Monetary Policy Instrulments for Developing

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Public Disclosure Authorized Monetary Policy Instrulments for Developing

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edited by Public Disclosure Authorized Gerard Caprio, Jr. Patrick Honohan

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Monetary Policy Instruments for DevelopingCountries

editedby Gerard Caprio, Jr. Patrick Honohan

A World Bank Symposium

The findings, interpretations, and conclusions expressed in this study are entirely those of the authors and should not be attributed in any manner to the World Bank, to its affiliated organizations, or to members of its Board of Executive Directors or the countries they represent.

Because of the informality of this series and to make the publication available with the least possible delay, the manuscript has not been edited as fully as would be the case with a more formal document, and the World Bank accepts no responsibility for errors.

The material in this publication is copyrighted. Requests for permission to reproduce portions of it should be sent to Director, Publications Department, at the address shown in the copyright notice above. The World Bank encourages dissemination of its work and will normally give permission promptly and, when the reproduction is for noncommercial purposes, without asking a fee. Permission to photocopy portions for classroom use is not required, although notification of such use having been made will be appreciated.

The complete backlist of publications from the World Bank is shown in the annual Index of Publications, which contains an alphabetical title list and indexes of subjects, authors, and countries and regions. The latest edition is available free of charge from the Publica- tions Sales Unit at the address in the copyright notice or from Publications, World Bank, 66, avenue d'1ena, 75116 Paris, France.

Gerard Caprio, Jr., is a senior financial economist, Financial Policy and Systems Division, Country Economics Department, World Bank. Patrick Honohan, a research professor at the Economic and Social Research Institute, Dublin, was at the time of writing a senior economist in the division.

Library of Congress Cataloging-in-Publication Data

Monetary policy instruments for developing countries / edited by Gerard Caprio, Jr., Patrick Honohan. p. cm. - (WorldBank symposium) Papers from a conference sponsored by the Country Economics Department of the World Bank Includes bibliographical references. ISBN0-8213-1969-8 1. Monetary policy-Developing Countries-Congresses. I. Caprio, Gerard. II. Honohan, Patrick. III. International Bank for Reconstruction and Development. Country Economics Dept. IV.Series. HG1496.M635 1991 332.4'91724-dc2O 91-38837 CIP a

Foreword

Rapidstructural change and widespreadadoption of fi- from industrial and middle income countries, together nancial sector reforms in developing countries have with some of the Bank's own financialsector specialists placed pressure on traditional instruments of monetary and those of the International MonetaryFund, to discuss control. It is widelyaccepted that, if the necessarymac- the lessons of recent experiencewith indirect methods of roeconomiccontrol can be maintained,a move to an in- monetary control. The seminar formed part of the direct, market-oriented system of monetary policy Bank's ongoing effort to evolve and disseminate best instruments will help the financial sector perform in a practice in various aspects of financialsector reform. It sounder and more efficient manner, resulting in the is hoped that this volume,which reports the edited pro- maximum contribution to economic development. ceedingsof the seminar,will be of value to policymakers It is not long since many industrial countries adopted and students of developingcountries. sweepingadjustments of their systems of monetarycon- In keeping with the informal character of the semi- trol, dismantling bank-by-bankcredit ceilingsand sec- nar, the viewsexpressed should be regarded as personal toral credit allocations. A number of middle-income ones: they do not necessarilyreflect the viewsof any in- countries have also progressed along similar paths. stitution. Manyother countries are now lookingat the experience of these pioneersto see what lessons can be learned. MillardF. Long With these developmentsin mind, the FinancialPol- Chief,Financial Policyand SystemsDivision icy and SystemsDivision of the WorldBank organized a TheWorld Bank seminar in May, 1990, which brought together experts

Acknowledgments The editors acknowledgethe contribution of a number of peopleto the productionof this volume.Robert Katt provided invaluableassistance in editing the transcribed portion, proofing,and laying out the finishedvolume. Karin Waeltidiligently assisted in the transcription process itself,while Wilai Pitayatonakarnand MeganPomeroy organized the word processingfor later drafts. Regardingthe seminar itself,Yahaya Doka and Susan Sebastianassisted with organizationalissues, while MillardLong and AlanGelb contributedthe inspirationand impetus for both the seminar and this volume.We also gratefullyacknowledge J.B. Zulu and DouglasScott of the InternationalMonetary Fund's Central BankingDepartment for providingthe assistanceof their unit, and severalanonymous referees for helpful comments. Nonetheless,the opinions expressedherein reflect only those of the authors, participants,and the editors. The WorldBank conference "Monetary Policy Instruments for DevelopingCountries" took place on May16-18, 1990,in Washington,D.C., under the sponsorship of the CountryEconomics Department.

iii

Contents

Contributors and Participants ix

1. The Useof MarketInstruments for MonetaryPolicy 1

GerardCaprio, Jr. and Patrick Honohan

The Objectivesof MonetaryPolicy 1 Instrumentsfor SmoothingBank Liquidity 3 Copingwith Shocks 6 The Impact of GovernmentDeficit Financing 7 ExternalFlows and MonetaryPolicy 7 ConcludingComments and Outline of the Volume 8

PARTI. NUTSAND BOLTS: PRACTICAL ISSUES ON MOVINGTO INDIRECTIMPLEMENTATION OF MONETARYPOLICY

Introduction 13

2. Central Bank LiquidityManagement and the MoneyMarket 15

Paul Meek

Central BankMonetary Management 15 GeneralGuidelines for MoneyMarket Development 22 The Caseof Indonesia 24

Discussion 29

3. The Useof MonetaryPolicy Instruments by DevelopingCountries 37

R. Barry Johnston

WhyIs There a Need to ReformMonetary Control Techniques? 37 KeyElements in a LiberalMonetary Control Framework 38 Managingthe Reformin MonetaryControl Techniques 42

Discussion 44

v 4. BuildingFinancial Institutions for a Market-BasedMonetary Policy 49

Steven Grenville

AnotherModel for OpenMarket Operations 49 Issues for the AustralianModel 51 Use of OpenMarket Operations to AffectMonetary Demand 53 Conclusions 60

Discussion 61

PARTII. MONETARYTARGETING AND CONTROL

Introduction 65

5. MonetaryTargeting: Lessons from the U.S. Experience 67

David Lindsey

1970 through October1979 67 October1979 Through the Fallof 1982 68 The Fallof 1982to October1987 70 October1987 to the Present 73

Discussion 80

6. MonetaryTargets: European Experience 83

CharlesGoodhart

On MonetaryTargets 84 The EuropeanMonetary System 87 Central Bank Independence 88 Comment:Policy Constraints in DevelopingCountries DonaldJ. Mathieson 91

Discussion 93 An Elaboration 98

PARTIII. BUDGETDEFICITS AND MONETARY POLICY

Introduction 103

7. Impact of GovernmentDeficits on MonetaryPolicy: The Caseof Italy 105

Cesare Caranza

The Economicand FinancialPicture 105 A NewStrategy for MonetaryPolicy 105 Resultsof the NewPolicy 106 The RemainingProblems 107 PotentialSolutions 107

vi 8. Impact of GovernmentDeficits on MonetaryPolicy: The Case of Chile 109

Juan AndresFontaine

Factorsin Chile'sFinancial Liberalization 109 ManagingMonetary Policy in Chile 110 Debt-EquitySwaps 112

9. MonetaryManagement with High Inflation:The BrazilianExperience 115

CarlosAlberto Queiroz

Developmentof the MoneyMarket and MonetaryPolicy 115 The Yearof Super-HighInflation 116

Discussion 118

PARTIV. THE INTERACTIONOF EXCHANGERATE AND MONETARY POLICY

Introduction 123

10.Exchange Rate Policy 125

Charles Freedman

Some Definitions 125 FixedVersus Flexible Rates 125 MonetaryPolicy and Intervention Policy 127 Sterilizationof Changesin InternationalReserves 128

11. Interaction of ExchangeRate Policy and MonetaryPolicy: The Caseof Malaysia 131

Lin See Yan

Malaysia'sEconomic Background 131 ExchangeRate Policyand MonetaryPolicy 132 Conclusion 134

Discussion 134

vii

Contributorsand Participants

Contributors MichaelKlein Country Department, Europe, the Middle East and GerardCaprio, Jr. North Africa,The WorldBank Financial Policyand SystemsDivision, The World Bank DavidE. Lindsey Board of Governorsof the Federal ReserveSystem CesareCaranza ExecutiveDirector, The WorldBank Paul Meek Paul MeekAssociates, formerly Federal ReserveBank of CharlesFreedman New York Bank of Canada DonaldJ. Mathieson Stanley Fischer ResearchDepartment, InternationalMonetary Fund MIT,formerly Chief Economist, The WorldBank Ann-MarieMeulendyke Jean AndresFontaine Federal ReserveBank of NewYork Consultant,formerly Banco Central de Chile CarlosAlberto Queiroz Peter Garber BancoCentral do Brasil BrownUniversity DouglasScott Steven Grenville Central Banking Department, International Monetary ReserveBank of Australia Fund

Charles Goodhart RezaVaez-Zadeh London Schoolof Economics Central Banking Department, International Monetary Fund Patrick Honohan Economicand SocialResearch Institute (Dublin),for- Lin See Yan merly Financial Policy and Systems Division, The BankNegara Malaysia WorldBank

H. BarryJohnston Central Banking Department, International Monetary Fund

ix Participants Sikander Rahim S. Ramachandran The WorldBank RobertoRocha Andre Ryba Jean-JacquesDeschamps SilviaSagari AlexanderFleming Fernando Saldanha Tom Glaessner Khalid Siraj Kristin Hallberg AlfredoThorne MagdiIskander John Todd RoyA. Karaoglan MoinaVarkie AshokKhanna MichelWormser MichaelKlein KatherineMarshall IMF HerminiaMartinez Barbara Mierau-Klein IldefonsoGuajardo FernandoMontes Negret Jian-Hai Lin Paul Murgatroyd MelhemMelhem AlbertoMusalem BobM. Traa Joseph Pernia TarisaWatanagase Paul Popiel LorenaZamalloa

x The Use of Market Instruments for Monetary Policy

GerardCaprio, Jr. and Patrick Honohan

For a century or more it has been acceptedthat inappro- some ofthe key issuesraised. The next section discusses priate decisionsas to the price and availabilityof credit, the objectivesof monetary policy and how these have or as to the expansionof monetaryaggregates, could have evolvedin recent years. There followsan account of the damaging effects on price and output stability in the different policy instruments availableto the monetary economyas a whole. Just how such monetary policyac- authorities. How these instruments have been used to tions have their effectand what is the best way to imple- cope with the main shocks affectingmonetary policy- ment policyhas, however,remained controversial.In the those related to government deficitfinancing and to ex- last few years, there have been considerable changes in ternal flows-are the subject ofthe penultimate section. the way in which many industrial countries approachthe Thepaper endswith a brief overviewof the main messag- formulation of monetary policy. The changes have ac- es of the papers and discussionsreported in this volume. companied rapid developmentin the sophisticationand depth of financialmarkets and have been both a response The Objectivesof MonetaryPolicy to this development and a catalyst for it. In developing countries, both the evolution of financial markets and Some basic relationships are fairly reliably estab- growing disenchantment with directed credit programs lished for many countries and can be taken as a basis for and with bank-by-bankcredit ceilings have led to in- a more completeunderstanding of how the financialsec- creased interest in at least examiningand possiblymov- tor works in a market-orientedeconomy. For example, ing to indirect methods of implementing monetary overa protractedperiod, rapid growth in the money sup- policy. plywill lead to sustained inflation;an increasein the cost Asa result of the WorldBank's increased involvement of credit or a reduction in its availabilitywill dampen in financial sector development issues, especially economicactivity' and will also tend to slow the under- through the growing number of structural and sectoral lying rate of inflationdespite representingan additional adjustment loans with a financialcomponent, it has been cost to industry. asked to provide assistance in this area. Given that the On the other hand, there is not a clear one-for-onere- mechanisms by which monetary policy is implemented lationshipbetween monetary growth and inflationin the can have important implicationsfor the long- term de- short run. Domesticprices can be sticky;exchange rates velopment of the financial sector (as explained below), can overshoot their equilibrium levels followinga dis- the WorldBank has respondedto these requests in con- turbance and may even veer awayfrom equilibriumfor a junction with the International Monetary Fund (IMF), while. Innovationsin the financial sector may alter the whose interest in assuring effectivetools for monetary equilibriumrelation betweenmoney, prices, and output policyis clear.Indeed, the importanceof this topic led to in ways that are hard to predict and may lead to an in- a session at the conferenceon collaborationbetween the crease in the volatility of this relationship (Goodhart WorldBank and the IMF. 1989;Lindsey and Wallich 1989). This paper providesan overviewof the policyissues in Acceleratinginflation in many industrial countries in this area that face developingcountries in the light of in- the 1960sand 1970scaused authorities to review their dustrial country experienceduring the last couple of de- approach to monetary policy.It became widelybelieved cades. It drawson discussionsat the seminar and, while that the common use of interest rates as operating tar- not pretending to be a thorough summary, captures gets for monetarypolicy had contributedto inflation,as

1 2 Gerard Caprio, Jr., and Patrick Honohan politicalpressures had combinedwith policyinertia to proach was widely used in European countries in the slow the responseof monetary policyto rising prices. In 1970s and still forms the basis of monetary policy in the absence, at least from the early 1970s,of fixed ex- many developingcountries (especiallyin Africa).Howev- change rate anchors, excessivemonetary expansionhad er, the definition of the institutions to be included in been tolerated.To correct this state of affairs,several in- such credit ceilings gave rise to many opportunities for dustrial countries began to rely more heavily on the avoidancethrough disintermediation and the develop- quantity of money as an indicator of monetary condi- ment of near-bank and parallel credit markets, which tions or even as an intermediate target. It was felt that greatly reduced the effectivenessof these instruments. the money supplywould prove to be a good leadingindi- Bank-by-bankceilings also distorted competitionby pe- cator of inflationaryconditions; keeping it under control nalizing more dynamic institutions and discouragedre- would stabilizeinflation. The degree to which the money source mobilization; once a bank reaches its credit supply was targeted, to the exclusionof other factors, ceiling, it has no incentiveto competefor additional re- varied from country to country.In particular,a degreeof sources, regardless of the profitabilityof its clients' in- interest rate stabilitywas also maintained in most coun- vestment opportunities (Johnston and Brekk 1989; tries. However,for some two and a half years (1979 to Cottarelli et al. 1986). Various suggestions have been 1982)the U.S.authorities allowedinterest rates to move made for attempting to restore competition by permit- rather widely,in an attempt to keep on course for their ting the trading of credit quotas betweenbanks or by es- monetarytargets. tablishing an automatic link between each bank's Just as the monetaryaggregates became more closely current deposit mobilizationand the allocation to it of targeted, they began to perform less reliablyas a predic- future credit ceilings. However,these theoretical sug- tor of inflationaryconditions or of the state of aggregate gestionshave never been systematicallyapplied, as many demand, as noted by Goodhart (1989) and others. In governmentspreferred to replace the bank-by-bankap- some part, this contrary behaviorreflected liberalization proach altogether. of financial markets, which had been occurring around proch atether. the same time (Broaddusthe ametime(Braddu195;1985; JddJudd and nd SaddngScadding 182,1982; tangledDirected with credit the implementation programs haveof regularly monetary become policy. en-In de Vries 1986).To some extent, it also occurred because ticuledw iethe developingcontry pol near substitutes for the targeted aggregateswere uti- particular, a variety of developingcountries and several Iized by the markets, once the authorities attempted to industrial countries have had monetarypolicy subverted exert contractionarypressure. For example,in the Unit- by attempts to exemptpriority-sector credit from overall 2 ed States, controlsed Sttes,contols onn MIhelpeM1 helped spuspur thegrowhthe growth of drawbacksor bank-by-bankof directedceilings. credit Widespread schemeshas recognition led to a declineof the money market funds and led to a varietyof transactions dr opular it willingto red these serviceslinked to componentsof the broader money ag- in their popularity;once willingto reconsiderthese pro- gregates. grams, authorities havebecome more willingto examine By the end of the 1980s,most governments had for- monetary policyinstruments as well. mally or informallyabandoned the narrow focus on tar- Countries that move away from bank-by-bankcredit geting monetary aggregatesin favorof a more eclectic ceilings to a more indirect means of monetary control approach that allowedthem to include a number of dif- may find that they cannot achievepreset objectivesfor ferent indicators of the state of the economyas a guide money or credit aggregateswith the same degree of ac- to policy.They had also instituted a more flexibleregime curacy.The classicexample of this problem is the expe- of monetary instruments, which allowedthem to influ- rience of the United Kingdomin the 1970s,which saw ence monetary conditionsmore quicklythan in the past considerableexpansion in monetary depth when credit and with a graduated pressure. At the same time many ceilings were removed. Neither credit nor money dis- governments began to allow a much greater degree of playeda stable relationship with nominal GNPor infla- competition in the financialsystem; the use of more in- tion in those circumstances, and a single-minded direct means of monetary control in this more competi- pursuit of a rigid target for the aggregateswould have tive environment helpedto ensure that monetarypolicy been costly (Goodhart1989). Developing countries that measures were not as easilyevaded by disintermediation moveto indirect monetary control are also likelyto ex- as they had been in the 1970s. perience less certainty when using monetary aggregates Analternative approachto the focus on monetary ag- as intermediate objectives.It may be less difficult to gregates as the main intermediate objectiveof monetary achieve intermediate objectivesthat are elements of the policy has been the use of ceilingson aggregate credit central bank balancesheet, but the reliabilityof these as expansion.The ceilingswere usuallyensured by distrib- a meansof influencingaggregate demand or inflationre- uting sub-ceilings on a bank-by-bankbasis. This ap- mains relativelyunexplored for developingcountries. The Use of Market Instrumentsfor Monetary Policy 3

Instruments for Smoothing Bank Liquidity the availabilityof liquid funds. Third, the fluctuationsof interest rates provide much information to the central Banks settle their debts with one another and meet bank to help it gauge market conditions.3 Fourth, for cash withdrawals either by drawing on their credit ac- open economiesoperating a pegged exchange rate sys- counts at the central bank or by using currency in their tem, the regime often providesfor an automatic stabiliz- vaults and tills. Theseassets, representingbank liquidity ing response of short-term interest rates to foreign or the reserves of the banking system, are liabilities of exchangeflows. the central bank. In case of need, banks can also sell liq- Liquidity management in most industrial countries uid assets or borrow from each other or from the central takes placetoday in a much more developedand compet- bank. Over the longer run, banks can repaytheir short- itive money market than was the case only a fewyears term borrowingthrough the proceedsof maturing loans ago. While other policyand technologicalchanges have to customers or by mobilizingadditional deposits.The also playeda part in developingmoney markets, it can be speed and ease with which such actions can be taken de- said that the more flexibletechniques of monetary man- pends on the sophisticationof the banking system. agement have required and encouraged these develop- Whenthe banking systemas a whole is short of liquid ments. The economyhas been well served by a deeper funds,there is a generalizedupward pressure on interest money market,which allowsgrowing numbers of corpo- rates and a tendency for bank credit to be expensiveand rate borrowersdirect access to short-term fundswithout scarce. Such pressures can be easedby central bank ac- having to pay for bank intermediationcosts. The deeper tion to provide liquidity to the system; an important money market has also ensured a more competitiveand function of the central bank is to ensure that seasonal probably less costly system of bank intermediation. and random influenceson liquidityconditions are offset, Firms that are allowedto hold certificatesof depositsor so that they do not result in correspondingvariations in commercial paper bearing market rates of interest will interest rates. On the other hand, the central bank can not settle for below-marketrates on their deposits. De- also take the initiativeto ease or tighten liquiditycondi- veloping countries can also benefit from such reforms tions depending on how it perceivesa need to stimulate (and somealready are) as they, too, movetowards refined or to restrain aggregateexpenditure (Binhadiand Meek techniques of monetary management. In particular, 1989). deeper money markets allow banks to economizeon li- In the past, many central banks providedsemi-auto- quidity holdings; their absence may partly explain the matic borrowing facilities to banks at posted interest predominanceof assertions that banks in the poorest rates (knownas the discountrate, Bankrate, or Lombard countries are exceedinglyliquid (Caprioand Honohan rate), which were varied infrequentlyand which effec- 1990). tively placed a ceiling on short-term interest rates. The most striking illustration of how apparently dif- Where banks were customarily borrowersfrom the cen- ferent regimes of monetary control actually achievethe tral bank, its posted rate also provideda floor for short- same result is the relation of posted rates to market term interest rates, as surplus banks could lend to deficit rates. In some countries (for example,France and Cana- banks at or near the posted rate. Becauseof the political da) the central bank's posted (discount)rate is normally sensitivityof this key rate, upward adjustmentswere of- kept well abovemarket rates. In others (for example,the ten made too late and in steps that were too small. UnitedStates, Japan, and the Netherlands)it is normally Asa result, most central banks in industrial countries belowmarket rates (Kneeshawand Vanden Bergh 1989). have moved awayfrom automatic lending facilitiesand The resolution of this apparent paradoxlies in the differ- now manage interest rates in a more flexiblemanner, us- ent manner in which lending at the discountwindow is ing a variety of new instruments. Each country has practicedin the two groups of countries.Where the dis- adapted its system of liquidity control in accordance count rate is below the market rate, its availabilityto with localconditions, with the result that a great variety borrowers is administrativelyrestricted. In these sys- of arrangements are in use, though each tends to satisfy tems it is normal on any given day to see some banks certain key requirements.First, there is no longeran au- borrowingat this rate. But most avoidor limit the need tomatic availabilityof borrowing from the central bank to borrow by holding a margin of excess reserves,even at posted rates; accordingly,short-term interest rates though the opportunitycost of these reserves,represent- tend to be more flexiblethan in the past. Second,most ed by the interbank lending rate, is abovethe discount systems still have an upper and lower buffer to prevent rate. In this situation, the discount rate providesa firm undue interest rate gyrations in case the day-to-dayin- lowerbound to interest rates; it is also a somewhatflex- struments for influencing interest rates are unable to ible upper buffer in that the banking system will be ad- cope with a big surge in the demand for liquidityor in mitted to the central bank discount window if the 4 Gerard Caprio, Jr., and Patrick Honohan interbank rate moves too far abovethe discount rate. In Asregards the last category,outright open market oper- countries where the discount rate is kept well above ations in domestic securities are most appropriate to market rates (clearly indicating its penalty nature), it meet trend needs for liquidity changes. However,they provides an upper bound to interest rates, but is not are not used extensivelyoutside the United States,partly heavily used by banks because of the availability of becausemost other countries do not haveas rich a mar- cheaper market alternatives.A central bank operatinga ket of first-rate short-term securities. Lowerquality se- higher-than-market discount rate policy usually has a curities are unlikelyto be useful as collateralbecause of wayof stepping in quicklyto providea depositfacility (or their credit risk, while long-termsecurities are more ex- to offer short-term bills on itself at a givenyield), in or- posed to interest rate variations. Indeed, this is one of der to placea floorbelow interest rates if they are quickly the principaladvantages of reversedoperations: by buy- falling too far. Thus, when Germany moved its posted ing a government security and contracting to resell it at central bank lending rate from just below to well above an agreed price, the authorities retain the initiative in market interest rates in the mid-1980s,it also began to terms of amount, maturity,and timing, regardlessof the conduct the bulk of its money market interventions terms of the underlying security.5 Reversed operations through mechanisms that did not involve the posted can be implementedwithout much effecton the price of lending rates. In particular, it began to use what are the underlyingsecurity, and they have most of the char- known as "reversed transactions" (explainedbelow) in- acteristics of a secured loan without having to be made stead of lending. at the postedrate. Theshortage of first-classcollateral in Some industrial countries have not achievedthis de- developingcountries has made reversedtransactions es- gree of flexibilityin their interest rate management.For peciallyuseful; although the central bank can decide to example,Belgian banks hold large quantities of govern- make any asset eligiblefor repos on a bilateral basiswith ment bills,whose yield represents the cost of short-term selectedinstitutions, acceptanceby a wide range of mar- funds in Belgium and is essentially determined by the ket participantswill be crucial to promoteactive trading authorities' funding decisions.In Sweden,the banks are in reversedtransactions. subject to an automatic graduated scale of central bank For speedyaction, central banks often turn to foreign lending rates and a central bank deposit facility.In con- exchange(forex) swaps, which are reversedtransactions trast, the central bank lending rate in the United King- in foreign exchangemarkets (Kubarych,1978). The size dom is used more as a fine-tuning mechanism and is of the foreign exchange market also means that large managed on a day-to-daybasis. volumesof liquidity can be addedor drained in this man- Betweenthe floor and ceiling buffersprovided in the ner. It is the main intervention technique used by the manner just outlined, the central bank usually has a va- Swissauthorities. However,this approach is not without riety of other instruments to influence bank liquidity drawbacks. First, there are usually only a handful of conditions. Many of these involve quantity rather than large participants in the foreign exchange market, so price (interest rate) decisionsby the authorities. For ex- forexswaps are not good for providingor withdrawingli- ample, it is normal for central banks to makeprojections quidity on a broad base from the whole bankingsystem. as to the liquidity needs of the system over a period of Second,provision of liquiditythrough forexswaps (i.e., one month or more and to make interventionsto add or buying foreign exchangespot with a contract to resell it drain the amount of liquiditythat seems,on average,ap- later) at a time of speculationagainst the domestic cur- propriate for that period. Predictableshorter-term fluc- rency is very risky for the authorities, as they cannot be tuations can similarly be met with instruments of the sure there willbe no devaluation.The authorities in sev- appropriatematurity. It willbe desirableto dealwith un- eral countries, industrial as well as developing,have lost expectedpressures using different instruments tailored large gamblesof this type. to the particular circumstances.Use of one instrument Shifting government deposits between commercial rather than another can come to signal the authorities' banks and the central bank is another tool by which the intentions, so that action taken to offsetsome expected authorities can influence liquidity conditions, as noted fluctuation is not misunderstoodas a change of policy, by CharlesFreedman below.A rise in commercialbanks' thereby avoiding unintended speculative pressures in share of government deposits increases bank liquidity the market. just as do expansionaryopen market operations.Howev- Among the instruments used are reversed transac- er, unless there are only a fewbanks (as in Canada,where tions4 in domestic securities and foreign exchange, the instrument has been most used-see Shearer, transfers of government deposits,and outright purchas- Chant,and Bond 1984),this instrument suffers from the es and sales of domestic securitiesand foreign exchange selectivitymentioned for forexswaps. There can be tech- (Kneeshawand van der Bergh 1989;Meulendyke 1990). nical difficultiesas well: the procedure needs to be gov- The Use of Market Instruments for Monetary Policy 5

erned by a framework agreement on the distribution been problems of government domestic payments ar- among banks, the remuneration of the deposits,and the rears. In these cases action to correct underlying defi- security that the government receives for its deposits. ciencies, for example by rehabilitating the banking Shifting government depositsneither requires nor fur- system,encouraging new entrants, and clearing up do- thers the developmentof money markets. This is at the mestic paymentsarrears, is desirable anyway.It should same time a practical advantageand a reason for not re- be tackled before attempting market-oriented reforms lying on them indefinitely.Nevertheless, the manage- that cannot be supported by the current state of the fi- ment of governmentdeposits needs to be givenattention nancial system.In severaleconomies, such as Indonesia in the context of monetarymanagement, as the distribu- and Taiwan,the central bank has issued its own short- tion and size of these deposits will influence liquidity term paper to get around the problem of a deficiencyof conditions whether or not they are consciouslybeing collateral; this solution is being activelyconsidered in used as an instrument of policy. Botswana. The move from a system of monetary management One advantage to using specialized money-market where the central bank provides liquidityon a bilateral brokers or market-makers,instead of banks, is that they bank-by-bankbasis, as with the discountwindow, to one have the incentive and a clear objectiveto widen the where the focus is on managing the overall quantity of number of counterpartieswith whom they deal, a point liquidity,requires the developmentof markets in which emphasized clearly by Meek. Even if it is possible for the banks and possiblyother participants can compete these brokers to fund their lending from banks, a wider for their liquidityneeds. This point is stressed especially clientelewill tend to lowertheir fundingcosts. It also al- by Paul Meekin the next paper.Once again, there is no lowsthem more flexibilityin managingtheir portfolioby unique model for successfuldevelopment of such mar- sellingpaper outright to nonbank clients. In seekingout kets; various institutional arrangements are possible. this clientele,they will broaden the scope of the money However,participants in the wholesale market for very market, providebetter cash management opportunities short-term funds require trustworthy counterparties for large companiesand other wealth-holders,and im- and an instrument, or collateral, of the highest quality. prove the access of quality borrowers to short-term fi- For these reasons, several countries conduct their li- nance at the lowestpossible interest rates. On the other quidity management in a restricted market to which hand, it may be more efficient, especially in smaller only selectedinstitutions, for example,the banks or ap- countries, for the central bank to deal directly with proved money brokers, are admitted. banks without going through the additional intermedi- Although there is alwaysthe risk that, by restricting ank withou going ou the additionalinterm - the number of participants, the authorities will not aryter ofbrokers. Manyof theoadvantagesof having bro- achieve as competitive a market as might otherwise kers may be lost if they are wholly-ownedand controlled emerge,a restricted market of this type can be a useful by the banks. first step towardsthe evolutionof a widermoney market. If central bank managementof bank liquidityis to be In Thailand, for instance, the commercial banks make effectivein influencingmonetary conditions generally, it bids and offersfor repurchase transactions in long-term is essentialthat banks do meet their cash obligations,in- government paper. The transactions are for a few pre- cluding the maintenance of any reserve requirements. definedmaturities and the central bank,acting as a bro- Unauthorizedoverdrafts that arise from the clearing of ker and market-maker receives the bids, arranges checks must be automatically penalizedby the central matches, and may intervene on its own account. An al- bank with sufficient severity to make such overdrafts ternative approach in which the central bank also deals quite exceptional.However, it is not strictly necessaryto with a restricted market is the treasury bill auction in have formal reserve requirements to achieve monetary the Philippines. Fewer than twenty (nonbank) autho- control, as demonstratedby their absencein Canadaand rized dealers participate, but the auction provides the the United Kingdom.Banks will necessarilyhold some main instrument of interest rate policy in that country, reserveson a voluntarybasis to meet a bunching of with- as the authorities decidehow many ofthe bidsto accept. drawalsor loan requests from important clients (Caprio In some countries it is not possibleto identifya suffi- and Honohan 1990; Simpson 1987; Harrington 1987). cient number of appropriately credit-worthy counter- Nonetheless,many countries do have reserve require- parties, as where the bankingsystem has been weakened ments, and there is the view,noted by David Lindsey, by widespreadloan lossesor where the financialsector is that these requirements provide a fulcrum on which too small or concentrated. Elsewhere,there may be a monetary policy can operate with a more reliably pre- shortage of good qualitycollateral, as where the govern- dictable impact on monetary aggregates (Lindseyand ment doesnot borrow domesticallyor where there have Wallich1989; Lindsey paper in this volume). 6 Gerard Caprio, Jr., and Patrick Honohan

