This Selected Issues paper on Samoa reviews limitations to the existing framework of monetary policy, and suggests ways to improve its effectiveness. It examines current instruments at the disposal of the central bank to conduct monetary policy, before showing why monetary policy execution can be sometimes difficult. It also shows that such problems are not uncommon in economies with shallow financial markets. The paper also takes stock of developments since the early 1990s, and asks what major impediments to sustained private development remain.

Abstract

This Selected Issues paper on Samoa reviews limitations to the existing framework of monetary policy, and suggests ways to improve its effectiveness. It examines current instruments at the disposal of the central bank to conduct monetary policy, before showing why monetary policy execution can be sometimes difficult. It also shows that such problems are not uncommon in economies with shallow financial markets. The paper also takes stock of developments since the early 1990s, and asks what major impediments to sustained private development remain.

I. Improving the Effectiveness of Monetary Policy1 in Samoa

A. Introduction

1. The framework for monetary policy in Samoa has improved as part of the comprehensive program of reforms started in the early 1990s. The management of monetary policy has shifted from direct controls over the banking system to indirect instruments, which has helped strengthen the effectiveness of monetary policy, but given the shallowness of financial markets, policy execution is sometimes difficult.

2. This paper discusses the limitations to the existing framework of monetary policy, and suggests ways to improve its effectiveness. The paper examines current instruments at the disposal of the central bank to conduct monetary policy, before showing why monetary policy execution can be sometimes difficult. It also shows that such problems are not uncommon in economies with shallow financial markets. Finally, the paper suggests possible measures to improve the effectiveness of monetary policy.

B. How Is Monetary Policy Conducted and How Effective Is It ?

3. The CBS introduced indirect monetary policy instruments in 1998. Financial deregulation measures, initiated as part of the government’s comprehensive reform program, led to the removal of direct controls over the banking system and the introduction of indirect instruments. The CBS eliminated controls over interest rates, removed credit ceilings and the liquid asset ratio (LAR) it imposed on banks. Instead, the CBS moved to open market operations (OMO). It started issuing securities through tenders, and introduced repurchase agreement (repo) and discount windows. In this framework, the conduct of monetary policy requires the regular issuance of CBS securities. Both repo operations and the discount window of the CBS securities are considered to be a standing facility whereby banks can voluntarily have assess to liquidity.

A01ufig01

CBS Securities

(Stock, millions of tala)

Citation: IMF Staff Country Reports 2007, 184; 10.5089/9781451840735.002.A001

Source: IMF, International Financial Statistics.

4. However, credit growth can not always be controlled through interest rate-based instruments. Given its small size and the importance of government operations in the economy, major projects are often initiated by the government, and may therefore not be sensitive to interest rates.

Samoa: CBS Securities

  • CBS securities have maturities ranging from 14 to 365 days and are issued through Dutch style auctions.

  • While in theory, commercial banks, nonbank financial institutions, private nonfinancial companies, church groups, trusts and members of the public are all eligible to participate, only commercial banks have so far been active participants.

  • There is no secondary market on CBS securities.

  • The CBS’s official rate is a weighted average of interest rates on all CBS securities issued in a month.

5. CBS securities are issued through auctions, but resulting interest rates may not always reflect liquidity conditions. The CBS sets an acceptance range for the tender rate, which is usually lower than commercial banks’ lending rates given the low credit risk of the CBS. If the interest rate set at the auction is above what the CBS is willing to offer, it may decide not to issue securities. As such, auctions of CBS securities are not fully competitive. In addition, the variety of participants in auctions is limited: only commercial banks are currently participating.

6. Moreover, the interbank money market and the securities markets are underdeveloped in Samoa. The interbank market is in its infancy: only commercial banks2 participate in the interbank money market with, until recently, one bank raising liquidity and two other banks providing liquidity. Also, besides CBS securities, there are no other risk-free securities that could be used for OMO: given its strong fiscal track record, the government has not issued any securities. Finally, there is no secondary market for CBS securities.

7. Recent events have demonstrated some difficulties with existing instruments when faced with the need to tighten monetary policy. Recent events can be divided into two parts: in the second half of 2005, bank lending surged ahead of the South Pacific Games and because of major government projects (including the new Development Bank of Samoa building), which accelerated import growth. The CBS tried to tighten monetary policy by issuing CBS securities and guide interest rates gradually higher, but banks did not bid. With its securities issuance program frozen, the CBS could not show any increase in short-term rates. The intended monetary tightening did not succeed and private sector credit growth remained unabated. As a result, Samoa lost a significant amount of foreign reserves, with the import coverage ratio declining by 1½ months in 11 months (from May 2005 to April 2006). Eventually, the CBS had to use moral suasion to persuade banks to curb lending.

