Financial programs supporting stand-by arrangements in the upper credit tranches typically include ceilings either on the domestic credit extended by the central bank or on the domestic credit extended by the banking system as a whole. 1 Domestic credit ceilings are applied whether a country has a fixed or a flexible exchange rate. The emphasis placed by the Fund on domestic credit has recently been subjected to criticism. One criticism arises from the fact that, whereas domestic credit expansion is the important determinant of international reserve developments, it is the rate of monetary expansion that is the important determinant of price level and income level developments. A recent assessment of the economic outlook in the United Kingdom concluded:
As a concept, DCE [domestic credit expansion] is less appropriate than sterling M3 for monitoring the overhang of purchasing power which is a potential risk of an inflationary avalanche. DCE is primarily an operational device for enforcing a squeeze on the domestic money supply of a country whose balance of payments is leading to a loss of reserves…. [Sterling M3] should be reinstated as “the focus of our monetary policy”….2
In the context of flexible exchange rates, domestic credit ceilings have been criticized as being inappropriate; the overall balance of payments is seen as the result of official intervention policy and not the result of credit expansion. In 1977, a number of distinguished economists reported that: “The IMF recommendations for control of domestic credit expansion rather than money growth have no rationale in a world of floating exchange rates. Their proposals are a poor substitute for effective policies that can reduce inflation and increase growth.” 3 The purpose of this paper is to examine the appropriateness of domestic credit ceilings under alternative exchange rate regimes and to assess whether it would be beneficial to replace or supplement domestic credit ceilings with money supply ceilings.
The structure of this paper is as follows. Section I discusses the concept of domestic credit in relation to the more familiar concept of the money supply, and examines a number of definitional and measurement problems. Section II compares domestic credit and money ceilings under exchange rate regimes where there is a known predetermined parity or target for the exchange rate. Section III compares domestic credit and money ceilings under flexible exchange rates.
Mr. Day was an economist in the External Adjustment Division of the Research Department when this paper was prepared. He is an external graduate of the University of London and received his doctorate from the University of Birmingham.
See G.G. Johnson and Thomas M. Reichmann, “Experience with Stabilization Programs Supported by Stand-By Arrangements in the Upper Credit Tranches, 1973-75” (unpublished, International Monetary Fund, February 28, 1978); and Richard C. Williams, “Evolution of Alternative Forms of Credit Ceilings” (unpublished, International Monetary Fund, May 26., 1971).
“Economic Outlook,” Midland Bank Review (Summer 1978), p. 9.
See the statement of the Shadow European Economic Policy Committee (made jointly by Messrs. Karl Brunner, Allan H. Meltzer, Peter Bernholz, André Fourcans, Michéle Fratianni, Brian Griffiths, Pieter Korteweg, Manfred J.M. Neumann, Michael Parkin, and Jean-Jacques Rosa), reprinted in the U. S Congressional Record, Vol. 123 (June 21, 1977), p. S 10344.
Although the term “domestic credit expansion” is normally used to refer to the banking system as a whole, the majority of stand-by arrangements have placed ceilings on the domestic credit extended by the central bank (or monetary authorities) only. The terms “domestic credit” and “net domestic assets” are synonymous.
Aside from problems concerning revaluations, interest earnings, and retained profits, the flow variable—domestic credit expansion—is simply the change in the stock variable—domestic credit—over the relevant time period.
Lending to the overseas sector is most important in countries, such as the United States and the United Kingdom, that have major international financial centers. In other countries, there is a tendency to include lending to nonresidents as a foreign asset rather than as a domestic asset. From a theoretical point of view, such a practice is not to be recommended, for reasons given later on.
For simplicity only, this section uses primarily “fixed exchange rate language” where credit is assumed to affect the balance of payments rather than the exchange rate.
There is a sense in which credit extended to the overseas sector may be seen as beneficial for the balance of payments. This is when credit is extended for the purpose of financing domestic exports. However, exports financed in this way give rise to no inflow of funds through the exchange market. In the absence of significant imperfections in the domestic and international credit markets, credit extended ostensibly for this purpose is more appropriately viewed as credit extended for the purpose of accommodating an outflow of capital or precluding the need for an inflow of capital—a purpose detrimental to the balance of payments.
It is shown in Section III that, in this context, net capital imports (exports) by commercial banks lead paradoxically to a reduction (an increase) in the money supply.
