Abstract
This Selected Issues paper for The Bahamas reports that the largest portion of tourism expenditure in The Bahamas comes from stayover visitors, and total tourism spending has been stagnant. The Bahamas is a small open economy highly dependent on tourism and the offshore financial sector. Private consumption expenditure in the country or countries of origin is the most important determinant of tourism in The Bahamas.
III. The Bahamas’ Monetary Framework: Objectives, Instruments, and Options for Reform1
A. Introduction
1. The Central Bank of The Bahamas is studying the possibility of a reform of monetary policy instruments. The central bank (CBB) has long relied on direct credit controls and restrictions on capital flows to manage liquidity, but has become concerned about the microeconomic efficiency of these instruments and is reconsidering its monetary framework. Fund staff has advocated since the early 1990s the adoption of more market-based instruments of monetary policy to enhance the role of price signals in the allocation of financial resources. Direct controls have nevertheless been retained, as the depth of the domestic capital market was—and still is—seen as insufficient to support open market operations.
2. This paper explores the possible move to market-based instruments of monetary policy in The Bahamas. Following a description of the CBB’s monetary policy objectives and the current monetary framework, the paper (i) examines the performance and drawbacks of the current framework; (ii) discusses the potential benefits of a transition to a market-based mode of monetary control; (iii) examines possible impediments to the development of an efficient money market; and (iv) suggests how market-based instruments could be introduced. The paper’s concluding section discusses a possible strategy and near-term steps that would set the stage for a successful transition toward market-based instruments of liquidity management.
B. The Central Bank’s Monetary Policy Objectives
3. The Bahamas dollar has been pegged at par with the U.S. dollar since 1973,2 and keeping an adequate level of international reserves has also been a key objective.3 The Central Bank Act stipulates that the external assets of the central bank shall at no time be less than 50 percent of demand liabilities (the sum of currency in circulation and demand deposits at the central bank, including deposits of public corporations). In practice, the Monetary Policy Committee (MPC) of the CBB has held international reserves in excess of the statutory minimum.4
4. The central bank monitors a variety of indicators to assess the adequacy of reserves. The MPC approaches the issue of reserve adequacy by monitoring financial indicators, including ratios of net international reserves (NIR) to base money and to M2. Although these ratios in recent years have risen well above the statutory minimum, they currently do not appear excessive, either relative to emerging markets with good market access or in historical perspective (Figures 1 and 2). The CBB also keeps an eye on a real sector indicator (reserves in months of imports), which appears comfortable.5
The Bahamas. Monetary Authorities Foreign Assets, 1974–2004
Citation: IMF Staff Country Reports 2005, 224; 10.5089/9781451804720.002.A003
Source: IMF, International Financial Statistics.The Bahamas. Monetary Authorities Foreign Assets, 1974–2004
Citation: IMF Staff Country Reports 2005, 224; 10.5089/9781451804720.002.A003
Source: IMF, International Financial Statistics.The Bahamas. Monetary Authorities Foreign Assets, 1974–2004
Citation: IMF Staff Country Reports 2005, 224; 10.5089/9781451804720.002.A003
Source: IMF, International Financial Statistics.
Cross-Country Comparison of International Reserves, 2004
Citation: IMF Staff Country Reports 2005, 224; 10.5089/9781451804720.002.A003
Source: IMF, International Finance Statistics1/ Tonga and Vanuatu are not rated by Moody’s.Cross-Country Comparison of International Reserves, 2004
Citation: IMF Staff Country Reports 2005, 224; 10.5089/9781451804720.002.A003
Source: IMF, International Finance Statistics1/ Tonga and Vanuatu are not rated by Moody’s.Cross-Country Comparison of International Reserves, 2004
Citation: IMF Staff Country Reports 2005, 224; 10.5089/9781451804720.002.A003
Source: IMF, International Finance Statistics1/ Tonga and Vanuatu are not rated by Moody’s.C. The Current Monetary Policy Framework
5. The MPC retains a large degree of discretion in dealing with unanticipated variations in NIR. The MPC monitors developments in bank liquidity and credit, money supply and reserve money, and bank soundness indicators, with a view to taking corrective action if, in the MPC’s view, losses of international reserves threaten to put pressure on the exchange rate.
6. Direct credit controls and moral suasion have been the main instruments of monetary policy since the late 1980s, with changes in the discount rate playing a secondary role. Containing credit growth is seen as instrumental in stemming reserve declines by restraining domestic demand, which is import-intensive owing to the economy’s openness. Credit controls have often taken the form of lending limits of a prudential nature; during September 2001–August 2004, they have included a ceiling on bank loans and advances to private and public sector.6 Moral suasion has been used to support policy implementation, as there are no penalties for noncompliance with the credit ceiling, and capital controls have also at times been used to support credit policy.7 Changes in the discount rate have been infrequent over the last decade.
7. The CBB also operates automatic standing facilities. The CBB operates a rarely used discount window to provide collateralized short-term credit to domestic banks for liquidity purposes. The interest rate (the discount rate) is used by the CBB to signal changes in the stance of monetary policy.8 The CBB underwrites treasury bills and government bonds if tenders are not fully subscribed. It operates a secondary market window for treasury bills, whereby banks and other investors can sell treasury bills to the CBB at a penalty of 50 basis points, and buy treasury bills from the CBB’s portfolio at a penalty of 10 basis points. Similarly, it operates a secondary market window for government bonds.
D. Performance and Drawbacks of the Current Framework
8. The current framework appears to have worked reasonably well in achieving policy objectives and has allowed some degree of monetary independence. The September 2001–August 2004 episode of credit controls highlights the framework’s features. Until late 2003 the aggregate credit ceiling was not binding due to the gradual disbursement of loan commitments, and because credit demand by businesses was weak owing to depressed economic activity.9 Aggregate bank credit growth was gradually reduced to near zero by end-2003. Moral suasion was used—successfully through end-2003, according to CBB officials—to correct overshooting by individual banks. However, with the rebound in NIR, banks started to anticipate the removal of credit controls and began expanding credit in early 2004. Throughout the 2001–04 period, domestic interest rates were broadly stable, in contrast to the sharp swings in U.S. rates, highlighting the relative independence of domestic monetary conditions from international monetary developments.