8. By the first half of 2006, liquidity conditions became very tight. In addition to lending commitments, banks became faced with large payments for the restructuring of state-owned Polynesian Airlines and dividends to several foreign parent companies. Given insufficient holdings of securities, banks were unable to tap the discount facility. To allow banks to settle these payments, the CBS resorted to lowering the Statutory Reserve Deposit (SRD) rate from 4.8 percent to 3.5 percent in October 2006.

A01ufig02

Selected Liquid Assets Held by Commercial Banks

(Millions of tala)

Citation: IMF Staff Country Reports 2007, 184; 10.5089/9781451840735.002.A001

Source: IMF, International Financial Statistics.

9. The tight liquidity situation also led to the emergence of an interbank money market. First, commercial banks dealt with it by rediscounting all the CBS securities they held. This was however not enough, and one commercial bank with insufficient liquidity resorted to borrowing in the interbank market from two other banks. This helped kick start the interbank money market. The amount of transactions increased from March 2006: according to the CBS, interbank trading volumes rose to tala 18 million a month in 2006 from tala 3 million in 2005. Also, reflecting the tight liquidity, interbank rates rose.

A01ufig03

Interbank Money Market Transaction

Citation: IMF Staff Country Reports 2007, 184; 10.5089/9781451840735.002.A001

Source: CBS.

C. Challenges of Monetary Policy in Similar Economies

10. As in other Pacific islands economies, Samoa’s economy is particularly vulnerable to shocks. It is a small economy with a sizable trade deficit and limited access to international financial markets. Samoa’s balance of payments is dominated by remittances from overseas Samoans and travel income (amounting to 24 and 20 percent of GDP respectively in 2005-06). Remittances are generally stable but receipts from tourism can be volatile and significantly affected by natural disasters such as cyclones. This has happened in the past: in 1991, travel income declined by 20 percent following two cyclones, Ofa and Valerie. Samoa’s external position can also be affected by domestic shocks, such as a deterioration in the fiscal situation or rapid private credit growth. In these conditions, monetary policy should be able to deal with shocks affecting the balance of payments in order to preserve the foreign reserve position and maintain the basket peg.

11. Several factors can impede the effectiveness of monetary policy. There could be macroeconomic factors: fiscal dominance, undeveloped government securities market and structural liquidity surplus. Alternatively, financial markets may not be sufficiently developed: the interbank market may be shallow, the secondary market for government or central bank securities may not be active. Finally, the institutional framework may not be adequate: central bank autonomy could be lacking, the liquidity forecasting framework and liquidity payment systems could be weak. These factors are recurrent to various degrees throughout the Pacific islands region, but in Samoa, the effectiveness of monetary policy is mostly limited by the insufficient development of financial markets.

12. The effectiveness of market-based instruments depends on the level of development of financial markets. There are usually three steps in the development of market-based monetary policy: first, financial intermediation is developed; then the interbank market takes off before finally financial markets develop. At the end of the third step, liquidity management can fully rely on market-based instruments.3 Samoa is in the process of moving to the second stage.

13. In some Pacific islands, central banks had to revert to the use of direct instruments when faced with difficulties in controlling liquidity. The National Reserve Bank of Tonga (NRBT) used reserve requirement control and credit ceilings to deal with the rapid monetary growth in the late-1990s. Since then, the NRBT has often relied on the reserve requirement ratio and credit ceilings to control the liquidity. Similarly, the Reserve Bank of Vanuatu (RBV) introduced LAR to induce commercial banks in holding government securities and/or the RBV notes (the central bank securities).

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D. What Could Be Done to Improve the Effectiveness of Monetary Policy?

14. Several measures could be considered to improve the effectiveness of monetary policy. Some measures focus on improving the current framework relying on indirect instruments. Other measures deal with possible situations of tight liquidity.

Monetary Policy Effectiveness

15. The development of well functioning interbank money market and securities markets is essential to ensure an effective monetary policy, especially when tightening. Doing so would require increasing the variety of market participants in the interbank market and in auctions of CBS securities. This could be done by having structurally cash rich entities such as the National Provident Fund (NPF) participating in the interbank market, as well as in auctions of CBS securities. Also, broadening the CBS’s acceptance range for rates at auctions could improve the determination of interest rates. The development of government securities would also be an important step: this would provide an alternative to CBS securities for the conduct of open market operations and relieve the CBS from fully bearing the cost of the tightening adjustment.