An additional merit of reserve requirements is that day-to-dayfluctuations in liquidity conditions. Coun- they can be adjusted to produce desired changes in li- tries that have ignored this point have experiencedlarge quidity. They can be raised in times of unexpectedly swings in interest rates as banks have had to scramble strong capital inflows to effecta broad-basedmopping- continuallyfor reserves. up of excess bank liquidity,thereby sterilizing the do- Theassets eligibleto satisfyreserve requirements are mestic impact of the inflows.Apart from such occasional usually defined to include specifiedclasses of deposit at circumstances,however, reserve requirementsare often the central bank and possiblyspecial government bills. consideredtoo blunt an instrument to be used for vary- Some countries also include vault cash. Most countries ing liquidityconditions. Even slight variations in them do not include instruments that bear a full market rate can produce large changes in the amount of deposits of interest, and therefore the requirement represents a consistent with reserves. Furthermore, as money mar- distorting tax on financial intermediation. Admittedly, kets become more sophisticated,the scope widens for the central bank does providevaluable services free of avoidanceof reserverequirements through the substitu- charge to the banking system,but these servicesare not tion of non-reservableinstruments. Indeed, this motive proportionalto the tax base.When inflationand nominal was also prominent in the rise in severalcountries of market-clearing interest rates combine with high re- money market accounts. These accounts were popular serve requirements,the tax can be very severe. Accord- because they evadedreserve requirements and thus al- ingly it is best to limit the size of reserve requirements lowedthe payment of higher interest rates. and to link the rate of remuneration on required re- Reserverequirements were originally introduced in serves to the market rate (evenif for revenue purposesit many countries as a prudential measure to ensure that is kept some distancebelow market). banks would have sufficient liquidity on hand to meet unexpecteddeposit withdrawals.For that reason, they Copingwith Shocks were expressedas a fraction of deposits. For monetary control purposes, there is no reason why they could not For the most part, the assets that make up bank re- be expressedas a proportion of credit, especiallyif credit serves-usually currency and deposits at the central is considered a more relevant intermediate objectiveof bank-are liabilitiesof the central bank (seeFigure 1-1). monetary policy.This has been done in various coun- Non-bank holdings of currency are a relativelypredict- tries. It is also possibleto have a progressiveschedule of able quantity. (Exceptin centrally planned economies, reserve requirements-for example,through marginal they also are alwaysprovided fully to meet demand;con- reserve requirements on extensionsof credit as overall trol over the moneysupply does not mean squeezingthe credit targets are approached-as a more flexiblealter- availabilityof hand-to-hand currency.) To influence the native to bank-by-bankcredit ceilings. In most coun- quantity of bank liquidity,the central bank must there- tries, where reserve requirementsare based on deposits, fore have regardto the remaining elementsof its balance the requirements are defined by reference to a previous sheet. Adjustments in these elements usually reflect, level of deposits.This allows easymonitoring, though it through the balance sheet constraint, a simultaneous may introduce some delay in the impact of monetary adjustment in bank liquidity.The other main items are policyon the aggregates.This "lagged-reserveaccount- central bank lending to banks, holdings of government ing" also makes it easier for banks-especially those obligations,and foreign exchange reserves. (For exam- with an extensivebranch network or a cumbersome re- ple, when a bank purchases foreign exchange from the porting system-to know on a timely basis their re- central bank for a customer, the central bank's foreign quired levelof reserves.Whatever the base or purpose of exchangeholdings fall, as does the bank's deposit at the reserve requirements, the requirement to maintain the central bank.) By removingthe banks' automatic access reservesshould allow the flexibilityof permitting aver- to borrowing from the central bank at or below market aging overthe maintenance period,to avoidunnecessary rates, it is possibleto bring the first of these items under

Figure 1-1. SimplifiedCentral Bank Balance Sheet ASSETS LIABILITIES Net ForeignAssets ReserveMoney Currency issued DomesticCredit Claimson government,net Bank deposits Claimson banks Other non-governmentdeposits (if any) Claimson nonfinancialfirms (if any) Capital,reserves etc. The Use of Market Instrumentsfor Monetary Policy 7 control. The other two items, which may present greater function for some time, despite the difficultiesof high difficulties,are treated below in turn. and unpredictableinflation (withmonthly rates of inflation rising as high as 80 percent or more). The Impact of Government DeficitFinancing In Chilealso-though inflationhas been much lower in recent years-monetary policy is operated through Some countries have establisheda firm separationof objectivesfor the real interest rate. In effect,this interest monetaryand fiscalpolicy in that they prohibit any lend- rate is transmitted to the market through the central ing from the central bank to the government.Less rigor- bank's lending windowand its deposit facilityfor banks. ous rules in other countries establish quantitativelimits The preciseapproach is somewhatdifferent; it relies on on such lending. Where lack of fiscal restraint presents the daily monetary correction factor (about one-thirti- serious risks to monetary stability,such rules can have eth of the previous month's calculated inflation rate), merit, despitetheir arbitrary nature. In most countries, which is commonlyused as a basis for indexedcontracts however,the central bank has to cope with providingan in Chile. Indexationof monetary instruments remains environment in which the financing of the government controversial,however. Many feel that, by loweringthe deficitis achievedwhile maintaining as much monetary perceivedcosts of inflation,indexation reduces the will- and generaleconomic stabilityas possible. ingness of politicalauthorities to take the necessaryfis- In Italy, enormous governmentdeficits have been fi- cal steps to halt it. On the other hand, the extensionof nanced from domestic savings, while inflation has de- indexationto household mortgage debt (which has not clined. The central bank has withdrawn from direct been successfullyimplemented in all of the countriesat- support of the governmentbond market.6 This has been tempting it) can create an important lobbyagainst infla- achieved by maintaining a level of real interest rates tion. which, though high, especiallyin recent years, can only be describedas realistic in the context of the large deficits (Padoa-Schioppa1987). As Cesare Caranzaexplains External Flowsand MonetaryPolicy below, the authorities have progressivelydismantled Conceptually,a freely floatingexchange rate concep- regulations that had been designed to provide captive tually means that there are no flowsinto or out of the markets for governmentpaper (such as obligatorymini- central bank's foreign exchange reserves. In the polar mum holdings by contractual savings institutions and oppositecase of a rigidlyfixed exchange rate, the central controls on holdings of foreign currency assets). Now bank has no freedomto control its foreign exchangere- holders of government paper do so voluntarily. They serves,as it has agreed to acceptor provideforeign cur- continue to be willing to absorb more, whereas those res, asaIt has funds ondemand. Beten cur- who were penalizedby the regulations of the past have renraaest dometi fudsfond emand.B etween these been slowto acquirevoluntary holdings. The withdrawal two extremesare a variety of differentapproaches to ex- of the central bank has reduced the rate of creation of change rate management, which generate a variety of bank liquidity and has slowed the growth in nominal implicationsfor the operation of monetary policy (Argy money.These changes have allowedthe currency to re- 1982). tain its position in the European MonetarySystem ex- If a country has adopteda free float, it cannot rely on change rate arrangementsand have reduced the rate of exchangerate policyto give it a stable price level.Mone- domesticprice inflation, tary policy-particularly limiting the nominal expan- Where a government has not been able to survive sion of bank liquidity-will be the key to controlling without extensivemonetary financing,it has provedim- inflation. In these circumstances,a stable interest rate possible to restrain inflation. In Brazil, the extremely may be the enemy of price stability,particularly if infla- high inflationof 1989left the central bank no option but tionary expectations build up and result in more and to confine its objectivesto maintaining a functioning more borrowing from the central bank at the-now too system of financial intermediation, again by ensuring low-stable interest rate. that interest rates were at a realistic level.Making no at- An active interest rate policy in a floating exchange tempt (at the level of monetary policy)to restrain the rate regime has a double effecton demand conditions in nominal expansionin monetaryaggregates, the author- the economy.By acting to raise interest rates, the au- ities instead focusedon indicators of inflationaryexpec- thorities increase costs and lowerdomestic demand di- tations, including the parallel markets in foreign rectly. The resultant capital inflowsserve to appreciate exchangeand gold.They adjusted interest rates on a dai- the currency, thereby also reducing external demand. ly basis to achieve positive ex ante real interest rates. Thus, the number of sectors exposedto the first-round This tactic allowed the financial sector to continue to impact of monetary policyis increased,and the negative 8 Gerard Caprio, Jr., and Patrick Honohan impact on any one sector, such as housing, may be di- mixture of theory and practical experiencefrom coun- minished. tries as different (albeit neighboring) as Indonesia and A fixed exchange rate, by contrast, should ensure a Australiaillustrates just what is meant by market-based good degree of price stability,depending, of course, on monetary policy.The need for a parallel developmentof what currency or basket has been adopted for the peg. securitiesmarkets, as policyinstruments evolve,is high- But the exchangerate is fixedonly as long as the author- lighted, together with some practical suggestionsabout ities have sufficientreserves or foreignborrowing capac- how to encouragethis. ity to defendit. An inappropriatelyhigh levelof domestic The second part, "MonetaryTargeting and Control," liquidity expansion (resulting, for example, from the stands back from operational details to look at the mac- central bank financing much of a high budget deficit), roeconomicobjectives towards which monetary policyis willresult in a steadydrain of reservesand, eventually,a directed.The pronounced change in industrial country forcedabandonment of the peg, perhaps precipitatedby attitudes to monetary targets is stressed,and the limita- a well-judgedattack on the currency by speculators. tions of the old approach for developingcountries are A fixed exchangerate can also be vulnerable even if noted. monetary policyis not systematicallymisaligned in this Thetwo main factors tending to knock monetarypol- way. For example, spontaneous short-term capital in- icy offcourse are the exigenciesof governmentdeficit fi- flows,if not sterilizedby offsettingaction by the central nance and the management of international balance of bank, may relax domestic credit conditions so far that payments flows and the exchange rate. Parts Three wagesand costs generallyget out of line. This weakens ("BudgetDeficits and MonetaryPolicy") and Four ("The the competitive position of the economyand results in Interaction of ExchangeRate and MonetaryPolicy") look an unsustainabledrain on reservesover the longer run, at these factors in turn, with case studies from develop- especiallyif the capital flowsare reversed.7 Prompt ac- ing and industrial countries. tion by the central bank to sterilize some of the inflow The papers and discussionsreported in this volume may be necessaryto prevent this cycle,which has been contain manydetailed recommendationsfor the applica- observedin severaldeveloping countries as well as in the tion of monetarypolicy instruments to developingcoun- smaller developedcountries. There can also be sponta- tries. A number of key messages may be highlighted neous speculativeattacks on a fixedexchange rate-al- here. though the onus must be on the authorities to proveto * Indirect methods of monetary control require a their own satisfactionthat the flowsare spontaneousand certain degree of interest rate volatility. As do not reflect an underlying weaknessin the economy. stressed by Paul Meek,the challenge for the au- Few countries have sufficientresources to ride out such thorities is to act promptly and vigorouslyeven unwarranted speculativeattacks without adjusting poli- when unpalatableinterest rate increasesare need- cy.The normal action is to allow the drain of domestic ed. Theymust also ensure that their institutional liquidity,which such an attack produces, to raise inter- set-up makesprovision for them to lowerinterest est rates-dramatically if necessary.This can make un- rates, when that is appropriate. successfulspeculation so costlythat the attack is quickly * The successfulcentral bank will listen to the mar- choked off. ket as well as guiding it. Freed from the con- However,the impact of the balance of payments on straints of quantitative controls, financial monetaryconditions need not be destabilizing.Indeed it markets will often signal inflationarypressures or has long been observedthat a fixedexchange rate coun- an impending slump, thereby assisting the for- try whose competitiveposition deteriorates will experi- mulation of monetaryplans and policy.8 ence a current account deficit which, if not sterilized, * The stabilityof money demand relationshipscan- will tighten domestic liquidity conditions enough to not be relied upon in developingcountries, partly lower domestic demand, divert the production effort because there is not sufficient historical experi- into exports,and improvecompetitiveness. ence with liberal markets on which to base forecasts. David Lindsey, Charles Goodhart, and ConcludingComments and Outline of the Steven Grenvilleall noted the difficultieswith in- Volume termediate targets even in industrial countries with more experienceand the result that mone- The remainder of the volume is organized in four tary targeting no longerholds the position it once parts. The first part, entitled "Nuts and Bolts," contains did. Accordingly,it may be necessaryfor develop- contributions on the day-to-daypracticalities of operating countries to concentrate directly on targeting ing monetary policy under a market-based system. A foreign exchangereserves rather than on choos- FH,' I1L' 9 Maltket Iwirumlentl lo,, Monciarv Polit v 9

ing an intermediate target such as the quantity of cessive holdings of liquidity, can curtail growth both in money.9 Barry Johnston advocates this approach, the financial sector and in the rest of the economy. Al- though he observes that a tight monetary policy though not all countries are in a position to apply imme- can result in private capital inflows rather than diately the experience already gained by industrial reducing the current account deficit. countries in operating indirect methods of monetary * As noted by Johnston, there may be one-off port- control, it can be expected that more and more monetary folio adjustments following financial market lib- authorities will soon begin to follow the lead of several eralization and the removal of quantitative Asian countries, in particular. controls. The authorities must be prepared for these adjustments, often involving a greater ex- Notes pansion of credit demand than of deposit supply. The inflationary consequences may be arneliorat- 1. TIhat is, for an economy not experiencing financial ed by appropriate interest rate levels or, depend- repression. If, on the other hand, interest rates have ing on circumstances, capital inflows, been repressed to artificially low rates, and credit ra- * Optimal functioning of indirect methods requires tioned arbitrarily, an increase in interest rates may lead the development of new markets; these in turn to greater availability of credit and an improvement in enhance the efficiency of financial markets and long-term growth prospects. their ability to serve the economy, including its 2. In France, a program dubbed the "encadrement du investment needs. As argued by Meek, the objec- credit' entailed a target for the net asset growth of each tives of financial market development and mone- financial institution, with penalties imposed that were a tary policy thus go hand in hand. Cesare Caranza (geometrically rising) function of the extent of the trans- shows how this complementarity became crucial gression (Mourgues 1988 and Joint Economic Commit- to the success of Italian policy in the 1980s. A re- tee 1981.) tlntil 1979, however, credit for energy, exports lated passage is Juan Andres Fontaine's concrete and "social" housing was exempt. As expected, credit to account of how the development of debt-equity these sectors boomed and led to a loss of monetary con- swaps by the Chilean authorities contributed to trol. Coffee exporting countries in Central and West Af- stabilization there. rica were among those who experienced similar * Also, it is useful to provide some hint of caution difficulties in the late 198)s. about the risks for central bankers in being too 3. For market movements to have meaningful infor- doctrinaire about the market-oriented policy in- mation content, the market must be fairly competitive. struments advocated in this volume. Several of If there is only a handful of institutions in the market, the papers that follow give illustrations of practice they could collude to send misleading signals to the deviating trom the pure market approach. With- monetary authorities. out necessarily endorsing every one of these, we 4. These are often known as '"repos" or "swaps."A re- cannot disagree with the general point that emer- versedl transaction involves the sale of a security and an gencies can arise that do require old-fashioned agreement to repurchase it later at a fixed price. It makes non-market-clearing solutions."' liquid funds available to the seller for the agreed dura- Finally, shifting away from direct means of control- tion of the transaction. The relation between the current ling monetary policy is by no means universal in its ap- price and the agreed future price establishes an implicit peal. Direct controls are simple to operate. They seem to interest rate for what, for many purposes, can be offera sure handle on overall credit or money growth. As thought of as a secured loan. noted by several observers, moving away from direct 5. Thus the central bank can do a one-day or one- controls often involves a fundamental reorientation of week repo with a 3(0-yearbond as an underlying security. central bankers and government officials, not only in re- In Tunisia, the government has in effect securitized part gard to directed credit but also concerning the financing of the banks' loan portfolio by allowing some loans, pre- of government debt. However, monetary officials in a va- sumably to high-quality risks, to serve as the underlying riety of countries have found that there is no fool-proof basket of securities for repos. This operation also could method to guarantee the achievement of any overall be viewed as a rediscounting of a basket of loans, com- monetary target. Bank-by-bank credit ceilings suffer pared with the usual rediscounting of specific, or indi- from the same limitation; eventually, nonbanks arise to vidual, loans. escape credit limits, and banks have every incentive to 6. Although the overall public sector borrowing re- evade controls. Moreover, such ceilings limit competi- quirement has remained above 10 percent of GDP since tion and, by choking off innovation and prompting ex- the niid-1970s, in recent years the non-interest compo- 10 Gerard Caprio, Jr., and Patrick Honohan

nent has declined to 2-3 percent of GDP.Indeed, the Goodhart,Charles, 1989."The Conduct of MonetaryPol- pressure of a rising interest bill, associatedwith the need icy,"The Economic Journal, June.

to finance government debt at market rates, has in- _ , 1984. Monetary Theory and Practice: The UK creased the pressure on the government to reduce the experience,London: Macmillan. non-interest deficit. Harrington, R. 1987. Asset Liability and Management, 7. Short-term capital inflowscan be spurred by a va- Organizationfor Economic Cooperationand Devel- riety of factors,such as a rise in the price ofa natural re- opment, Paris, occasionalpaper. source, as in the case of oil or natural gas exporting Johnston, R. Barry,and Odd Per Brekk, 1989."Monetary countries, or a significant liberalizationof the domestic Control Proceduresand FinancialReform: Approach- economy,as in the Southern Coneeconomies during the es, Issues, and Recent Experiences in Developing 1970s. Countries,"International MonetaryFund, WP/89/48, 8. Steven Grenville (and indirectly, Paul Meek) de- June. scribe how the central bank benefits from allowingthe Joint Economic Committee,1981. Monetary Policy, Se- market scopeto move interest rates. Discussingthe link lective CreditPolicy, and IndustrialPolicy in France, with exchange rate policy,Charles Freedman goes fur- Britain, West Germany,and Sweden, A staff study for ther in arguing that the authorities can do little to fight the Joint EconomicCommittee of the Congressof the against fundamentalmarket forces. United States,June. 9. Authoritiesin large economiesshow signs of mov- Judd, John P. and John L. Scadding, 1982. "The Search ing toward an eclectic approachwhere ultimate targets for a Stable MoneyDemand Function," Journal of of inflation and growth are emphasized. Officials in Economic Literature, September. smaller economiestend to focus more (or exclusively) Kneeshaw,John T.and P. Vanden Bergh, 1989."Changes on the exchangerate or foreign exchangereserves. in Central BankMoney Market Operating Procedures 10. Don Mathiesonmakes this point about responses in the 1980s,"BIS Economic Papers, No. 23, January. to financial system failures, while Carlos Queiroz illus- Kubarych,Roger M. 1978. Foreign Exchange Markets trates the knife-edgealong which the Brazilian mone- in the United States, Federal Reserve Bank of New tary authorities have walked in a difficult policy York. environment. Lin See Yandescribes the (controversial) Lindsey,David E. and Henry C.Wallich, 1989. "Monetary use of targeted interest subsidiesin responseto a foreign Policy,"in TheNew Palgrave,edited by John Eatwell, exchangecrisis. MurrayMilgate, Peter Newman.New York, NY: W.W. Norton. References Meulendyke,Ann-Marie, 1990. U.S. Monetary Policy and Financial Markets, Federal Reserve Bank of New Argy,Victor, 1982. "Exchange-Rate Management in The- York. ory and Practice," Princeton University,Princeton Mourgues,Michelle de, 1988. LaMonnaie:System Fin- Studies in International Finance, No.50. ancieret TheorieMonetaire. Paris: Economica. Bernanke, Ben, 1989. "MonetaryPolicy Transmission: Padoa-Schioppa,Tommaso, 1987. "Reshaping Monetary Through Moneyor Credit," Federal ReserveBank of Policy,"in Macroeconomicsand Finance:Essays in PhiladelphiaBusiness Review, January/February. Honor of Franco Modigliani, Rudiger Dornbusch, Binhadi and Paul Meek, 1989."Implementing Monetary Stanley Fischer,and John Bossons, eds. Cambridge, Policy,"forthcoming in a volume by the Australian Mass:MIT Press. NationalUniversity. Roubini,Nouriel, 1988. "Offsetand Sterilization under Broaddus, Alfred, 1985. "Financial Innovation in the Fixed Exchange Rates with an Optimizing Central United States - Background, Current Status, and Bank,"NBER Working Paper no. 2777, November. Prospects," Federal Reserve Bank of Richmond Simpson,Thomas, 1987.Money, Banking, andEconom- WorkingoPapera85-2. ic Analysis, third edition. Englewood Cliffs, N.J.: Caprio,Gerard and PatrickHonohan, 1990. "Whatis Ex- Prentice-Hall. cess Liquidity,"processed, World Bank. Shearer,R.A., J.F. Chant, and D.E.Bond, 1984.The Eco- Cottarelli,Carlo, GiampaoloGalli, PaoloMarulo Reedtz nomics ofrtheCaadian FinancialSystem, pp 444-52. and Pittaluga, 1986. "MonetaryPolicy through Ceil- ings on Bank Lending,"Economic Policy, October. de Vries,Rimmer, 1986. "GlobalCapital Markets:Issues and Implications,"in WallenbergPapers, volume 1, no. 4, October. PART I

Nuts and Bolts: Practical Issues on Moving to Indirect Implementation of Monetary Policy

Introduction

The move from direct to indirect monetary controls was be viewedas "front-line"tasks, beforethe authorities can accomplishedfirst in industrial countries with smoothly rely on open-markettype operationsas a channel for im- functioningmoney and capital markets. Policymakers in plementing policy.For example,policy makers willben- developingcountries are starting without these advan- efit from being able to forecast seasonal patterns in tages. This sectiondeals with the basic practical require- credit demand. When a central bank is able to forecast ments for moving to indirect controls. The key is flowsaffecting bank liquidity,it is in a better position to ensuring that the monetary authorities have the tools achieve desired trend in interest rates. Meekremarks necessary to smooth bank liquidity.Central bank inter- that this is not strictly necessaryfor short-term liquidity vention in the markets for treasury bills and similar in- managementpurposes, and there are differencesof opin- struments are usually the mediumthrough which policy ion on how much effort should be devotedto the short- is effected. term forecasts.However, for the medium-termformula- Severalspeakers stressed the fact that movingto indi- tion of monetary policy objectives,forecasting of flows rect monetary managementand the developmentof effi- does become a more central part of the whole exercise, cient securities markets were closelylinked. Neither can as pointed out by BarryJohnston. Centralbanks aiming be wholly successfulwithout the other. In country after for greater reliance on indirect methods of implement- country, this developmenthas required shifting governing monetarypolicy should make an early start on build- ment bond sales from captive banks to a wider market. ing these skills. The process has been quite recent even in industrial The pros and cons of reserve requirements,including countries. (StevenGrenville describes the Australiancase precise methods of calculation and enforcement, were in this part, and the Italian and Chilean cases are de- debated.Although reserve requirements can aid the cen- scribed in Part III.) tral bank in its effortto determine banks' liquidityneeds, Though developmentof the money markets will not they can easilybecome a tool for taxingthe financialsec- occur overnight, Paul Meek and Steven Grenvilleboth tor and reducing the competitiveposition of the banks. emphasized that the way monetary policyis conducted Reserverequirements are not necessaryfor implement- can do much to either stimulate or retard their developing monetary policy-this point resurfaced during the ment. Deeper money markets will not only facilitate a presentation by DavidLindsey in Part II-but they can smooth implementationof monetary policybut also im- help strengthen the central bank'shand in times ofmon- provethe efficiencyof the financialsystem.' Issuing gov- etary restraint by making the banks come to it for liquid- ernment paper too frequentlyor providingliberal access ity. On the other hand, reserve requirements have often to the discount windowstifles the developmentof inter- been used as a form of taxation, reducing the effective- bank lending. Similarly,if the authorities eliminate vari- ness of the bankingsystem. Such distortionscan be min- ability in interest rates, they will prevent the emergence imized by remunerating banks for the reservesthey are of brokers and dealers, who could facilitate the absorp- required to hold. tion of interest rate risk in the private sector. As Barry Another controversial issue was the proper role of Johnston also argued, all of this requires a significantre- banks in developmentfinance. Mr. Johnston expounded orientation in the thinking of the monetaryauthorities. 2 one view in this old debate, arguing that banks should Sufficientattention has to be paid to so-called"back- not providelong-term credit, which was more appropri- officesupport" in the central bank, which in fact should ately the role of a capital market. Others have argued

13 14 Introduction to Part I that one of the roles of banks is to engage in the term based methods were developedusing central bank and transformation of risk, and that by pooling risks and ju- private securities rather than those issued by the Gov- diciouslymixing debt maturity,banks can safelypartici- ernment.) pate in term lending. For instance, one leading The speakers in this session had considerablepracti- economic historian has attributed a slowdownin U.K. cal experiencein money market affairs. Paul Meekwas growth during the latter part of the nineteenth century vice president and monetary adviser in the open market to the British banks' withdrawalfrom term lending; in area ofthe Federal ReserveBank of NewYork from 1973 contrast, the increasedwillingness of German banks to to 1985.Since then he has servedas a consultant to cen- make term loans is seen as having boosted industrial tral banks, including those of Indonesia,Malaysia, Paki- growth there (Kennedy1987). stan, China, Portugal and Singapore. Steven Grenville Dr. Grenville'spresentation drew on the recent Aus- has had a distinguished career at the ReserveBank of tralian experienceof a rapid transformationin the finan- Australia,while Barry Johnston worked at the Bank of cial sector and in the conduct of monetary policy.He England and the U.K.Treasury before joining the Cen- underlined the importance of admitting non-financial tral BankingDepartment of the International Monetary institutions into the money market as a means of in- Fund. creasing competition, a potentially important point in many small developingcountries where there are only a Notes handful of banks. He also stressed that the presenceof a captive market for government securities can subvert 1. The greater the liquidityof the money market, the the developmentof a market. For instance, accounting less need of banks to hold excessiveamounts of liquidity. conventionscan inhibit institutions (reluctant to recog- Grenvilleprovides evidence of a significantdecline of ex- nize the capital loss) from selling,before maturity, low- cess liquidity in Australia,as the money market deep- interest bonds they have been forced to acquire. This ened. point is raised later in the contributionsby Cesare Car- 2. Speakers did not, however, advocate special tax anzaand Juan AndresFontaine. The simultaneousdevel- privilegesto promote money or capital market develop- opment of an active government securities market and ment. new monetary policy instruments, which are comple- mentaryprocesses, requires close coordinationbetween Reference the monetaryauthorities and those charged with public debt management. If debt management is allowed to Kennedy,William P., 1987.Industrial Structure, Capital take precedence,this can slowthe effectivetransition to Markets, and the Origins of British Economic De- market-basedmonetary control. (The Indonesian case, cline, Cambridge UniversityPress, Cambridge, En- discussedby Meek, providesan examplewhere market- gland. 2

CentralBank LiquidityManagement and the Money Market

Paul Meek

Central banks have a major role in developingand imple- Central Bank MonetaryManagement menting monetary policy, conditioned by the political and legal system within which they operate. They must In developing countries the monetary authorities be concernedwith two aspects of monetary policy: eco- have tended to use dirigiste approaches to economic nomic management and liquidity management. Eco- management. They have often chosen to set interest nomic management involves promoting sustainable rates and exchangerates administrativelyand to impose economicgrowth over the longer term by keeping mon- credit control on individualbanks as a means of influ- etary and credit expansion in step with an economy's encing the balance between the supplyand demand for non-inflationaryoutput potential. It requires operating real resources. The credit control approach has been within the constraints imposedby foreign exchangere- used frequentlyin Asia,often in conjunction with a na- serves, external debt, and the availability of foreign tional planning exercise-in India, Indonesiaand Paki- grants and credits. Liquidity management, in contrast, stan, for example. Oftentimes the authorities also has a shorter time horizon. It involvesassuring that the prescribe institutional holdings of government and oth- banking system can provideflexibly in the short-run for er securities and attempt to direct credit to favoredeco- the cash and payment needs of the society. nomic sectors. Administrative control over credit Central banks have other important functions that expansionoften works well for a time in the formal fi- bear on their monetary policy responsibilities.In most nancial system,to moderate inflationarypressures while countries they are required to assure the soundnessand fostering development. In time, however, it reduces safety of the payments system, regulating and supervis- competitionwithin the banking system, favorsexisting ing the operations of the commercial banks, and fre- lines of business at the expenseof new enterprises,and quently other financialinstitutions as well. An adequate results in high intermediationspreads. Government en- supervisorysystem and an effectivelegal system may be terprises and the governmentitself are apt to take an in- prerequisitesto the desirability,or even feasibility,of de- creasing share of credit flows, sapping growth. These veloping financial markets as a means of fostering eco- adverse consequenceshave sparkedwidespread interest nomic efficiency. in liberalizingfinancial systems to spur competitionthat Assuming that the preconditions do exist, central will encouragesavings and improveresource allocation. banks can help money markets developby the way they To central banks, the encouragement of money and carry out their liquidity management function. The securities markets offers one means of enhancing effi- present paper takes up first the issues involvedin such ciencyby multiplyingthe channels through which sav- management. It then presents some general guidelines ings and credit can flow. Such markets also enable for developingan efficientmoney market. Finally,it gives monetary policy to operate flexiblyto foster national an in-depth look at Indonesia'sexperience in recent years macroeconomicgoals, while leavingthe distribution of in movingfrom a credit control systemof monetarycon- domesticsavings and investment to competitive forces. trol to one involvingopen market operations in a fledg- Theycan also assist the central governmentin financing ling money market. its own cash requirements in a non-inflationarymanner.

