Appendix Monetary Policy Implementation in Small Countries
62. Some small countries have been able to develop effective market-based operational frameworks for the conduct of monetary policy. Countries that succeeded had typically achieved significant progress in establishing a strong market infrastructure, although the money market may have been restricted to a well functioning interbank market and at times, a thin government securities market. Countries that did not succeed in establishing competitive markets have at times been forced to resort to moral suasion, or even reverted to direct controls.
63. Following the four -stage stylized process proposed in the paper, countries with limited market participation, in particular due to the small size of their economy, may not go beyond Stage Two, that is the “Interbank Market Development Stage.” For countries to be able to reach such a stage of market development, they need to have developed an efficient payments and settlement infrastructure to encourage individuals and corporations to use the banking system to settle transactions. Once the banks have developed a broad deposit base, they can expand their lending operations. They also need to have made significant progress in establishing a sound and competitive banking system so that an interbank market can emerge. The experience gathered in the case studies suggests that interbank markets with four or five participants can be efficient provided none of them dominates the market.
64. Emergence of a functioning interbank market allows the central bank to start conducting monetary operations with a view to manage overall liquidity conditions in the system. Henceforth, monetary policy can be anchored on the central bank’s balance sheet, and the shift from rules-based instruments to money market operations can be initiated, with a view to influence liquidity in the system through monetary operations to change the size or composition of the central bank’s balance sheet. It needs to be emphasized that such operating such a framework requires the development of a liquidity forecasting capacity at the central bank.
65. A possible mix of rules-based instruments and money market operations for such countries would involved reliance on money market operations conducted in the interbank market, supplemented with reserve requirements that can be met on average over the period and standing facilities to set a corridor for interbank market rates, as follows:
Reserve requirements. They may be maintained on average over the period. Assets eligible may include deposits with the central bank and, in incipient interbank markets, central bank securities issued to withdraw excess liquidity. To limit the distortionary effect, particularly if the ratio is high, deposits with the central bank can be remunerated at rates in line with market rates, and the central bank securities eligible to satisfy the requirement issued through an auction.
Standing facilities. Combining a deposit and a refinancing of standing facilities to form a corridor for interbank market rates can both help stabilize the market and provide room for market development. Reliance on standing facilities is particularly useful to absorb temporary liquidity shocks, in a context where the market infrastructure may not be in place to allow the central bank to undertake fine tuning money market operations.
Money market operations. Auctions of central bank credit (when the central bank needs to lend to the system) or of central bank bills (when the central bank needs to borrow from the system). The central bank can use volume tenders, but needs to ensure that the interest rate it applies is positive in real terms.
66. Participation in a monetary union can help establish reliance on money market operations for the conduct of monetary policy. Participation in a monetary union entails losing monetary policy independence and the exchange rate as a mechanism to adjust to shocks. However, that loss may not be significant for small open economies if the degrees of freedom for an independent monetary policy were restricted due to the relevance of the exchange rate. Thus, the benefits that participation may bring in fostering fiscal discipline, such as through the implementation of fiscal convergence benchmarks, may be more important. Also, in the case of small countries, the central bank is the agency most likely to be in a position of strength in terms of the human and technical resources to develop an institutional capacity that can be used to advise member countries’ fiscal authorities, or to develop and monitor the fiscal convergence benchmarks, therefore facilitating the coordination of fiscal and monetary policy. Finally, participation in a monetary union can facilitate money market development. In particular, it may help reach the critical size that is needed for markets to emerge.
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The instruments are ordered starting with those that can be used in shallow money markets, and ending with those that need developed money market to be effective. Some of them (reserve requirements and standing facilities) may be used at all stages of money market development.
The country cases (Eastern Caribbean Currency Union, Democratic Republic of the Congo, Egypt, Kyrgyz Republic, Malta, The Gambia, Tonga, Tunisia, Uganda, Ukraine, Vanuatu, and Zambia) are presented in a Supplement.
A structural liquidity surplus may build up due to capital or foreign aid inflows or export booms in commodity-producing countries, leading to an increase in international reserves.
See Appendix I in the Supplement for a survey of the transmission channels.
In the case of Malta, the operations of the central bank in the government securities markets may have led to the perception that it attempted to manage interest rates across the yield curve.
However, when the substitutability between domestic and foreign assets is high the exchange rate channel may play a role due to a high response of the exchange rate to policy-induced changes in interest rates. This is the case in dollarized economies.
See Appendix II in the Supplement for the ECB and Banque de France experiences.
Fiscal dominance also includes central bank’s provision of subsidized funds to priority sectors; conducting foreign exchange transactions at nonmarket clearing levels. Such activities should be discontinued in the early stage of financial reforms.
In the Democratic Republic of the Congo, the central bank resorted to a rationing of currency; in Tonga, it resorted to bank-by-bank credit ceilings and moral suasion.
Participation in a monetary union entails losing monetary policy independence and the exchange rate as a mechanism to adjust to shocks. However, that loss may not be significant for small open economies if the degrees of freedom for an independent monetary policy were restricted due to the relevance of the exchange rate. Thus, the benefits that participation may bring in fostering fiscal discipline may be more important (Fasano, 2003).
Analysis of the cost and benefits of a monetary union needs to take into account factors outside the scope of this paper, including patterns of trade, correlations of economic growth, and political and institutional considerations.
See Sundararajan, Dattels, and Blommestein (1997), and IMF and World Bank (2001) for a survey of best practices regarding market-based public debt management frameworks.
See Appendix III in the Supplement for a review of liquidity management and forecasting.
It is agreed that a liquidity surplus does not hamper monetary policy transmission in deep markets.
See Appendix IV in the Supplement for a review of experiences in this regard.
In using reserve requirements for liquidity management purposes it is, however, advisable to avoid frequent changes in the level of the ratio in view of the disruptive effects this may have, particularly in shallow markets or when there is unevenness of the distribution of excess reserves among banks.
As evidenced by the country experiences presented in Appendix III in the Supplement, other rules-based measures may be used, such as mandatory deposits with the central bank, or switching government deposits from the commercial banks to the central bank.
While such a framework is a second best solution, it can serve until a stronger one is set up.
These findings for small countries are corroborated by a recent study by the Group of Ten (2001) on the consequences of financial sector consolidation in large countries.
Desirable transparency practices are set out in the IMF’s Code of Good Practices on Transparency in Monetary and Financial Policies.
See IMF and World Bank (2001) for details.
Effective coordination between the financial supervisor and the monetary authorities is critical to underpin market development.
A summary of the paper findings and concludions for small countries is presented in an Appendix.
Reliance on less frequent OMOs allows the central bank to accept a wide range of assets taken as collateral.