large deviations of money market rates from the Central Bank’s instrument rates. Large fluctuations could cause uncertainty about the Bank’s interest rate policy and lead to turbulence in currency and money markets.
90. The discount quota was a limited overdraft facility for commercial and savings banks. The purpose of the discount quota was to smooth fluctuations in the money supply which were connected to uneven revenue collection by the Treasury. The change in reserve requirements, including averaging over the reserve period, obviated the need for the discount quota.
91. Foreign currency accounts at the Central Bank were established in 1979 when deposit money banks were allowed to offer domestic foreign currency accounts. Their main purpose was to make it easier for smaller deposit money banks, which did not have access to foreign accounts, to manage foreign currency deposits. Cooperation among the savings banks has reduced the need for this service. Moreover, the foreign currency accounts at the Central Bank had a detrimental effect on the development of the money and currency markets because the accounts channeled funds to the Central Bank that otherwise would have found their way onto the markets.
92. On February 23, 1999, the Central Bank temporarily introduced new liquidity restrictions on credit institutions. The rules were introduced partly as a prudential measure and partly as a short-term monetary policy instrument that will effectively restrain credit growth. The new liquidity rules differ from previous rules that were abolished in March 1998. Two specific measures were introduced: (i) liquidity should never be negative, and (ii) on a monthly average basis, the liquidity ratio should be 1.5 percent or greater. Liquid assets are defined as the sum of net deposits of credit institutions in the central bank, and domestic and foreign credit institutions with a maturity of 90 days or less, T-bills, and cash held in kronur or foreign currency. The base for the ratio is the same as the base for reserve requirements—total liabilities of credit institutions after deducting equity and interbank debt. Credit institutions will be allowed an adjustment period until these restrictions become fully effective in July 1999. The new rules are expected to increase the liquid position of credit institutions by 25–30 billion kronur. During the adjustment period, the new rules may also reduce trading volume in certain markets such as short-term foreign debt and the interbank market. The Central Bank intends to develop alternative provisions for prudential regulation of credit, in conjunction with the financial institutions and the Financial Supervisory Authority, under whose jurisdiction the rules fall. The alternative provisions will likely replace the liquidity restrictions, and be based on a maturity analysis of the balance sheet of banks in order to provide more flexibility. However, new legislation will be required for provisions related to maturity analysis and will not take effect until approved by Parliament, following its return in autumn 1999.
REFERENCES
The Central Bank of Iceland, Autumn Statement 1998.
“Deregulation of the Financial Sector”, in OECD Economic Surveys, Iceland, 1998, pp.56–75.
Economic Statistics Quarterly, 1999, Central Bank of Iceland.
The Economy of Iceland, Autumn 1998, Central Bank of Iceland.
Gudnason, Eirikur, 1996, “The Icelandic financial system”, in Changing Financial Systems in Small Open Economies, BIS Policy Papers No. 1, Basle, Switzerland, pp. 62–90.
Prepared by Valerie Cerra.