The Bahamas. Monetary Variables and Interest Rates, 1999–2005
Citation: IMF Staff Country Reports 2005, 224; 10.5089/9781451804720.002.A003
Sources: Central Bank of The Bahamas; and IMF, International Finance Statistics.1/ Broad money in this figure includes deposits of public sector agencies.2/ Net international reserves of the central bank.The Bahamas. Monetary Variables and Interest Rates, 1999–2005
Citation: IMF Staff Country Reports 2005, 224; 10.5089/9781451804720.002.A003
Sources: Central Bank of The Bahamas; and IMF, International Finance Statistics.1/ Broad money in this figure includes deposits of public sector agencies.2/ Net international reserves of the central bank.The Bahamas. Monetary Variables and Interest Rates, 1999–2005
Citation: IMF Staff Country Reports 2005, 224; 10.5089/9781451804720.002.A003
Sources: Central Bank of The Bahamas; and IMF, International Finance Statistics.1/ Broad money in this figure includes deposits of public sector agencies.2/ Net international reserves of the central bank.9. The insulation of domestic interest rates from U.S. rates is largely a consequence of exchange controls, and a seeming absence of price competition among banks.10 Even in the face of large excess bank liquidity (paragraph 14 below), bank deposit and lending rates have been remarkably stable. In practice banks post the same prime lending rate, and appear not to compete on the basis of interest rates.11
10. The long-standing reliance on direct instruments of monetary policy may also have reduced interest rate flexibility. Credit controls have reduced the scope for banks to gain market shares, so the incentives to compete by adjusting lending rates, or seeking to attract deposits, have been diminished.12
E. Transition to a More Market-Based Monetary Regulation
11. The authorities are considering helpful steps to deepen domestic financial markets. The government is contemplating measures to promote a secondary market for government bonds, to revitalize the Bahamas International Stock Exchange (BISX), and to increase the role of market-based interest rates in signaling the cost of funds. The CBB views the creation of a money market as a component of this reform, and is also proposing a cautious and gradual liberalization of capital controls, to further integrate the country in the region, increase competition in the banking sector, and give citizens broader investment opportunities. A first step may be a reduction in the premium on investment currency13 (currently at 25 percent for outflows, and 20 percent for inflows), and in the long run possibly its elimination. Other measures may include expanding the listing of foreign securities on the BISX through depositary rights; and allowing cross-listings of Bahamian and foreign companies on principal CARICOM exchanges.
12. The CBB issues government treasury bills (3- and 6-month maturities) through an auction held on average once a month. The CBB determines the cut-off rate and the interest rate on treasury bills is typically low; the rate has recently fallen to close to zero owing to high levels of bank liquidity.14 Government bonds (with maturities up to 25 years) are not auctioned, but issued through the CBB at a pre-set interest rate.15 There are almost no secondary market transactions in government securities, as holders tend to keep them in their portfolio until maturity. This is in part because government securities are held to meet the Liquid Asset Ratio (LAR) requirement for financial institutions, and because of a lack of alternative investment choices available to the National Insurance Board (NIB) and private pension funds.
The Bahamas. Interest Rates and Free Bank Reserves, 1999–2005
Citation: IMF Staff Country Reports 2005, 224; 10.5089/9781451804720.002.A003
Source: Central Bank of The BahamasThe Bahamas. Interest Rates and Free Bank Reserves, 1999–2005
Citation: IMF Staff Country Reports 2005, 224; 10.5089/9781451804720.002.A003
Source: Central Bank of The BahamasThe Bahamas. Interest Rates and Free Bank Reserves, 1999–2005
Citation: IMF Staff Country Reports 2005, 224; 10.5089/9781451804720.002.A003
Source: Central Bank of The Bahamas13. Presently, the supply of existing short-term financial instruments is limited, and the majority of domestic currency transactions are intermediated through domestic banks.16 There is a legal ceiling on the amount outstanding of treasury bills (25 percent of the fiscal revenue of the three preceding years). The ceiling is currently binding, hence auctions are limited to roll-overs. The CBB’s portfolio of government securities is small relative to banks’ free reserves (B$76 million at end-March 2005 against B$262 million). Nonbank financial institutions play only a small role in intermediating funds; and the market capitalization of companies traded in the BISX is low (33 percent of GDP in 2004). The single most significant nonbank investor is the NIB, with assets amounting to close to B$1.2 billion, or 20 percent of GDP at end-2004, half of which consists of government bonds.
14. Structural excess bank liquidity and relatively predictable liquidity needs have reduced the scope for interbank transactions. Excess bank reserves sharply increased during 2004 and early 2005, as strong external inflows outpaced the private sector’s capacity to borrow, even after the relaxation of credit controls.17 In such a setting there is no great need for interbank transactions, as the central bank is structurally on the borrowing side of the market, and banks on the lending side. At the same time, there do not appear to be other institutions with significant short-term liquidity management needs to help foster the development of the money market. This situation appears to be an obstacle to the development of a vibrant money market that would yield market-based short-term interest rates. However, since the discount rate is currently above the interbank rate, the CBB’s involvement as a lender of last resort does not appear to have crowded out interbank activities.18
The Bahamas. NIR and Free Bank Reserves, 1994-2005
(In percent of M3)
Citation: IMF Staff Country Reports 2005, 224; 10.5089/9781451804720.002.A003
Source: Central Bank of The Bahamas.The Bahamas. NIR and Free Bank Reserves, 1994-2005
(In percent of M3)
Citation: IMF Staff Country Reports 2005, 224; 10.5089/9781451804720.002.A003
Source: Central Bank of The Bahamas.The Bahamas. NIR and Free Bank Reserves, 1994-2005
(In percent of M3)
Citation: IMF Staff Country Reports 2005, 224; 10.5089/9781451804720.002.A003
Source: Central Bank of The Bahamas.Inter-Bank Market in The Bahamas
(In millions of Bahamian dollars at end of period)
Interbank float.
