The Evolution of Monetary Instruments and Policy in Spain

CHRISTOPHER BROWNE and LEO VAN HOUTVEN*

I. Monetary Policy in the 1950s

N THE 1950s, a prime task of the Spanish monetary authorities was I to satisfy the financing needs of the public sector at large, including not only the central administration but also the public enterprises (mainly the National Institute for Industry and the State Railway Sys- tem), and the autonomous government agencies, mainly those in charge of the marketing of agricultural products. Public expenditure grew in that decade at a much faster rate than tax revenue, and there was considerable recourse to borrowing from the banking system. Between 1953 and 1956 the rate of increase in credit granted by the banking system to the public sector, which contributed less than 20 per cent of gross domestic product, was greater than the rise in credit to the private sector. Public issues of securities exceeded private issues of bonds and shares each year from 1952 to 1956 (Chart 1). Most of the deficits of the central administration were covered by bond issues,

* Mr. Browne, a graduate of Adelaide University, South Australia, and Cam- bridge University, England, was an economist in the Southern European Division of the European Department of the Fund when this article was written. He is now in the International Finance Section of the Overseas Economic Relations Division of the Commonwealth Treasury, Canberra, Australia. Mr. Van Houtven, Assistant Director of the European Department of the Fund, obtained degrees in law and economics in Belgium and then pursued graduate study at the London School of Economics. 56

©International Monetary Fund. Not for Redistribution MONETARY INSTRUMENTS AND POLICY IN SPAIN 57 largely subscribed to by the commercial and savings banks. The financing needs of the agricultural marketing agencies and the public enterprises were satisfied by borrowing from the central bank, to which these

CHART 1. SPAIN: FINANCING OF THE PUBLIC SECTOR, 1952-61

Source: Banco de España, Boletín Estadístico.

©International Monetary Fund. Not for Redistribution 58 INTERNATIONAL MONETARY FUND STAFF PAPERS entities had direct access for virtually unlimited amounts. Increasing use of these facilities was made from 1954 on (Chart 2). Issues of government securities were readily placed with the banks because, regardless of the length of maturity, they could automatically be pledged at the Bank of Spain for advances equivalent to 80-90 per cent of their market value. Collateral loans were granted to any holder of these bonds, including the public, at rates as low as 3 per cent, but the commercial banks were the largest subscribers to new issues and made the most use of the facility. The securities were particularly attractive assets for the banks, because they were as liquid as cash and yielded interest. The savings banks were also purchasers of bonds, since they were required to hold in public securities 65 per cent of any increase in deposits. The banks held at the Bank of Spain most of the securities that could be pledged, drawing advances when there was a need to replenish liquidity. A large part of the Bank of Spain's outstanding claims on the banks consisted of collateral advances throughout the 1950s (Chart 2). The priority given to the needs of the public sector prevented the authorities from exercising control over total domestic credit. The banks had ample access to liquidity through the Bank of Spain, as there were no limits to advances against the collateral of public securities. Further, the authorities lacked the classical instruments of monetary policy. Inter- est rates were kept at very low levels in order to enable the Government to obtain cheap finance and in the belief that such low rates would also stimulate private investment. The official discount rate, at which the Bank of Spain would rediscount short-term commercial paper held by the banking system, was of limited significance. The facility was little used, even though bills were accepted without limit until 1957, because it was cheaper for the banks to pledge government securities as collateral for loans. Although the authorities were unable to control the overall volume of lending by financial institutions, they strongly influenced the distribution of finance between sectors by their administrative decisions. More- over, government regulations severely restricted competition in the financial system, which was strongly compartmentalized. Short-term financing was generally held to three months, and the banks limited longer-term financing mainly to companies which they controlled. A few large banks dominated the sector; there was little competition between them because, since the late 1930s, the establishment of new banks and bank branches had been prohibited by law and the administrative regulation of interest rates extended to deposit and lending rates for all classes of banks. In

©International Monetary Fund. Not for Redistribution MONETARY INSTRUMENTS AND POLICY IN SPAIN 59 the late 1950s, the commercial banks, which also acted as investment banks, held about 70 per cent of the assets of the credit system. The savings banks, which held about 20 per cent, were required to invest most of their deposits in public securities and to invest the remainder

CHART 2. SPAIN: NET CLAIMS OF THE BANK OF SPAIN ON THE PUBLIC SECTOR AND THE BANKS, 1952-61

Source: Banco de España, Boletín Estadístico.