15 16 Paul Meet'k

Howevera financial system is organized,the central that financialmarkets can bring providesstrong justifi- bank has to find ways of providingliquidity routinely so cation for movingahead with their development.But the that banks can meet varying short-term demands for credit demandsof the governmentand private business cash and credit without impairing the reservesthey are can get out of hand unless the monetaryauthorities pos- required to keep with it. Banksdraw downtheir working sess the authority and the will to make interest rate balances at the central bank whenever there is a large changes that enforce market rationing. public demand for currency or credit to pay taxes,meet payrolls,or pay bills. If the central bank does not offset Approachesto Liquidity Management the resultant drain on bank reserves, the banks are forcedto scramblefor funds, drivingup interest rates or Central banks in developingcountries usually begin repatriating funds from abroad. Similarly,if it does not operatingin a financialenvironment dominatedby com- mop up the surplus reservesproduced by a return flow mercial banks.These expand their branchesand services of currency after major holidays,short-term interest as the economy's financial requirements increase with rates will fall and there may be an outflow of funds development. In time, finance companies, merchant abroad.The central bank can rely on its discountwindow banks, discounthouses, stock exchanges,and insurance to handle the fluctuations of bank reservesin relation to companiescan develop,depending on the pace of busi- requirements-setting terms on which the individual ness developmentand the enabling actions of the fiscal banks can deal directly with it. Or it can initiate open and monetary authorities. In this environment the cen- market operations to offsetsuch changes, leaving it to tral bank usually permits individual commercial banks the interbank market to distribute the reserveswithin to replenishtheir reservesby borrowingfrom the central the banking system. A sizable share of reserve changes bank, discountingapproved paper with it at posted rates, involve uncontrolled movements in other elements of or selling it foreign exchange.Commercial banks with the central bank's own balance sheet. The treasury excess reservesmay be permitted as well to buy foreign makes large net disbursements from its accounts with exchange or government securities directly from the the central bank at some seasons, adding to reserves, central bank. The central bank itself respondspassively while at other times its balances swellwith tax receipts, to the demandsof the commercialbanks, balancing the having the oppositeeffect. When the central bank inter- system as a whole by a series of bilateral transactions venes in the foreign exchangemarket to maintain conti- with individualinstitutions. nuity, its purchases and sales impact bank reserve The interest and exchangerates at which the central positions and the domestic money market. It must also bank deals with the commercialbanks depend upon its take account of swings in the net credit to banks that approach to economic management, including the ex- may result from the central bank's arrangements for tent to which it permits domesticresidents to switch be- check collectionand payment.It has to balance the col- tween domestic and foreign currency. If credit controls lectivereserve position of the banking system if it is to are the principleinstrument of monetary policyand ac- keep domestic short-term interest rates reasonably cessto foreignexchange is controlled,the rates at which steadyfrom day to day. the authorities discount or sell paper bilaterallymay be Oncea central bank moves from credit control by ad- arbitrary and remain fixedfor long periods.In Pakistan, ministrativefiat to the use of financialmarkets, its eco- for example,the State Bankdeals with excessliquidity by nomic and liquidity management commitments are in selling 91-day treasury bills on tap at a 6 percent dis- constant tension. The authorities cannot become ob- count rate. Then when a bank needs reserves, it redis- sessedwith holding short-term rates steadyif they are to counts the bills before maturity at 6.05 percent. The managethe economyproperly. They must be preparedto State Bank's rates of issue and discount bear little rela- change short-term interest rates promptly as their per- tion to effectivereturns on bank depositsor loans, but its ceptions of the economicoutlook change. Holdingsuch bill operations keep the rates on daily interbank loans rates steady for extended periods can easily result in steadyat around 6 to 6.5 percent. Such routine accom- moneyand creditgrowth overa longertime horizon that modation inhibits the developmentof liquiditymanage- is either excessiveor deficient. Those central bankers ment skills that are needed in a modern economy. who have relied on credit ceilingsas their principaltool Whena central bank phases out credit controls,it has for economic management may find it hard at first to to adapt its liquiditymanagement techniques in order to change quickly enough the terms on which they make influence money and credit growth through interest reservesavailable. Operating in financial markets with rates. Oftenthe first step is to developan array of rates at flexibleinterest rates involvesa basic change in orienta- which it is preparedto make loans or to sell short-term tion. The improvementin savingand resourceallocation assets. It might, for example,establish lending tranches Central Bank Liquidity Management and the Money Market 17 that involve a step-up in interest rates as individual spect to the calculationperiod. Commercialbanks make banks increasetheir borrowing.The central bank could every effort to meet their requirements since deficien- still rely on balancing the system in the short run cies usually subject bank managementto embarrassing through bilateral transactions with individual banks. inquiriesfrom the central bank as well as the assessment For the longer term, it would have to adjust the levelof ofa penalty.In a fewcountries, the monetary authorities rates or the structure of its discount facilitywhen money operate with zero or minimal reserve requirements, ex- and credit growth appearedto be departing significantly erting their leverage on the working balances of the from a desired path. banks. In the United Kingdom,for example,the Bank of Amore important step toward market-orientedpolicy England has an understanding with the major banks procedures takes place when the central bank assumes that their workingbalances with it will each day remain responsibilityfor evening out swings in bank reserves at or abovea certain level. relative to demand on its own initiative, rather than Theperiods selected for reserve calculationand main- waiting passivelyfor individualbanks to come to it. Once tenance affect the manner in which both the central it begins to supply or absorb liquiditythrough market bank and the commercialbanks go about their business. intervention, the discount window plays an important, Use of a single day in calculating requirements-per- but subordinate,safety valve role. Operationallythe cen- haps the end of a monthly or semi-monthly period- tral bank can supplyreserves through the market when- givescommercial banks an incentiveto minimize depos- ever the short-term interbank rate rises abovea certain its on the day in question. The reserves required may point and withdraw them whenever the rate falls below change significantlyfrom one period to the next, since some lower point. The distribution of reserves among depositson the basedate can vary a great deal depending different banks is left to the interbank and other asset on the day ofthe week or time of the month. Usinga dai- markets. The discount window serves as a backstop in ly averagecalculation for the baseperiod has distinct ad- case reservesremain short after the central bank oper- vantages. There is less scope for commercial bank ates. churning to reduce requirementsthrough their own action, when each day'sdeposits enter the reserve calcula- The Banking System 's Demand for Reserves tion. The averaging process also tends to dampen swings short-term interest in required reserve levelsbetween periods. To maintain reasonably steady .. The length of the reserve maintenance period influ- rates from day to day, the central bank seeks to provide The le aden of reservesni avail- bankswith sufficientreserves to meet any mandatoryre- ences the scale and frequencyof swmgsIn reserveavail- serve requirements plus whatever excess reserves or ability that the central bank seeks to offsetand hence, working balances the payment system needs. What this the behavior of the money market. If the commercial implies for central bank operations dependson the de banks must meet their requirementsof minimum work- posits commercialbanks maintain with it in practice, as ing balances every day, the central bank faces each day determinedby their workingneeds as well as the regula- the formidabletask of countering the net effecton re- tions governing reserve requirements and transfers of serves of all uncontrolled changes in its balance sheet. funds and securities. The Bankof England,for example,must operate daily in the moneymarket to balance that day'sreserve changes, Reserve requirements with end-of-dayloans to discount houses availableto meet residual needs. The overnight interbank rate In most countries, the central bank specifiesthe re- moves during each day as individualbank reserve posi- serves that commercialbanks must hold, usually calcu- tions change. One cannot make up tomorrowfor today's lated as a fraction of selected categories of customer shortfall. deposits with each bank. Some central banks use uni- Malaysia'sexperience provides another example.Until form requirements across deposit categoriesto equalize recently Bank Negara Malaysiaspecified that required the implicit tax involved,while others specifylower re- reserves be maintained on a semi-monthlybasis, but quirements on time and savings deposits than on de- held them frozen throughout the maintenance period. mand deposits.The process of liquiditymanagement can Accordingly,the separateworking balancesof the banks be adjusted to whateversystem is in place. Typically,re- bore the full brunt daily of all changes in the central quired reservesare calculatedon the basis of depositson bank's balance sheet. Since Bank Negara at the time one day or on the averageof depositsduring a specified made credit availableat day'send onlyat a markup over reserve calculationperiod. The banks must keep the re- the highest interbank rate of the day, the swings in the serves during a reserve maintenance period, which is rate were quite large. Assoon as it allowedbanks to meet usually laggedfrom a fewdays to severalweeks with re- their reserve requirements on a daily averagebasis and 18 Paul Meek modifiedthe rate charged on residual loans to the bank- ated by their customers.Not surprisingly,when the mu- ing system, the scale of its daily market operations sic stops at the end of the day, there are usually dropped sharply and the daily interbank rate steadied unanticipatedsurpluses that cannot be disposedof until within a narrow range. the next day.The more banks there are in the system,the Manycentral banks have chosen to allowcommercial greater the volume of excessreserves that are likely to banks to meet their requirements on a daily averageba- accumulate during the reserve period. sis over the maintenanceperiod as a wayof reducing the In the United States, for example,many of the banks scale of reserve imbalancesand of dampening swingsin and the other depositoryinstitutions that have accessto the interbank rate. Some imposelimits on how low end- the Federal Reserve'sdiscount windowand wire transfer of-daybalances can be in relation to requirements,to re- facilities have very small reserve requirements. Their duce the likelihoodthat the banks as a group will accu- need for working balanceswith the Federal Reserveex- mulate large deficiencies during the period. Large ceeds their requirements.As a result the aggregatevol- cumulative deficitsor surpluses can exert considerable ume of reserveson the central bank's booksat the end of upward or downwardpressure, respectively,on the daily each day'stransfers of funds and securities is quite size- interbank rate when banks attempt to square their posi- able-almost US$1billion in 1989. In conducting its tions as the end of the period approaches.To moderate open market operations, the Federal Reservemust add such pressures, some central banks permit reserve ex- an estimate for excessreserves to estimated required re- cesses or deficits to be carried forward, within limits, servesin eachtwo weekreserve period, to producea pro- into the next reserve maintenance period, as is done in jected demand for total reserves. If it wishes to raise the United States. short-term interest rates for economicmanagement rea- The length of the lag betweenthe reserve calculation sons, the central bank does not fully meet this demand, periodand the reservemaintenance period affects the re- forcing banks to increase their borrowing from it. If it serve management problem facing both commercial wishes to lowerrates, it can supplymore reservesthan it banks and the central bank. If both the central bank and expectswill be demanded. the commercial banks have deposit data in hand before A banking system's need for excess reservesdepends the reserve maintenance period begins, then both will in part on whether the central bank's rules allow vault know in advancethe reserve targets at which they are cash to be counted toward the fulfillment of require- shooting. If the two periods overlap,both must operate ments. When vault cash can be counted, commercial on the basis of projections,which are likelyto have siz- banks typically retain enough, distributed in their able margins of error. It helps when both have a good fix branch banks, to meet local demands for cash while on requirementsin time to take corrective action before seeking to minimize the expensivemovement of cash. the maintenanceperiod ends. With such informationthe Some banks may then find that the residual require- central bank can make reasonableestimates of the total ments met by central bank balances are less than they reservesthat the banking systemwill demand during the need for working balances. The smaller these residual maintenanceperiod to coverrequirements and allowfor balances in relation to bank activity,the more likelythat the excessreserves necessary to lubricate the payments banks will hold excessdeposits with the central bank. On system. the other hand, if vault cash cannot be counted toward Advanceknowledge may be desirable from an opera- requirements, then commercial banks will seek to min- tional standpoint,but it is not critical. The central bank imize the cash held in their own vaults, withdrawing still has to estimate the uncontrolled factors affecting cash as needed from the central bank and redepositing the supplyof reserves.Variations in currency in circula- excess cash with it. Both the central bank and the com- tion, treasury balancesat the central bank and other fac- mercial banks willthen incur significantadditional costs tors may well be considerablylarger than the variations in transporting and handling the cash. in required reserves.The central bank will alwaysface a The central bank's own rules for permitting transfers margin of uncertainty about the demand for reserves of funds on its booksfrom one bank to another also in- that will impact the money market. fluence the banking system's demand for excess reserves.Some central banks, Bank Indonesiafor one, will The Demandfor Excess Reserves honor transfer orders only if the transferring bank has collected funds on deposit in its account. In conse- Whateverthe levelof requirements,banks customar- quence, most Indonesian banks maintain deposits be- ily need a certain amount of excessreserves to keep the yond their requirements in order to transfer funds early system operatingsmoothly. In managingtheir positions, in the day or to be able to meet adverse clearings.Bank banks have to cope with large in and out transfers initi- Indonesia in its open market operations has to allow for Central Bank Liquidity Management and the Money Market 19 a sizable demand for excess reserves. Moreover,banks ernment or take down a portion of new government typically pay a higher interbank rate in the morning loans. These credit activities, which may loom quite than after the clearing,usually one percentage point or large in the central bank's balancesheet, are a source of more. reserve changes, necessitating an equilibrating re- In contrast, the Federal ReserveSystem in the United sponse.The central bank must cope with changes in re- States required for many years only that banks have ad- serveavailability from whateversource, including those equate balances at the end of the business day. To en- that originatewithin the bank itself. courage an efficientfinancial system in an environment Many central banks have a formal discount window with thousands of banks, it allowed banks to transfer that purports to be availableto commercial banks that funds or make paymentfor securities even if such trans- experiencereserve shortages but which in fact goes un- actionsresulted in temporary overdraftsin their Federal utilized because the discount rate is set well abovethe Reserve accounts. One consequence was the develop- cost of adjusting through other means. Banks in Paki- ment of a very efficientinterbank (Federalfunds) mar- stan can obtain neededreserves by discountingtreasury ket. Individual banks could redress a loss of funds bills at a rate well below the formal discount rate, while experiencedin the normal course of businessby borrow- the State Bank uses credit controls for economic man- ing funds overnightor for longerterms from banks with agement. In Indonesiaa few years ago, banks could sell surplus funds. Borrowingbanks in the major cities go foreign exchange they held abroad to the central bank into overdraft automatically each morning when they for same-daycredit, whereasthe discount rate was usu- wire funds to their lending banks to repay the previous ally three percentage points or so abovethe daily inter- day's loans. They cover the overdraftwith incoming re- bank rate. What matters is not the definition of the ceipts or borrowingsthat are credited to their accounts formal discount windowbut the alternatives the banks later in the day.This practice of extendingintraday cred- face in making reserve adjustments on their own initia- it to banks that are overdrawnexposes the Federal Re- tive. serve to the risk that a bank fails before it restores its If central banks depend on influencingmoney and balance at the central bank. Concernedabout its credit credit growth through interest rates, they can still estab- exposure in a world financial system with enormous lish an array of rates at which they will deal with their transfers, the Federal Reservehas been developingnew commercialbanks to adjust liquidity.Balance in the sys- rules and proceduresfor monitoring and controlling its tem as a whole is achievedthrough independentactions exposure without adverselyimpacting the operation of of the banks themselves in bilateraldeals with the cen- financial markets. tral bank.Rates in the interbank market for fundsreflect The Supplyof Reserves the interaction of bank credit demandswith the central bank's rate schedules.They, in turn, affectthe rates that In managing liquidity,a central bank developsits own the banks quote on deposits and loans. Monetarycon- proceduresfor supplyingor absorbingreserves. As noted trol's effectivenessdepends on the readiness of the au- earlier, this may involve a passive response system in thorities to move its administeredrates. which discount window rules allow depository institu- Thecritical step forwardin liquiditymanagement oc- tions to discount various kinds of paper or obtain ad- curs when the central bank undertakes to supplyor ab- vances when confrontedwith a shortageof reserves.The sorb reserves on its own initiative. It then addresses central bank may also stand readyto sell treasury or oth- reserveshortages or surpluses in the system as a whole, er paper at preset rates to bankswith excessfunds. Once leaving the distribution of reservesto the operation of a central bank undertakes to manageliquidity actively, it the money market. Open market transactions are based must itself add to, or reduce,reserves by buying or sell- on competitivebids or offeringsby market participants, ing assets in the money market. The discount window not a preset central bank schedule,and the central bank then becomes a safety valve rather than the principal determines the amount of securities purchased or sold. means of meeting liquidityneeds. The introduction of open market operations does not eliminate the need for discount windowoperations. In- The Discount Window dividualbanks still need a lender of last resort when they find themselvesshort at the end of the day,after all in- The managementof liquiditytakes as giventhe other terbank transfers have taken place.The discountwindow credit activities of the central bank. Central banks often providessuch a facilityto individualinstitutions but no serve as the channel for distributing subsidizedcredits longer is the vehicle for major adjustments in reserves. to favoredenterprises or sectors of the economy.Or they The interaction betweenopen market operationsand providetemporary overdraft facilities to the central gov- the discount window is central to economic manage- 20 Paul Meek ment. Arrangementsdiffer considerably from country to OpenMarket Operationsand the Developmentof the country. In the United States, with its thousands of de- Money Market positoryinstitutions, accessto the windowis restrained by internal rules that define acceptable borrowing in Centralbanks cannot rely on open market operations terms of frequency and institutional size. When open foraeconomicpandliquiditymanagementrwithout consid- market operations do not fully meet the banking sys- erable developmentof the financial structure and mar- tem's demand for total reserves,the banks increasetheir kets. Yet central banks have a leading role to play in recourse to the discountwindow; the Federal funds rate these institutional developments.An excellentexample also rises but remains moderate even though the dis- ofthe steps that can be taken is providedby Malaysia.'At count rate is belowthe Federalfunds rate. The spreadbe- an early stage after independencein 1957,the monetary tween the two rates indicates the bite of policy authorities encouraged the formation of new national tightening. It increaseswhen the Federal Reservesatis- commercial banks and branch banking,which resulted fies reserveneeds more through rationedrecourse to the in a sharp decline in the dominant share previouslyheld discount window than through purchases of govern- by foreignbanks. The first discount house wasorganized ment securities in the open market. The central bank in the 1960s,and the number had grown to seven by can probe toward monetary restraint or ease without 1986.The BankNegara Malaysia also persuadedthe trea- moving the discount rate. Changes in the discount rate sury to begin issuing securities with different coupons are used to reinforce changes in market rates initiated and maturities to meet the needs of a wide range of in- through open market operations, when the economic vestors,includingthe EmployeesProvident Fund, which situation callsfor advertisingpublicly the shift ofpolicy. took down 20-yearbonds. In 1973,the year in which the A different approach is used by the Bank of Canada Malaysianand Singapore currencies ceased to be inter- whose banking system consists of a few banks with na- changeable,the sale of treasury bills moved to an auc- tionwidebranching systems.The Bankof Canadasets its tion basis and the Malaysianringgit wasfloated. Bankers discountrate each weekat a penalty markup overthe av- acceptancesand negotiable certificatesof deposit were erage issuing rate establishedon three-month treasury authorized in 1979. Finance companiesand merchant bills in the weeklyauction. As long as the central bank bankswere establishedas well in the 1970s. finds the existing level of short-term market rates satis- BankNegara from its beginning required the banks to factory from an economic management standpoint, it hold specifiedliquid assets in addition to required re- providesfully the reserve needs of the banking system, serves, to assist in monetary control and to ensure that so that there is no need for borrowing at the discount the banks playeda direct role in financing the govern- window. However,if the economic situation calls for ment's developmentefforts. In 1986 the primary liquid higher rates, the Bank of Canada holds back on supply- asset requirement stood at 10 percent of total deposits ing reservesso that one or more banks are forcedto bor- and was met principallywith holdings of treasury bills rowat the penalty rate. This generates upward pressure and depositswith the discount houses. Banks were re- on all short-term rates. Once these have risen to the de- quired to hold an additional 10 percent in secondaryas- sired level, the central bank resumes meeting the full sets, consisting of commercialbills and other Malaysian needs of the system so that there is no further need for governmentsecurities. The issuanceof treasury bills and banks to borrow. other government securities was kept within the The Bank of Italy establishesa step function of dis- amounts that banks and other financial institutions count rates confronting its individualbanks. The more were required to hold so that the interest rates on these often a bank borrowsfrom the central bank, the higher issues were usually below those that would have pre- the rate it pays. This approach involvesa measure of vailedin a free market. The discounthouses wereable to market disciplineon the individualbank, rather than the pay a higher rate on depositswith them than were avail- administrative guidance used by the U.S. Federal Re- able on treasury bills because they were permitted to serve System.The central bank can initiate an increase hold higher-yieldinggovernment securities with matu- in interest rates by limiting the supplyof non-borrowed rities out to three years, which the banks could not reserves, forcing individual banks to borrow at higher count as primary liquid assets. The interbank market and higher rates. When rates have risen to the appropri- was quite activein maturities ranging from overnightto ate level,the Bankof Italycan resume supplyingreserves one month, while transactionsin maturities out to three as neededand adjust its discountrate scheduleappropri- months were common. ately. As noted earlier, Bank Negara managed liquidity by posting rates at which it would buy bankersacceptances, as well as treasury securitiesmaturing out to 20 years. It also might sell treasury bills, and on occasionother gov- Central Bank Liquidity Management and the Money Market 21 ernment securities, on the posted yield curve. At one henceforth it would look to open market operations as time it also placed government depositswith the banks the primary means of managingdomestic liquidity.The for one month or longer in an effortto influencemarket discount windowwas relegated to a subordinate role, rates. The banking department participated actively in availableto individual institutions only under special the foreign exchange market to maintain a degree of circumstances. continuity in the value of the ringgit. It also occasionally used swap transactions to relieve strains in the domestic Forecasts and the Management of 7TeasuryBalances money market and served as lender of last resort to the banks. A central bank embarkingon the use of open market This passiveapproach sufficed to meet the system'sli- operationsto manage liquidityfinds it helpfulto develop quidity needs, stabilizing the daily interbank rate once forecastsof the likelybehavior of the major components bankswere allowedto meet their requirements on a dai- of its own balance sheet. In many countries, the inter- ly average basis. However,the central bank's own will- locking patterns of treasury receipts and expenditures ingness to trade government securities bilaterally on a subject bank reserves to sizable, and often erratic, posted yieldcurve left little opportunityfor a secondary swings.The central bank also needs to compensate for market to develop.The fact that government securities predictableflows of currencyinto and out of circulation carried below-marketyields made them unattractive to in connectionwith the country's payment practicesand anyone not subjectto liquid asset requirements.The dis- seasonalpatterns. The central bank's own net extensions count houses consideredtheir function primarily one of of credit to state enterprises or favoredindustries need to maturitytransformation. They concentrated on carrying be included in the reserve outlook.Transactions in for- profitablya portfolio of treasury and short-term private eign exchange are much less predictable,but their ef- instruments with the inexpensivefunds generatedby the fects on bank reserves,as they occur, shouldbe available qualificationof their deposits as primary liquid assets. to the manager of domesticopen market operations.Ma- They could, in fact, shift a part of their interest rate risk jor swingsstemming from changes in required reserves to the central bank by selling to it from portfolio.The and other factors may be reasonablypredictable-for ex- houses did play an active role in developingthe markets ample, the credit float stemming from the check collec- for bankers acceptanceand certificatesof deposits,buy- tion process in the United States. Forecasts of the ing the securities and selling them under repurchase prospective movements in reserves from such factors agreements for shorter periods at rates that provideda can give the central bank guidanceconcerning the mag- positive interest rate "carry."But the secondarymarkets nitude and directionof its own intervention.What is im- were thin even in these instruments. portant to decision-makingis the discipline that such In 1987 BankNegara began the transition to a policy forecastsimpose rather than the size of forecast errors. of promoting an activesecondary market in government A regular forecasting procedure provides the manager securities and managingliquidity through market inter- not only with information but also enables him to ac- vention. Takingadvantage of a decline in interest rates, quire a feel for the likelymargin of error in the forecasts the treasury increased its sales of treasury bills and themselves. shorter maturities of Malaysiangovernment securities Reserveforecasts are not, however,a prerequisite for to the point that these bore market yields.Bank Negara effective liquidity management through open market began buyingand selling such issues only on its own ini- operations. The interbank market itself provides con- tiative and at the rates at which they were trading in the tinuing information on the interplay between the de- emergingsecondary market. In early 1989 it designated mand for reserves and their availabilityin the banking seven discount houses as exclusiveunderwriters of the system.Commercial bankers in charge of managingthe weeklytreasury bill auctions,with the requirement that reserve positions of their banks keep close watch on they make secondarymarkets to all comers. BankNega- where they stand in relation to their reserve require- ra also reduced the primary liquid asset ratio to 5 per- ments.They bid for funds in the interbank market if they cent, to encourage them to depend more on market- are short and lend funds there if a long positionis build- making for profits and less on their privilegedposition as ing up. In an active market, the interbank rate indicates deposittakers. At the same time the Bankappointed the whether aggregate demand is building up in relation to discount houses, seven merchant banks and four com- supply. Since the object of liquidity management is to mercial banks as primary dealers in Malaysiangovern- maintain reasonablestability in the overnight interbank ment securities. They were made responsible for rate, the central bank can intervenewhen the rate moves underwriting auctions of such issues and making sec- aboveor belowthe range it desires.It can use repurchase ondary markets in them. Bank Negara announced that agreements to inject reserves on a temporary basis, to 22 Paul Meek counter unusual strains, or the reverse of such opera- to maintain public confidencein the safety of deposits tions if the money market becomes undesirablysloppy. and the integrity of financial transactions. The central These short-term operations are an important supple- bank serves as fiscal agent for the ministry of finance- ment to the outright purchases or sales of securities ad- banker to the government,servicing its depositaccounts dressed to longer-lastingdevelopments in the demand and issuingits securities.It is the operatingarm of mon- for total reserves. etary policy in both economic and liquidity manage- The consciousshifting of treasury balances between ment. the central bank and the commercial banks can play a Thispaper has concentratedthus far on the contribu- useful role in reserve management outside the market. tion the central bank can make to market development In the United States, the treasury maintains balances by using the markets to manageliquidity and the econ- with most banking institutions and makesdeposits in, or omy. But more than the central bank's own activityis calls on, such balances as necessaryto even out its own needed to energizea new market. Its transactionswill be balances at a level agreed on with the Federal Reserve only a small part of the total in a well-functioningmar- System. This procedure helps cushion bank reserves ket. The central bank must take steps to enhance the from the variabilityof tax collections,expenditures, and standing of the instruments availablein the market and securities sales. In Canada, the treasury has delegated the dealerswho make the secondarymarket in them. A management of its balances to the Bank of Canada, good money market rests on the participationof a wide which shifts balances as its primary means of managing range of businessesand investorsseeking safe outlets for liquidity.While this approach deals admirablywith li- their short-term funds. It is not enough for the central quidity in its system, it does bypass the money market. bank to embrace rate flexibilityin its own operations if The central bank of a developingcountry can contribute the market remains limited to transactions between it more effectivelyto financialmarket growth if it is itself and the commercial banks. The central bank must find an activeuser of the market than if it developsa system waysof encouragingdealers or brokers to seekout retail that bypassesthe market. customers in business and finance, so that the market will developbreadth and depth. General Guidelinesfor MoneyMarket Development Instruments Nurturing an efficientmoney market is a many-sided A money market needs instruments to trade that are endeavor.Such a market requiresa legal,regulatory, and of high quality,to attract the short-term funds of those supervisoryframework that assures market participants who prize safetyof principalmore than yield. A treasury that contracts will be promptly fulfilled and that the bill or central bank certificatematuring in three months credit risks of buyingand sellingmarket instruments are or less provides an ideal instrument. Both are of the small and manageable.Official oversight is needed to highest quality, eliminating default risk except in the keep tabs on the market's functioning and to discipline most extraordinaryof circumstances.Either can anchor those that engage in unsound business practices. There the short-term market, providing a reference yield for must be negotiable instruments of high credit quality, privatepaper. The central bankshould normally conduct issuedunder lawsand rules that spell out the conditions the auctions of such paper as well as provide the book- of issuance and the protections available to the buyer. keeping and transfer facilities that facilitate trading. It The market requires financial intermediaries-either can underscorethe qualityof the paperby discountingit dealersthat buy and sell from position at their own risk in its lending operations.When the central bank gradu- or brokers that charge a commissionto bring buyersand ates to managing liquidity through the market rather sellerstogether. The central bank,money market instru- than through the discountwindow, it can take the lead ments, and dealers all have essential roles to play in de- in buying and selling such open market paper.The cen- velopingan efficientmarket. tral bank must also overseethe credit qualityand market practicesof the dealersor brokers that make the second- The CentralBank ary market. In developinga treasury bill or central bank certifi- The central bank is a natural leader of efforts to im- cate market, it is important that the issues sold at auc- prove a nation's financialsystem. It oversees and helps tion mature at intervals of at least a week, as in the organize the paymentssystem neededto supplythe cash United States. Dating 91-day paper to mature on each and credit requirements of the economy.It supervises business day of the week as in the United Kingdomre- the banks, and often other financialenterprises as well, duces the size of each maturity and inhibits trading in Central Bank Liquidity Management and the Money Market 23 the resulting 65 issues. Spacing issues at least a week can performthe function of bringing buyers and sellers apart makesit easier to achievea tradablesize. It also en- together,charging one or both a commissionfor the ser- hances the role of dealers, since they willbe called on to vice as in the interbank and foreign exchangemarkets. write a repurchase agreement to the specificdate their But developinga good secondarymarket for short-term customer needs cash or to repurchase an instrument instruments usually requires an intermediarythat is a from him on that day. The length of the maturity auc- dealer rather than a broker-one prepared to buy and tioned initiallycan reflect the existing stage of develop- sell from position, embracing the risks and rewards of ment. In a rudimentary market, it can be as short as a ownership.Such a dealer has a strong incentiveto build fewweeks. As the Indonesianexample later in the paper customer participationin the market, for only that will makesclear, it is not even critical that the amount to be enable him to control his own risks. auctionedbe announcedin advance.What is necessaryis A dealer in securities has three sources of earnings. that biddersbe free to bid at rates of their own choosing First, he can usually earn a positive return from financ- and that the issuer accepts bids in sufficientvolume at inga positionin short-term securities dayto dayor week market rates to providea tradable supply.One can move to week at a lowerinterest rate than is being earned on to standard-sizeauctions and extend the maturity to 13 the securities themselves. Secondly,a dealer makes a weeks as the central bank, dealers, and other partici- spread on the differencebetween his bid and askedpric- pants learn to use and trade the instrument effectively. es-the greater the activity,the more he makes. Finally, Central banks need also to work activelywith banks the dealer can make a capital gain-or loss-from and market makers in developingthe market for bank changes in the value of his position as interest rates rise certificates of deposit (CDs)and bankers acceptances. or fall. Their supervision of the banks provides the investing In the early stages of developinga market, dealers public with assurance that such bank liabilities are of normally focus on the positive "carry"between the rate high quality,even though not as risklessas treasury bills earned on securities held in position and the rate at or the central bank's own liabilities. The central bank which they can be financed for shorter periods. The prescribesthe conditionsunder which banks can accept spread is often quite large becauseof the premium banks privatedrafts to createacceptances and deals itself in the and others place on liquidityin the absence of a func- market as a means of assuring itself that its regulations tioning secondarymarket. Dealerscan usually financea are being followed.The central bank also allows finance position that is ten, twenty,or even fiftytimes their net companiesand merchant banks to issue their own short- worth, since they need only supply a narrow margin of term paper.Here, too, it must providea degreeof super- collateral on such high quality,short-term paper. The vision if the paper is to be acceptableto a wide range of earnings potential on a leveragedposition is quite large investors. in a stable rate environment.The dealer is rewardedfor In time, once public confidencein the money market taking the risk that interest rates will rise and that he builds up, it may become possible for businesses with may have to renew his short-term financing at rates high credit standings to place their own paper with in- higher than he is earning on his position.But the lever- vestors, either directly or through dealers. Such com- age of his positionexposes the dealer to a substantial risk mercial paper usually bears a higher interest rate than that his entire equity can be wiped out by a rise in rates. bank-sponsoredpaper but still enablesthe issuerto raise Accordingly,the dealer needs to developcash customers funds at a lower rate than through borrowing directly to whom he routinelysells money market paperoutright from a bank or through bankers' acceptances.Use of as an investmentof their liquid funds.In case ofa rise in such an instrument dependson the develepmentof a so- rates, such customers experienceonly the opportunity phisticatedgroup or investors,which are willingto bear cost of foregoinghigher earnings for the remaining life the risks ofbuying such paper to obtain the higher yields of the security.The dealer,however, would have to mark they offer. down the value of his whole inventory and could be forced to sell at a loss in order to maintain margins on Brokers and Dealers the securities pledgedto lenders. Nurturing a group of dealers that make secondary In building a good money market, the central bank markets in short-term paper involvesmany challenges needs to encouragethe developmentof dealerswho will to the central bank. It must selectthe dealerswith whom make markets in short-term instruments. Such market it willtrade, establishingcapital requirements and devel- making is essential to enable buyers of the paper to sell oping a reporting system that permits it to assess the it beforematurity, to raise cashwhenever they need it. In risks that dealersare running in their day-to-dayopera- well-developedmarkets with many participants,brokers tions. Thecentral bank willneed to see that the maturity 24 Paul Meek of the paper it or the ministry offinance sells to the deal- Monetary Policy and the FinancialSystem ers doesnot overreachtheir abilityto managetheir maturity risk. It should conduct its own operations on a At the time of the 1983 reforms, Bank Indonesia re- best-price basis that enforces competition among the lied on a system of individualbank credit ceilingsas its dealers. It may providesome support to fledglingdealers primary defense against excessive domestic money through special financing facilities, an underwriting growth.It also employeda complexsystem of rediscount commission,or by givingthem a favoredrole in a set of credits to priority sectors (termed liquiditycredits) and liquid asset requirements imposedon financialinstitu- controlled the loan and deposit rates of the five state tions. Note, however,that such privilegescreate vested banks, which accounted for three-quarters of commer- interests and may be hard to withdrawas the market de- cial bank deposits. Whenever reserve shortages devel- velops. oped,the central bank advancedliquidity credits to the There is alwaysan adversaryelement in the relation banks. between the central bank and the dealers. This flowsin Monetarypolicy goals were set in the contextof an an- part from its supervisoryrole, but dealers are also apt to nual government-wideplanning exerciselinked to a five- want central bank protection from some of the business year plan for the economy,one in which state enterprises risks that are properly theirs. They may tend to prefer played a major role. Bank Indonesia based allowable the passiverole of earning a positive carry rather than credit growth for each fiscal year on the money supply developinga customer market, looking to the central growthbelieved consistent with anticipatedreal growth bank to rescue them if it raises interest rates in pursuit and allowableinflation, after allowingfor the expected of its economicobjectives. The central bank has to prod behavior of the balance of payments. The central bank them into market-making by tying its recognition to worked out with the Ministryof Finance credit ceilings their outright transactions with customers. Only by for each of the large number of public enterprises. The buildinga goodcustomer basecan dealersmanage inter- openness of the financial system, with capital move- est rate risk in bad times, in order to surviveand prosper ments virtually free of controls and individualspermit- in good times. While some specialaid may be necessary ted to hold dollar balances domestically,counseled a in unusual circumstancesto buttress the market's abili- cautious approach to credit expansion.Fortunately, the ty to continue making markets, the central bank must central bank enjoyedconsiderable autonomy within gov- avoid developinga market in which the "carry" profits ernment by virtue of the legal changes made in the accrue to the dealers and the interest rate losses are 1960sto enable it to bring runawayinflation under con- borne by the central bank. trol. The 1983 reformsaimed at increasingthe flowof pub- The Case of Indonesia lic savings through the financial system and reducing the extension of subsidizedcredit by the central bank. Indonesiapresents an interesting exampleof a coun- The existing credit control system was abolished out- try that has recentlymoved from administrativecontrols right. Bank Indonesia was charged with developing to flexiblemonetary management through market oper- means of pursuing annual monetary growth targets ations.2 This shift has been part ofa broad governmental without interfering directly in the lending and deposit- effort to use market forces to restructure the economy. taking activities of the commercial banks. The state The authorities have sought to enhance financialcom- banks were freed from controls over their deposit and petition and thereby promote a high level of domestic lending rates, enabling them to competemore effective- savingsand a more market-orientedallocation of real rely with the private banks, which had grown rapidly in sources. The motive force for this transformationeffort previousyears by servingan active privatebusiness sec- came from the sharp fall of oil prices in the early 1980s. tor. Banks were also permitted to sell certificatesof de- At that time, the petroleum sector accountedfor 20 per- posit for the first time. However,the conceptof the state cent of GNP,70 percent of exportsand two-thirdsof gov- banks as engines of developmentlingered on. They re- ernment revenues.The drop in oil prices cut deeplyinto tained their privilegedposition as channels for subsi- government receipts at a time when borrowing abroad dized liquidity credits and remained the only becamemore difficult,necessitating a substantialcut in institutions permittedto hold the depositsof state enter- development outlays. The government responded in prises. 1983 by devaluingthe rupiah by 38 percent against the In developing indirect means of monetary control, dollar to encouragenon-oil exports and by instituting a Bank Indonesia confronted a money market that was newprogram of domestictaxation. Major changes in the still in a formativestage. It included an interbank mar- financialsystem were also set in motion. ket and a small market for the paper issued by non-bank Central Bank Liquidity Management and the Money Market 25 financialinstitutions (NBFIs),which were authorizedto foreign exchangeto the central bank for same-daydeliv- engage in lending and underwriting operations. There ery. A serious problem for both economic and liquidity wasalso a foreign exchangemarket, in which BankIndo- management arose in August-September1984 when nesia balancedthe net demand or supplythat developed U.S. interest rates and the dollar's exchangevalue rose in the bourse.Commercial banks borrowed unsecured in sharply.Bank Indonesiaallowed the rupiah to depreciate the interbank market, principallyfrom overnightto one at a somewhatfaster rate than previouslyagainst the dol- week, although there was some activity in maturities of lar to spur the exportsector. This movetriggered a spec- one month and longer. The state banks mainly supplied ulative outflowas banks and their customers sought to funds while private domestic banks and foreign banks hedge against the possibilityof another maxi-devalua- were the chief borrowers,reflecting in part restraints on tion. Respondingto the drain ofbank reserves,rates rose bank branching. All banks held substantial reserves as high as 90 percent in the overnightinterbank market abroad and could convert them to rupiah on the same as banks scrambled for funds. Bank Indonesia relieved day through bourse transactions with the central bank. the strain by openinga specialcredit facilitythat enabled the banks to borrow for up to one year. This, together Developinga RevisedStrategy of Monetary Control with the return flowof fundsprompted by the high rates, restored liquidityand brought interest rates back down. After the reform, Bank Indonesia continued to pre- Togive it a tool for supplyingreserves in such circum- pare annual objectivesfor monetary growth related to stances, Bank Indonesiaestablished regulations in early the government's five-yearplan. It deviseda format for 1985 under which commercialbanks and finance com- tracking the monetarybase weekly in relation to a target panies could issue trade bills and bankers' acceptances corresponding to the Bank's annual monetary growth (SBPUs-Surat BerhargaPasar Uang).The central bank objectives.To foster indirect methods of monetary con- also empoweredFICORINVEST as its agent to discount trol, the central bank introduced in 1984 a redesigned the new instrument at an announced scheduleof rates as discount window and its own central bank certificates well as to discount outstanding SBIs,the central bank's (SBIs-Sertifikat Bank Indonesia).It discontinuedpay- own certificates.Only bank-endorsedSBPUs were made ing interest to the banks on excessreserves, stimulating eligiblefor discount at FICORINVESTor Bank Indone- activity in the interbankmarket. Byselling SBIs,matur- sia. BankIndonesia stood readyto discountpaper for Fl- ing in one and three months, Bank Indonesiaprovided CORINVESTat an attractive rate to the extent it could the banks with an investment outlet and could absorb not financeits position elsewhere.The new facilitypro- excess reserves. The SBIs were sold weeklyat auction, vided banks a means of obtaining reservesindirectly at but the central bank controlled, and seldom changed, lowerinterest rates than the officialdiscount rate. the rates it offered. Bank Indonesia named FICORIN- Proceedingby trial and error, BankIndonesia learned VEST,an NBFI95 percentowned by it, to makea second- to manage the liquidity of the banking system quite ary market in the new instrument. smoothly, although it was somewhat handicapped by The central bank introducedtwo discount windows: lack of timely information on the current level of re- FacilityI to providecredit to meet liquidityneeds for up serves and the reserve outlook. The commercial banks to two weeks and Facility II to provide credit for two maintained reserverequirements, calculated on the ba- months to encourage banks to make term loans. It set sis of contemporaneousliabilities, during four periods the discount rates for use of the facilitieswell abovethe each month. Those with surplus reserves-ordinarily rates on short-term interbank deposits to emphasize the state banks-invested in SBIs in the weeklyauction that bankswere to raise funds from depositors,not from at rates set by the central bank. Banksthat found them- the central bank.A bank borrowingat either windowwas selvesshort of reservescould discounttheir own SBPUs not required to submit collateral other than its own at FICORINVESTwithin the credit limits establishedby promissorynote. Bank Indonesia.They could also discount SBIswith FI- These initial arrangements had one notable short- CORINVESTat more attractive rates than were available coming. The central bank had no meansof adding to re- at the central bank's discount window.Bank Indonesia serveson its own initiative.In practice, the banks proved thus made a two-way market through FICORINVEST reluctant to use the discountwindow because of its high that kept the overnightinterbank rate from moving too rates and also because of concern that such borrowing widely.The banks avoidedthe discountwindow, prefer- would reflect adverselyon the bank's credit worthiness ring the cheaperalternatives available at FICORINVEST. and management. To meet liquidity needs, the banks, The market for SBIsand SBPUsbegan to develop.Fl- which maintained foreign exchangeabroad about equal CORINVESTwas able to financea portion of its portfolio to Bank Indonesia'sown holdings, dependedon selling of SBIsand SBPUsthrough repurchaseagreements away 26 Paul Meek