16. If the development of Samoa’s financial markets remains limited, the CBS could in some circumstances revert to direct instruments to slow credit growth. This should however be done only as a last resort. More frequent uses of the SRD as an instrument of monetary policy could be considered. This would call for changing existing rules requiring cabinet approval for changes in SRD rates. The reintroduction of LAR could encourage financial institutions to hold CBS securities, strengthening the securities market, and hence making interest rate signals more meaningful. Already, all commercial banks have an internal rule for holding certain percentage of their assets in risk free assets for prudential purposes.

17. Further strengthening of the CBS communication policy could enhance the accountability and transparency of monetary policy and guide market expectations. Further disseminating the central bank’s views on the Samoan economy and its monetary policy stance to the private sector and the public would help guide market expectations. At the same time, the CBS could clarify its monetary policy objective. While it is true that under the current framework, the CBS can influence inflation, reaffirming that the CBS’s objective is the maintenance of the peg, with the import coverage ratio as an ultimate target would help strengthen the transparency of monetary policy.

Liquidity Management

18. In case of very tight liquidity conditions, the CBS could expand the range of acceptable assets for OMOs. Introducing foreign exchange swap operations for OMOs could be one possibility. When the amount of CBS securities in the market is limited, the CBS could buy U.S. dollars spot from banks with a repurchase agreement to supply liquidity. At the same time, shifting to an averaging for the reserve requirement ratio during the maintenance period would ease commercial banks’ liquidity management. Currently, banks have to meet the reserve requirement ratio at all time during the maintenance period. Shifting to an averaging within the maintenance period would provide flexibility for banks’ daily liquidity management.

19. The introduction of a “Lombard”-type standing facility could also improve the liquidity management. Samoa has two standing facilities: a discount facility and a repo facility for CBS securities. Introducing a “Lombard”-type facility would add a lender of last resort facility when a bank faces binding liquidity conditions and would be useful for setting up an upper bound on interbank interest rates. Also, current repo operations could be transformed into longer term OMO instruments allowing the CBS more flexibility to control liquidity conditions beyond the overnight maturity thereby helping to guide interest rates. “Lombard”-type facilities would give banks access to a facility to raise liquidity without having to sell securities. However, interest rates on “Lombard”-type facility should be set as at a punitive level so as not to impede the development of the money market.

20. Improvement of the quality of liquidity forecast and data would also be helpful. Recently the CBS started improving the method of liquidity forecast with technical support from the Fund’s MCM Department. Further improvement of liquidity forecast is needed so as to enable the CBS to act early on.

E. Conclusion

21. Despite the introduction of indirect monetary policy instruments by the CBS in the late-1990s, the recent episode has shown that current instruments are not enough. The CBS was not able to slow the rapid growth in credit using its indirect instruments alone. It had eventually to resort to moral suasion.

22. The development of a well functioning interbank money market and securities markets together with a further strengthening of the CBS’s communication policy are needed. Developing financial markets, and especially money markets is a required condition for a country to rely on indirect monetary policy instruments. To do so would require expanding the number of participants in money markets, and diversify the securities, by eventually introducing government securities. Also, strengthening the CBS’s communication policy could enhance the accountability and transparency of monetary policy and guide market expectations.

23. Meanwhile, an increase in the target for the import coverage ratio of foreign reserves could give the CBS a needed cushion. Given the vulnerability of the economy to shocks, and past experiences of rapid losses in foreign reserves, an increase in the import coverage target for foreign reserves from the current four months to five months would give the CBS an additional cushion. This would be especially important under the current conditions of limited effectiveness of monetary policy.

References

  • Buzeneca, Inese, and Maino, Rodolfo, 2007, “Monetary Policy Implementation: Results from a Survey,” IMF Working Paper No. 07/7 (Washington: International Monetary Fund).

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  • Laurens, Bernard, 2005, “Monetary Policy Implementation at Different Stages of Market development,” International Monetary Fund, Occasional Paper No. 244 (Washington: International Monetary Fund).

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1

prepared by aiko mineshima (ext. 36156)

2

There are four major commercial banks in Samoa. Two (ANZ and Westpac) are subsidiaries of foreign banks and the rest are domestic banks (National Bank of Samoa and Samoa Commercial Bank).

3

See Laurens (2005) and Buzeneca et al (2007).

Samoa: Selected Issues and Statistical Appendix
Author: International Monetary Fund