©International Monetary Fund. Not for Redistribution 60 INTERNATIONAL MONETARY FUND STAFF PAPERS in prescribed sectors, mainly housing and small enterprises. The official credit institutions holding 10 per cent of the assets of the credit system played only a minor role; most of their lending was also channeled to priority sectors at preferential credit conditions. The bond and share markets were narrow, and access was restricted for private borrowers. First attempts to gain control over the volume of liquidity were made by the authorities after the acceleration of inflation and the emergence of severe balance of payments difficulties in 1955-57. The volume of securities issued by the public sector was sharply reduced. In 1957, deposits by the public sector at the commercial banks were switched to the central bank and ceilings were placed on ordinary rediscount lines available at the Bank of Spain. More importantly, it was decided not to make further issues after 1958 of securities that could be automatically pledged. Also in 1958, in an effort to limit central bank financing, the National Institute for Industry was given authority to- raise capital through bond issues. However, these measures had little immediate effect. The ordinary rediscount ceilings were frequently raised; no ceilings were placed on collateral advances, and no penalty rates were imposed on these borrowings. The credit lines available with the central bank remained sufficient to meet the liquidity needs of the banks. Further, no limitations were placed on lending by the central bank to the central administration and the agricultural marketing agencies. Effective monetary restraints were incorporated in Spain's stabilization program of 1959. Since the range of available instruments was limited, the monetary program relied mainly on overall quantitative credit ceilings, supported by increases in interest rates. The ceilings covered lending by the central bank to the public sector and lending by the commercial and savings banks to the private sector. Furthermore, all direct advances to the autonomous agencies and public enterprises by the central bank were stopped, except for loans to the agricultural marketing agencies. In principle, the latter were of a seasonal nature only and largely determined by the size of the harvest, a factor beyond the control of the authorities. The rise in total credits to the public and private sectors in 1959 and 1960 remained well below the ceilings, primarily because, by the time the stabilization program was introduced, the economy had begun to slow down—assisted by a contractionary fiscal policy. In addition, since the banks were accustomed to very high liquidity ratios, they restricted their credit granting when they became convinced of the impending change in policy, even though their

©International Monetary Fund. Not for Redistribution MONETARY INSTRUMENTS AND POLICY IN SPAIN 61 liquidity remained ample. By mid-1960, the balance of payments position had improved substantially and, with a view to stimulating economic activity, monetary policy was relaxed by removing the ceiling on lending to the private sector and reducing the interest rates of the Bank of Spain.

IL The Banking Reform of 1962 and the Credit System in the 1960s

Following the 1959 stabilization program, other measures culminated in the 1962 banking reform, which was to determine the setting of monetary policy for the remainder of the decade. The reform provided for the introduction of a number of monetary policy instruments which, if made fully effective, would have given the authorities power to achieve appropriate and flexible liquidity control. In practice, however, this aim was given low priority whenever it conflicted with other objec- tives. The principal aim of the authorities became tb provide abundant and cheap financing to encourage the growth and development of the private sector. The reform included measures to diversify the financial system in order to improve competitiveness, but it also strengthened the policy of granting preferential credit to priority sectors. An important element in the 1962 reform was the clarification of lines of responsibility for monetary and credit policy. All power remained vested in the Central Government through the Minister of Finance. The Bank of Spain was nationalized and given responsibility for the execution of monetary policy and for the supervision of the commercial banks. The Institute for Medium- and Long-Term Credit was established to oversee the operation of the official credit institutions, and the Savings Banks Credit Institute was set up to supervise the savings banks. The Governor of the Bank of Spain became the President of both of these institutions.

LIQUIDITY CONTROL Spain's banking reform of 1962 gave the authorities power to require the banks to maintain minimum holdings of cash, government securities, and other assets in relation to domestic deposits. However, in the period up to mid-1969, little use was made of this power to control bank liquidity. A minimum cash ratio for commercial banks was not established until 1970. A liquidity ratio which fixed the minimum proportion

©International Monetary Fund. Not for Redistribution 62 INTERNATIONAL MONETARY FUND STAFF PAPERS of deposits to be held by the commercial banks in cash, in deposits at the Bank of Spain, in public securities not pledged at the Bank of Spain, and in bills eligible for "special rediscount" (see below), at 10 per cent was introduced in February 1963; it was raised to 13 per cent in May 1963 and remained at this level until 1969. Com- mercial bank holdings of public securities were generally adequate to meet this requirement, but the use of the ratio did exert some restrictive pressure in 1964. In September 1965, a public assets ratio was introduced; it specified the proportion of deposits the commercial banks were required to hold in public securities, whether lodged at the Bank of Spain or not. Originally set at 15 per cent, this ratio was successively raised in steps of 1 percentage point to 22 per cent in 1969. By 1968, the public assets ratio had effectively superseded the liquidity ratio. However, the public assets ratio was designed mainly to ensure adequate bank subscriptions of investment bonds issued by the Treasury from 1960 on to finance the official credit institutions, rather than to control bank liquidity. The achievement of adequate control over bank liquidity was further impaired in the 1960s by the granting of automatic credit facilities in the form of "special rediscounts" at the Bank of Spain for certain types of commercial paper. This posed the same basic problems for monetary control that had existed in the 1950s when most public securities could be automatically pledged at the Bank of Spain. Under the special rediscount system, the commercial banks could automatically rediscount at the Bank of Spain any commercial paper issued with approval of the Institute for Medium- and Long-Term Credit by enterprises in priority sectors. These bills had varying maturities ranging up to eight years. In addition, under the ordinary rediscount system, the commercial banks could obtain advances for a period of up to three months against commercial and financial paper up to a maximum fixed period- ically by the authorities. The ordinary rediscount ceilings were often raised to ensure that the banks had sufficient liquidity to meet the needs of the private sector, and the decisions of the Institute for Medium- and Long-Term Credit ensured a ready supply of bills eligible for special rediscount. The banks made considerable use of these facilities. At the same time, the banks continued to have access to central bank loans against the collateral of government securities. Although the issue of debt that could automatically be pledged had been dis- continued, the banks had large holdings, some of which had maturities running beyond the year 2000, and the authorities did not retire exist-