from the central bank.It also resold the two instruments rate in four steps from 18.5percent in Aprilto 30 percent on an outright basis to a limited extent. The two-way in early July. It also sharply reduced,and then eliminat- market madeby FICORINVESTalso facilitatedthe trans- ed, FICORINVEST'scommitted credit lines for the pur- fer of funds within the banking system.The state banks chase of SBPUs.The overnight interbank rate, which had were the principalbuyers of SBIs,while the privateand been in a 13 to 14 percent range in April, rose to a 35 to foreign banks relied on discounting their own SBPUs 40 percent range in early July. regularly to meet part of their financingrequirements. These drastic measures succeeded in defending the rupiah's exchangerate and generating a large reflowof Problemsof Economic and Liquidity Management funds in the next few months. Theyalso led Bank Indo- nesia to rethink its approach to reserve management. In pursuing its monetarygrowth objectives,Bank In- Rigidlyfixing short-term interest rates had contributed donesia confrontedthe openness of its financialsystem to the crisisby inhibiting change. The central bank con- and the modest size of its exchange reserves. In 1985, cluded that the large credit lines outstanding to the against the background of declining U.S. interest rates banks through FICORINVEST'sdiscount facilitiesposed and a weakeningdollar, it was able to loweropen market an unacceptablerisk offinancing speculative outflows. It rates and its discount rate by about 3 percentage points decidedthat henceforthit would deal in SBIsand SBPUs in order to stimulate domestic economicactivity. It was only on its own initiative,making its ownjudgements on also able to allow the rupiah to depreciateagainst the the scale of operations and the rates at which it would dollar at a modest pace, to the same end. But public sen- deal. sitivity to the possibilityof a further maxi-devaluation The refluxof reservesled to excess liquiditythat pro- remained a conditioning influence. Despitethe adverse vided a favorableenvironment for introducing sales of economic effectsof a large further decline in oil prices, seven-daySBIs in the market at auction nearlyevery day. the central bank could not reduce SBI and SBPUrates By October 1987, the central bank had negotiated a further during the 18 months followingAugust 1985. smooth transition of the overnight interbank rate back Unable to provide further stimulus through monetary to a range of 10.5percent to 12.25percent. Giventhe ex- policy,the authorities devaluedthe rupiah by 44 percent cess liquidity,there were fewoccasions on which the au- in September1986. thorities bought SBPUscompetitively in the market, so The movecaught nearly everyoneby surprise, exacer- the salesof SBIsbecame the main instrument for liquid- bating anxieties of businesses and individuals accus- ity management. The promising SBPUmarket dried up tomed to holding dollar,as well as rupiah, assets. While without the involvementof the central bank, reducing the sizeof the move should have defusedfears of further the adjustment options available to the private banks devaluation, it did not. Large outflows of foreign ex- that normallyhad loan demandsin excessof their depos- change developedin late 1986.The monetaryauthorities it generating capacity.The auction technique did, how- chose to maintain the existing rate structure for SBIs ever, enable the central bank to signal the direction in and SBPUsin support of domestic economic growth. which it wishedto nudge interest rates by the cutoffrate Therewas heavydiscounting of SBPUs at FICORINVEST, it set in the auction. BankIndonesia itself foundthe new sizablediscounting of SBIs,and moderate use of the Fa- rate flexibilitya great improvement over administered cility 1 discount window at its penalty rate-all to fi- rates. nance the purchase of foreign exchange from Bank Usefulas the auctions were, a number of problems Indonesia.The reserve strains generated by the outflow arose as the central bank regularly auctioned seven-day resulted in a rise of about 3.5 percentagepoints in short- SBIsto absorb liquidityand occasionallybought SBPUs term interbank rates, a modest counter to the outflows under repurchase agreements. The seven-day instru- themselves. ment was too short for any secondarymarket to develop. Althoughthis tempest subsided,a much more serious The state banks, which were the chief repositoriesof li- storm began to build up in April 1987. Bank Indonesia quidity,bought onlywhat they needed.In fact,they were initiallytried to maintain its lowinterest rate policy,but able to extract a substantial spread over the rate they this soon provedimpossible as a full-blownexchange cri- were receiving in overnight market by virtue of their sis emerged in Mayand June. Sharp increasesin the SBI market power. Bank Indonesia could not effectively and SBPUrates proved insufficientto stem the tide. In bring pressure on the banks through sales because they late June the Governmentdrained reserveson a massive could alwayslet their existingholdings mature over the scale by ordering four state institutions to withdraw Rp next few dayswithout replacement.Accordingly, it had 900 billion from time depositsat the state banks and to difficulty in February-March1988 when it sought to purchaseSBIs. The central bankraised its basicdiscount nudge rates higher to forestallexchange rate speculation Central Bank Liquidity Management and the Money Market 27 when the cabinet changed. The state banks simply did nounce in advancethe amount to be auctioned. This not bid to take up additionalSBIs at the higher rate lev- proved wise because bidding by the state banks proved els desired. erratic, depending on whether they were flush with funds or not. When the Ministryof Finance made large FurtherDevelopments outpaymentsto government enterpriseaccounts, a state bank receivingsuch funds would make large bids in the The appointment of a new cabinet and central bank auction at a narrow scale of rates, but once the funds governor in April 1988 led to an intensive reviewof the were spent, it might not bid at all. The 15 dealerschosen financialsystem. In Octoberthe governmentproclaimed by the central bank were all small in size relative to the a comprehensiveset of measures to make the financial state banks, so they made only small bids in the auction system more competitive and to give Bank Indonesia for their own account. Theyserved primarily as conduits scope for more effectiveopen market operations. They for the much larger bids of the state banks and were un- authorized the establishment of new national banks, able to make bids of any size in the secondarymarket. joint ventures with foreign banks, and rural credit The auctions themselves proceeded quite smoothly banks, subject to minimum capital requirements. They with Bank Indonesiavarying the amount sold in accor- permitted non-bank state and local government enter- dance with the bids received.The private banks and the prises to hold up to half of their funds with private na- NBFIssoon found that the new SBIs,and the compulso- tional banks, allowingthese banks to compete for such ry ones issuedthe previousOctober, could be sold under deposits for the first time. The regulations established short-term repurchaseagreements (repos)for a week or legal limits on the credits that banks could extend to a longerat rates lowerthan those at which they could bor- singleborrower, but expandedthe abilityof banksto pro- rowunsecured in the interbank market. The dealersalso vide foreign exchange services without prior approval. financed profitablytheir positions through short-term Non-bank financial institutions were also allowed to repos. There was some selling by private banks to the open a branch officein each of sevenmajor cities. state banks of the longer SBIs issued after the October Bank Indonesia reduced reserve requirements from package, but outright buying and selling of the newly 15 percent to 2 percent of banks' third party liabilities auctioned issueswas on a limited scale. and extended the requirements to NBFIs.This change Bank Indonesia continued to operate almost daily in helpedoffset a flat tax of 15 percent just imposedon the the market to maintain reasonablestability in the over- interest that the banks paid on time depositsand certifi- night interbank rate. Each businessday, the manager of cates of deposit. The combined effectwas to shift to di- operations would consider the ease or tightness of the rect taxation for the benefit of the governmentfrom the money market in relation to his objectives.Taking ac- indirect tax of reserve requirements, which accrued to count of the limited informationavailable on the reserve the central bank. The banks were required initially to outlook, he would decidewhether to sell seven-daySBIs buy three-month and six-month SBIs equal to 80 per- the next day or make repos on SBPUs.If the central cent of the cut in their requirements. bank's economic managementcalled for loweringinter- Bank Indonesia,operating under the authority of the est rates, then he would not satisfythe demand for long- reform package, took steps to develop further its open er-dated SBIs in the weekly auction. The banks would market operations and encourage the growth of the then have to dispose of their excessesin the interbank money market. It introduceda two-daylag in the settle- market or by buying seven-day SBIs, which carried a ment of foreign exchange transactions, cutting off the lower interest rate than the longer maturities. Coordi- accessto reserveson a same-daybasis. In January 1989, nating daily operations with the weeklyauctions in this it appointeda group of 15 privatebanks and NBFIsto act way,in 1989 Bank Indonesiawas able to maintain rea- as underwriters of the SBI auctions and as market mak- sonable stability in the overnight interbank rate in the ers in the secondarymarket. The central bank required short run while loweringits levelprogressively over the all bids to be submitted through the market makers,pay- period. ing them a small commissionon their successfulbids. It also improvedthe mechanism for transferring owner- Lessons of the Experienceto Date ship of SBIs,so that the new dealers could re-sell them to non-banksas well as banks, either outright or under Bank Indonesia has made notable progress in devel- repurchase agreement. oping more flexibletechniques for managing liquidity The central bank began selling one-month SBIs in a and pursuing its monetaryobjectives. The road has been weeklyauction in January 1989,and introduceda three- rather rocky,punctuated by periodicdisturbances stem- month maturity in May.At this stage it chose not to an- ming from devaluationfears and currency outflows.But 28 Paul Meek the authorities have responded to each challengewith Whereasthe weeklyauctions could be standardizedin institutional changes that have moved toward a more amount, BankIndonesia's daily operationswill necessar- market-oriented approach. They have begun to adjust ily vary in size, depending on the reserve situation. short-term interest rates flexiblyin accordancewith eco- There is no need to restrict the sales of short-datedSBIs nomic and foreign exchange market developments.By to a seven-daymaturity. There may be times when excess maintaininga steady,modest pace of depreciationof the liquidityis so great that BankIndonesia would prefer to rupiah againstthe dollar,they seem also to have reduced sell SBIsmaturing in two or three daysin order to mop significantlyexpectations of further maxi-devaluations. up such liquiditywithout creating a reserve shortage in This has permitted a reduction in the interest rate pre- the next reserve-averagingperiod. The central bank also mium that previouslywas necessaryto keep from losing needs to use its regulations and operationsto promote a exchangereserves. levelplaying field for financial competition,countering The Indonesianexperience indicates that it takestime the tendencyof the state banks to exert market power.At to move from a system of administered controls to a the same time, better coordination is needed with the more market-orientedone. Central bankers tend to see Ministry of Finance to developa mechanismfor reduc- credit controls as powerfultools yieldingpredictable re- ing the size of the net flowsin and out of its central bank sults, and they enjoythe power such controls givethem. account. BankIndonesia's daily operations couldthen be Relinquishingcontrols means giving up the familiar- kept within the developingcapacity of the market. setting limits on quantities and interest rates-for the The banks and dealersstill relytoo much on auctions uncertain world of influencingdeposit growth by chang- conducted by Bank Indonesia rather than operating as ing interest rates and affectingthe demand for deposits competitive,profit-oriented units. Some big banks tend and other financial assets. The administrative mindset to rely on the auctions to adjust their reserve positions does not change overnight. Market developmentneeds even though they could trade profitablyin the secondary to proceed step by step so that both the authorities and market. The dealers depend on Bank Indonesia's com- financial institutions gain confidencein their ability to missions and maturity transformation-financing long- function in the evolvingsystem. The central bank has to er paper with short-term funds-for their profitability. keep close watch on developmentsyet avoid bailing out Theyhave been content to earn the wide spread between poor managementdecisions in the financialsector. the rates on longer-datedcentral bank paper and their fi- In Indonesia both the central bank and the financial nancing costs without much concern for the risk that in- communityare still learning how to operate in a com- terest rates may fluctuate.They are likelyto quit making petitive market environment. Bank Indonesia can now markets at the first sign of trouble and turn to the cen- manage liquidity effectivelywith the present market. tral bank for rescue.The dealersare not large enough to But the secondarymarket for SBIsand SBPUslacks suf- accommodatethe potentialactivity of the state banks in ficientcapital and operationalexpertise to allowthe cen- SBIs.But they could do much more than they have done tral bank to affect interest rates with the speed that thus far to make small markets and educate customers would be neededto copewith the kind of exchangeflows about the gains to be earned by riding the yield curve. experiencedin the past. There is more it can do to en- These are not unusual teething problems for a new courage a better secondarymarket. market whoseparticipants are learningto manageinter- Oneneed is to distinguishclearly the weeklyauctions est rate risk. In the past, the dominant position of the of longer-datedSBIs from the daily sales of seven-dayor state banks has posed a problem because of the market shorter maturities. Todevelop the secondarymarket it is power they exert.Already there are signs of keen compe- desirableto build up a regular and predictablesupply of tition in the market for the depositsof state enterprises three-month SBIs,leaving it to dealersto make second- that may alleviatethis problem. The central bank itself ary markets in the outstanding issues. Eliminating the can reinforce market competitionthrough its own oper- weeklyauction offour-week SBIs would be helpful, since ations. It must transact business only on a best-priceba- selling that maturity now enables investors to obtain sis and avoid supplying SBIs to state banks that have them from the central bank without recourseto the sec- missed in the auction. Bank Indonesia should require ondary market. Pre-announcingthe amount to be sold dealersto sell SBIsoutright to non-bankcustomers and each week of the three-month issue would enable bid- stand ready to bid in the secondary market on a scale ders to know the total amount for which they must com- commensurate with their capital position. It should pete.It should result in somevariation in the cutoffrate weed out those who only take the central bank's com- from week to weekand also promote swappingof issues missions for submitting the bids of others in the auc- alreadyoutstanding for the new issue. tions. Central Bank Liquidity Management and the Money Market 29

BankIndonesia needs as well to developa strategy for cation of financialresources. One should expectfurther improving the market in bank paper: the SBPU.Com- progress in Indonesia. pletelyphasing out central bank support for that market through FICORINVESTin 1987was a mistake. TheBank Notes can help reinvigoratethe market by buying SBPUsperi- odicallyfrom the dealers on an outright basis. Its SBI 1. See Lin See Yan,"Monetary Control and Financial marketing effort can also help if the volume of three- Reform:Malaysia's Experience," International Monetary month SBIsin bank portfolioscan be built up sufficient- Fund, Central Banking Seminar,November 28 -Decem- ly so that it alternates betweenpurchases and sales in its ber 9, 1988, and Bank Negara Malaysia,Money and daily open-market operation. That would afford more Banking in Malaysia,1989. opportunitiesfor participatingin the SBPUmarket. 2. This section draws heavily on Binhadi and Paul In the finalanalysis, it is the market participantswho Meek, "Implementing Monetary Policy in Indonesia," have to developthe moneymarket. The central bank can November9, 1989,which is to appear in a forthcoming carry out its liquiditymanagement in waysthat use the volume publishedby the Australian NationalUniversity. market. But the market's rationale has to rest on the ser- See also V.Sundararajan and LazarosMolho, "Financial vice it providesto financialinstitutions and the economy Reformand MonetaryControl in Indonesia,"presented at large. The steepness of the yield curve suggests that at a conferencesponsored by the Federal ReserveBank there are ample incentives for the money market to of San Francisco,September 23-25, 1987. make an important contribution to a more efficientallo-

Discussion

Question: If you were advisingthe government of a ceptancesin the United States. So, embeddedin the Fed- developing country on setting up a market for short- eral ReserveAct was a commitment to try to develop a term government securities, what could influence your market for bankers' acceptances.The first governor of choice as to whether it should be a market in treasury the New York ReserveBank had been the president of bills or central bank bills? Does the fiscalposition of the BankersTrust Company.One of the major activities of governmenthave anything to do with the choice? the central bank in the 1920swas the effortto developa NewYork market for bankers'acceptances. This is a case Mr.Meek: I would think so, yes. In general, it is in the in point ofa central bank setting out to developa market. central bank's interest to try to developmarket mecha- The treasury bill market also came along in the 1920s,at nisms for raising treasury cash. Otherwise,the treasury about the same time. is knockingat the central bank's door. So, giventhe pol- I do not know why they chose to auction a 91-daybill icy mandatesof the central bank, it has a large self-inter- on one particular date and have it mature on a single est in trying to work with the treasury,to get the treasury date. But that was highly beneficialto the development to issue securities as market instruments.A treasury bill of a treasury securities market because it gave dealers a market is a good place to start. role in underwriting the issue and financing positions Indonesiawas a specialcase becauseit had no treasury with repurchaseagreements. I think that choicewas im- instruments. But I think you have to look at each situa- portant in the market's development. tion on its own.The important thing is to findsomething In part, differencesbetween the U.S.and U.K.govern- that fitswith whateverstage of developmentexists in the ment debt markets spring from very different debt man- country. For example,if a market has alreadystarted in agement philosophies. The tradition in the United commercialbankers' acceptances,then the central bank Kingdom has been to finance the government at the ought to participatein that market. long-term end of the market with coupon issues- It may be of some interest that one of the purposesin gilts-rather than with short-term instruments. The founding the U.S. Federal ReserveSystem-one of the United States pursued over the years-to its disadvan- narrow self-interests of the commercial banks-was to tage in some respects-a policyof debt marketing: "We authorize U.S.bankers' acceptances.They were tired of have something for everybody.We have bill auctions ev- financing all these things with bills drawn on London. ery week, and every month we have a two-yearissue, a Theydid not have the legalauthority to have bankers'ac- three-year issue. Wehave a five-yearissue, a ten-year is- 30 Paul Meek

sue, and so on." The U.S. Treasuryis unconcerned that Mr. Honohan: When you say it was useful to move everythingis not financedon a long-term basis. And so from a one-weekto a two-weekreserve maintenance pe- the U.S. marketable debt has a much shorter average riod, do you mean that it helpedto lowerthe volatilityof maturity than U.K.debt. interest rates?