Inter-Bank Market in The Bahamas
(In millions of Bahamian dollars at end of period)
| 1999 | 2000 | 2001 | 2002 | 2003 | 2004 | 2005 | ||||
|---|---|---|---|---|---|---|---|---|---|---|
| Jan | Feb | |||||||||
| Due to: | ||||||||||
| Demand deposits | 22.7 | 29.4 | 40.9 | 42.7 | 37.9 | 36.3 | 40.7 | 35.0 | ||
| Fixed deposits | 51.0 | 42.9 | 88.8 | 96.2 | 74.4 | 63.1 | 75.5 | 77.6 | ||
| Total deposits | 73.8 | 72.3 | 129.7 | 138.9 | 112.3 | 99.4 | 116.2 | 112.7 | ||
| Due from: | ||||||||||
| Demand deposits | 23.9 | 24.7 | 37.6 | 42.0 | 43.5 | 39.2 | 44.0 | 42.0 | ||
| Fixed deposits | 50.9 | 43.9 | 82.4 | 97.2 | 73.1 | 71.2 | 80.4 | 77.4 | ||
| Total deposits | 74.8 | 68.5 | 120.0 | 139.2 | 116.6 | 110.4 | 124.4 | 119.4 | ||
| Interbank (net) 1/: | −1.1 | 3.8 | 9.7 | −0.3 | −4.3 | −11.0 | −8.3 | −6.7 | ||
| Memorandum items: | ||||||||||
| Total B$ bank deposits | 3,096.1 | 3,368.2 | 3,518.6 | 3,650.5 | 3,810.6 | 4,150.1 | 4,188.6 | 4,178.5 | ||
| Interbank deposits, in percent of total B$ bank deposits | 2.4 | 2.0 | 3.4 | 3.8 | 3.1 | 2.7 | 3.0 | 2.9 | ||
Interbank float.
Inter-Bank Market in The Bahamas
(In millions of Bahamian dollars at end of period)
| 1999 | 2000 | 2001 | 2002 | 2003 | 2004 | 2005 | ||||
|---|---|---|---|---|---|---|---|---|---|---|
| Jan | Feb | |||||||||
| Due to: | ||||||||||
| Demand deposits | 22.7 | 29.4 | 40.9 | 42.7 | 37.9 | 36.3 | 40.7 | 35.0 | ||
| Fixed deposits | 51.0 | 42.9 | 88.8 | 96.2 | 74.4 | 63.1 | 75.5 | 77.6 | ||
| Total deposits | 73.8 | 72.3 | 129.7 | 138.9 | 112.3 | 99.4 | 116.2 | 112.7 | ||
| Due from: | ||||||||||
| Demand deposits | 23.9 | 24.7 | 37.6 | 42.0 | 43.5 | 39.2 | 44.0 | 42.0 | ||
| Fixed deposits | 50.9 | 43.9 | 82.4 | 97.2 | 73.1 | 71.2 | 80.4 | 77.4 | ||
| Total deposits | 74.8 | 68.5 | 120.0 | 139.2 | 116.6 | 110.4 | 124.4 | 119.4 | ||
| Interbank (net) 1/: | −1.1 | 3.8 | 9.7 | −0.3 | −4.3 | −11.0 | −8.3 | −6.7 | ||
| Memorandum items: | ||||||||||
| Total B$ bank deposits | 3,096.1 | 3,368.2 | 3,518.6 | 3,650.5 | 3,810.6 | 4,150.1 | 4,188.6 | 4,178.5 | ||
| Interbank deposits, in percent of total B$ bank deposits | 2.4 | 2.0 | 3.4 | 3.8 | 3.1 | 2.7 | 3.0 | 2.9 | ||
Interbank float.
15. Looking forward, consideration could be given to either establishing a formal operational target for the supply of reserve money, or for interest rates. Best practice in relatively shallow financial markets with capital controls is for the central bank to signal its intentions by targeting reserve money.19 These countries tend to move to targeting interest rates at a later stage when domestic financial markets deepen.20 This would require the definition of a benchmark interest rate and the establishment of a market-based vehicle, e.g. auctions or open-market type operations, for the CBB to signal its interest rate objective.21
F. A Possible Reform Strategy
16. A transition to more market-based monetary policy instruments is expected to be part of a broader long-term strategy to modernize and open up the financial sector. The government intends to reform the market for government bonds, revitalize the BISX, and increase the role of market-based interest rates. Consideration is also being given to a gradual relaxation of capital controls to further integrate the country in the region, increase competition in the banking sector, and give citizens broader investment opportunities. While this process would need to proceed in a careful and well-sequenced manner, there seems to be scope for the CBB to begin to introduce market-based policy instruments (Box 1).
17. In particular, the CBB needs to manage excess bank liquidity and take steps to let market forces allocate financial resources. The key considerations that may need to guide the selection of a mix of instruments include:
Unremunerated reserve requirements are a tax on the banking sector, and raising them should remain an option of last resort.
It would be preferable to select instruments that generate a continuous CBB presence in the money market, as opposed to one-off operations.
A capacity to forecast market liquidity would need to be developed at the CBB.
Care would be needed to ensure that the CBB is in a position to conduct monetary policy in a manner that does not impose a financial burden on the central bank and inhibits its independence.
18. On this basis, the CBB would seem to face three policy options for developing market-based policy instruments, each of which presents difficulties. The MPC would need to carefully evaluate these options, assess the adjustments they require in the operations of the CBB and other market participants, and engage in a dialogue with the finance ministry about their cost implications.
Issuing the CBB’s own paper for open market-type operations. The maturity of CBB’s paper should be shorter than that of treasury bills and the quasi-fiscal implications of liquidity management operations should be recognized. The experience in other countries indicates that central bank losses resulting from the issuance of central bank paper may be substantial and could eventually entail the need for the government to recapitalize the central bank.