©International Monetary Fund. Not for Redistribution MONETARY INSTRUMENTS AND POLICY IN SPAIN 63 ing debt as it matured. Despite the commercial banks' substantial indebtedness to the Bank of Spain, changes in the lending policies of the Bank were only occasionally made to limit bank lending; except for the public assets ratio, no limits or penalty rates were imposed on borrowings against collateral. The choice between using the various types of credit facilities was largely determined by the banks on the basis of their relative cost. The interest rate on collateral loans was raised in 1965 and 1966, after which the banks made much greater use of the cheaper rediscount facilities. The financing of the public sector did not pose problems of the magnitude of the 1950s. The growth in fiscal receipts of the central administration was more closely linked to the growth of expenditure. Claims of the credit system on the public sector rose much more slowly than in the earlier period and were substantially below the increase in such claims on the private sector (Chart 3). Net claims on the public sector declined as a proportion of domestic credit from 43 per cent in 1959 to 24 per cent in 1969. However, certain difficulties remained. Apart from the renewal of maturing issues of long-term debt, the main new borrowing instrument used by the Central Government was five-year investment bonds bearing 4.5 per cent interest, the proceeds of which were transferred to the official credit institutions. The only bond issues made to finance central government expenditure were university debt certificates in 1968 and 6-month and 12-month Treasury bills in 1969, and the amounts raised were relatively small. The financing of the National Institute for Industry was largely assured by bond issues; the main subscribers to these were the savings banks, which were required by the Minister of Finance to invest a large share of their resources in government securities and other approved bonds. The savings banks preferred bonds of the National Institute for Industry to lower-yielding investment bonds. Other public enterprises were in the main financed directly by the Treasury. From the monetary point of view, the major loophole in Spain's system of public sector financing related to the agricultural marketing agencies. As part of the 1962 reform, advances from the Bank of Spain to the Treasury were limited to 12 per cent of the total annual expenditure of the Central Government and autonomous agencies, but this measure excluded the agricultural marketing agencies. No limits on their access to central bank finance had been included in the 1959 stabilization program or in the 1962 reforms. Their losses incurred in supporting the Government's price policies for various commodities

©International Monetary Fund. Not for Redistribution 64 INTERNATIONAL MONETARY FUND STAFF PAPERS

grew steadily in the 1960s. Their financing needs were not limited to "seasonal" or "harvest" requirements but grew rapidly to cover irre- cuperable operating losses incurred as a result of the Government's agricultural pricing and trading policies. The heaviest losses were

CHART 3. SPAIN: CREDIT EXTENDED BY THE BANK OF SPAIN TO PUBLIC AND PRIVATE SECTORS, 1961-72 (Annual percentage change)

Source: Banco de España, Boletín Estadístico.

©International Monetary Fund. Not for Redistribution MONETARY INSTRUMENTS AND POLICY IN SPAIN 65 those of the National Cereals Service and the Supply and Transport Commission. The system of subsidies was extended by the establishment of the Wine Surplus Commission in 1963 and the Cotton Board in 1964. Borrowings from the Bank of Spain assumed substantial proportions, and outstanding borrowings increased nearly every year to the equivalent of over 50 per cent of the banks' outstanding claims on the public sector in 1968 and 1969 (Chart 4). The easy availability of finance in the 1960s and the lack of liquidity control are reflected in the rise in the supply of money and quasi-money (savings and time deposits) at an annual average rate of 19 per cent (Table 1 and Chart 5). The high degree of liquidity of the economy is indicated by the steady rise in the ratio of money and quasi-money to gross national product (GNP) from 55 per cent in 1959 to 84 per cent in 1969. The latter figure was almost double the average prevailing in the industrial countries at the time, and in no other major country

TABLE 1. SPAIN: STRUCTURE OF THE CREDIT SYSTEM, 1961-72 (Values in billions of pesetas, end of period) 1961 1972 1961-72 Average annual percentage Credit System Amount of credit change Total assets Bank of Spain 92 364 15 Commercial and industrial banks 344 2,220 18 Savings banks 107 975 22 Official credit institutions 73 321 14 Claims on public sector Bank of Spain 37 66 6 Commercial and industrial banks 65 328 16 Savings banks 58 167 10 Official credit institutions 12 58 15 Credit to private sector Commercial and industrial banks 218 1,604 20 Savings banks 25 385 28 Official credit institutions 52 238 15 Liquid assets and liabilities Money and quasi-money 448 2,974 19 Money supply 224 1,133 16 Currency in circulation 84 328 15 Sight deposits 140 805 17 Savings deposits 150 936 18 Time deposits 74 905 26 Commercial and industrial bank deposits 276 1,840 19 Savings bank deposits 98 905 22 Source: Banco de España, Boletín Estadístico.

©International Monetary Fund. Not for Redistribution 66 INTERNATIONAL MONETARY FUND STAFF PAPERS in the 1960s did liquid assets expand at such a fast rate in relation to GNP. The rate of growth of quasi-money was particularly rapid, but the rate of growth of the money supply (narrowly defined) kept pace with the increase in GNP. In most industrial countries, the quantity of

CHART 4. SPAIN: NET CLAIMS OF THE BANK OF SPAIN ON THE PUBLIC SECTOR AND THE BANKS. 1961-72

Source: Banco de España, Boletín Estadístico.