See, for example, J.J. Polak and Victor Argy, “Credit Policy and the Balance of Payments,” Staff Papers, Vol. 18 (March 1971), pp. 1–24 Manuel Guitian, “Credit Versus Money as an Instrument of Control,” Staff Papers, Vol. 20 (November 1973), pp. 785–800; and William H.L. Day, “A Comparison of Alternative Domestic Credit and Money Aggregates as Instruments of Control” (unpublished, International Monetary Fund, March 16, 1977). The simplest possible monetary model of balance of payments determination treats the demand for money as exogenous. This immediately leads to the result that shifts in the demand for money must be accommodated by either movements in domestic credit or by balance of payments flows. Under such a model, it is futile for the authorities to attempt to control the supply of money. Unless supply is allowed to adjust, shifts in the demand for money will result in persistent money market disequilibrium, persistent balance of payments disequilibrium, and limitless cumulative changes in net foreign assets. Controlling domestic credit is then the only policy option open to the authorities.
A variable is said, in this paper, to be controlled rather than subject to a ceiling when the analysis implicitly assumes that the variable is maintained at a predetermined level. Obviously, a ceiling on a variable per se has no immediate constraining effect if the actual level of the variable is well within the ceiling or if there is an incipient reduction in the variable from its ceiling. In particular, a domestic credit ceiling only precludes sterilization when domestic credit is already at its ceiling and there is a payments deficit.
For simplicity, this paper distinguishes only the trade account and the capital account in the balance of payments. This is to avoid ambiguities that arise when one is considering the current account. For example, it is uncertain whether an incipient decrease in the money supply will improve or worsen the current account; while the visible trade balance will improve, the invisible trade balance may worsen owing to increased interest payments on capital pulled into the country.
Holding domestic credit constant and having an endogenous money supply will not necessarily lead to a steady state in which the trade account is in balance. For example, if new opportunities for profitable investment within a country are continually opening up, or if the public sector deficit is excessive in relation to the private sector’s propensity to save, a steady state could well be reached in which the money supply is constant and the overall balance of payments is in equilibrium, but in which there is a trade deficit that is offset by a continuous inflow of capital.
For a fuller discussion, see Day,op.cit., pp. 17–20.
This problem is likely to be more severe for deficit countries sterilizing outflows rather than inflows (and surplus countries sterilizing inflows rather than outflows). Owing to the asymmetrical nature of the risk of parity changes, it is possible that an increasing stock of capital could flow out of a deficit country without a growing interest rate discrepancy against the country, while a growing interest rate discrepancy in favor of the country would be needed to induce an increasing stock of capital to flow into the country.
See Day, op. cit.
For deficit countries, actual sterilization of capital inflows would mean that domestic credit would be forced to remain below its ceiling or target level; for surplus countries, sterilization of capital outflows would mean that domestic credit would be expanded above its target level.
For countries that could allow more expansion without increasing the rate of inflation if they could only stand the balance of payments effects, money supply increases resulting from capital flows would be desirable up to a certain level and should be allowed for in a money supply ceiling.
It is recognized that “faster” does not necessarily mean more efficiently.
In an empirical study of 40 countries, the velocity of reserve money was found to be more stable than the velocity of money; see J.R. Lothian, “The Demand for High-Powered Money,” American Economic Review, Vol. 66 (March 1976), pp. 56–68.
Overvalued and undervalued exchange rates are assumed in this section to be characterized by a significant and persistent excess demand for, and supply of, the domestic currency. It is recognized that there may be occasions when an exchange rate appears, say, overvalued on this basis but undervalued on the basis of relative price and cost considerations.
A money supply ceiling would not preclude a country from maintaining an undervalued exchange rate through the technique of large-scale intervention in the forward market. The immediate impact of spot purchases of foreign currency on the money supply and reserves can be sterilized by swaps in which foreign currency is simultaneously sold spot and purchased forward. Equiv-alently, an undervalued exchange rate can be imposed without any immediate consequences for the money supply by simply undertaking outright forward purchases of foreign currency.
This statement applies strictly only to a comparison of a central bank domestic credit ceiling and a reserve money ceiling.
Financial programs supported by the use of Fund resources have, in a number of instances, included a “balance of payments test” comprising an explicit floor on net foreign assets. Such floors have been designed to ensure that exchange rate movements would be used to counter excessive balance of payments pressures on the reserves.
In the event that it were deemed appropriate to resist market forces by abnormally large purchases of domestic currency in the exchange market, it would clearly be necessary to increase the domestic credit ceiling. In order to avoid the possibility that forward intervention could be used to maintain an overvalued exchange rate, domestic credit could be defined to equal the money supply less the sum of net foreign assets and net forward foreign currency claims.
Section I described how controlling domestic credit leads to the money supply being affected by foreign interventions when domestic credit is defined in such a way that foreign interventions appear below the line in the balance of payments; the money supply is, by definition, insulated from foreign interventions when they are placed above the line.