Mr. Grenville:I thought I would say a word for the Mr.Meek: By useful,I meant the market moved inter- other side,just in caseanyone things the U.K.system has est rates in an appropriate direction without central nothing at all in its favor.We have a system in Australia bank intervention. In the U.S.system, for example,when like that in the United Kingdom.Those who want to buy Wednesdaywas the settlement day in a one-weekperiod treasury notes at tender can get them at any time in the and Friday counted for three daysof the seven, the room followingweek; the notes mature 90 days from date of to maneuveror bet on the future course of interest rates purchase. This approachhas the advantageof putting an was modest. The two-weekperiod gave the banks more automatic shock absorberinto the system.It is left to the scopefor betting on the future course of interest rates. If market to work out on which days over the next week the Federal Reservetrading deskhad a borrowingstarget there willbe excessliquidity. The market can then get rid when a lot of bullish economic information came out, ofthis liquidityby taking up treasury notes on those par- desk managers would say the Federal Reservewill have ticular days. It is just one way of handing over to the to tighten up interest rates. So they would go long early market a bit more of the decision-makingprocess and in the period to ensure their reserve requirements were smoothing out the liquiditychanges. We do have that bit covered.The overall effectwas to firm up interest rates. of advantage. If there were a seriesof strong economicdata, the federal funds rate might firm up by a percentage point over Mr.Meek: Of course, that stems from the fact that the time, simply because expectationsabout the future had Australiansystem, like that of the United Kingdom,re- changed. The Federal Reservewas in the enviableposi- quires that the systembe balancedout at the end ofeach tion of being ableto sit back.We were not interveningon day. If you have reserve requirements, averagingover a the funds rate; we did not have narrow limits on it. If the period of time is obviouslymuch easier for all con- economicdata continued to movethe same way,some of cerned. the movetoward tighter moneywould alreadyhave taken place. It helped overcomethe internal lag in the cen- Question: You mentioned the benefits of having a tral bank's decision-makingprocess. On the other hand, two-weekperiod for averaging reservesto meet reserve if the economic data moved differentlyand expectations requirements, rather than a one-weekperiod. Is that al- changed, the funds rate would come back down.There waysthe case?Would it not depend on the stage offinan- wasa range of plus or minus one percentagepoint on the cial developmentof that particular economy? funds rate that the market itself would moveby virtue of having a two-weekperiod, whereasthe one-weekperiod Mr.Meek: Oh sure, I think that can be tailored to the lacked that. individualcountry. My suggestion to Indonesia(of a two- Myobservation from one visit to the GermanBundes- week period) severalyears ago was made at a time when bank wasthat their one-month reserve periodgave them they had contemporaneous reserve requirements. But even more of a market-ledeffect on interest rates. the actual state of reserveswas not known until many weeks after the fact. So the central bank had no idea of Question: I want to followup on the last question.In the banks' needs for reserves. The managers have no an inflationaryeconomy, would you suggest introducing guidanceas to the demand for reservesto meet require- a money market at once or controlling inflationfirst be- ments. fore proceedingto the creation of the money market? In the case of Indonesia,this was not a very important or disturbing problem;they do not have the kind of vol- Mr.Meek: I think that developinga money market, a atility that occurs in the U.S.banking system.It does not primary and secondarymarket in treasury debt, is some- really matter whether or not the reserve requirements thing that should be on the agenda of the central bank are contemporaneous. If you have lagged reserve re- all the time. Countries have had a long period of time, quirements, the important thing is that all the banks twenty yearsor more, to developcredit controls and oth- know at the beginning of the reserve holding period er means of financial control that we all now think are what their requirements are. And the central bank not optimal.Over the past ten years, the countries them- knows their requirements. That knowledgeis of some selveshave learnedthat this kind of system is inefficient, value. leads to a misallocationof resources, and is not good for Central Bank Liquidity Management and the Money Market 31 long-term growth. There is a fashionin these things; ten Mr Honohan:If reserve requirementsare often used, years ago very fewpersons had any interest in the finan- and are perceived,as a fiscal instrument and not as a cial markets in developingcountries. Now it is all the monetary instrument, would not that fact militate rage. against their introduction in a system where previously there were none? Wouldit not be dangerousto blur the Question: When credit controls are removed,some- distinction between fiscal objectives and fiscal instru- times the central bank tends to start changing the re- ments on the one hand and monetary objectiveson the serve requirements.What has been the result, especially other? when reserve requirements were initiallyraised, of trying to reduce them again? Mr. Meek:Yes, I think that risk exists. However,at times circumstanceslead us to recommendsecond-best Mr.Meek: I am sure other people in the room have a or third-best measures.I had thought that I would never better fix on that than I have. Myown personal view is advocateliquid asset requirements.Then I went to Chi- that it dependsvery much on the developmentproblems na to advise them on debt management. The Chinese in the particular country. I agree with all of the argu- had sold nine-year bonds, and then five-year bonds, ments for a "level playing field"-low reserve require- three-year bonds, and two-yearbonds; 1990 is the year ments and such things-under idealcircumstances. But they all come due. They have no mechanismfor refund- in a country that has great difficulty collecting taxes, ing. And the banking system owns almost none of the then some level of reserve requirements doesn't seem bonds. I suggested that as a temporizing measure they like a bad idea to me. Of course it cannot last for a long might introduce a liquidasset requirementstemporarily periodof time. to, in effect,provide the funds that they could use to pay To return to the exampleof Indonesia,they cut their off the existingbonds. I have been told they did not ac- reserve requirements from 15 percent to 2 percent, but cept myadvice. They just made the state enterpriseshold then imposeda 15 percent tax on interest paid by com- onto their bonds. mercialbanks to depositors,which is reallyjust the same thn. Th onl real difrec wa tha inta ,oh Mr.Honohan: I don't know whether that is better or thing.tralbanl realedifferene wars thatistrear gofthe worse than one country, which shall remain nameless, central bank receiving the earnings, the treasury got that organizes its bond sales by paying off all the old them. bonds in Novemberand issuing new bonds in February. I become a little concernedthat some advisers per- Theyhaven't workedout how to bridgethe Novemberto haps over-emphasizethe importanceof the levelplaying February period. field, equalizingopportunities, and avoidingany incen- tivesthat may lead one part ofthe market to developfast- Question: Do you have a rule of thumb for when the er than other parts.When a developingcountry is still at central bank ought to exit from making the market? To a fairlyearly stage of development,I think those may be what indicators might it look when deciding to begin ideals and goals toward which the system should evolve getting out of setting prices?. over time. But I do not know that they are the most pressing immediateconcerns. Mr.Meek: I think the whole movementtoward markets and toward abandoning credit ceilingsas a mone- Question: Would you advocate varying reserve re- tary control is the basic issue. That issue need not be quirements from time to time as a monetary instru- finallydecided when the market is started, but the cen- ment? tral bank must commit to moving in the direction of markets. Mr Meek:Well, that affectsthe wedgebetween the in- Asan example,Pakistan had a credit control program terest rate paid on depositsand interest rates charged that involvedceilings on all the commercialbanks. They borrowers.That may have some value. Too frequently, had a simple rule for issuing some treasury securities. though, I think reserve requirements have been raised Theyissued 91-daytreasury bills on any dayat 6 percent, and liquidasset requirementshave been installedprima- and they were prepared to repurchasethem at 6.05 per- rily to channel funds to the governmentfrom the private cent. The 6 percent was unrelated to the market rate, sector. All of this redounds to the disadvantageof the which would have had to be around 8 percent. Rather,it country's economic development. I'm not sure one performed the function of liquidity management per- should encouragethe use of reserve requirements,but I fectly well. Anyonewith excess funds bought bills at 6 don't really have a position on it. percent; if someone needed funds, he could sell bills 32 Paul Meek back to the central bank at 6.05 percent. The banking less than that of the private banks,which have close ties systemmanages the wholeliquidity system through this to private enterprises. As a result, the borrowers in the kind ofmechanism, but it is not a secondarymarket or a interbank market are largely the national private and market in which treasury bills have any significantrole foreign banks. One of the monetary reformswas to drop as a money market instrument. the limitation on the amount a participantcould borrow I think the decisionshould be made on a case-by-case in the interbank market, because these banks had good basis. Evenso, I think there are more opportunitiesthan loan demand. may at first appear.I shall never forget advising some Although the state banks are suppliers to the inter- yearsago in Portugal.It wassaid that, because it wasjust bank market, the rates at which they are willingto sup- a small country,they couldnot aspireto open market op- ply indicate their managers have not been completely erations for a long time, if ever.After I was there about a converted to maximizing profits. For example, rather week, I pointed out that they were already doing open than placing excessreserves available in the afternoonof market operations.Three times a weekthey were having one day, if the rate is lower than they expect,they will an auction of participationsin the central bank's portfo- hold the reservesfor fear of loweringrates on money to lio. Their explanationwas that, because they had nation- be placed the next day. They end up holding excess realized all the banks and had a credit ceiling, the banks serves becausethey do not act to maximizeprofit. attracted far more deposits than they could utilize for I think this is a "teething" problem; these banks are lending within the credit ceiling. The central bank was just learning how to function in competitive markets sharing its higher-yieldingtreasury securities, so the na- and in a more competitive banking system. One of the tionalized banks would not go bankrupt. To them, that healthy aspects is that the private banks have generated was not an open market operation,it was moppingup ex- a lot of competition for deposits. Whenwe visited there cess liquidityin the system. So there are many ways to last year, we found that this competition had produced begin developinga market. some unexpectedresults. Whereasthe central bank and government were anxious to lower interest rates, the Question: What kinds of financial institutions are state banks were afraid to lowertheir rates because they able to trade in central bank certificatesin Indonesia? would lose depositsto the private banks. As one would expect,all this is getting worked out over time. Mr. Meek: Central bank certificates can now be bought by anyone.They are bought initiallythrough the Question: You said that the recipients would receive dealers,who act as agents. I have encouragedthe Indo- dollar deposits?Was there much currency substitution nesians to direct sales efforts towards the insurance in favorof the dollar?Was there capital outflowto Sin- companiesand other financial institutions who are nat- gapore? ural residual holders of liquid balances in this form. Dealers have begun by contracting repos (repurchase Mr.Meek: I think the answer involvesthe difference agreements)with them for a week. The rate these insti- between wholesale and retail. That is, individuals can tutions receiveis better than they can get at a bank. Asa hold time depositsthat are denominated in dollars and result, they have developeda fairly good repo market. carry an interest rate that follows rates in Singapore, The central bank did developall the housekeepingfacil- though with some lag. Individualswith small holdings ities,and so on, to permit fairly rapid transactionsin the do not have direct accessto Singapore.There is not a lo- paper. cal dollar market that pays a wholesale rate, in some That is just what needsto be done;one needsto devel- sense, for dollar deposits. That market is only available op a nonbank market for the central bank paper. Origi- in Singapore.Businessmen or bankers who have larger nally,holders of central bank certificateswere limited to holdingsand are worriedabout devaluationturn in their the banks, but now anyone can hold them. rupiahs to the central bank for dollarsand placethe dollars in Singapore. Question: Is there also an interbank market in Indo- nesia, and who are the main suppliers of funds to it? Mr. Grenville:There were two ways by which enterprises couldbypass the localbanker. If they could not get Mr.Meek: Yes, indeed. The state banks,which hold 75 liquiditywithin the credit ceiling, they could get it on percent of deposits, typicallyare the ones that receive the local market at the market rate. That bypassedthe large governmentdeposits. They do not know how long commercial banks, but they paid much more for it. Or they are goingto have them, so these banks have a high they could try to pick it up in Singapore,where they liquiditypreference. By and large, their loan demand is could get credit denominated in foreign currency. Central Bank Liquidity Management and the Money Market 33

Mr.Meek: Also, the central bank provided.swapfacili- casting their balance sheet. There is a discipline this ties for foreign currency.But not everybodycould access brings: a knowledgeof seasonal demands. The central Singaporecredit. bank people alreadyhave a visceralsense for that; they know there are certain demandsfor cash, and so on. Mr. Honohan: In some countries the authorities And yet, although forecasting the future balance maintained credit targets for the sake of the current ac- sheet is useful and teaches those involveda gooddeal, it count in the balance of payments.They want to restrain is not necessaryfor effectiveconduct of open market op- overall expendituresto get the current account right. In erations. Indonesia has a complete and comprehensive that case, this kind of leakageto Singaporeor some oth- system even though the central bank does not forecast er readilyavailable market is a big problem.In other cas- the demand for reserves. The interbank rate itself tells es, the authorities do not care about the current one whether the system is short or over-supplied.Every account; they just want to ensure that no officialfinanc- afternoon around six o'clock, the DeputyGovernor de- ing is involved.If they can encourageprivate capital in- cideswhether or not to have an auction of seven-daycer- flows, that is well and good. Private inflows do not tificates the next day. He knows what the foreign require official financing of the balance of payments. exchangemarket has done and what central bank certif- Then the money from Singaporeis treated as welcome. icates are maturing. He can guess whether the system However,since it might leavequickly in some cases, it is will be short or long the next day and decidewhether or a shakier kind of financing. not to do something. So, desirablethough it may be, one does not need projections of reserves to conduct open Question: Youtalked about the other mechanismsfor market operations. liquidity management. Could the central bank have In the Indonesiancase, there wasa one-daylag. They managedbank liquidityby withholdingor increasing li- wouldannounce at the end ofone daythat they were go- quiditycredits? ing to auction certificatesor make repos the next day.So they were not reading the eventsof the day on which an Mr. Meek:They used that approach at times in their operation took place. credit restraint program, which produced a liquidity shortage. And in really tight times, they would make Mr.Grenville: In Australia,where we have goodstatis- such credits available.Basically, though, the timing of tics and a goodrelation betweenthe central bankand the priority credits is not under the central bank's control. government, we do this whole task. We do these daily Theyoriginate in the commercialbanks and come to the forecasts of liquidity,as I am sure they do here in the central bank. It is an uncontrolled element to which the United States, going out severalweeks ahead. That pro- central bank must respond. cess is very useful for our understandingof the market. Part of the problem with the steep yield curve is the Weeven publish each morning at 9:30 a.m. the amount inflowand outflowof the treasury's balancesat the cen- by which we think the system willbe down or up. So we tral bank.These tend to be large relative to the size ofthe stick our necks out. But when we get the bids in from market. So a question arises on whether to supplement peoplewho want to do businesswith us, we may change the open market operationwith a mechanismfor placing our minds on how much we want to do in the market treasury fundswith the banks. Malaysiafor example,did that day.We can make mistakes;the market sometimes this at one point, although it was not for the purpose I has a better feel for what is happeningwith liquidity,and am suggesting. The central bank was allocated certain it lets us know.Just becausewe plan to do $A500million treasury funds that it could depositwith banks. in market operations,does not mean we will actually do However,in Indonesia I have not yet detected any $A500million. If you set it up right, the market can tell great enthusiasm in the central bank for a mechanism you a lot. that would place treasury depositsaway from it. In lieu of that, clearly a much better informationalsituation is Mr.Meek: Yes, in the Indonesiancase with contempo- needed, one in which the treasury and the central bank raneous accounting,that is the best guidance the central share intelligenceon big receipts or deposits. Some ef- bank has. The information the banks have about their fort has been made in that direction, but it is still imper- positionis much more up to date than the central bank's fect. information about their position. Most central bankerswith experiencein open market operations would agree in the utility of being able to Question:With respect to the issue of credit control forecast the balance sheet. I suggested to the Indone- and the market, it seems that the important question is sians fiveyears ago that it would be good to start fore- whether the officialinterest rate right now is more or 34 Paul Meek less in line with the world interest rate. If it is, the au- that is sure it will not devalueand has the means of pro- thorities would not have a big problem in trying to con- vidingthe liquidity,that is, has accessto large reserves. trol credit. In the Europeanarrangement, where unlimited reserves are available,that could be the correct response for a Mr.Meek: In their situation with modestexchange re- government that is sure where it is going: either the serves and a completelyopen system, they cannot pur- country should devalueat once or it should lend in un- sue a differentinterest rate policy.Since I visited there, limited amounts. In practice,this route is not often fol- the large premium for devaluationrisk has diminished lowed;spikes in interest rates occur before devaluations considerably.They are conducting their operations in in the Europeansystem. such way that peopleare now beginning to believe that However,the optionof lending in unlimited amounts the gradual adjustment ofthe exchangerate is enough to is not availableto Indonesia.Therefore, there appearsto meet their needs and that there will not be another be a deficiencyin the arrangements for this kind of ex- maxi-devaluation. change rate system. If the country does not have the The implicationsof those maxi-devaluationsfor mon- credit facilities to back up its policy on exchange rate, etary policyare interesting. They limited what the cen- perhaps it should go to a much more flexibleexchange tral bank could do to lower interest rates, because they rate system insteadof one with temporarypegs and ma- resulted in a risk premium which kept rates higher than jor devaluationjumps at intervals. manypeople thought they should be. Mr. Meek:I think the latter is what the Indonesians Question: For some countries, foreign currency de- have undertaken to do. That approach has usually posits are quite large. What was the size of the foreign- washed out fairly quickly.For example,they made the denominated deposits in Indonesia at the time of the mistake in December 1986 of trying to ride the crisis maxi-devaluation?They were not that large, were they? through. Theyhad no intention of devaluing,and so on, but that just culminated in a much bigger crisislater on. Mr.Meek: They were not huge, no. Theywere limited Since that time, things have been reasonablywell be- mostly to urban areas and reasonablysophisticated peo- haved. ple. Mr.Grenville: The Indonesiansoffered to swap local Mr. Honohan:I have a question about these devalua- currency for foreign currency.This swap facilitywas not tions. A crucial, difficult issue comes up for a central open for everyone but open for those with heavy ex- bank that is operating one of these unsteady exchange change rate exposure.That, in a sense, is making a bet rate policies,one that is supposedlyfixed but is beingad- on whether there will be a devaluation.If the swapoffer justed at intervalsby these maxi-devaluations.As you de- is used and no devaluationoccurs, then the central bank scribed the risk premium, it is more than could be is all right. If the devaluationdoes happen, the central justifiedover long periods of devaluations. bank has taken major losses. This is a common phenomenon,but what should be the central bank's response to a surge in this premium? Mr. Honohan:Yes, that is the key point. Is the gov- I accept that the central bank must livewith the premi- ernment sure it can maintain the rates? In the case as de- um and cannot avoid responsibilityfor the effectof the scribed,which may have been an oversimplification,the devaluation.The dilemma arises when lenders assume central bank knew that it did not want to devalue and that another maxi-devaluationwill occur, probably soon, had no intention of doing so. If it can stay with that po- but the central bank knowsthere is no plan for a maxi- sition, the dice are loaded;it knows that it will win the devaluation.The situation is a bit like the crises of the bet. If the bank'sactions indicatethat it knowsit willwin nineteenth century: what should central bank policybe the bet, when it offersthe bet nobodywill take it. How- when there is a run on the overallsystem? The old solu- ever,to hedge the bet by sayingthat this week the inter- tion was that the central bank should lend as much as est rate is 20 percent, next week it will be 23 percent, possible. revealsa lack of confidence.

Mr.Meek: At high rates. Mr.Grenville: But when the bet is much bigger than the foreign exchange reserves, the central bank gets Mr.Honohan: Or, at least in practice,just to provide worried.They did not get to that stage, but they went to all the liquiditythat is required. Now,that might be the the stage where foreign currency swaps were not far appropriate response for the hypothetical central bank short of their total foreign exchangereserves. Central Bank Liquidity Management and the Money Market 35

Mr. Honohan: Yes,and central banks lose these bets Question: I think that betting against the market is a because,as in the case of the Philippines,they are forced dangerouspath to follow.If there is an expectationin the to take the bet. They probablyknew they would lose it, market, there is little you can do about it. In 1982, the and they did lose it. Argentine central bank went into this rough exercise. The result was that, as they say in Argentina, "all the Mr.Meek: For a central banker in a situation like that losseswere socialized."The privatesector wascomplete- in Indonesia,the best response is a quick defense. The ly wiped out by the high cost of the debt in foreign cur- sharp rise in interest rates in the middle of 1987 evoked rency.All the losseswere taken by the central bank. So I many complaints.Yet, it is not clear that the rise had any think it is very dangerousto try to intervene in a market, lasting economicconsequences. In fact,I think it formed for the central bank to take such a high risk. the basis for the growing confidencethat there would In the case of Indonesia, I understand there were not be another maxi-devaluation. some dollar-denominateddeposits, which the systemap- parentlywas able to continue intermediatingdespite the Mr. Grenville:The two things go together. One very expectationof devaluation.Perhaps there were also dol- good move the Indonesiansmade wasto price the use of lar-denominatedloans. When the banks receivea deposit the currency swapfacility in line with the interest rates. in dollars,what do they do?Do they also lend in dollars? The premium (or cost) of the swapwas based on the dif- That is one solution; another would be to index de- ferencebetween domestic (i.e., rupiah) and foreign (i.e., posits or loans denominatedin dollars,or to indexbonds U.S. dollar) interest rates. As domestic interest rates to the dollar.Indexation is alwaysone wayto cope with a rose, the swap premium also rose. While the central devaluationrisk. Mexicohas followedthis course for the bank wasoffering the bet, it wasalso makingthe bet pro- last couple ofyears. Realdomestic interest rates in Mex- gressivelymore in its favor.If it wins the bet, it is in a ico have been extremely high. The government has be- very good position. gun to issue indexed bonds; this allows the banking system to index deposits and loans in dollars. But the Mr.Honohan: If a rise in short-term interest rates for dollar interest rate domestically is still high, which severalmonths is not costlyfor the economyand for in- provesthe problem is not just the expectationof devalu- vestment decisionsand businessconfidence, then surely ation but also some risk of default.There is no financial one should go for the short-term rise. Still, I am not sure engineering that can solvethis problem. it is without significant costs. Those costs could be a heavy price to pay in situations where the country Mr.Honohan: I think you are saying that countries in should just devalueat once. In other cases, the country volatilesituations without significantforeign exchange willbe able to ride it out; if the central bank is not wrong, reservesreally cannot commit to a fixedexchange rate sooner or later the money has to come back. If it can without heavycosts. A fixedexchange rate policy,where hold out, it will be all right. the possibilityof devaluationexists, is a risky policy to follow. Mr.Caprio: In general,the Central Bankhas to guard against a common occupationalhazard, to wit, that of Note not recognizing when a disequilibriumis fundamental. At least a part of the "art of central banking" involves 1. Editor Note:This point was emphasizedby Deputy making such difficultdecisions. GovernorLin of BankNegara Malaysia;see chapter 11.