©International Monetary Fund. Not for Redistribution MONETARY INSTRUMENTS AND POLICY IN SPAIN 67 money fell in relation to GNP and was substantially below the 33 per cent prevailing in Spain in 1969. Spain's economy had entered a long period of expansion in 1961. Through 1964, rapid economic growth was achieved in a climate of

CHART 5. SPAIN: MONETARY SURVEY, 1961-72

Source: Banco de España, Boletín Estadístico.

©International Monetary Fund. Not for Redistribution 68 INTERNATIONAL MONETARY FUND STAFF PAPERS relative price stability combined with overall balance of payments sur- pluses. The first signs of disequilibrium began to emerge during 1965, and toward the end of that year the authorities acted to curb the growth of demand. However, in view of their inability to control bank liquidity indirectly, they had again no alternative but to resort to overall quantitative credit controls. The commercial and savings banks were asked to limit the increase in their lending to the private sector to 17 per cent in 1966. This move was unexpected, and the banks reacted strongly to official credit restraint, as they had in 1959. They remained desirous of maintaining very high liquidity ratios by international standards. Their reaction may also have reflected their incomplete knowledge of the Government's future policy plans. As a result, the authorities reversed their restrictive policy after only four months and markedly increased the ordinary rediscount ceilings after April 1966. Special rediscount ceilings were increased substantially in 1967, and monetary policy remained easy in 1968 and 1969.

INTEREST RATE POLICY

Interest rate policy was not used as an instrument of liquidity control. Throughout the period from 1962 to 1969, the authorities pursued a policy of low and stable interest rates to achieve their principal aim of a high level of private investment, and the structure of rates was extremely rigid. The authorities set maximum rates payable on all types of deposits with the commercial, industrial, and savings banks. The maximum lending rates of the banks against the collateral of commercial paper were to be no more than 1 percentage point above the rate at which the paper was eligible for ordinary or special rediscounting at the Bank of Spain. The rates charged by the official credit institutions were fixed by the Government at artifically low levels. The official discount rate was raised only once, at the time of the 1967 devaluation, mainly for psychological reasons (Chart 6). This interest rate policy was erroneously based on the assumption that the restrictive system adequately shielded the Spanish credit system from foreign influences. However, as international interest rates rose in 1968 and 1969, the differential between Spanish and foreign rates widened considerably. This led to a large short-term capital outflow and overall balance of payments deficits that helped to prompt reforms after mid-1969.

©International Monetary Fund. Not for Redistribution MONETARY INSTRUMENTS AND POLICY IN SPAIN 69

FLEXIBILITY OF THE CREDIT SYSTEM AND SELECTIVE CREDIT CONTROL The 1962 bank reform included a number of measures to broaden the structure and increase the competitiveness of the financial system. While progress was made, the structure of the credit system did not alter substantially and the commercial banks retained their dominant position.

CHART 6. SPAIN: INTEREST RATE STRUCTURE, 1961-73

Source: Banco de España, Boletín Estadístico.

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The law preventing the opening of new banks and bank branches was repealed. To reduce the influence of commercial banks over the non- financial sector, their holdings of private bonds and shares were subject to a limit equivalent to their capital and reserves, and provisions were made for the establishment of industrial banks that would specialize in long-term financing of enterprises and would not be permitted to undertake short-term financial operations, except with those firms in which they had important participations. However, because the authorities controlled bank deposit rates, the industrial banks had difficulty in competing for funds and their operations expanded only slowly. At the same time, the obligation of the savings banks to invest nearly two thirds of their increases in deposits in government securities was gradually eased. This did enable them to expand their lending to the private sector at a faster rate than the banks between 1962 and 1969, but the main reason for the easing of restrictions was the lack of availability of a sufficient volume of public issues. The official credit institutions were reorganized, and their role was expanded to increase the availability of finance to priority areas in the private sector. However, after 1965, their rate of new lending fell off sharply (Chart 3). They were not allowed to compete for deposits, but they obtained low-cost loanable funds through the transfer to them by the Treasury of the proceeds from the medium-term bonds placed with commercial banks. Large sectors of Spain's economy were able to obtain finance on preferential terms that did not reflect market conditions. Numerous distortions were introduced by the selective credit policy of the authorities. Bonds issued by the public sector carried low rates of interest. Sales were assured by the imposition of reserve requirements on the commercial and savings banks. The role of the official credit institutions—originally envisaged as the provision of medium-term and long- term finance to branches of industry that normally do not have access to security markets or might have difficulties in obtaining long-term bank credit—was steadily widened to provide subsidized funds to various sectors which the Government wished to encourage. Loans were made available for export industries, tourism, machinery, and shipbuilding and for businesses operating in accordance with the Development Plan in concerted action programs, in industrial sectors designated as qualifying for special investment facilities, and in growth centers selected for industrial or agricultural development. The Govern- ment fixed the volume of lending annually, issuing investment bonds to ensure the provision of adequate funds. Interest rates were fixed at the