Converting treasury bills into a monetary policy tool. Under this option treasury bills would have two distinct functions—deficit financing and monetary control. To fulfill this dual function a legislative change might be needed to relax the legal ceiling on the amount of outstanding treasury bills.
Introducing auctions of short-term central bank deposits (to withdraw liquidity) and repurchase/reverse repurchase agreements of government securities (to withdraw or inject liquidity). The central bank’s portfolio is fairly small, which limits its potential impact. However, consideration could be given to securitizing CBB’s advances to the government (advances are limited to 10 percent of revenue of the preceding three years). Securitized advances should be marketable, and the CBB could consider engaging in repurchase agreements with the market using its portfolio of government bonds and securitized advances. The maturities of repos should be shorter than that of the underlying instrument, in part to clearly differentiate government financing from monetary operations. It could also auction short-term deposits.
19. Consideration would also have to be given to the desired structure of the money market. The CBB would need to define which counterparties would be most appropriate to foster the development of the money market. Counterparties—i.e., institutions with which the CBB would transact on a regular basis—could include all clearing banks or a restricted set of primary dealers. The CBB should also hold discussions with banks about the reforms of instruments and operations, as banks would need to adjust their internal operations and upgrade manpower skills to participate in an active money market. To foster the development of the money market, the CBB should streamline its standing facilities, which should be solely accessed by counterparts at penalty rates. In particular, the CBB should close its secondary windows for government securities.
Malta’s Process of Financial Liberalization
Like The Bahamas, Malta’s economy is heavily influenced by external developments. Malta is a small island economy with a population of about 400,000 and a GDP per capita of over US$ 14,000. It is highly dependent on a few sectors, in particular tourism. In the early 1990s, its banking sector was very liquid; there was no interbank market and no effective market for government securities and other instruments.
The Central Bank of Malta’s (CBM) operates monetary policy under an exchange rate peg. Under the CBM Act, foreign exchange reserves covers at a minimum 60 percent of CBM’s liabilities. In the early 1990s, before the start of financial sector reform, the CBM’s only monetary policy instruments, in addition to interest rate controls, were liquidity requirements. Capital controls also facilitated maintenance of the peg.
Financial market liberalization preceded capital account liberalization. Financial reforms started in the early 1990s in a favorable economic environment with large levels of international reserves, low inflation, and a low level of public debt. Trading of government stocks and equities commenced on the Malta Stock Exchange in 1992. Capital account liberalization was started in the early 1990s; the approach was very gradual, stretching over more than a decade.
Financial reform was supported by a transition to indirect instruments of monetary policy. The CBM introduced auctions of 14-day time deposits and repurchase agreements with securities to steer short-term interest rates. Its standing facilities created a corridor for the overnight money market rate, with a lower boundary set by the rate on the CBM’s overnight deposit facility, and rate on the overnight lending facility setting the upper boundary. In January 2004, the CBM adjusted its operational framework and introduced a narrower but symmetric corridor of 300 basis points around a central intervention rate. These changes were made to increase the efficiency of the monetary transmission mechanism through which changes in overnight interest rates impact market rates.
The Bahamas Monetary Policy Instruments
Current laws authorize the CBB to assess penalty for the nonobservance of reserve requirements at one tenth of 1 percent of the shortage calculated on a daily basis. However, the maximum penalty rate cannot exceed twice the bank rate.
Open position in domestic currency asset and liabilities is limited to B$500,000 either way, which requires commercial banks to sell or buy foreign exchange to or from the central bank if actual holdings exceed or fall short of this limit. The open position is calculated on a daily basis and exceptions are generally not granted. The CBB is currently reviewing the open position with the expectation of increasing the limit to B$5,000,000 either way.
| Description | Objectives | Remarks |
|---|---|---|
| 1. Central Bank Discount Rate Rate applies to borrowing by banks and nonbank financial institutions from the central bank. A surcharge can be applied to discourage frequent or heavy borrowing by banks. | Changes in the discount rate affect market interest rates, since the commercial banks’ prime rate is tied to it. Also, changes in this rate are used to signal the central bank’s view of the liquidity situation in the banking system, and achieve other objectives such as maintaining a reasonable spread between domestic and US rates, or to reduce debt service on mortgages when warranted by economic conditions. | Changes in the discount rate and corresponding adjustments in the prime rate have been infrequent since 1994. According to the CBB, varying interest rates through the discount rate would be less effective for consumer lending where there is little evidence that local borrowers display interest rate sensitivity. |
| 2. Reserve requirements The reserve requirements, calculated against commercial banks’ deposit liabilities, apply in two tranches—statutory reserves and liquid asset ratio (LAR). Statutory reserves comprise vault cash and banks’ deposits with the central bank. In addition to statutory reserves, the eligible assets for LAR are the treasury bills and government bonds, bonds issued by the Bahamas Mortgage Corporation, and commercial bank loans for low income housing development. | Changes in reserve requirements affect the liquidity position of commercial banks and their ability to extend credit. The CBB may increase the statutory reserve requirement up to 20 percent, and the LAR to 25 percent, of banks’ deposit liabilities. The reserve requirements also serve as a prudential objective, as a back-up for the banks’ deposit liabilities. | The CBB has not used changes in the rate of primary required reserves as an active tool of monetary policy. Increases in the secondary reserves ratio were also avoided as they would accentuate the bias for the captive market for government securities. Reserve requirements have not been changed since they were instituted in 1974 and remain fixed at 5 percent for statutory reserves and, for LAR, at 15 percent for demand deposit, and 20 percent for savings and fixed deposits. Penalties are assessed if actual reserves holding fall below requirement.1/ |
| 3. Capital Controls All outward capital transfers by residents, including purchases of securities and direct investments, require authorization by central bank.2/ | Used to avoid large and uncontrolled capital movement that could affect the balance of payments and deplete international reserves. | The CBB has forwarded a proposal for the gradual relaxation of some capital restrictions, which is currently being considered by the Government. |
| 4. Selective/prudential controls and moral suasion | Controls have been applied through use of margin, collateral requirements and other prudential limits on private sector loans. In addition, moral suasion is used to indicate to banks that they should restrict credit. | CBB has made frequent use of this instrument. Most recently, between September 2001 and August 2004, the CBB required banks to limit total private sector lending to outstanding balance at that time. Since August 2004 the CBB has been imposing maximum debt service ratio and minimum collateral requirements for personal loans. |
| 5. Other instruments Shifts in public sector bank deposits among commercial banks. | Amounts and timing of the shifts can be managed to affect banks’ liquidity position. | Not currently in use. The CBB used the placement of the social system’s deposits as a monetary instrument in the late 1980s. |
| 6. Open Market Operations Central bank buys and sells government securities to banks and nonbank institutions. | Objective is to add or reduce liquidity in the financial system (and the economy as a whole) thereby influencing the ability of financial institutions to provide credit to the private sector. | The CBB does not make use of open market operations for liquidity management purposes. Purchases of and sales of treasury bills are carried out in line with government financing objectives. |
Current laws authorize the CBB to assess penalty for the nonobservance of reserve requirements at one tenth of 1 percent of the shortage calculated on a daily basis. However, the maximum penalty rate cannot exceed twice the bank rate.