The Use of Monetary Policy Instruments by Developing Countries

R. Barry Johnston

Today'ssession is entitled nuts and bolts, and this lecture lowing elements: direct controls on interest rates (in- is on new instruments and techniques. BeforeI get down cluding preferential rates for certain loan categories); to "nuts and bolts," I think it is worth reminding our- aggregate and individualbank credit ceilings;selective selvesthat the typesof instruments and techniquesI will credit controls and preferential central bank refinance describe are developedin pursuit of broader objectives facilitiesto direct credit to priority sectors; and high re- for economic growth and development.I stress this be- serveand liquid asset requirements,designed both to ab- cause the transformation to a more market-orientedfi- sorb liquidityand to providegovernment deficit finance. nancial systems is not necessarilyeasy to accomplish.It The directcontrols have a number ofdrawbacks. They often involvesa fundamental reorientationof thinking in often become ineffectiveover time as an instrument of the central bank as regardsits role in allocating financial monetary control and inhibit efficient resource alloca- resources, the commercializationof state-ownedfinan- tion. Creditceilings and other directcontrols force insti- cial institutions and in the government concerning the tutions into portfolio positions that they would not payment of market-relatedinterest rates on its debt. otherwise voluntarily accept. Hence, banks and their The reform of monetary instruments should also be customers have incentivesto avoidthe direct controls. viewedas only part of broader financial reforms which The implicittax imposedon commercialbanks, and thus aim at making the financial system more responsiveto on their borrowersand depositors,by credit ceilings, in- market forces and more competitive.I would include in terest rate controls,and high (but low-or non-renumer- this: ated) reserve and liquid asset ratio requirements, (1) Steps to liberalizeinterest rates encouragesthe emergenceof other, unregulated, finan- (2) A reduced reliance on direct controls to allocate cial intermediaries and instruments that compete with credit and the removal of other discriminatoryregula- the regulated ones. This weakens monetary control by tions that inhibit competition between financialinstitu- eroding the effectivenessof the direct control and dis- tions and fragment the financialsystem torts monetary indicators. (3) A reduction in the barriers to entry of new finan- Monetarycontrol is also weakenedwhen credit ceil- cial institutions and the exit and restructuring of existing ings involvea buildup of excessliquidity at regulated in- inefficientinstitutions stitutions, as this discourages deposit-taking by (4) The development of new financial markets and regulated institutions, and in turn inhibits savings mo- new financialinstruments. bilization or causes disintermediation.Savings mobili- Financial reform is in its turn an integral part of zation may not be promoted simply by mandating broader economicliberalization that involvesa shift from positive real deposit rates at regulated institutions, as allocating resources through directives, controls, and they may either turn awaydepositors or find waysof pay- subsidiestoward a greater role for market forces. ing lower effectivedeposit rates. It is generallynot possible to control both the cost and quantity of credit, Why Is There a Need to Reform Monetary although in practice this is often attempted using direct Control Techniques? controls. The efficiencyof credit allocationis also adverselyaf- The system of monetary control in most developing fected by direct controls. It is difficultto design proce- countries has typicallyinvolved some if not all of the fol- dures that do not penalize more efficient institutions,

37 38 R. Barry Johnston

and the support of inefficientinstitutions may lead to rates. Such a system doesnot rely on high or even com- higher averagetransaction marginsand lendingspreads. pulsory reserve or liquid asset requirements but only on High liquid asset ratios create captive markets for gov- the central bank's ability to manage its own balance ernment securities and an inappropriatepricing of cred- sheet and to control the terms at which it is willing to it, including a substantial interest subsidy to provideassistance to cover reserveshortages. government.With direct controls, little attention is paid The central element of the indirect approachto mon- to developingmoney and capital markets,which are cen- etary control is therefore the central bank's control over tral to the efficientallocation of resources. the items in its own balance sheet. Paul Meekhas described what these items are. Table 3-1 breaks these KeyElements in a LiberalMonetary Control items down into nondiscretionaryfactors-those which Framework are beyondthe short-term control of the central bank- and the discretionary operations of the central bank, Themain elementsof the reform of monetary control which can be used to manage the supplyof reservemon- instruments are ey relative to the demand for it, to meet required and (1) The developmentof a frameworkfor making de- precautionary reserve balances or the level of money cisionsabout interest rates and the path of financialvari- market interest rates. ables in a liberalsystem The frameworkfor managementcan be formalizedby (2) The introduction of new techniques for govern- developinga reserve money program that involvesfore- ment domesticdebt management castingthe main nondiscretionaryelements and setting (3) A reform of central bank operationsand facilities out the options for the discretionaryfactors in order to (4) Supporting institutional reforms. achieve policyobjectives, or to adjust the policy targets in response to unanticipated movements in reserve The Monetary Control Framework money components.The establishmentof such a framework requires a blend of economicand statistical analy- In a liberalsystem, the main instrument of monetary sis and operational experience and often involves control is the central bank's control overthe stock of re- reorganization in the treasury and central bank. The serve money (cash and balances with the central bank) treasury needsto be able to monitor and forecast its own and hence over money market interest rates. Money cash position,while the central bank has to developthe market rates, in turn, affectother lending and deposit frameworkfor forecastingand coordinatinginformation Table3-1. Components of the Reserve Money Program and DiscretionaryPolicies

NondiscretionaryElements DiscretionaryElements and Policies Net purchaseor sales of foreign exchange Policywith regardto the exchangerate and net against local currency. foreign exchangemarket intervention. Changein currency in circulationoutside Obligatoryreserve requirements;penalties for obligatory the central bank. reserve shortages;availability and interest rate on borrowingfrom the Central Bank. Changesin holdings of obligatoryreserves and Governmentdeposit and debt management. precautionarybalances due to changes in bank depositsand balance sheet totals. Net receiptsand paymentsthrough government Sales of central bank and treasury bills at auction; accountswith the central bank including policytowards the tap window;and short-term redemptionsand issuesof governmentsecurities. money market intervention. Redemptionsof central bank bills and tap sales of Changes in rediscount policiesand discountwindow rates. bills;maturing central bank loansand assistance, and current receipts;and paymentsby the central bank. Automaticcentral bank credits to priority sectors. The Use of Monetary Policy Instruments by Developing Countries 39 on the trend in other domestic and external variables ing a volume ofbills in excessof the forecastreserve sur- and developingthe overall implicationsfor the cash re- plus. In this case, and assuming the forecasts are serves of the financialsystem. accurate, banks would find themselvesshort of reserves The establishmentof the monetary operatingframe- and interbank rates wouldtend to rise. If the sale of trea- work shouldbe one of the critical first steps in the adop- sury bills reducedthe aggregate supplyof reservesbelow tion of indirect instruments of monetary control. In reserverequirements, banks would haveto seek margin- practice, however,the establishment of such a frame- al accommodationfrom the central bank and the inter- work is often givenlower priority than, say,the more vis- est rate at which the central bank providesthe assistance ible auctioning of treasury bills. Consequently,the would becomethe key determinant ofthe overalllevel of efficiencywith which monetarypolicy has been conduct- interest rates. An expansionary stance would involve ed with indirect instruments has sometimesbeen poor. sellingfewer bills than the forecastcash surplus. In this case bankswould have excesscash reserves,which could DomesticDebt Management push interest rates down.Interbank rates wouldfall, and there wouldbe repaymentsof central bank credit. In this The starting point for developingmarket-based mon- framework,the design of rediscount facilitiesis an inte- etary control in developingcountries has often been pro- gral element of reserve and interest rate management. cedures for the primary issues of treasury bills and/or Selling techniques for primary bill issues include central bank bills. In some countries the catalyst has "free"auctions, fixedprice tenders, and tap sales at pre- been markets in longer-term government securities. determined interest rates. Under free auctions, the cen- However,because commercial banks are often already tral bank announces the volume of bills to be sold and required to hold treasury bills to meet liquid asset re- asks for competitive bids. Bills are allocated starting quirements or have built up excess reserves with the with the highest bid price and moving to the next high- central bank, treasury and central bank bills are often a est, etc., until the tender is fully sold.Under a fixedprice useful first instrument in developingmarket-based pro- tender or with tap sales, the central bank sets the inter- cedures. est rate on bills and acceptsthe volume demand at that Issues of central bank paper have been considered rate. With a free auction, interest rates fully adjust to useful because of the potentiallygreater freedomfor the achieve the quantitative objectivesfor the sale of bills central bank to tailor issues of its own paper to achieve and hence for the targeted stockof reserves,but this may monetary objectiveswithout direct interference from risk volatilityin interest rates from auction to auction. governmentbudgetary considerations.However, the net On the other hand, with a fixedprice tender, the interest budgetaryand monetaryimpact from using central bank rate is determined in the short run and quantitiesare al- rather than treasury paper is similar, and the choice is lowedto vary. The tender price can be varied from one largelyan operational decision. tender to the next to exercise the desired quantitative The role of security issues as instruments of mone- control, but this procedure may risk a "bias to delay"in tary control can be illustrated using basic financialflow adjusting interest rates. and balance sheet equations. The basic approach is to In many countries that are introducing market-ori- generate projectionsof (a)the supplyof cash reservesre- ented procedures,bills are auctioned, but no tender vol- sulting from transactions by the government and the ume is announced in advance. The central bank central bank and (b) the privatesector's demand for cash exercisesits discretionin acceptingor rejectingbids, de- reservesresulting from the public'sdemand for currency pending on its quantitative or interest rate objectives. and the banking system's demand for required and pre- The decision not to announce the tender amount can cautionary cash reservebalances. The volume of securi- thus give the central bank added flexibility,although at ties issued is used to manage the differencesbetween the cost of reducing informationto market participants. these suppliesand demands. In the initial stages, the benefits to the central bank of A neutral monetary policy stance-i.e., one which the increased flexibilitycan help overcome concerns would leavemoney market rates unchanged-would in- about implementingnew monetary control procedures. volveremoving an excesssupply of cash reservesby sell- In some cases, bills are auctioned and tender volumes ing a volume of treasury bills to the private sector equal announced in advance,and a permissible range is also to the differencebetween the forecastsupply of cash re- announced for bids that wouldbe accepted. servesand the estimate of demand (or relievinga fore- The introduction of treasury bill auctions often needs cast reserveshortage by not rolling overmaturing bills). to be accompaniedwith a broader reform ofthe domestic A restrictive policystance designedto raise interest rates debt management instruments and policy.For example, would involvethe creation of a reserve shortage by sell- the simultaneoussale of treasury bills at auction and on 40 R. Barry Johnston tap at rates closeto those determinedin the auctions can market liquiditybetween the issues. If not offset by the deflectdemand from the auction and bias upwardthe in- central bank,the resulting reserve shortagesor surplus- terest rate bids at the auction.On the other hand, allow- es could result in excessivevolatility in interest rates and ing captiveinstitutions to bid at the auction can bias the could complicatebanks' compliancewith legal reserve bidded interest rates downward.In either case, the auc- requirements. tion bidswill not be representativeof market rates. The aim of achieving interest rate flexibilitywhile avoidingexcessive volatility often callsfor day-to-dayin- CentralBank Facilitiesand Operations terventionby the central bank.The most common forms are lending through the central bank rediscount win- In support of the developmentof a more market-ori- dow, outright sales and purchases, and repurchases of ented financialsystem, the central bank may have to re- securities. form its existingfacilities and introduce new operational The availabilityof usable collateral is often a critical arrangements. bottleneck in central bank day-to-dayliquidity management and the developmentof money markets more gen- Refinance Facilities erally.For example,in many countries,the use of lender- of-last-resortfacilities is inhibited by the lack of unen- Inanceisamany courcenta re freetial. refi cumberedcollateral. Banks may hold large stocks of liq- nance~~~~~~~~~~isamjrsuc.frsremnyceto.Sc uid assets, but these are not usable as they are held to refinance is often automatic against eligible bank loans meet liquidasset re uirements.To increasethe usabilit and carries below market interest rates. The central q qs y bank often lacks the instruments to control the expan- of liquid assets, the liquid asset requirements can be re- sion of the refinance in the short-run, which therefore placed with norms that would specifythe averagehold- has the potential to undermine monetarycontrol, while ings of liquid assets over a sufficientlylong period so as the preferential interest rates distort the allocation of not to restrict banks' ability to utilize liquid assets at a credit and the competitiveposition of different financial particularpoint in time. Alsothe central bank should en- institutions. Bringing this preferential refinance under courage the developmentof bankers acceptances (BAs). control is often a matter of urgency. The BAis a convenientinstrument that can be used to Reformsof the refinance facilitiescould include the collateralize interbank trading between institutions of introduction of bank-specificcredit ceilingson the vol- diverse credit standing and can be used by the central ume of short-term refinance and raising and unifying bank to inject liquiditywhen there is a shortage of trea- the interest rates on this refinanceat the bank rate. The sury or central bank bills. With an increasedavailability bank rate should be raised and maintained above the of collateral,the rediscountwindow can becomea useful treasury bill rate. Such short-term refinance should instrument for liquidity management by banks and eventuallybe merged with the central bank's dailymon- hence for the central bank to direct the level of interest ey market operations. rates through its rediscount rate policy. As regards long-term project refinance,this could be A rediscountwindow only providesa facilityto elimi- auctioned,as this would help determine a more appro- nate reserveshortages; there is a risk that the rediscount priate pricing for long-term funds and providethe cen- rate wouldbe viewedas the indicativerate for all interest tral bank with closer control over its total volume. Over rates, inhibiting their market determination. These time, as the capital market develops,the auction rates problems can be mitigated by providing graduated ac- and capitalmarket rates wouldconverge and the auction cess to the rediscount facilityat progressivelyhigher pe- of refinancecould be phased out and replacedwith capi- nal rates and special interest-bearingaccounts with the tal market transactions. central banks for excessreserves. Theseprocedures are basedon preannouncedinterest Proceduresfor Day-to-DayLiquidity Management rates and leavethe initiativeto obtain or disposeof bank reserves entirelyto the commercial banks.The alterna- Auctionsof primarybills to the general publicinvolve tive is for the central bank to take the initiativeas re- administrativecosts and delays.As a result, primary bill gards the quantity of intervention and leave interest issues have tended to occur no more frequently than rates to be market-determined. For example, when once a week, which also seems reasonablyoptimal tim- shortages are indicated, the central bank could an- ing for these issues. However,as the actual outcome for nounce its willingness to buy bills up to a certain reserves may deviate significantly from the outcome amount, then ask for competitiveoffers; when surpluses projectedby the authorities, there may be a need for sup- are indicated,the central bank can announce its willing- plementary central bank operations to manage money ness to sell a certain volume of bills, then ask for com- The Use of Monetary Policy Instruments by Developing Countries 41 petitive bids. The central bank would then be able to tral bank needs only to communicate to the dealers or acceptthe bids and offersto meet its interventionand in- banks its desire to trade and the direction in which it terest rate objectives. By restricting the auctions of wishes to dealand to ask for interest rate bids and offered money market intervention instruments to a few key amounts. Repurchases are self-liquidatingand can be money market participants,these auctions can be more targeted to temporary fluctuations in bank reserves. flexiblyimplemented than the general auctions of pri- They overcomethe frequent problem of a shortage of mary bills. Experience indicates that active secondary specificmaturities and the large transaction costs in- markets are most likelyto developwhen the central bank volved in buying and selling securities outright to man- begins these daily discretionary operations and ceases age a temporary liquidityimbalance. They are therefore posting intervention rates. a flexibleand cost effectivetool for managing highly The developmentof daily operationsoften needsto be variablebank reserves. supportedby reforms of reserverequirements. Penalties for noncompliancewith reserve requirements may have SupportingArrangements and Institution Building to be increasedto ensure that the reserve requirements are a binding target for the central bank's day-to-day Paul Meekhas alreadytouched on these issues.In ad- money market operations. The lagging of reserve re- dition to financial institution building, let me briefly quirements can help provide the authorities with firm mention a number of broader structural and policy is- informationabout the levelof reservesdemanded by the sues that should also be addressedas part of the reform banking systems.Also, averaging the periodfor compli- of monetary instruments. ance with the requirements can introduce additional The liberalizationof interest rates is often inhibited flexibilityand reduceinterest rate volatilityand the need by the captivemarkets for governmentsecurities created for day-to-dayintervention by the central bank. by high liquid asset requirements or other portfoliore- One of the major sources of noise in the money mar- strictions. Liquidasset ratios may therefore need to be ket can be the clearing and settlement arrangements. reduced or the range of assets eligible to meet the re- The money market provides a means of access to good quirements expandedto include prime quality private funds for the processing of payments and the mainte- papers.This wouldbe desirableanyway, as a wayof stim- nance ofovernight required reservebalances. To take op- ulating the market in BAsand other private papers.Pub- timal reserve positions, a bank requires up-to-date lic sector financial institutions (and the central bank) informationon its cash positionand its customers' pay- should havetheir securitiesallotted outsidethe auctions ment flowsand time to offsetthese, if necessary,through the money markets. If banks do not knowtheir require- to a dsrtin ateauctio rule T e iomguaran-. ments for goodfunds until afterthe money markets have teta aktbsdsse ol ecmeiie IHence,measures to increase financial sector competi- closed, the consequencesare thinner markets, greater tion, including bank restructuring and the reduction in volatility in interest rates, increased risk for market barriers to entry that I mentioned at the beginning, may makers, and larger holdings of precautionary reserve have to eny the reformsa balances by banks. The lack of information creates a se- have to accompanythe reforms. rious problem for the central bank, since the central For interest rates to have the appropriate impact on bank would not know the aggregate shortages or sur- resource allocation,borrowers have to be responsiveto pluses that it wouldneed to offsetin its dailymoney mar- market prices. A high incidence of credit undiscipline ket operations. and loan delinquency,or arrangementswhere borrowers One way of avoiding these problems is a system of or banks expect to have their loans coveredby the gov- same-daysettlement for money market transactionsand ernment, can render interest rates meaninglessin the next-daysettlement for all other payment orders. In this allocationof credit. The strengthening of bank supervi- waybanks and the central bank can know,usually in the sory arrangements,bankruptcy laws, and the legal pro- morning, the net payment orders transacted the previ- cedures for loan recovery may therefore have to ous day that have to be settled today.They can then enter accompanythe financialreforms. the money market to trade and balancetheir settlement Asa result ofinterest rate liberalization,interest rates positions. Similarly, the central bank can establish a on government debt may rise, with budgetary implica- timetable for its own money market intervention. tions. Similarly,parastatals and other borrowers,which Repurchasetransactions have a number of advantag- have accessto bank loansat preferentialrates, may expe- es for central banks in managing money market liquidi- rience an increase in borrowing costs. As a result, cer- ty. It is not necessary to have developed financial tain projects may no longer be viable and productive markets to undertake a repurchasetransaction. The cen- sector restructuring has to take place. 42 R. Barry Johnston

Managingthe Reform in MonetaryControl If the initial financialsystem is highly regulated,with Techniques each regulationsupporting the other, it may be difficult to implementa gradual, effectivereform. In such cases, Let me finishthis talk by discussingsome of the com- a major one-stepchange in the operational system may plex issues in the implementationof monetary control be unavoidable.This has been the policy followedin a that can accompanyfinancial reform-issues that we are number of countries. However,rapid structural changes only now coming to grips with. carry a risk of a loss of monetary control and broader financial sector instability and require careful manage- Sequencing of Reforns ment. A detailed examinationof the sequencingof financial The successfultransition to more market-orientedfi- reforms in five countries has providedsome important nancial systems requires careful consideration of the conclusionsabout the dynamicsof the growth of depos- speedand sequencingof reform. It takes time to build up its and credit followingfinancial liberalization. These are expertise,to changeattitudes, and to establishnew insti- illustrated in Figure 3-1. In the pre-reform period, de- tutional arrangements necessary to ensure effective posit growthdeclines because of the negativereal depos- monetarycontrol and competitivemarket mechanisms. it rates and the overall repressednature of the financial This suggests a phasedapproach to reform. system.Credit growth is maintainedthrough increasing Underthe phasedapproach, interest rates couldbe set liquiditysupport from the central bank. Depositgrowth free in stages, for example,by gradually widening the that is lower than credit growth is associatedwith in- permissible ranges for deposit and lending rates or by creasing resource pressures in the pre-reformperiod. steadilyadjusting minimum depositrates and maximum After financialliberalization, both credit and deposit lending rates. The traditional instruments-reserve re- growthincrease. However,the responseof credit growth quirements and rediscountwindows-could be deployed is initially more rapid than deposit growth. The decline initiallyto manage bank reservesand thereby the credit- of depositsin the pre-reformperiod reflected a voluntary creating capacity of the banking system,while phasing portfolio response to financial repression rather than out credit ceilingson banks.However, credit ceilingson specificcontrols. In the post-reform period there is a individualbanks could still inhibit competition;there is gradual portfolioadjustment by depositors to the new a risk-evident in some countries-that the phasing of liberal financial situation. Credit growth, in contrast, reform is so slow that little fundamentallychanges. was constrained by direct controls with an excess de-

Figure 3.1 Dynamics of Credit and Deposit Growth with Financial Liberalization

A. PositiveReal Interest Rates B. NegativeReal InterestRates

Growvthof A Growvthof Ai aggregates aggregates in real | Credits in real tenns terms Credits

Deposits D/s=

Date offinancial Date offnancial liberalization '/liberalization

Time Time

Deposit growth minus credit growth Deposit growth minus credit growth The Use of Monetary Policy Instruments by Developing Countries 43 mand for credit. Once the direct controls are removed, ming, at the level of the banking system, is likelyto be financialinstitutions respond by meeting the excessde- made more difficultand responses more uncertain fol- mand for credit, and credit expandsrapidly. The initial lowing the change to indirect monetary control proce- effect of the financial liberalizationis, therefore, to in- dures. crease the resource imbalances. First, the relationshipsbetween money and credit and The subsequent development in deposit and credit final objectivesthat existedduring the pre-reformphase growth depends on the structure of real interest rates. are likelyto be less reliable followingfinancial reform. Whenreal interest rates are positive,the growth of credit The introduction of new instruments may shift the in- slowsdown comparedwith the initial post-reformcredit terest sensitivityof money demand.For example,a liber- boom. The growth of credit may remain higher than in alization of interest rates on bank depositsmay result in the pre-reform period because of the general increased broad money becoming less sensitiveto changes in the role of the financial sector in mobilizingand allocating general levelof interest rates. The removalof creditceil- resources followingfinancial liberalization. The growth ings that constrain portfolio allocation can result in ofdeposits continues to increase.This reflectsthe lagged portfolioshifts, including a demand to hold larger mon- portfolioadjustment to the financialliberalization mea- ey balances at any given level of interest rates and in- sures, the developmentof newfinancial instruments and come. Higher interest rates may lead initially to institutions followingthe liberalization,and the reduc- distressed borrowing. Money multipliers may also tion in central bank liquiditysupport of financialinstitu- change with reform, for example,when there is reinter- tions, which in turn are forced to mobilizedeposits to mediationto the bankingsystem leading to reduced cash meet credit demand.After some point the growth of de- holdings by the non-bankpublic. posits and credit converge,allowing for balancedgrowth Second,the attainment of short-run quantitativetar- with a higher levelof overallresource mobilizationthan gets for bank credit, consistent with a desired outcome in the pre-reformperiod. for the balance of payments(established as part of the fi- If real interest rates are negative in the post-reform nancial program),would be extremelydifficult when in- period, this encourages a more rapid growth of credit terest rates or the cash reserve of the bankingsystem are and slowergrowth of deposits.The maintenance of neg- the principal monetary control instruments. This re- ative real rates requires expansionarycentral bank poli- flects the considerable uncertainty about the size and cies that financethe faster growthof credit in relation to even the sign of the short-run interest elasticity of the deposits. As a result, the growth of deposits does not demand for bank credit. This is not to say that an overall catch up with the growth of credit and resource imbal- inflation or balance of payments outcome could not be ances remain. These may be wider than in the pre-liber- achieved using indirect monetary control instruments alization period. but that precise financial programming at the level of Even with the maintenance of positive real interest the banking systemwould be difficult. rates, there is likely to be an initial post-liberalization A practicablemonetary policyframework consistent credit boom that can pose a threat to economicstability. with a market-oriented system of monetary control, The managementof the credit boomis a critical element quantitative performance criteria, and explicit targets of successfulfinancial liberalization. For example,finan- for the balance of paymentsis likelyto be one definedat cial liberalizationmay have to be accompaniedby a ster- the level of the central bank's balance sheet rather than ilization operation aimed at absorbing excessliquidity. the banking system. Monetary control would be exer- However,to the extent that the initial credit growth re- cised through sales of securities to the private sector, flectsa one- time stock adjustment to a new equilibrium with the aim of achievingquantitative targets for the net position,an attempt to constrain it solelythrough inter- domestic assets of the central bank. This framework est rates could result in veryhigh real interest rates. The wouldalso be consistent with the use ofbroad or narrow economy-wideimplications may thereforehave tobeoff- monetary aggregates as intermediate targets. The set- set by an accompanyingreduction in the fiscaldeficit or ting of quantitative targets on the central bank's balance a temporary increasein externalborrowing sheet also fits neatly with the use of primary auctions of securities as the principal market-basedinstrument of Designof FinancialPrograms in the Post-Reforn monetary control in underdevelopedfinancial markets. Period These are areas and questions that are under study.

The design of financialprograms may have to be re- thought followingfinancial reform. Financial program- 44 R. Barry Johnston

Discussion

Mr.Caprio: What role do you see for liquid asset ra- where you have experience,why did they actually take tios? In some countries, the authorities view them as a the decision? tool of monetary policy;in others they are viewedas a Mr. Johnston: In some cases it was evidentthat ceil- tool for prudential concerns. ings were having no influence. Basicallythey were just repressing a number of regulated banks. Outside the Mr. Johnston: Liquid assets should not be a tool of ceilings,you had the "gossamer"banks, which were do- monetary policy.They should be primarily a prudential ing things similar to what the regulated banks did but instrument. That is why I emphasizethe availabilityof were not subject to the ceilings. In that sense, the au- usable collateral. Unfortunately,when you set require- thorities had lost monetary control. Wehave worked on ments the collateral becomes unusable. Therefore,the one that was near that point. prudential buffer that the stock should provide is not For other countries,it wasvery much a consciousde- there. One may have banks that meet a liquidityrequire- cision.They wanted to liberalize their financialsystem; ment of 35 percent of assets but have no collateral to they wanted to moveto market-orientedprocedures, and trade. So they cannot go into the money market; they this was part of that process. They realized they could cannot go to the central bank. The central bank quite of- not have a liberal system if they had credit controls. I ten ends up having to announce another window at think these have been the two main reasons. which it makesunsecured loans, becausethe banks cannot use their liquid assets stock as collateral. Question:Has there been a case of liberalizationthat Quite often liquid asset requirements cannot be rap- has been both rapid and stable? idly reduced without major effectson the government's borrowing position because much of its deficit is fi- Mr.Johnston: I am not aware of one, although my ex- nancedthrough liquid asset requirements on the banks. perienceis not extensive.On the one hand is the example As I suggested,the first step is to try to get these liquid of Korea, where liberalizationhas been in progress for AsIsuggested, first stepistotrytogettheseltenthe years; they are still regulated, and they have not had assets into a usable form, so they can serve the pruden- instability. But I do not think that is rapid financial tial role of providing liquidity to the banking system. transformation.The present experiencein Eastern Eu- This should be the primary objective.For this reason, rope is still being playedout. I do not think they haveyet the liquid asset requirementshould be stated as an aver- experiencedthis problem,but it is premature to say what age over one or two months, so the banks can use it on a is happening there. The circumstancesmay be a bit dif- dailybasis, but re-establishthe needed ratio for the stat- ferent in Eastern Europe, where the banking systems utory period. were much more constrained and the private sector was In addition, many bank supervisorsemphasize that not sufficientlydeveloped to take advantage of the re- the country should determine its minimum liquid asset movalof ceilings. requirements based on strictly prudential guidelines. Such guidelinesmight look at the maturity structure of Question:What about the experiencein NewZealand the assets and liabilities, rather than just mandating a with rapid liberalization? blanketratio of 35 percent on the whole balancesheet. It is better to analyze in finer detail the system's needsfor Mr. Caprio: They began liberalizationin 1984. New liquidity.For example,demand deposits are not really Zealand did everything very much like the southern very liquid,in the sense that they normally are returned cone countries. They opened up on the capitalflow side to the system. On the other hand, one-month deposits and removed all the credit controls. Real interest rates tend to be withdrawnwhen they mature. The aim should went up to about 15 percent, then came down to about be to developrelative weights and ratios which will pro- 8-10 percent. In fact, New Zealand's experience more vide an appropriateamount of liquidityfor the system closely resembles graph A in Figure 3-1. There was a for prudential reasons. boom in credit for about five years, but it finally came back in line with deposits. Question:At the beginning of your presentation,you mentioned reasons why one should or might want to Question:In many cases in the developingcountries, moveaway from direct credit controls. For the countries banks must rely on short-term deposits. They lack the The Use of Monetary Policy Instruments by Developing Countries 45

longer-term resources they need, which of course ex- ment-financeinstitutions are getting highly subsidized plains why term credit is not available for economic loans. As a result, no one else can make any money pro- growth. Besides interest rate regulation, is there any- vidinglong-term resources.There is no role for the cap- thing the central bank can do and should do to encour- ital market. Theyield curve may be bendingdownwards, age saversto shift to longer-termsecurities? so no one can intermediateat the long end because long- term borrowersare getting all this priority credit. Mr.Johnston: I am of the viewthat commercialbanks should not be in the business of providing long-term Question: So you are saying that Germanyand Japan credit. Short-term financing institutions have short- are wrong in dependingon the bankingsystem for long- term liabilities.Most of their assets are in trade and oth- term financing. er credit. Those assets should not be directed into longer-term lending;that is the role of the capital markets. Mr. Johnston: Well,that is a broader issue. Yes,that The wayto get longer-termcredit is to developthe capi- raises the whole question of how one sets out the liber- tal markets. Get bonds and equities into the system; let alization process.There is a different model.The one we the private sector take the responsibility.But do not put have discussedhere is the model of liberalizingthe fi- the risk on the banks. nancial systemso that it takes the decisions.The Korean In these countries, the banks are already weakened. and Japanese model is different. There, funds for devel- To try to force them outside their preferential lending opment were directed through the banking system. In policies can be a risky strategy.Instead, the risk should Japan they have had to reform becauseof the increasein be dispersed more generally in the system, and that is the public sector bonds being issued. I agree there is a the role of the capital markets. To generate the capital fundamental question of what is the appropriatedevel- markets, change the refinance facilities, make interest opment model. rates flexible,and reduce the preferential credits. Ulti- mately, that will help to get long-term credit into the Question:We have been talking about monetary lib- economy. eralizationand the accompanyinginstability. You made a point that I think is quite important. At the same time Question: Operationally,should we be encouraging that a moneymarket is developed,a frameworkfor deci- the simultaneous development of the capital market ikig within tecentral a fmus aob dece- when we areworkngwththemonetarysector?Ordoeswhenweare wihworing the mnetarysector?Or doe oped.sion-making Isn't thiswithin something the central that bank basically must also cannot be devel- be gotten from a text book. One must see it operating and Mr. Johnston: Definitelyit should be simultaneous. then start to developthe decision-makingcapability. In- The working paper that has been circulated specifically variably,while the learning is occurringthere will be in- recommends reform of the monetary instruments si stability.There is no way to avoid this; it is a cost that multaneously with developmentof the money market must be paid for the long-term gain of having a liberal- and capital markets. These elements of the system are ized market. mutually supporting;each is needed for the overall system to progress. Participant: The people in that market have to learn I believethe emphasisshould be on the capital mar- how to take the risks. kets. Ultimately,that is where the domestic resources should be mobilizedto financedevelopment. Mr.Johnston: Part of the role of the Fund and of the World Bank is precisely to help speed up the learning * Question:I suppose,though, the emphasis wouldde- process.The CentralBanking Department providesresi- pend on the level of institutional developmentin the dent experts to central banks, to advisethem on precise- economyas a whole. For some countries, is it not unre- ly these questions. alistic to expectthe capital markets to provide much in the way of resources in the near term? Few countries Question:Yes, but wouldn't you say that what can be have capitalmarkets providingeven one quarter ofgross done is to reduce the periodof instability,yet there will investment needs. inevitablybe some instability?