©International Monetary Fund. Not for Redistribution MONETARY INSTRUMENTS AND POLICY IN SPAIN 71 time each loan was made, and these were generally low. The financing of these sectors on preferential terms was assisted by the concurrent growth of the special rediscount lines. Furthermore, the savings banks were required to invest a specified proportion of their deposits—30 per cent until 1968 and subsequently 35 per cent—in the form of specialized credits to certain areas, including low-cost housing, small farms, and small enterprises in industry and commerce, as well as loans for workers to purchase housing and securities under schemes introduced in 1966 for which special deposits could be opened. This, combined with the requirements to invest in government and private securities declared eligible by the Minister of Finance, meant that the savings banks could freely invest only 20 per cent of their assets. The distortion extended to the market for new issues. Since few issues were taken up by private individuals, the Minister of Finance's list of securities that could be purchased by the savings banks played a major role in determining which enterprises could successfully float bonds. Privileged access to finance was an important factor in determining the allocation of finance within the economy. The liquidity and public assets ratio, together with the direct credit lines available to the autonomous agencies at the Bank of Spain, ensured cheap finance for the public sector. At least 30 per cent of credit to the private sector was supplied on favorable terms in the 1960s. This estimate allows only for the lending by the official credit institutions (with the exception of the local credit bank), lending by the savings banks to sectors specified by the authorities, and bank lending against commercial paper eligible for special rediscount facilities (Table 2).

III. A New Approach to Monetary Policy Since 1969 Far-reaching changes have been made in Spain's monetary system since mid-1969, with the aim of activating monetary policy as an instrument of short-term demand management. In the 1960s, the objective of providing abundant and cheap financing for the private sector was achieved, but no other aims of the 1962 reform were pursued. The authorities failed to gain control over bank liquidity because of the continued growth in the availability of central bank credit and the lack of reserve requirements for the commercial banks. Competition among financial intermediaries was stifled by the high degree of administrative regulation of interest rates and the compartmentalization associated with selective credit policy. In the past four years, the scope

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TABLE 2. SPAIN: PREFERENTIAL CREDIT TO THE PRIVATE SECTOR, 1962-72 l (Values in billions of pesetas)

Preferential Credit to Private Sector Preferential ~ XntiiL Uldll f~VpHiv_/lCUltl odoc Official Commer- Credit to Percentage credit Savings cial Private of Total Year institutions banks banks Total Sector Credit 1962 7 8 2 17 74 23 1963 11 9 3 23 73 31 1964 12 11 3 26 85 31 1965 24 13 3 40 144 28 1966 26 13 3 42 114 37 1967 22 18 4 44 126 35 1968 24 26 12 62 194 32 1969 24 33 17 74 236 31 1970 7 35 16 58 187 31 1971 5 53 -1 57 265 21 1972 -2 55 -11 42 416 10 Source: Banco de España, Boletín Estadístico. 1 These figures are an approximate calculation based on published data, which in- corporate: (1) all lending to the private sector by the official credit institutions except the local credit bank; (2) savings bank required lending to priority areas of the private sector, equivalent since 1968 to 35 per cent (previously 30 per cent) of any increase in deposits; and (3) commercial bank lending against bills eligible for special rediscount. for liquidity control has been improved through both the development of new policy instruments and the use of instruments already available to the authorities, and the role of market forces in the collection and allocation of financial savings has been strengthened. The impetus to reform was heightened when the balance of payments sharply deteriorated in 1969 because of a high level of short- term capital outflow, partly associated with higher interest rates abroad. The authorities began to restrict monetary policy by introducing an overall credit ceiling in September 1969. The Minister of Finance urged the banks to limit their lending for the year to an increase of 18 per cent over 1968. It was soon realized, however, that this target was unen- forceable and could not be achieved because the demand for credit remained strong. Credit restraint to improve the external position was then sought by raising interest rates 1.5 percentage points and by the introduction of a scheme in December 1969 requiring 20 per cent of the value of imports to be deposited with the Bank of Spain in advance of orders being placed for goods. The latter measure caused a sharp curtailment of liquidity in the first half of 1970. After June 1970, the restrictive impact of the scheme ceased, when repayments exceeded new deposits. By that time, however, the balance of payments position had markedly improved, and domestic demand pressures had ceased. The compulsory

©International Monetary Fund. Not for Redistribution MONETARY INSTRUMENTS AND POLICY IN SPAIN 73 deposit was reduced to 10 per cent in January 1971 and abolished in June 1971. The Bank of Spain's rediscount rate, affecting the whole structure of interest rates, was reduced three times in 1971 in line with reductions abroad and the needs of the domestic economy.

LIQUIDITY CONTROL After the immediate objective of stabilization had been achieved, measures were taken to make the system more responsive to the management of liquidity. The main thrust was to reduce access to credit from the Bank of Spain both directly and by immobilizing paper that could be pledged and rediscounted automatically through its inclusion in minimum asset requirements. The reduction in the credit facilities of the Bank of Spain related to both private and public sectors. The implementation of these measures was facilitated by a very large increase in bank liquidity, which resulted in part from a temporary slowdown in demand for credit from the private sector from mid-1970 to late 1971 but mainly from the unprecedented rise in foreign reserves. The monetary measures, supplemented by appropriate changes in management of public debt, absorbed part of the excess liquidity in the hands of banks, but until early 1973 they had not been designed to restrain the growth of bank credit. Issues of public securities that could be pledged automatically and that matured in October 1970 and December 1971 were retired, in contrast to the earlier policy of extending maturing debt. These were replaced with bonds ineligible for rediscounting. The system of financing the agricultural marketing agencies was changed in 1970 in order to limit their access to funds from the Bank of Spain. Under the new arrangements, budgetary allocations are made to cover losses resulting from the Government's agricultural policies, and advances from the Bank of Spain remain available only to cover seasonal requirements. In 1971, advances fell for the first time in seven years. In August 1971, the Government took over and repaid virtually all of the outstanding debt of the National Institute for Industry to the Bank of Spain. The Central Government issued bonds to cover its financing needs for 1971 and 1972, instead of using the credit facilities available at the central bank. In these two years, public sector indebtedness to the Bank of Spain fell by almost half in contrast to rises each year from 1963 through 1970 (Chart 4). The issue of bills eligible for special rediscounting at the Bank of Spain was abandoned in June 1971. There had been a large increase