Open position in domestic currency asset and liabilities is limited to B$500,000 either way, which requires commercial banks to sell or buy foreign exchange to or from the central bank if actual holdings exceed or fall short of this limit. The open position is calculated on a daily basis and exceptions are generally not granted. The CBB is currently reviewing the open position with the expectation of increasing the limit to B$5,000,000 either way.
| Description | Objectives | Remarks |
|---|---|---|
| 1. Central Bank Discount Rate Rate applies to borrowing by banks and nonbank financial institutions from the central bank. A surcharge can be applied to discourage frequent or heavy borrowing by banks. | Changes in the discount rate affect market interest rates, since the commercial banks’ prime rate is tied to it. Also, changes in this rate are used to signal the central bank’s view of the liquidity situation in the banking system, and achieve other objectives such as maintaining a reasonable spread between domestic and US rates, or to reduce debt service on mortgages when warranted by economic conditions. | Changes in the discount rate and corresponding adjustments in the prime rate have been infrequent since 1994. According to the CBB, varying interest rates through the discount rate would be less effective for consumer lending where there is little evidence that local borrowers display interest rate sensitivity. |
| 2. Reserve requirements The reserve requirements, calculated against commercial banks’ deposit liabilities, apply in two tranches—statutory reserves and liquid asset ratio (LAR). Statutory reserves comprise vault cash and banks’ deposits with the central bank. In addition to statutory reserves, the eligible assets for LAR are the treasury bills and government bonds, bonds issued by the Bahamas Mortgage Corporation, and commercial bank loans for low income housing development. | Changes in reserve requirements affect the liquidity position of commercial banks and their ability to extend credit. The CBB may increase the statutory reserve requirement up to 20 percent, and the LAR to 25 percent, of banks’ deposit liabilities. The reserve requirements also serve as a prudential objective, as a back-up for the banks’ deposit liabilities. | The CBB has not used changes in the rate of primary required reserves as an active tool of monetary policy. Increases in the secondary reserves ratio were also avoided as they would accentuate the bias for the captive market for government securities. Reserve requirements have not been changed since they were instituted in 1974 and remain fixed at 5 percent for statutory reserves and, for LAR, at 15 percent for demand deposit, and 20 percent for savings and fixed deposits. Penalties are assessed if actual reserves holding fall below requirement.1/ |
| 3. Capital Controls All outward capital transfers by residents, including purchases of securities and direct investments, require authorization by central bank.2/ | Used to avoid large and uncontrolled capital movement that could affect the balance of payments and deplete international reserves. | The CBB has forwarded a proposal for the gradual relaxation of some capital restrictions, which is currently being considered by the Government. |
| 4. Selective/prudential controls and moral suasion | Controls have been applied through use of margin, collateral requirements and other prudential limits on private sector loans. In addition, moral suasion is used to indicate to banks that they should restrict credit. | CBB has made frequent use of this instrument. Most recently, between September 2001 and August 2004, the CBB required banks to limit total private sector lending to outstanding balance at that time. Since August 2004 the CBB has been imposing maximum debt service ratio and minimum collateral requirements for personal loans. |
| 5. Other instruments Shifts in public sector bank deposits among commercial banks. | Amounts and timing of the shifts can be managed to affect banks’ liquidity position. | Not currently in use. The CBB used the placement of the social system’s deposits as a monetary instrument in the late 1980s. |
| 6. Open Market Operations Central bank buys and sells government securities to banks and nonbank institutions. | Objective is to add or reduce liquidity in the financial system (and the economy as a whole) thereby influencing the ability of financial institutions to provide credit to the private sector. | The CBB does not make use of open market operations for liquidity management purposes. Purchases of and sales of treasury bills are carried out in line with government financing objectives. |
Current laws authorize the CBB to assess penalty for the nonobservance of reserve requirements at one tenth of 1 percent of the shortage calculated on a daily basis. However, the maximum penalty rate cannot exceed twice the bank rate.
Open position in domestic currency asset and liabilities is limited to B$500,000 either way, which requires commercial banks to sell or buy foreign exchange to or from the central bank if actual holdings exceed or fall short of this limit. The open position is calculated on a daily basis and exceptions are generally not granted. The CBB is currently reviewing the open position with the expectation of increasing the limit to B$5,000,000 either way.
The Bahamas: Use of Monetary Policy Instruments, 1981-2005
The CBB imposed a 35% equity requirement for consumer bank borrowing to restrain private sector credit demand. The effectiveness of this policy was limited by design shortcomings, as providers of in-store financing of consumer durables purchases substituted for direct consumer credit frombanks.
Financial sector stability became a concern during 1988-1994, when resources become scarce and banks bid up interest rates to attract deposits. The CBB suppressed such pressures by maintaining a ceiling on deposit interest rates.