Mr. Johnston: But we normally find that, when the Mr.Johnston: Yes,I think that is right. What I have capital market is not providingany resources, it is be- been presenting is the case for trying to at least be aware cause the central bank is providingthem or the developthat it will happen and designing the instruments that 46 R. Barry Johnston can minimizethe instability.That is where we should re- In particular, opening the treasury bill auctions to the ally try to work.I don't think we can avoidthe instability. non-bank sector providesan alternativesource of funds. Thosewho otherwisewould deposit funds with the bank- Mr.Caprio: If I understand the point of the last ques- ing system can now buy treasury bills. Therefore, the tion, it was directed more toward fashions.It is fashion- market can help to reduce the monopolisticposition in able now to have a treasury bill market,just as it usedto banks. This is particularlytrue if the banks are not pay- be fashionableto have a steel plant. But no attention is ing market rates on their depositswhen the government paid to whether or not the central bank should have,for starts to issue treasury bills. example,a forecastingdepartment. Sri Lanka, for example, had a fairly monopolistic banking system.When the central bank started to mar- Mr.Johnston: Yes,that is true. Everyoneis running ket treasury bills aggressively,the banks lost deposits. out to trade treasury bills but not providingthe support Nowthere is a very liberal, free, and competitiveinterest for that market. That is reallywhere there is a problem. rate structure, at least on the wholesale markets. This followedfrom the aggressivepolicy of the central bank Question:You mentioned the desirabilityof variable- in issuing treasury bills. So use of a money market in rate instruments. In the contextof a high-inflationenvi- this way may actually be part of one's strategy for re- ronment when your market is in the process of emerg- formingthe system. ing, what is your view of instruments indexedto some As this exampleshows, financial reform is a case-by- kind of price index? case process.There is no generalmodel. The IMF'sexperience in dealingwith a large number of countries indi- Mr.Johnston: We have varying views on this. It de- cates how the instruments I have discussed can be pends on whether you are in the process of a fundamen- helpful. Evenso, everycountry needsto be examinedas tal adjustment program that is intended to bring an individualcase. inflationdown. In one country that was in that situation,we suggest- Mr. Honohan:In that context,a large number of the ed not to index,even though they had inflationof 50 per- African countries don't yet satisfy the basic precondi- cent a month. Theidea was not to index,so as to increase tions. Their whole structure is at an earlier state. the speedof adjustment. However,the central bank did specifyin its auctions a nominal interest rate, which at Fordexample,ing isomeAficns ctrs aren the time was about 20 percent, as an indicator to the many deposit-taking institutions that are not allowing market. With annualmarkt. iflaionruninginflation ithannal running att prhasperhaps 20002,000 can'tthe depositors pay, just tocome withdraw back next their week." funds. TheyIn the say, United "We percent, this of course raiseda credibilityissue that had cat pay , if a banknext couldn thUge to be addressed.The adjustment program was designed States of the 1930s,if a bank said it couldn't pay,a huge to address that issue, and so the decisionwas not to in- crowd of depositorsformed and began hammering on dex. the doors. But in Africa,though the banks concernedare More generally,if a country is not in the position of not allowing withdrawal of more than perhaps $200 a fundamentallyrestructuring its financialsystem-is not week per account, there are no lines, becausedepositors intending to announcean adjustment program-in fair- know they will not get any money. The depositorsjust ness the only thing to do is to index.The index needs to leave,hoping that some day something will happen. be kept as current as possible;lags in updatingthe index- Thoughyou may say that there is an absence of good ation should be reduced to lessen the inflation risks. In- collateralin the market, and bankers'acceptances might dexation itself does not necessarilyundermine market providea solution, realisticallymost banks will not buy orientation becauseyou can still sell index instruments bankers' acceptances!They won't even trust an inter- belowpar and allowthe market to determine the real in- bank loan. terest rate. Youjust index the inflation component. Mr.Johnston: In that case, the acceptancesyou first Question:How can you introduce a competitivemar- use to get the system started are those of whomeveris a ket for treasury bills in situations, typical in Africa, good primary credit risk. Then it is his credit rating that where there is little competition in the banking systems you trade. So it is not the banker's acceptancethat you and where the banks form a club or cartel. trade. For example,you might get the oil companyto issue the paper,if the central bank is lending to the com- Mr.Johnston: In some countries, starting to bring in pany.That is how you can generate some paper to trade market instruments has, in itself, weakenedthe cartel. in a money market. The Use of Monetary Policy Instruments by Developing Countries 47

Mr.Honohan: Nobody has yet taken you up on what I With respect to your question about credit, we once thought was a pretty dramaticassertion. At least I under- did a survey just to find out about credit. We sampled stood you to say that, "For the purpose of adjustment journal articles published over the last fiveor so years. programming, let's not bother with aggregate credit There were 450 articles on the demand for money and anymore. If we want to go down the route of indirect one article on the demand for credit. I defy anybodyto monetary control, we are not going to hit those credit show me a stable demand for credit function. Charles targets.We can hit narrower aggregates,i.e., elementsof Freedman has supported the concept of credit as an in- the central bank's balance sheet. The IMF should put termediate aggregate but has recently retracted on the into its adjustment programs that, whilethere could be basis that demand-for-creditis no more stable than the intermediate targets such as broad money, the govern- money demand functions.In short, if we could establish ment is not required to hit those targets." appropriateways of estimating a demand for credit and I have two questions about this assertion. First, will we thought they were reliable, then yes, it would be a this work for a very unstable country,and get them out useful instrument. At the moment, I am not optimistic; of their mess? Currently,we talk about the balance of but we should not stop the search for that reason. paymentsgap and filling the gap. We tell the country it has to fill a gap of US$50million, of which this amount Mr. Grenville:The thing that forced Australian au- will come from the World Bank, this much more will thorities in the direction of targeting credit was not so come from the IMF,and some more from somewhere much the change in which side of the balance sheet was else. The monetaryprogram is all worked out on the ba- beingwatched as it was the breadth of the credit aggre- sis of how much credit there will be. If, instead, you de- gate. We wanted something broad because of all the cide not how much credit there will be but only the churning that was occurringwithin balance sheets dur- amount of central bank money,you may end up with a ing the deregulationprocess. For example,when we re- residual gap. moved our reserve requirements, that fundamentally Second, when you spoke of an intermediate target, changed the wayM3 operated.Just a fewyears earlier, a you mentioned broad money but not credit. Do you re-regulated system had changed it in the other direc- think credit should be droppedaltogether? tion. To try to eliminate that churning within the balance sheet of the formalfinancial system, we were forced Mr.Johnston: Onthe first question,when the levelof to something that gave the very broadestrepresentation the central bank is programmed, the external target is of what was happening to the system.That is why some the net foreign assets of the central bank. That is a re- of us did not accept that a more stable relationship can- serve position.You can do the programming on the cen- not be gotten for credit than for money. tral bank's balance sheet or on the banking system. Indeed it has been done on the banking systemfor many Mr.Johnston: WhenI worked for Charles Goodhart,I countries. But the external target is different; it is not wasasked to estimate the disequilibriummonetary mod- the overall balance of paymentsbut the net foreign as- el of the U.K.economy. The ideawas that we would de- sets of the central bank. So it doesn't create a problem. velop a model for the disequilibrium of monetary One can still develop exactly the same flow of funds aggregatesthrough the counterpart equations.My diffi- structure. The aggregates to be included differ from culty with that approachwas why would one attempt to those at the aggregate level,but it can be done. It is not generate a model for money,which throughout most of a big problem. the literature is the more stable aggregate,from all these unstable counterparts.The counterpartsdid not seem to Mr. Honohan:So the program is designedin terms of me to haveany basic forecastingrelation to the genera- foreign assets; therefore it is still the external financing tion of money. In fact, the causalityruns the other way gap that is being addressed? around. Where I think you and I part companyis on the idea Mr. Johnston: Yes. In fact, the Western Hemisphere that the counterpartsare in some sense more stable than Department of the IMFhas usually done their program- the monetary function itself. I think the counterparts, ming on the central bank balance sheets. The AfricaDe- betweenone another, offseta lot of the noise in any one partment has tended to use the bankingsystem. The Asia of them. The monetaryaggregate, over longer periods,is Departmenthas used both, but more on the bankingsys- the most stable ofthe components.That is why it is more tem. Therefore,we are not necessarilymoving into new useful. territory in terms of programs.Rather, the use of instru- Still, having said that, I cannot say that M3 has been ments changesthe waywe think about programdesign. a stableaggregate in the UnitedKingdom. It has been re- 48 R. Barry Johnston defined a number of times. And they will continue to re- Question:It seems to be more difficultto get banks to define it as the financial system evolves, because competeon the lending side than on the deposit side. basicallyM3 tries to measure a conceptof moneythat is difficultto measure. Where do you cut off money from Mr. Johnston: Certainly it is true that if there is no other assets?That is the fundamental problem,and it is capitalmarket, there is no substitute for bankcredit, and not an easilyresolved problem. There are a lot of criteria that is a problem. In Indonesia, reduction of exchange for defining money,but none is satisfactory.Going to a controls led to an injection of competition,which freed narroweraggregate helps to some extent, but it still has up the system.So you can bring in externalcompetition; these problems. you can allowentry of some foreign banks. Also, the country probablyhas a lot of state-owned Mr.Honohan: On the issue of money demandstability banks, over whose decisionssome moral suasion could in the developingcountries, from my own limitedexpe- be exerted.In one small country, one of the big banks is rience, for the variouscountries for which I neededto do state ownedbut wasa memberof the bankingcartel. The such an analysis,it wasdifficult to get well-behaved,sta- authorities there complainedthere was no competition. ble-lookingdemand for money functions showinginter- We said, "Canyou not generate competitionyourself by est elasticity.Even in the franc zone, which is a rather telling the state-ownedbank to leave the cartel and set stable area, it wasdifficult. For the most of the rest of Af- its own rates?"One needs to look institutionallyat the is- rica, too, and in China there was a lot of instability. sues.

Mr.Johnston: The problem is that the data are not Mr. Honohan: Under the influence of our agencies, availableto do adequatetesting. For example,GNP series the central bank in Ghana decidedto deregulate interest are at best annual and lag by a fewyears. It may be pos- rates. They said, "Weno longer regulate the bank's poli- sible to get some other aggregates,but the inflation fig- cy."Now the Ghana commercialbank, which is ownedby ures are not reliable. The interest rate series may not be the government and has 50 percent of the market, sets particularly representative. So the immediate, major interest rates. Deregulationin this case wasjust a trans- problemto be faced is what to estimate. There is not the fer of control from the central bank to the commercial richnessof information that can be had in the industrial bank. countries, in which to search for stable aggregates. Therefore, quite often one ends up with some rough Mr. Johnston: That agrees with my point about the rules of thumb about where money is goingand, hope- phasingof reforms.As another example,Sri Lankaintro- fully,an adequate reviewprocess. duced a repurchase market, but nobody ever traded re- This increasesthe importanceof havingthe indepen- purchase agreements because the process was so dent central bank "captain" in place. That person has to cumbersome. One of the adjustment program condi- exercisea lot of judgment about the movementsin the tions had been to establisha repurchase market,but this monetary aggregatesand does not have the support of, did not mean that it wasa functionalmarket. for instance, stable demand equations, to conclude that These examplesshow why it is important to think interest rates should or shouldnot be raised.He must be more fundamentallyabout what we actually are trying to able to ask questions such as, "Whathappened? Did one accomplishin these processes.It is not just a question of of the large importers come in yesterdayand put this throwing a lot of monetary instruments at the system large monetary perturbation into the system?" That is and hoping. why I feelthat the judgmentalaspects ofmonetary policy need to be well developedin the developingcountries. Building FinancialInstitutions for a Market-Based MonetaryPolicy

Steven Grenville

Mybrief is to talk about Australia,which I shall do, but three times. It became clear that we could not fix it, so not in great detail. Australia is an interesting case be- we floated. cause, in a period of ten years from about 1975 to 1985, There may be countries where sequencingis impor- we went from a system of extreme controls to a system tant. Without doubt it is an interesting issue to think that is very deregulated.The current system has floating about. But our experienceis that you do what is neces- exchangerates, and we operate monetarypolicy through sary to evadethis steamroller coming towards you. You open market operations. do not think much about exactlywhat to do exceptto get Wedo, however,have some idiosyncrasiesin Australia. out of the way. If I were to explainexactly how our open market opera- One of the lessons from our deregulation is that the tions worked,it would resemblethe story of the bumble- process, once started, has a momentum that was not bee-aeronautical engineers tell us that it cannot foreseen.In history,when one looks back, certain criti- possiblyfly. Yet it does, and our system in Australia is a cal eventsmay be seen, such as the assassinationof Arch- bit like the bumblebee.If someonehad presentedthe cur- duke Ferdinand setting off the First World War. In rent design beforeit wasput into practice,we would have Tolstoy'sWar and Peace,the critical event occurs when read the description and said there is not the slightest Kutuzov decides to move towards Borodino. Tolstoy hope that such a system can work. Andyet, it works per- makesthe point that, at the time, it doesn't seem like an fectlywell for us. At this conference,you have heard that important event.The decisionhaving been made, events differentsystems suit differentplaces. I think that is true; roll on, and one doesnot have many choices. our system is fine for us, but I would not wish to impose it on anyone else. It is an accident of history as much as Another Modelfor Open Market Operations anything. Therefore,I shall try to distillfrom our experiencethe The previous speakershave had the chance to set out things that might have relevance elsewhere.Since you the big picture. WhileI know I am supposedto stay with have heard not one but two papers with a similar ap- the little picture, the case study, I cannot resist having a proach, I do not want to go through the same details go at the big picture, too. Again,the lesson to take home again. I shall try instead to approachsome of the same is- from all these versionsof the big picture is that no single sues from a different angle and hope to provokediscus- viewof the world is exactlyright. Weall have slightlydif- sion as we proceed. ferent perspectives.Besides, some of our actions were The story of that ten yearsof transition might be sum- based on a viewof the way systemworks. So I shall take marized as "what went wrong, and how we tried to fixit." a fewminutes to set out my point of view. We did not have the opportunity for intellectual consid- Figure 4-1 showsthe central bank'sbalance sheet and eration of the question of sequencing.We respondedto the commercial banks' balance sheet. The diagram is what was happening in the market. For instance, we did routinely used to teach the credit multiplier,which I am not floatthe exchangerate in 1983because we finallyhad sure you remember from Economics1. On the left is the gotten around to readingMilton Friedmanand suddenly central bank's balance sheet. Suppose we conduct an recognizedthat we needed a floating exchange rate to open market operation that adds a dollar to the bank regain control of monetary policy.Rather, we floated be- serves, as recorded on the liabilityside of the central cause the old systembroke down.We tried to fixit two or bank's accounts, and of course, that dollar also appears

49 50 StevenGrenville

Figure 4.1 Sample Balance Sheets for the Central Bank and Commercial Banks

CENTRAL BANK COMMERCIAL BANKS

ASSETS LIABILITIES ASSETS LIABILITIES foreign exchange bank reserves (+$J) loans bonds deposits -loans to govt. currency bank reserves -open mkt. opns. (+$J) on the asset side of the balancesheets of the commercial Within the old perspective,reserve requirements act banks. On the usualview of the credit multiplierprocess, as the critical fulcrum of the system. In our model, the there is a required reserve ratio, linking deposits and fulcrum is the payment system,the check clearing sys- bank reserves,which is the fulcrum holdingthe balance tem. We leave that check clearing system either flush sheet together. Becausewe have that extra dollar of de- with funds or short of funds. That is how we change in- posits, loans can increase, which holds the whole bal- terest rates. Wedo not change rates by selling bondsand ance sheet together. The critical fulcrum is the level of findingthat the price of bondshas changed,so therefore bank reserves. the interest rate, which is the inverseof the bonds' price, Of course, in this model the extra dollar goes into has changed. Rather,when the banks get together every bank reserves,and this allowsthe banks to expandtheir night to clear the checks written on them, we make it balance sheets. To increase loans, banks must change more or less difficultfor them to have enough reserves. the interest rates they charge on loans. To fund these If we want interest rates to go up, we keep them short of loans, the banks bid for deposit funds. So there is a reserves.They becomeworried and do various things to change in the monetary aggregates, as bank deposits raise interest rates. rise. There is also a change in interest rates. According From my perspective, then, the required reserve ratio to this model, then,* out of the open market operation ~~~~~~~~~~~~~isuimpourtantunimportant. TeqsysemeThe system cucould oaoperate ct,perfectly l well comesa change in monetaryaggregates and a change in without reserve requirements. In fact, Australiaessen- interesta hatgesin monetaryaggregates and a changein tially has no required reserve ratio. There are prudential interestrates. ratios, but they certainlyare not ratios that are changed From our experience,we do not see the system oper- for purposesof monetary policy.Over time they have ac- ating like that. Rather, in our view the world is much tuallydecreased, as other systems of prudential controls simpler. The open market operations affect short-term have been added,such as capitaladequacy requirements. interest rates directly.They directly affectthe cash rate, The important thing, though, is that reserve require- the short end of the yield curve.And that, in a sense, be- ments are not the fulcrum of the monetary policy sys- comes the cornerstone for the whole of the yield curve. tem. The system would work perfectlywell with zero The holder of a 90-daybank bill considers the cost of reserve requirements. holding that bill to maturity and what the central bank When a country sets up a monetary policy system or will do to influence the short-term interest rate. In our when someone offerssuggestions on such systems, the model, therefore,open market operations affectinterest key point to remember is how costlyand distorting those rates directly,which affectthe cost of funds in the com- high reserve requirements can be. In Australiaback in mercial banks' balancesheets. This in turn affectsloans, the 1950s,the banks providedabout two-thirdsof finan- since there is an interest elasticity on the demand for cial intermediation. By the early 1980s,because reserve loans. requirements had been placed on the banking system, Overall,this view ends up in much the same place as their role in intermediation had fallen to 40 percent. the first view of the system. The differences between Other participants had entered and taken the action, them are not worth fighting over.Still, like manydoctri- largely because of the various constraints imposed on nal issues,we can debate them at length. It ought to be the banks. When constraints are imposedon the banks, possible to resolve these various views simply because the action moveselsewhere. The financialsystem moves balancesheets must balance.Identities remain identical, awayfrom the controls,and the central bank finds itself so all of these differencesin models can be reconciled. controllingjust a small pieceof the system. But the differencesdo represent different perspectives As further evidenceof how bad the distortion can be, on the mechanismsunderlying the balance sheet. considerwhat occurred when Australiareduced the re- Building Financial Institutionsfor a Market-Based Monetary Policy 51 serve requirement so that it became solelya prudential are privatepaper, that is all right from the standpoint of requirement. AfterSeptember 1988when the reduction controllingliquidity. The real questionconcerns wheth- occurred,the action moved back to the banks.The effect er the central bank wants to hold that private paper on showedin the balancesheets. In the year after the reduc- its balance sheet. Is the paper secure? Is it homoge- tion, M3 (a bank-basedmeasure of the monetary aggre- neous? Those are the important issues. So neither re- gate) grew by 30 percent. Any unaware outsider-a serve requirements nor bonds as such are important to Martianversed in the economicsof Milton Friedman- our open market operations. who came into Australia in that period in late 1988 and Nowcomes the part that will probablybe the greatest early 1989would have thought we had a hopelesslyloose heresy of all. With respect to operational targets, and I monetary policy.M3, the aggregate we had previously emphasizeoperational targets, our concern is the inter- targeted, was growingat 30 percent a year. In fact,Aus- est rate rather than the quantityof any aggregate.We do tralia had quite tight monetary policiesat that time. The the calculations to estimate whether the system is in abnormal growth in M3was simply the effectof this in- surplus or deficit-or, as we say,"up" or "down."That es- termediation returning to the banks' balance sheet after timate is taken into account in the daily open market op- we sharply reduced the reserve requirements. As it re- erations. Ultimately, however, we are looking at the turned, things which hadn't been caught in M3 were interest rate in a very short-term, operationalsense. suddenlybeing captured. Weall knowthe reasons why interest rates cannot be Allthis churning within the system also explainswhy used as a long-term goal. First, they are normallynomi- we havenot been successfulin targeting any of the mon- nal rates, and all sorts of problems arise in relating them etary aggregatesin Australia.But my main point is that back to real rates. Secondly,there is the problem of dy- things like reserve requirements can be very costly if namic instabilitythat the text books discuss.If a nomi- they are not properlyset up. At present, we do not want nal interest rate is being targeted and nothing else, the much in the wayof reserve requirements at all. Wehave system is unstable.If the system receivesa shockthat in- a system that works perfectlywell with no reserve re- creases inflation,the real interest rate decreases.There- quirement. fore, the economygoes even faster.That is the dynamic Speaking of potential heresies, I should add that we instabilitythat results if a nominal interest rate is the could operatethe systemwithout bonds,too. Wehappen sole long-term target. So again, do not misunderstand to use bonds for our open market operation becauseit is me; I am not suggestinginterest rates as a long-term ul- convenient.Still, it is not at all the textbookmodel. We timate target. Rather,in practiceone is forcedoperation- are not selling bondsto change the price of bonds so that ally to use interest rates as the operationalobjective. the inverse of the price-the interest rate on bonds- Of course, in the conceptualframework I explained,a changes. Rather,we are interested in the other "leg" of monetarytarget is still possiblein principle.The balance the bond transaction. When we sell a bond, we receive sheet (Figure 4-1) still balances. The funding of those cash. It is the cash "leg"in which we are interested, be- loans is the monetaryaggregate. And so, by operating on cause we want to change the state of liquidity in the interest rates and thereby influencingloans, depositsare banks' check-clearing system. What happens on the affected.Since deposits are affected,the monetaryaggre- bond side ofthe transaction is not important. What does gate is beingaffected. So, whatever one takes as the long- matter is the cash that was paid for that bond when we run target, it can still be envisionedwithin the frame- sell it, and this reduces banks' liquidity, leaving them work presented in the diagram. Still, operationallythe uncomfortablyshort of funds when they come to clear interest rate in the short term is what one must follow. their checkswith each other. Alternatively,when we buy a bond we put cash into the system. Issues for the Australian Model I do not want to leavethe wrong impression.Bonds are veryconvenient to use in open market operationsbe- While Figure 4-2 is very simple,it encompasseswhat cause there is no credit risk. The government issues the Australianauthorities are trying to do, at leastat the them; they are homogeneous. But you could operate conceptual level. The curve SS is the supply of bank li- with anything. Youcould sell the officefurniture, if you quidity,which is what we think the central bank can con- had enough officefurniture and you could do the trans- trol. Through the central bank's actions, SS is moved to actions. If you are selling the officefurniture and getting the left or right. By doing that, we operate on the de- cash for it, that would work perfectlywell because it is mand for bank liquidityand change the interest rate. At the cash leg of the transaction that matters. Of course, the conceptual level, that is what occurs, and it raises sellingthe officefurniture would be very messy,it is ob- three issues.The first is how one actuallymoves SS, the viouslybetter to sell pieces of paper.Even if those pieces supply of liquidity.Since that is the purpose of perform- 52 Steven Grenville

Figure 4.2 Supply and Demandfor Bank Reserves credit somewhere in the system. If it were only the banks' checks that were being cleared,the systemwould alwaysbalance exactly at the end of each day. But the Interest SI payment system is hit by other shocks from outside the rate S system, largely things that originate on the central bank's balance sheet. Such things include the central bank's transactions on the foreign exchange market. Othersoriginate in the government,because the government runs a budget deficitand governmentdebt imping- es on the system. So the clearing house system is being - - - - -i - - - -hit by a great many shocks each day.Those shocks are, in effect,moving the SScurve left and right and affecting interest rates. Some are rather large shocks, in fact. The systemshould have some safetyvalves. We can use this diagramto show, at least at the conceptual level,how to put safetyvalves into the system.In i...... < a systemas simple as the one portrayed, the safetyvalve would simply be to release liquidity into the system when the interest rate reaches a levelyou want. Normal- ly, this would be something like a rediscount rate or lender-of-last-resortinterest rate. If the central bank as- sesses the supply of bank liquidity incorrectly,interest rates go up but only until this safety valve level is reached.To prevent rates rising abovethat level,the system would supply as much liquidity as the system demands, once interest rates get to that level. S SI Bank There is one final point to be made about this model. Reserves There is a tendency to want to smooth out all the little bumps in this system.As the payment system is buffeted ing open market operations, we shall spend the most by all sorts of shocks and those SS curves for the supply time on it, in the followingsection. Thesecond issue- of liquidity move back and forth, one may desire to get on which I shall spend very little time, although it is rid of the movement.One can, of course, get rid of many both difficultand interesting-is the slope(interest elas- of the bumps. The government has the power to set up ticity) ofthe demandcurve. That slopegives you the abil- institutions that remove many of them. A case can be ity to change interest rates. made, though, for not getting rid of every bump in the In this simple conceptualmodel, if the demand curve market. had no slope, interest rates could not be changed by Central banks fall along a spectrum. At one end are changingthe supplyof liquidity.There is a raft of issues those that want to control the rate of interest in the mar- concerned with ensuring that the demand for bank re- ket exactly,every single day.The Bank of England is at serves is interest-elastic. Ensuring interest elasticity is that end ofthe spectrum.At the other end, some central not always easy in a system like ours, where clearing banks are preparedto leavea fair amount of latitude, on house requirements absolutelymust be met. The inter- a day-to-daybasis, to the system. The rates are left to est elasticityof the demand for liquidityis not so clear.A bump up and down from day to day. Leavingthe market certain amount is required, but more than that is not a certain degree of latitude helps to depoliticizeinterest needed. It is an on-offdemand with a hair trigger. That, rate determination. Central banks that rigidly control however,is a story for another day. everyshort-term interest rate can be askedby politicians The third issue concerns the importance of a safety to lower them, or worse still, to attempt to lower long valve. In practice, operating a system like this requires term rates over which they have little or no control. that something like a shock absorber or a safetyvalve be In addition to providing this political heat shield, a built into it. The payment system, through which the degree of flexibilityalso dampens the public's expecta- central bank performs its operations,is hit by all sorts of tion that the central bank shouldexplain every little fluc- shocks everyday. The clearanceof checks betweenbanks tuation in interest rates. In Australia,we found this quite is very easy-they alwaysmatch exactly.For every per- useful. When the rate on interbank liquidityfunds fluc- son who has written a check, for everydebit, there is a tuated, there were not a great many persons-journal- Building Financial Institutionsfor a Market-Based Monetary Policy 53 ists and so on-ringing us up to ask if we were at the end of the day,the central bank is left with this ob- tightening monetary policy.Most persons acceptedthat ligation to dealwith all comers. This obligationworries there were day-by-dayfluctuations. By the time it be- those of us who want the central bank to gain control came apparent that we had tightened monetary policy, over its balance sheet. The fixedexchange rate entails an the journalists were too embarrassed, having missed obligation; the central bank has no choice but to deal when it actually occurred,to ring us up. It was a tech- with people who either want to exchange foreign ex- nique for softening that difficulttime when you want to change for localcurrency or vice versa. raise interest rates. Foreign currency, then, can become a window through which a central bank may lose control over its Use of Open Market Operationsto Affect balance sheet.Another such windowmay occur through MonetaryDemand the seconditem on the assetside ofFigure 4-1. Although this item is labeled "Bonds," it includes all means of I shall now return to the first of the issues raised fundingthe governmentdeficit. Supposethat, when the above:how to actuallygo about shiftingthe supplycurve government runs a deficit, it funds that deficit not by SS through open market operations. Three things are selling bondsto the public but by sellingbonds (or some needed to carry out open market operations:(1) the cen- piece of paper like a bond) to the central bank. In the tral bank must have control of its own balancesheet; (2) process, reservemoney increases. the system needs a good, professional,money market; To close this second window,the central bank must and (3) the commercial banks must be unshackled. I strike some sort of deal with the government on what shall expandon each ofthese requirements individually. will be done with the budget deficit and how it is to be funded. By now, Australia is fortunatelyin the position GainingControl of the CentralBank's Balance Sheet where there is a verypure separationof government debt policyfrom monetarypolicy. This means, of course, that Barry Johnston and Paul Meekboth alluded to the the government has undertaken to fund deficitsby sell- first requirement, control over the central bank's bal- ing government bonds or other securities to the public ance sheet. I think we have all said, in one way or anoth- and willnot ask the central bank to fund it. er, that open market operations cannot be done if the Not every country can afford that luxury, and Paul central bank does not have control of its balancesheet. Meekreminded us earlierthat it is not something every The simple model of a central bank balance sheet in central bank should absolutelydemand. It may be very Figure 4-1 can be used to illustrate the point. In the past nice to operate in a system where the central bank need in Australia,we lost control over the balance sheet in never worry about the government'sdeficit messingup three places, basically.The first is marked as "Foreign its open market operations,because the deficitis always Exchange"in the figure.We had a fixedexchange rate. fully funded by selling bonds. From the point of view of the central bank, a fixed ex- Althoughthat is the idealsituation, in Australiaa sys- change rate is an obligationto deal at that rate with any- tem that lacked that commitment until about 1982 one who comes to the central bank with currency to worked reasonablywell. Theyhad a few different meth- exchange.At the end of the day,they come to the bank ods of selling bonds: these methods all had in common with their foreign exchange,and it must give them do- that they never sold enough bonds to fund the govern- mestic currency. These transactions increase the other ment deficit.This meant that the first part of the central side of the central bank's balance sheet. The two items bank bond sales,which looked like open market opera- for Bank Reservesand Currency are, of course, reserve tions, were reallydebt managementin disguise.We sim- money. So the transactionsincrease base money. ply could not leavethat liquidityfrom unfunded budget Thus, as long as the exchangerate is fixed,there is at deficits in the system, so the first requirement of our least the potential for the central bank to lose control open market operationswas to sell bondsto soakup that over its balance sheet. If the exchangerate is set in the liquidity. right place, so market participants do not want to deal That kind of systemworks all right, too, but it is a bit with you, that is fine. That is one way of maintaining messy.In our case, it meant that bonds were being sold control over the balancesheet. A pure floatingrate is not by the treasury to the public-a rather reluctant pub- necessary,if the market clearing rate can be predicted lic-at a certain price X. For the most part, the purchas- exactly every day and if the exchangerate is set at that ers were captivebondholders, who were in fact forcedto point. In Indonesia,which Paul Meekdiscussed earlier, buy our bonds. That necessarily constrained our open the rate is set everyday. In my viewof the world, that is market operations, because having sold government a fixedrate; it is a fixedrate that changesevery day. But debt to these poor captivesat price X, it was difficultto 54 Steven Grenville sell it to the public in the form of open market opera- things are designedto do one thing: to give the central tions at a more attractive yield.We did do a bit ofthat but bank control over its balance sheet. it was difficult. We are now in a much better systemwith full separa- FosteringA Strong and ProfessionalMoney Market tion of debt policyfrom monetarypolicy. But if you can't get perfection at once, you work with whatever con- Thesecond major requirement for open market oper- straints you have. ations is to have a market in which to operate.A country The third window for loss of balance sheet control may be able to get by with something pieced together does not showvery clearly in Figure 4-1. It concernsthe and held in place with bits of wire, so to speak. But the rediscount facility.Especially when one is setting up a central bank cannot really carry out good open market market for government securities, the tendency is to operations until there is what I would characterizeas a want to providerediscount facilities.One way to provide professionalmoney market. liquidity to that market is to tell potential purchasers An interesting example came up in the course of a that if they buy these government securities and subse- previous floor discussion. Suppose the country is run- quentlywant to sell them back, they can do so, perhaps ning a budget deficit and sold instruments to house- at a different price. Yet,whenever the central bank has a holds, for instance, to finance that deficit. As a case in commitment of that nature, it has lost control over its point, Australiahad a very successfulhousehold instrument, which was called an Australian Saving Bond. Inbalnce Australia,Aushtratoa we ehad ext fairly generousgent. ous rediscount, lend-lend When we set its interest rate at the right level, house- er-of-last-resort,facilities when we were trying to build holds-meaning small investors-bought these like up a government securities market. Over time we have hot-cakes.That was the waywe funded our budget deficit made those facilities less and less attractive. In terms of when it started to blow out in the middle of the 1970s.It Figure 4-2, we have pushed the line for the rediscount wasa verysuccessful form of fundingfor a budget deficit. rate far abovewhere we want interest rates to be. In oth- Whynot make instruments like these AustralianSav- ings Bondsthe basis of the central bank's open market er words,we prefer to control Interest rates by our open operations?The instruments are out there; why not buy market operations,rather than by the public tappingthe and sell those? The argument against doing so is that safety valve of the rediscount rate to get their extra this instrument went into households.In fact,it wasgiv- funds. If peoplewere consistently coming to our redis- en the special characteristic of a constant principalval- count windowfor significantsums of money,after sever- e, bae weallowedithe o b redscont at any al tosedys o ntha, chrge f te opn maket ue, because we allowed them to be rediscounted at any al days of that, those in charge of the open market stage at their facevalue. For that reason, they would not operations wouldhavetorunontotheirswords.Itwould have made a good instrument for open market opera- be regarded as a failure. tions. But even if these bonds had not had that charac- We would not want to do that because interest rates teristic, by using them as the basis of open market would once again be controlled.We would be back to a operations we would have been imposing capital gains form of the old system; the rediscount rate would in ef- and losseson households. fect become an interest rate that we were imposing on Nowit is possibleto operate on that basis, but I think the system.And one of the reasons for going to a system it makes it difficult;it is a constraint on open market op- of open market operations is to get awayfrom setting an erations. If you are planning an open market operation interest rate. Wewant to maintain a system where the that will impose a capital loss on households,then you market has a big hand in setting interest rates. So we do will probablyencounter constraints. It is much better to not want that rediscountsafety valve to be operatingvery be operating in a deep professional market, where big often. It is there in case somebodymakes a mistake, if an players are operatingwho understand there are risks of individual bank or financial institution needs it. But it capital gains and losses,so they cannot complain when should be seen as a safetyvalve and not as a normal way you impose capital losses on them. That is the sort of of setting interest rates. market required for open market operations. Allthese things must be done to get control over the One fortunate side effectof our long history of budget central bank's balance sheet. Ideallythere should be a deficitsin Australiawas that over the years we became floating exchange rate, which closes the Foreign Ex- goodat sellinggovernment securities. We had a well-de- change window.Ideally debt policy is completelysepa- velopedmarket in governmentsecurities long beforewe rated from monetarypolicy, which closes the windowof decidedto do any open market operations.The market loans to the government.And ideallythe rediscount fa- was not in fact deep enough to sell all the bonds needed cility is only used for trivial sums of money.All these to fund the budget deficit, but it was a well-developed Building Financial Institutionsfor a Market-Based Monetary Policy 55