©International Monetary Fund. Not for Redistribution 74 INTERNATIONAL MONETARY FUND STAFF PAPERS in bills eligible for special rediscount during 1970 and the first half of 1971, mainly in regard to export credits, because a government- controlled commercial bank had taken over the financing of export credit from the official institutions. The scope for ordinary rediscounts with the Bank of Spain was also considerably reduced. Ceilings were cut back sharply in September 1970 and in the second half of 1971. As a result, 1971 was the first year in which the aggregate ordinary and special rediscount lines declined. Although the ordinary lines were raised a little in mid-1972, at the end of the year the available lines were only one third of their peak, which was reached in 1966. Total rediscount ceilings at the Bank of Spain were 70 billion pesetas at the end of 1972, of which 15 billion pesetas represented ordinary rediscounts and 55 billion pesetas represented special rediscounts. Unused rediscounts amounted to 17 billion pesetas. In addition, commercial banks' holdings of government securities that could be pledged automatically amounted to about 70 billion pesetas at the end of 1972, of which only 5 billion pesetas had been used to obtain collateral advances. Liquidity was ample during 1971, enabling the banks to sharply reduce their net indebtedness to the Bank of Spain through repayment of borrowings and building up of deposits. In the second half of 1971, their cash and deposits at the Bank of Spain exceeded their borrowing from the Bank for the first time since 1965, and the banks retained this position during 1972 despite a very great increase in lending (Charts 4 and 7). The free liquidity of the banks—defined as their holdings of liquid assets as a percentage of total deposits not needed to satisfy reserve requirements (see below)—rose from 2 per cent at the end of 1970 to a peak of 7 per cent in September 1971. The ratio fell during 1972 to below 2 per cent at the end of December, but it was swelled by the large inflow of foreign capital and rose to nearly 4 per cent in January 1973. Liquidity remained adequate to enable the banks to meet the strong demand for credit (Chart 7). The authorities introduced a minimum cash ratio for commercial banks in December 1970 and an investment ratio in July 1971. The cash ratio requires banks to hold the equivalent of at least 7.5 per cent of deposits, excluding foreign currency and convertible peseta accounts, in the form of cash and deposits and unused advances at the Bank of Spain.1 This immobilizes a substantial part of the advances

1 A cash ratio of 4 per cent was established for the savings banks in December 1971. This reduced the overall liquidity of the credit system, because it required the savings banks to transfer to the Bank of Spain deposits which they held with the commercial banks.

©International Monetary Fund. Not for Redistribution MONETARY INSTRUMENTS AND POLICY IN SPAIN 75 available against pledged government securities. The banks' holdings of bills eligible for special rediscount facilities are not included in the cash ratio, but they are covered under the investment ratio. The investment ratio requires commercial banks to hold 21 per cent (22 per cent prior

CHART 7. SPAIN: LIQUIDITY OF THE COMMERCIAL BANKS, 1963-73

Source : Banco de España, Boletín Estadístico, Suplemento.

©International Monetary Fund. Not for Redistribution 76 INTERNATIONAL MONETARY FUND STAFF PAPERS to January 1973) of their deposits in the form of unpledged public securities and bills eligible for special rediscount facilities within which 14 per cent (15 per cent prior to January 1973) of deposits must be held in public securities. Bills already discounted under special lines can be counted toward the investment ratio until they mature. The investment ratio replaced the liquidity and public assets ratios. The cash and investment ratios currently freeze almost all of the automatic credit facilities of the banks with the Bank of Spain and immobilize most of their holdings of government securities (Chart 8). Apart from their "free liquidity" (as defined above), the banks now have only small credit facilities with the Bank of Spain in the form of ordinary rediscount lines. For the future, bank liquidity can be managed in principle mainly through changes in cash and investment ratios.

IMPLEMENTATION OF MONETARY POLICY In recent years, the lines of responsibility for Spain's monetary policy have also been redefined and clarified and the procedures for their implementation have been streamlined. Changes in the cash and investment ratios can be made more easily than they could under the former requirements for changing the liquidity and public assets ratios. The Minister of Finance can fix the cash ratio at any proportion of bank deposits and can raise the investment ratio up to 25 per cent of bank deposits. The Bank of Spain has been delegated the power to supervise the operations of the commercial and industrial banks, the savings banks, rural banks, and other small nonbank financial intermediaries. These changes were introduced, together with a reform of the official credit institutions, in June 1971 (see Policies to increase the role of market forces in the allocation of credit, below). Supervision over these institutions is exercised now by the Official Credit Institute directly responsible to the Minister of Finance. The Savings Bank Credit Insti- tute and the Institute for Medium- and Long-Term Credit were abolished as a result of these reforms.