Includes surcharges for frequent or heavy borrowing by banks during 1981-83.
The Bahamas: Use of Monetary Policy Instruments, 1981-2005
| Period | Direct Limits on Bank Credit | Borrower Equity Requirements | Direct Interest Rate Controls | Changes in Discount Rate | Changes in Reserve Requirements and/or penalties | Changes in Exchange Controls |
|---|---|---|---|---|---|---|
| 1981 | X3/ | X | ||||
| 1982 | X3/ | |||||
| 1983 | X3/ | |||||
| 1984 | ||||||
| 1985 | X | |||||
| 1986 | X | |||||
| 1987 | X | |||||
| 1988 | X1/ | X2/ | ||||
| 1989 | X1/ | X2/ | ||||
| 1990 | X1/ | X2/ | X | |||
| 1991 | X1/ | X2/ | ||||
| 1992 | X1/ | X2/ | X | |||
| 1993 | X2/ | X | ||||
| 1994 | X2/ | X | ||||
| 1995 | ||||||
| 1996 | ||||||
| 1997 | ||||||
| 1998 | X | |||||
| 1999 | X | |||||
| 2000 | ||||||
| 2001 | X | X | X | |||
| 2002 | X | X | ||||
| 2003 | X | |||||
| 2004 | X | |||||
| 2005 | X | X |
The CBB imposed a 35% equity requirement for consumer bank borrowing to restrain private sector credit demand. The effectiveness of this policy was limited by design shortcomings, as providers of in-store financing of consumer durables purchases substituted for direct consumer credit frombanks.
Financial sector stability became a concern during 1988-1994, when resources become scarce and banks bid up interest rates to attract deposits. The CBB suppressed such pressures by maintaining a ceiling on deposit interest rates.
Includes surcharges for frequent or heavy borrowing by banks during 1981-83.
The Bahamas: Use of Monetary Policy Instruments, 1981-2005
| Period | Direct Limits on Bank Credit | Borrower Equity Requirements | Direct Interest Rate Controls | Changes in Discount Rate | Changes in Reserve Requirements and/or penalties | Changes in Exchange Controls |
|---|---|---|---|---|---|---|
| 1981 | X3/ | X | ||||
| 1982 | X3/ | |||||
| 1983 | X3/ | |||||
| 1984 | ||||||
| 1985 | X | |||||
| 1986 | X | |||||
| 1987 | X | |||||
| 1988 | X1/ | X2/ | ||||
| 1989 | X1/ | X2/ | ||||
| 1990 | X1/ | X2/ | X | |||
| 1991 | X1/ | X2/ | ||||
| 1992 | X1/ | X2/ | X | |||
| 1993 | X2/ | X | ||||
| 1994 | X2/ | X | ||||
| 1995 | ||||||
| 1996 | ||||||
| 1997 | ||||||
| 1998 | X | |||||
| 1999 | X | |||||
| 2000 | ||||||
| 2001 | X | X | X | |||
| 2002 | X | X | ||||
| 2003 | X | |||||
| 2004 | X | |||||
| 2005 | X | X |
The CBB imposed a 35% equity requirement for consumer bank borrowing to restrain private sector credit demand. The effectiveness of this policy was limited by design shortcomings, as providers of in-store financing of consumer durables purchases substituted for direct consumer credit frombanks.
Financial sector stability became a concern during 1988-1994, when resources become scarce and banks bid up interest rates to attract deposits. The CBB suppressed such pressures by maintaining a ceiling on deposit interest rates.
Includes surcharges for frequent or heavy borrowing by banks during 1981-83.
APPENDIX: Chronology of Monetary Policy Decisions by Instrument22
Absolute limits on outstanding credit
September 2001: In the wake of the September 11 terrorist attacks on the United States and the significant falloff in tourism activity, the Central Bank imposed a freeze on outstanding bank credit to the private sector. Banks were instructed to provide new credit only to the extent of resources provided from ongoing repayments, but were at liberty to determine how such resources would be allocated within their portfolios.
August 2004: Based on the improved outlook for the Bahamian economy, including tourism and foreign investment, which going forward, are expected to provide stronger support for domestic consumption and imports; restrictions on domestic banks’ Bahamian dollar lending, in place since 20th September 2001, were lifted.
Borrower equity requirements
November 1990: To relieve pressure on the country’s external reserves vis-à-vis the weakened economic environment and unsustainable private sector credit demand, the Central Bank directed commercial banks to insist upon a minimum 35 percent down payment (equity) requirement on consumer loans.
January 1993: Due to improved liquidity conditions, the Central Bank lifted the 35 percent equity requirement on consumer installment credit. The ceiling on deposits was reduced to 6.75 percent and banks’ Prime Rate fell by 25 basis points to 7.75 percent.
May 1998: In light of an accelerating trend in consumer credit growth, the Central Bank instructed financial institutions to insist on a 25 percent down payment or equity requirement on new consumer loans.
January 1999: Citing an improved outlook for bank liquidity and external reserves, the Central Bank lifted the 25 percent down payment requirement from new consumer loans.
July 2001: In view of moderating economic activity, and in order to encourage a sustainable outcome for external reserves and bank liquidity, the Central Bank encouraged lending institutions to adopt a more conservative posture toward private sector lending, including more rigorous application of collateral requirements and scrutiny of creditworthiness.
August 2004: To ensure that credit expansion is consistent with economic growth, banks were advised to pay particular attention to borrowers’ credit worthiness, with the immediate adoption of the following guidelines: a) Limit the existing or resulting total debt service ratio (on the aggregate of personal loans, mortgages, rent, and property maintenance) to 40 percent −45 percent of ordinary monthly income. b) Require a minimum equity contribution of 15 percent on all personal loans, with the exception of those secured with mortgage indemnity insurance.