INTEREST RATE POLICY When the long-standing policy of low and stable interest rates was abandoned in July 1969, the whole structure of rates was simplified, with the result that the responsiveness of interest rates to changes in market conditions was greatly increased. Most interest rates were linked to the official discount rate, so that movements in the latter would have

©International Monetary Fund. Not for Redistribution MONETARY INSTRUMENTS AND POLICY IN SPAIN 77 a much wider impact throughout the financial system. In the past three years, there have been five changes in the official discount rate. There were increases in June 1969 and January 1970 to a high of 6.5 per cent since World War II, and the general rise in interest rates quickly

CHART 8. SPAIN: CASH AND INVESTMENT RATIOS OF THE COMMERCIAL BANKS, 1971-73

Source: Banco de España, Boletín Estadístico.

reversed the high level of short-term capital outflow which characterized the years 1967 to 1969. Three cuts totaling 1.5 percentage points were made during 1971, when rates abroad declined and economic policy became expansionary. The rate for all advances against collateral, previously a variety of different rates, was fixed at 1.5 per cent above the discount rate, making the cost of advances against collateral significantly more expensive than borrowings under the ordinary and special rediscount lines. Collateral loans outstanding were reduced to almost zero because of their cost and the high liquidity of the banking system in 1970-72. From June 1969 until March 1972, export credit could be rediscounted at a favorable rate of 0.4 percentage point below the rate for other special rediscounts, but this differential was then eliminated (Chart 6). Restrictions on bank deposit and lending rates were eased in July 1969 in a move to spur competition. Rates payable on time deposits of less than two years, depending on their duration, were fixed between 1.0 and 2.5 percentage points below the official discount rate. The lower rates payable on sight and savings deposits are not linked to the official discount rate. After the restrictive interest rate ceilings on bank deposits of over two years were abolished, there was a substantial rise in those deposits, in part reflecting a switch from deposit and savings accounts. As a percentage of money and quasi-money in the hands of the public, time deposits rose from 22 per cent at the end of 1969 to 30 per cent at the end of 1972. Maximum rates for short-term bank loans against commercial paper were fixed at 0.9 to 1.5 percentage points above the Bank of Spain rediscount rate; and loans of 18 months to 3 years, which the commercial banks have been able to undertake since July 1969, were fixed at 2 percentage points above the official discount rate. During 1971, short-term lending rates declined by 1.25 percentage points and longer-term rates by 0.5 to 1.0 percentage point. During 1972, actual lending rates remained unchanged.

POLICIES TO INCREASE THE ROLE OF MARKET FORCES IN THE ALLOCATION OF CREDIT The reform of the official credit institutions in June 1971 reflected the aim of the monetary authorities of increasing the role of market forces in the allocation of credit. The Government continues to provide all funds to the institutions, but they have been given greater flexibility in their operations. The official credit institutions are required to balance their operative accounts, and lending rates are now more closely aligned

©International Monetary Fund. Not for Redistribution MONETARY INSTRUMENTS AND POLICY IN SPAIN 79 to market rates. In April 1970, lending rates were linked to the official discount rate, but during 1971, when the rate was cut by a total of 1.5 per cent, lending rates were only reduced by 0.5 per cent in most cases. Lending to priority sectors now benefits from interest rate subsidies financed through the budget, and losses incurred in lending for projects of exceptional economic and social importance may be covered by budgetary allocations. However, greater reliance on the market mechanism implies a diminished role for selective credit policies. In the second half of the 1960s, the rate of increase in lending to the private sector by the official credit institutions fell from 37 per cent in 1965 to 14 per cent in 1969. In 1970 and 1971 the annual rate of increase was 5 per cent, and in 1972 new lending declined (Chart 3). Other measures have been taken to reduce the availability of credit on preferential terms and to increase the flexibility of the financial system. The distinction between commercial and industrial banks has been gradually mitigated since 1969 by a series of measures that have increased the degree of competition between the two types of institutions. The liberalization in mid-19 69 of rates payable on time deposits over two years has enabled the industrial banks to compete more successfully for funds and to enlarge the scope of their activities. The liberalization in 1969 of rates charged on bank loans over three years has encouraged the commercial banks to increase their longer-term lending. The abolition of bills eligible for special rediscount facilities in mid-1971 has ended this source of preferential credit terms. In early 1973, it was announced that over the next three years the investment requirements of the savings banks would be eased. When this new policy is fully implemented, the savings banks will be required to invest 40 per cent of deposits in public and specified private securities, instead of the present 45 per cent, and 30 per cent in agriculture and other priority areas, with the added proviso that this ratio would not have to be split in specified proportions between different sectors as at present.