September 2004: In the aftermath of damages caused by Hurricane Frances, and to facilitate access by households and businesses to credit facilities for relief purposes, lending guidelines issued to domestic banks on 9th August 2004 were temporarily relaxed. Banks were advised that (a) the 15 percent equity contribution will not apply on such facilities, and (b) the threshold debt service ratio for the relevant borrowers was increased to 55 percent from the 40 percent −45 percent range.
Direct interest rate controls
December 1981: Amid historically low levels of liquidity, the Central Bank placed deposits totaling $12.0 million with select commercial banks at rates varying between 9 percent and 10 percent. In addition, banks were advised to limit the rate of interest paid on deposits to 10 percent so as to discourage the continuous shifting of deposits between institutions.
December 1987: an interest rate ceiling of 8.0 percent was imposed on all new deposits in order to limit abrupt shifts in deposits between institutions.
October 1988: Citing a need to avoid excessive upward pressures on lending rates amid tight liquidity and the bidding up of deposit rates among banks, the Central Bank maintained an 8.00 percent interest rate ceiling on all new deposits accepted by banks.
February 1992: In light of the trend in international interest rates and the prevailing weakness in the local economy, the Central Bank reduced the ceiling on deposit rates to 7.0 percent.
January 1993: Due to improved liquidity conditions, the Central Bank reduced the ceiling on deposits to 6.75 percent and banks’ Prime Rate fell by 25 basis points to 7.75 percent.
May 1993: As a result of excess liquidity in the system, the Central bank reduced the deposit rate ceiling to 6.25 percent.
April 1994: The Central Bank removed the 6.25 percent interest rate ceiling on deposit liabilities.
Changes in the discount rate
November 1980: To discourage commercial banks from availing themselves of the Bank’s accommodation in the wake of strong private sector demand and falling liquidity, the Central Bank imposed a surcharge of 2.0 percent on loans to banks, thus raising the cost of borrowing from the Central Bank to 13.0 percent.
November 1981: The Central Bank lifted the 2 percent surcharge on frequent borrowing by commercial banks.
January 1982: As part of its credit restraint policy, the Central Bank reinstated the 2 percent surcharge on frequent borrowing by commercial banks, which had been lifted in November 1981; while the effective bank rate was increased to 12 percent, the actual rate charged fluctuated between 10 percent and 12 percent.
April 1983: The Bank lowered its discount (bank) rate, the rate at which it lends to banks, to 9 percent from 10 percent. However, the rate for frequent and/or heavy borrowing was kept at 11 percent.
May 1985: In the context of slowing credit growth and rising external reserves and liquidity levels, the Bank decreased its Discount Rate by a full percentage point to 8.5 percent. Commercial banks in turn reduced their prime and savings rates by an equivalent amount, from 11.0 percent to 10.0 percent and 6.0 percent to 5.0 percent, respectively.
May 1986: The Central Bank reduced its Discount Rate from 8.5 percent to 7.5 percent, responding to high levels of liquidity in the local banking system, and consistent with prevailing trends in international interest rates. Commercial banks followed by decreasing their prime lending and savings rates to 9.0 percent and 4.0 percent, respectively.
December 1987: In an effort to discourage commercial banks’ use of the Bank’s resources, the Discount Rate was increased to 9.00 percent from 7.50 percent.
February 1992: In light of the trend in international interest rates and the prevailing weakness in the local economy, the Bank lowered its Discount Rate to 7.5 percent from 9.0 percent. Commercial banks responded by reducing the Prime Rate to 8.0 percent.
May 1993: As a result of excess liquidity in the system, the Central bank reduced the Discount Rate to 7.0 percent.
April 1994: In an attempt to stimulate the domestic economy, the Central Bank decreased the Discount Rate by 50 basis points to 6.5 percent, and commercial banks lowered their Prime lending rate by the same amount to 6.75 percent.
June 1999: Amid buoyant liquidity conditions and healthy, expanding levels of external reserves, the Central Bank reduced the Discount Rate by 75 basis points to 5.75 percent, in order to encourage reduced lending rates on mortgages and loans to the productive sectors. Commercial banks announced a similar reduction in their Prime lending rate to 6.00 percent, to take effect from July 1999.
February 2005: After considering the persistent level of excess liquidity within the banking system and the outlook for these conditions, which remained buoyant, the Central Bank reduced the Discount Rate by 50 basis points to 5.25 percent, effective February 14 2005. The Bank requested that financial institutions follow suit with a congruent reduction in the Prime Rate from 6.00 percent to 5.50 percent and similar reductions in their lending schedule. Commercial banks announced the reduction in the Prime Rate to 5.50 percent, effective February 15, 2005.
Primary and secondary reserve requirements and/or the associated penalties
May 1981: The secondary reserve ratio (liquid asset ratio) was established via a circular issued to all banks, stipulating the manner in which the LAR was to be calculated. The ratio was set at 20 percent against demand deposits, 15 percent against time and savings deposits and 15 percent against fixed deposits and borrowing from commercial banks and Other Local Financial institutions.
August 1990: The Central Bank Act was amended to allow the Bank to impose fines for secondary reserve deficiencies. The permissible penalty, also to be applicable to primary reserve shortfalls, was set at a maximum of twice the prevailing discount rate—to be applied daily—at the time of the deficiency.
December 1990: As a result of amendments passed to the Central Bank Act in August 1990, the Central Bank issued revised Operating Circulars, imposing fines on both banks’ secondary and primary reserve deficiencies at an annual rate of one percent of the deficiency.
Exchange controls
November 2001: As a further measure to protecting external reserves and liquidity, on November 30th the Central Bank temporarily increased the net external exposure limit on commercial banks’ foreign currency sales to the public to $5.5 million from $0.5 million.
March 2002: Given limited usage in the face of the credit tightening measures and more general restraint in private sector consumption, the move that increased commercial banks net external exposure limit was rescinded and the original $0.5 million limit restored.
References
Bahamas International Stock Exchange, “Steps to be undertaken to ensure the viability of a fully operational Bahamas securities exchange,” Report of the Bahamas Stock Exchange Committee.
Central Bank of The Bahamas, “Chronology of Monetary Policy and Related Developments” (published on the CBB’s website).
Central Bank of The Bahamas, “Quarterly Economic Review,” Vol. 13, n. 4, December 2004.
Central Bank of The Bahamas, “Monetary policy in The Bahamas,” 2002.
Central Bank of The Bahamas, “A Targeting Framework for External Reserves,” paper prepared for the MPC, December 19, 2003 (unpublished).
Central Bank of The Bahamas, “Annual report and statement of accounts,” 2004.
Central Bank of Malta, “Quarterly Review,” 2004:2.
IMF, Central Banking Department. “The Bahamas: Reform of the Monetary Management System,” January 1991.
IMF, Monetary and Financial Systems Department, “Implementation of Monetary Policy at Different Stages of Money Market Development,” May 2004. Main paper and country cases and appendices.
IMF, “The Adoption of Indirect Instruments of Monetary Policy,” Occasional Paper 126, June 1995.
Jeanne, Olivier and Romain Ranciere, “The Optimal Level of International Reserves for Emerging Market Countries: Formulas and Applications,” IMF, Research Department, May 17, 2005 (unpublished).
Schaechter, Andrea “Implementation of Monetary Policy and the Central Bank’s Balance Sheet,” IMF Working Paper WP/01/149.
World Bank, “Development of the government securities market in The Bahamas,” November 2002 (unpublished).
Prepared by Eric Verreydt (WHD).
The CBB was created in 1974, and continued the longstanding policy of pegging the exchange rate pursued by its predecessor institutions, The Bahamas Monetary Authority and the Commissioner of Currency (a currency board).
The classification of objectives and instruments is taken from the CBD’s January 1991 technical assistance report, “The Bahamas: Reform of the Monetary Management System.”
Excess international reserves are so-called “usable reserves,” i.e., reserves that are in principle available to finance a balance-of-payments deficit. The MPC is the monetary policy decision-making body at the CBB. It is chaired by the governor. Members currently include the deputy governor, head of research, economic advisor, inspector of banks, and the managers of bank supervision, accounting, computers, banking, and exchange controls. The MPC ultimately assesses reserves against what is needed to maintain confidence in the exchange rate peg. Since 2003, reserves have been targeted at 100 percent of base money or more, and at least 14 percent of M2, well in excess of the statutory limit, thus sharply reducing the potential availability of excess reserves to cushion external shocks.
Real sector indicators measure the capacity of reserves to smooth domestic absorption in response to crises. Policymakers, including the MPC, often use a rule of thumb of maintaining reserves equivalent to three months of imports. By another real sector yardstick (NIR-to-GDP ratio), reserves in The Bahamas, though they are relatively low relative to other emerging market economies, reached a historical peak in 2004 (see Figures 1 and 2).
Loans and advances to the public sector were small, as banks hold mainly government bonds. Undisbursed commitments to the private sector as of September 2001 were not affected by the ceiling. The insurance sector (which directly provides mortgages), though not subject to any ceiling, did not disintermediate on a large scale.
The main capital restrictions include a 25 percent premium on outward investment through an Investment Currency Market operated by the CBB; and prohibition for nonresidents to invest in Bahamian securities, except by special approval. A detailed description of instruments, the frequency of their use, and a chronology of monetary policy decisions are given in the Appendix.
Collateral for discount loans have in practice only involved the use of government debt instruments (registered stocks and treasury bills). The amount of any loan given to banks may not exceed 85 percent of the market value of the collateral, and its maturity cannot exceed the lesser of 92 days or the remaining maturity of the collateral.
The circumstances of individual banks however were not uniform.
Nine banks operate in the domestic commercial banking sector, of which one is government owned (Bank of the Bahamas); two are locally owned private banks (Commonwealth Bank and British-American Bank); five are subsidiaries of foreign banks (Citibank; Finance Corporation of The Bahamas; First Caribbean International Bank; First Caribbean International Finance Corporation; Scotiabank Bahamas); and one is a branch of Royal Bank of Canada. Eight of these banks are members of the association of clearing banks and with the CBB are at the core of the payment system. In addition there are 11 nonbank financial institutions of smaller size.
Bank deposit and lending rates are closely linked to the prime rate; the latter has followed signals given by the CBB through changes in the discount rate. However, past experience suggests that competition for resources intensifies sharply during episodes of tight liquidity (1988–94). While there may be elements of rigidity in the financial system, bank supervision reports show onshore banks, including locally-owned banks, to be well managed from a prudential and operational standpoint.
Bank lending rates are all floating rates, including for mortgages.
See footnote 7 for a definition of the premium on investment currency.
The auction is open to the general public, but the demand is nil as the yield is below bank deposit rates.
The majority of these bonds carries a floating rate linked to the prime rate.
Commercial banks’ monetary liabilities in domestic currency amounted to close to B$4 billion, or the equivalent of about 70 percent of GDP at end-2004 (about 50 percent of GDP a decade earlier).
Free bank reserves, which are unremunerated, amounted in March 2005 to the equivalent of 37 percent of NIR, or 6 percent of M3. This is about three times the apparent desired level, which in the long run appears to be in the range of 1½–2 percent of M3.
The spread between the interbank rate and the discount rate appears to be small. The rate on fixed-term interbank deposits in March 2005 was 4.25 percent, and the discount rate was 5 percent.
The choice of auctions techniques is not linked to the choice of operational targets, though volume tenders may be preferable in shallow markets as they help stabilize interest rate expectations. See IMF, Monetary and Financial Systems Department, “Implementation of Monetary Policy at Different Stages of Money Market Development,” May 2004.
Andrea Schaechter, “Implementation of Monetary Policy and the Central Bank’s Balance Sheet,” IMF Working Paper WP/01/149.
Open-market-type operations take place on primary financial markets, while open-market operations are conducted on secondary markets.
Source: Central Bank of The Bahamas. Selected excerpts from the Chronology published on the CBB’s website, classified by type of monetary policy instrument.