IV. Conclusions

Spain's reforms of the credit system since mid-1969 have much improved the scope for monetary policy as an instrument of short-term demand management and have considerably increased the role of market forces in the allocation of credit. The limitation of the banks' automatic credit facilities with the Bank of Spain and the introduction

©International Monetary Fund. Not for Redistribution 80 INTERNATIONAL MONETARY FUND STAFF PAPERS of obligatory cash and investment ratios were facilitated by the substantial increase in liquidity resulting from the balance of payments surplus and by the accommodating monetary policy adopted throughout 1971 and 1972 (Chart 5). Until 1973, therefore, the effectiveness of the reforms for the purpose of indirect control of bank liquidity and credit creation had not been tested. Additional reforms may be desirable to strengthen monetary policy as an instrument of demand management and to improve the flexibility of the credit system.

THE FIRST TEST FOR LIQUIDITY CONTROL During 1972, the rapid rise in bank credit and the public debt management operations of the authorities had led to a gradual erosion of the free liquidity of banks. The seasonally adjusted growth rate of liquid assets in the hands of the public had declined from an exceptionally large annual rate of 26 per cent in the last quarter of 1971 to 17 per cent in the third quarter of 1972 when the authorities had begun to achieve control over bank liquidity. They expected that they could hold the growth rate of money and quasi-money roughly unchanged throughout 1973, as was thought to be compatible with the forecast for the growth of the economy. However, this outlook changed radically as a result of exceptionally large inflows of foreign exchange in late 1972 and early 1973 which caused the free reserves of banks to rise sharply again (Chart 7). The authorities promptly responded to these developments. In Feb- ruary 1973, the Bank of Spain sold three-month Treasury bills for 6 billion pesetas at variable rates of interest primarily to absorb the excess liquidity of the banking system. From March 1973, the cash requirements of banks were effectively increased by requiring compliance with the minimum cash ratio on a daily basis rather than every six days as it had been. This change is estimated to have increased the effective cash ratio by about 0.8 percentage point or some 15 billion pesetas (Chart 8). In April 1973, the ordinary rediscount lines available at the Bank of Spain were cut by 5 billion pesetas to 10 billion pesetas. These actions demonstrated the determination of the authorities to attain control over bank liquidity, in the light of the requirements of the domestic economy. The free liquidity of the banks was reduced from 3.7 per cent in January 1973 to 1.5 per cent in June 1973, the lowest figure on record. However, in the first half of the year the rate of credit expansion had been considerably faster than the authorities desired. There was a

©International Monetary Fund. Not for Redistribution MONETARY INSTRUMENTS AND POLICY IN SPAIN 81 substantial inflow of foreign funds, reflecting the large balance of payments surplus, and the banks were able to meet the strong demand for loans from the private sector. Nevertheless, by the beginning of the second half of 1973 the authorities appeared to be in a position, for the first time in many years, to effectively pursue a policy to slow the pace of credit expansion. The active stance of the authorities was indicated by a number of measures taken in the third quarter of 1973. Further issues of Treasury bills were made, and the sale of Treasury bonds was resumed. The Bank of Spain rediscount rate was raised by 1 percentage point to 6 per cent in July 1973, and the whole structure of rates moved similarly upward. The Bank of Spain granted and recalled very short-term credits to the banks in an attempt to moderate temporary fluctuations in liquidity. Deposits of the official credit institutions with the banks were transferred at the direction of the authorities to Treasury accounts with the Bank of Spain. In October 1973, the ordinary rediscount lines were reduced by a further 4 billion pesetas. Despite the continued strong inflow of funds from abroad, the rate of monetary expansion began to slow after mid-1973.

AREAS FOR FURTHER REFORMS Additional reforms may be desirable to improve the efficiency of the credit system and of monetary policy in Spain. The measures taken in recent years to free interest rates on bank deposits and loans have improved the allocation of financial resources and have increased competition among financial intermediaries, but further progress can be made in that area. At present, interest rates on deposits of less than two years and on loans with a maturity of less than three years remain administratively set and are directly or indirectly tied to the discount rate. An interbank deposit market has sprung up recently and a Treas- ury bill market has been developed in 1973. The development of an active money market hinges on further measures to increase the flexibility of short-term interest rates. A unified market for short-term funds among financial intermediaries—in which the Bank of Spain would intervene at its initiative to cover bank needs after a general assessment of the situation—would also strengthen monetary policy. Moreover, the increasing integration of the Spanish credit system with international financial markets requires greater flexibility of interest rates in Spain in order to avoid disruptive flows of short-term capital. A number of measures have been taken in recent years to reduce the compartmentalization of the credit system. The restrictions on certain

©International Monetary Fund. Not for Redistribution 82 INTERNATIONAL MONETARY FUND STAFF PAPERS operations by the commercial and industrial banks have been eased, and the sharp distinction between these two types of banking institutions, which was first introduced in the banking reform of 1962, has been softened. Nevertheless, limitations on the activities of the banks remain, such as on the issuance of deposit certificates by commercial banks. The scope for investment by the savings banks has been widened, and the reform of the official credit institutions has strengthened the role of market forces in their operations. However, the authorities could consider further steps to increase the competition between the various groups of financial institutions and to reduce the scope of selective or allocative credit policy. This relates in particular to the remaining restrictions on the allocation of funds collected by the savings banks. Moreover, the development of an efficient bond market is hampered because savings banks can invest only in government-approved bonds and commercial bank holdings of industrial bonds are restricted. Prog- ress in these areas is a precondition for the creation of an efficient capital market, including a wide range of nonbank financial intermediaries, which will help Spain to continue its fast pace of economic expansion in the 1970s.