market. It had been operating since 1960 or so; open If your intention is to developa secondarymarket in market operations only started about 20 years later. We government securities, then you do not want parties were lucky,then, in that we coulddo it in two stages. We holding the government securities to maturity.A great developed the government securities market in the temptation when trying to developthe government se- 1960sand 1970s.And then in the early 1980s,we started curities market is to find a few readyvictims, a fewcap- to use that market for open market operations. tives, and load them up with government securities. Perhaps ten years ago, the buzz words for a sound That doesthe job if you just want to fund the budget def- market were "width,depth, and resilience."What should icit. It does not work if you want to use that market to be done to encourage a market with those characteris- carry out open market operations.So we got rid of those tics? Let me start with somethings one should either not captiveholders. do or do onlywith great reluctance. The first, to which I Figure4-3 illustrates how important the captivehold- have alreadyalluded, is to have captive holders of gov- ers were. In addition,the big holdersin those figuresare ernment securities. Captiveholders are parties-per- the banks. Tosome extent they werecaptive holders also. sons or institutions-who in one way or another are For instance, we made the savings banks hold govern- forced to hold the government securities that you are ment securities as their major asset. Of course, there selling. You may put honey around this instrument to were also prudential reasons for requiring the banks to make it attractive for them, but you get into trouble hold government securities.So there wassome sense in when you rely on captiveholders to take all your govern- which banks should be made to hold governmentsecu- ment securities. rities. The relative importanceof the prudential role and In Australiawe relied on the savings banks and the the deficit funding role cannot be clearly separated. life insurance companiesin particular.We gave the life However,the effectsare markedlydemonstrated by the insurance companiesa tax break if they took a certain life insurance companies. As soon as we unshackled proportion of government securities. The problem was them, they stopped holding government securities. As that once those securities were on their balance sheet, everyoneelse did in the 1970s,Australia had negative they would not sell them again. We had sold the securi- real interest rates. Weburned those captiveholders bad- ties to them at the wrong price; if they sold the securi- ly at that time. Theywill not be easilyburned again, and ties, they wouldactually take a loss in their accounts.So their balancesheets now reflectthat. they held them to maturity.Of course they actuallytook In summary, one must get past the stage of captive a loss on day one when they bought the securities from holders as quickly as possible. Open market operations us. But they did not have to crystalizethat loss as a cap- cannot be effectivein a market dominatedby captives. ital lossat all. The waythey avoidedhaving the lossshow Anotherthing not to do is to givetax breaks.There is up was to hold them to maturity. a great temptation to use tax breaks to encourage mar- Figure 4.3 Holders of Commonwealth Government Securities (End-June Figures) i Other EM Otherprivate [= Life assuranceoffices = OtherBanks Public bodies financial institutions E3 Autthori ed MM dealers _ Reserve Bank $B % 50 100o

40- 80-

30 60-

20 -4

X/I~~~~~~~~~

10 . 20 -

1977 1981 1985 1989 1977 1981 1985 1989 56 Steven Grenville kets, but there are disadvantagesin doing so. They seg- how much informationshould be given to the public on ment the market betweenthose who can take advantage the central bank's portfolioand on estimates of govern- of them and those who cannot. They distort secondary ment funding requirement over the longer term. Lastly, market activities if preferentialtax treatment is not ac- if securities are being sold by tender, the authorities corded to all securities.They are inequitablein terms of must decide: income distribution.They are a hidden indirect subsidy, * Howmuch information is providedto tenderers which does not appear on the balance sheet and whose * Administrativedetails such as settlement period effectivenesstherefore cannot be assessed. * Safeguardsto ensure that bidders actually fulfill More legitimate methods are available to foster a their bids market with width, depth, and resilience.Anything that * Who can participatein the tender encourages secondary markets is a good idea. Some- * Whether the tender is the sole method of setting times it helps if the government,the authorities, are ac- bonds,or is there a limited"tap" as well tive in trading in the market. But, as Paul Meekpointed * Howthe authorities participate in the tender out earlier, this must be done carefully.Do not take all * Whether there is a reserve price (i.e., maximum the businessaway from those whose interest is to earn a acceptableyield) profit by trading in the market. If the authorities do all * Whether to settle the tender at the differential the job, nothing maybe left for privatetraders. A balance yieldsthat tenderers have bid or to settle it by the must be struck. "Dutch auction" system of a uniform price In Australia,for instance, we deal in the government * Whether non-competitivebids are accepted (i.e., bond market almost every day for reasons unrelated to bidsfor a limited quantitythat willbe allocatedat, our open market operations.Each day,more or less,two say,the averageprice of the competitivebids) separate operations are done. The open market opera- * Howto ensure that the tender is covered.(The is- tion occurs early in the morning. Later,towards midday, sue here is whether to use a select group whith, we do some dealingin the bond market. Nowthat's just in return for some special concessions,ensures designedto help the bond market along. However,if the that the tender is fullycovered.) central bank dominatesthat market, then that can hurt When we first started selling bonds in Australia,we the privatetraders whom you want to develop. had an implicit understanding with the market that A rediscount facilityis another possibility.I have al- bondswith the same characteristicswould not be issued ready presented the case against an over-activeredis- twice. If we put out 15-yearbonds due to mature on a count facilityas a threat to control of the central bank's particular date with a particular yield, we would not is- balancesheet. sue bondswith exactlythose characteristicsagain. I sup- Yet another possibilityis derivativemarkets. In Aus- pose the reasoning was that the market should know tralia, the introduction of a ten-yearfutures contract for exactlyhow much ofa securitywould be placed.They did bonds gavea great boost to the bond market.The central not want the risk that, after they had bought from one is- bank had nothing to do with its introduction. It was a sue of securities, the central bank would subsequently private initiative that started because the market was floodthe market with securitieshaving exactlythe same there. Still, it certainly has increasedthe liquidityof the characteristics. bond market. At the start, the market seemedto want a varietyof se- The central bank may be able to encourageinstitu- curities.At one stage, there were over a hundred differ- tions in the market to repackagegovernment paper.For ent government securities issued with different yields example,the holder ofa large block ofgovernment secu- and different maturities. Somewere very popular; some rities may hold that on one side of its balance sheet, were not. Figure 4-4 showswhat the yield curve looked while repackagingit into smaller instruments to be sold like. The dotted line with all the spikes is a yield curve, on the retail market. Youcan encouragethat. although no one would recognize it as such from the Trivialas the point may seem,it is nonethelessimpor- textbook descriptionof a yield curve, which is supposed tant to determine the right kind of securities and the to be smooth. That did not happen with instruments right length of the issues. Issues to be decided on in- such aswe had on issue,some ofwhich were liquidwhile clude: should the instruments carry capitalrisk or be re- others were not. Thosewith a ten-yearmaturity that had deemableon demand at face value, be bearer bonds or the advantageof correspondingto the ten-year bond fu- inscribed,what should be the maximumholding period, tures were very liquid. They are represented by the two shouldthere be dealersor just brokers,who are the mar- downwardspikes in the figure. Other issues, which in ket makers, and what is the size, maturity and target fact had similar characteristics,nevertheless had vastly market for each issue. The authorities also must decide differentyields. Building Financial Institutionsfor a Market-Based Monetary Policy 57

Figure 4.4 Treasury Bond Yield Curve 15.00

14.50

14.00 .- * .,2. ,.***,,g,,,+, ,., / >

13.50 _ ' '' ' .',',, f , , *

13.00 _ ' , , 31-Mar-87

12.50

12.00 l l l l l l l ll l Jun-90 Jun-91 Jun-92 Jun-93 Jun-94 Jun-95 Jun-96 Jun-97 Jun-98 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-OS By givingthat kind of yield curve, the market was in market at all times. Read the market's signals,and take effecttelling us that it did not want the degreeof product advantageof the opportunitiesthat arise. differentiationwe thought it wanted. Instead, it wanted The critical issue for achieving liquidityin the sec- the product to be uniform. In fact, the liquidity was ondarymarket is to get the pricingright. The price of the greatestwhen most of the market was ten-year bonds. issuedinstrument must be a market price. Howdoes one Thatwas what the market wanted;the more ofthose that determine a market price? I shall be dogmatic here and were put out there, the better. That wasthe wayto get li- say a tender is necessary. quidity. As an intermediate system beforewe went to the full So, trivial as it may see, one must look at what is hap- tender, we tried a tap system. A stock of governmentob- pening in the market all the time. What suits the market ligationswas made availableat specifiedterms. If it sold at one stage may not suit it later.As the market develops, well, which indicatedthat it had been correctlypriced, its requirementsmight becomedifferent. When we real- we kept it at that price. If the price was wrong in either ized what the market was telling us, sometime around direction, that issue would be closedoff and another put March 1987, we started consolidation operations. We in its place. Table4-1 lists all the stocksthat were issued would buy back the unpopular securities and sell more during the period of about 20 months when the tap sys- of the "hot" (i.e., popular) ones, which we got the gov- tem was operating. ernment to issue. We did more than a billion dollars Wethought this tap system might work well because worth of these highlyprofitable deals, just quietlydoing it enabledus to take a stock offthe market if it was either some everyday. No one realizedwhat washappening; the unpopular or too popular; that is, if we had mispricedit. yield curve stayed unchanged.Gradually the market re- In that period of 20 months, we issued 22 different alizedwhat washappening, and the yield curve did what stocks. We worked hard to get issues on the market at the textbooks say it should. It became more or less a the right price. Yet, I must say that I believewe failed. straight line. The solid line in Figure 4-4 shows the yield For example,although we intended to sell $A500million curve several years later, for May4, 1990. In fact, the of stock 7, we sold $A12million. Stock16 went the other market caught on to us much sooner than that and flat- way.We intended to sell $A300and sold $A352million. tened out the yield curve. As the table shows, it was extremely difficultto get the In summary,this exampleillustrates that the actions price right, even though we were issuing new stock neededto encourageliquidity in the governmentsecuri- wheneverwe thought we had gotten the previousprice ties market may be roundabout and may change over wrong. Even with all that effort,we could not make it time. The important thing is to stay in touch with the work. 58 StevenGrenville

Table 4-1 Tap Stock Sales AMOUNT ($MILLION) TIMING INDICATED SALES MATURITY OPENING CLOSING 1 500 237 Apr 82 30.4.80 27.6.80 2 250 263 Apr 85 30.4.80 9.5.80 3 400 281 May86 2.6.80 6.8.80 4 500 293 Nov82 7.7.82 5.8.80 5 250 59 June 90 7.7.80 10.12.80 6 500 145 Feb 83 21.8.80 6.2.81 7 500 12 Nov84 21.8.80 7.11.80 8 300 224 May82 14.11.80 21.11.80 9 300 20 Sept 82 26.11.80 6.3.81 10 150 77 Dec 87 19.12.80 9.6.81 11 400 253 May83 9.2.81 8.5.81 12 400 47 July 84 9.3.81 9.7.81 13 500 383 Apr83 11.5.81 25.9.81 14 150 74 Aug 88 10.6.81 6.11.81 15 500 539 June 84 10.7.81 23.10.81 16 300 352 June83 28.9.81 23.10.81 17 500 178 Apr84 28.10.81 5.4.82 18 500 544 June85 28.10.81 13.11.81 19 150 19 Apr88 9.11.81 5.4.82 20 400 89 Nov 85 19.11.81 7.5.82 21 400 287 Feb 84 14.5.82 16.7.82 22 400 128 Aug 85 14.5.82 16.7.82 *UntilTap Stock 13 excludessubscriptions by the RBAand LCIR.Thereafter, RBA subscriptions only are excluded.

In 1982we went to a tender.That seems to me to be bond market. Within a year after we went to a tender sys- crucial in getting the price right. In turn, getting the tem, the market liquidity began increasing;it just grew price right is crucial to ensuring an active and liquid like wildfire. If you get the pricing right a lot of other market. Figure 4-5 showsaverage daily turnover in the things will look after themselves.

Figure 4.5 Bond Market Average Daily Turnover Unshacklingthe BankingSystem

$ billion With respect to the requirement to unshackle the 400 - commercialbanks, most countries start with their banks surrounded by constraints. If open market operations 350- are to be effective,all those shacklesmust come off. The simple reason is that the commercial banks are 300- the conduit, the core of the financialsystem. Whycarry 250- out open market operations,if they are not being used to affectthe banking sector,which in turn passesthe effects 200- on to the rest of the economy?The ultimate aim of carrying out open market operations is not merely to 150-o change interest rates in the short term cash market but to let those rate changes act as a basicbuilding blockof 100- the cost of funds, which a banking system or financial system then passeson to its customers. Therefore,un- 50 - less the banks are freed from constraints on interest rates and on their balance sheets, open market opera- 0y tions will not be effective. 75 177 1 79 81 83 85 87 89 years ended June Building Financial Institutionsfor a Market-Based Monetary Policy 59

It used to be that way in Australia;the banks' balance Figure 4.6 Liquid Assets in Excess of Minimum sheets were tied so rigidly that they could not move Requirements, as a Percentage of without coming to the central bank for permission.They % Deposits % were not ableto managethe liabilityside of their balance 10 10 sheet to match the asset side. Theywere passivedeposit 4 takers; they took whatever the customer brought to them in depositsand loaned them out. Becausethe sys- 8 8 tem was very bumpy, the banks had to hold large reserves. Figure 4-6 characterizes their balance sheet management. Until the early 1980s,they needed to hold 6 5 quarter weighted 6 large excess reserves. Those reserves changed a great moving average deal during the year.All their effortswent into managing that intra-year liquidity flow.The whole of their effort 4 4 wasaimed merely at trying to figure out what was likely to happen and how to respond. Now that the banks have been unshackled,they can 2 2 enter the short-term money market to get whateverde- posits they need. They operatewith much less excessliquidity. With that off their minds, they have time to o o think about other things than how to maintain their in- 1975 1977 1979 1981 1983 1985 1987 1989 tra-year liquidity.They can get on with the job that banks are supposedto be doing, which is to decidewho We are now using our liquidityoperations to smooth the good customers are and lend out the money they out these rate variations. The point of doing so is not take in to customers who will pay them back. simply to have a flat line instead of a wobbly line. The Other changesin the banking systemalso occurred in major benefit gainedfrom all this is that the attention of response to the removalof constraints. Figure 4-7 com- persons in the financial sector could move away from pares cash rates in 1983 and 1985.Under the old system, concern with having enough liquidityeach day and turn cash rates bounced around a lot; they smoothed out to the real businessof intermediation:the work ofbring- when the shackles came off. As Figure 4-7 shows, the ing in money depositsand lending it out productivelyto changesalso smoothed the intra-year pattern of interest borrowerswho will be able to repay it with interest. rate swings.

Figure 4.7 Cash Rates 1983 and 1985, Weighted Average Paid by Aughorized Dealers on Clients Loans Outstanding 1983 1985

20- 20 - 20 18- - 18 - - 18 16- 16- -16 14- 14 -- 14 12- - ~~~~~~~~~12-- 12 10 - ~~~~~~~~~10 10 8- ~~~~~~~8- 8 6- , l,,, ,, ,, |e|lllrlllll|slulllllllllll6 6 4- ~~~~~~~~~4- 4

Auguist September October Auigust September October 2 60 Steven Grenville

Conclusions downthis path. But once started downthat path, we had no choice. Let me say that, while this is how we did it in Austra- I must say I do not think the current system answers lia, imitating us might not be the best way.In particular, all of our problems.The current system has the potential open market operations are not necessarilythe right way to let us control the monetaryaggregates with a high de- to go for every situation. It was long ago that the old gree of precision.That is what we wanted; it is why we preacher said there is a time for everything.I believethat put the systemin place.Yet, now that we havethe ability, appliesas well to open market operations.As a country's we are not sure we want to use it. We have much less financial system develops,the central bank needs more confidencenow that we can steer our system using an sophistication in its operations. In a sense, the two intermediate goal. To be more specific, in Australiawe things go hand in hand; if a very unsophisticatedsystem have abandonedthe idea,at least for the moment, of an of central bank operationsis left in placewhile the finan- intermediate target. Weshoot straight for someultimate cial market is becomingmore sophisticated,the market targets.' will roll over that system, leavingthe authorities unable Therefore,even when one has put one ofthese sophis- to achievetheir objectives.Increased sophistication not ticated systems in place, they don't solveall of the prob- only createsthe need to changethe systemof operations, lems. Centralbankers will still be left with a great many it also creates the environmentin which the new system difficultissues on how to run monetary policy. can succeed.It is a matter of choosingthe right time, ascertaining the appropriatemoment for the change. Note The progress in Australiawas, in my view,paced by developmentsin the market. Among the critical events, 1. Editor's note: The interventions by Lindsey and our financialintegration with the rest of the world dur- Goodhartin the next section elaborateon this point. ing the 1970s was extremely important. It forced us Building Financial Institutionsfor a Market-Based Monetary Policy 61

Discussion Question:I have a question regarding the stabilityof had M3as a target. In the 1970s,we usuallymissed it but demand for reserves. Your graph makes it look easier not by much. Then in the 1980swhen the systemwas de- than it is in practice. Yousaid that the supplyof bank re- regulated,we missedit by more and more. Wefelt it was serves should be controlled, but in fact the demand for becoming less relevant because it focusedon the banks money,the demandfor reserves,can be extremelyunsta- while other financial institutions were increasinglyim- ble. In Colombia,many of the shocks to the system,par- portant. In January 1985,we abandonedtargeting of M3. ticularly the pressures coming from the Treasury,such We got out of the wayjust in time; we had targeted 10 as withdrawing money by collecting taxes or abrupt percent growth in M3 for that year, but it turned out to changes in expenditures, will shift this demand for re- be 18 percent. Wewould havelost all our credibilityif we serves drastically.This introduces a tremendous insta- had been that far off our declaredtarget. Yet,and this is bility in the interest rates. What has been your the keypoint, monetarypolicy at that time was tight. No experienceof the demand for reserves?How stable has it one said we had missedour target becausemonetary pol- been during the process? icy was loose. All the churning on the balance sheets, with depositsmoving out to thrifts and then back,led us Mr. Grenville:The demand for reservesin our banks out to broader and broader aggregatesin the attempt to is fairlywell definedand relativelystable. The big chang- nullify those intra-institutional changes. So we went to es come on the supplyside. In terms of Figure4-2, all the broad money.But that was not quite broad enough be- action is on the supplyof reserves,which is hit by huge cause it excludedbank bills, which we found were being shocks everyday. The success of our more recent policy used a good deal in intermediation. is that we have becomebetter at offsettingthose shocks. That led us to the broadest of the aggregates,which For example,government taxes used to fall due at one we call credit. It does not matter that it comesfrom the time of the year. We have persuadedthe government to other side of the balancesheet, it can be liabilitiesjust as spread those out during the year. We now have much well as credits,so long as it capturesthe total amount of more information on what shocks are hitting the sys- intermediation. But it turned out that aggregatewas not tem, so we have gotten better at capturing the changes good, either. In the mid 1980sthe credit aggregate grew in supply.The results, as Figure 4-7 shows, have been at 20 to 25 percent a year for the fiveyears from 1984to that interest rates, which were veryjumpy on a day-to- 1989.At this time, inflation was declining and nominal day basis and showeda clear seasonaltrend, are now sta- incomeaggregates were growing at around 12 percent. ble. To make a long story short, we do not think there is Nothing was done to the demand curve, which is in any intermediate target that will serve for us. Like all fact quite stable. One reason it is so stable is that the good central banks,we are concernedwith inflation and banks have faith in our ability to maintain adequatere- price stability.So we are interested in forward-looking servesin the system.The short answerto your question, indicatorsof inflation:how fast is the economyrunning; then, is that the demand has not been a problem for us, how tight is the labor market; what is happeningto price the supplywas what we needed to stabilize. expectations?We try to read the last of these from the shape of the yield curve. Question:You stressed that the operational focus is Whenwe think those indicatorsare changing,we ad- the interest rate, not in a long-term sense but rather in just interest rates because of our general view that the a short-term sense. Since your ultimate objectivesmay directionof causal transmission is from interest rates to be something like the price levelor the levelof nominal economicactivity. We have done extensiveGranger tests income, I suppose that your statement means that you but have not been able to find that connection directly. change the short-term target as circumstances vary. Althoughwe cannot prove the causal direction, we ac- Couldyou giveus some ideaof how you changeyour op- cept the common sense view that, if interest rates are erational targets as a function of the ultimate variables raised enough, projects become unprofitable, and that you want to achieve?Perhaps you could get into the growth of activitydecreases. intermediate aims and the ultimate aims ofthe exercise. That does in fact happen, but the calibrationof the transmission mechanism is extremely poor. For exam- Mr. Grenville:That would really require another two ple, in Octoberof 1987we realizedthat monetary policy hours, but I will answer briefly.From 1975 to 1985we needed to be eased. Starting in April 1988, we realized searched for an intermediate target. In those days, we the economy was running too fast. So we started to 62 Steven Grenville tighten, and we tightened again and again. Interest rates Mr. Grenville:That should act as a second lever for rose progressively.The treasury bill rate, for example, transmission.As interest rates rise, externalcapital wants climbed from 11 percent to 18 percent over a period of to come into Australia,but it cannot come in becausewe six to nine months. At 18 percent, the real rate of inter- have a floatingexchange rate. On an adjusted basis, there est was around 10 percent, which we reckonedwas a suf- should be no movement. ficiently tight monetary policy.The economy still was growingat 10 percent in real terms; employmentwas ris- Mr. Honohan: So the exchange rate increases,which ing at 4 percent annually.So, although we think we know makesyour exports lesscompetitive, which also slowsac- the transmission mechanism,the lags on it are extreme- tivity? ly long and the calibration extremely poor. Eighteen months after we first began tightening, the economy Mr.Grenville: Yes, so the transmissionmechanism not slowed,and that should eventuallybring down the infla- only adjusts interest rates for the activity but also may tion rate. leadto a higher exchangerate. The exchangerate went up sharplyfrom $AO.57per U.S.dollar in the middle of 1988 Question:Do capital flowsfrom outside affectthe lag to $AO.87several years later. Still, economic activity did in the transmission mechanism? not begin to slow until eighteen months after the tightening started. PART II

MONETARYTARGETING AND CONTROL

Introduction

Moving away from bank-by-bankcredit ceilings raises and the United Kingdom-have operated with no re- the questionof appropriateintermediate targets for cen- serve requirements.Lindsey noted that reserve require- tral bank policy. The presentations and discussions in ments help implement monetary policy when some this section focusedon the extensivelessons of the in- aggregate reservesmeasure is being targeted; if interest dustrial countries with targeting issues and their rele- rates are the real operating target, then there is little vance for developingcountries. David Lindsey,Deputy monetary control function for required reserves.When Directorof the Divisionof MonetaryAffairs at the Board reserve requirements are employedwith an aggregate of Governorsof the Federal ReserveSystem, provided a reservestarget, it is helpful to keep them uniform; oth- comprehensive insider's view of the difficulties in erwise the money multiplier can be altered by shifts achievingmonetary control in a periodof rapid financial among differentinstitutions. change and of the Fed's search for stable money and In countries participating in fixed exchangerate ar- credit relationshipswith real activity.In Europeancoun- rangements, national monetary policybecomes ineffec- tries, too, as Charles Goodhartreported, various mone- tive as capital mobility and asset substitutability rise. tary aggregates,credit, interest rates, and exchangerates Theseforces recentlyhave been at work in the European have all been consideredas potential targets. (Goodhart, MonetarySystem (EMS), with the dissolutionof barriers who is now Norman Sosnow Professorof Lending and to capital flowsand the rising substitution among EMS Financing at the LondonSchool of Economics,was for- currencies. Not unlike the experienceof the Southern merly Adviserat the Bankof England.)But, regardlessof Cone countries in South America a decade ago, the intermediate target, central bankers keep theirGoodhart described how, as the exchangerate peg has closely on the ultimate targets of inflation and output become credible,members of the "European Southern and, even in formerly more monetarist central banks, Cone" have been experiencing inflows of capital, deteri- have moved to an eclecticview of monetary policy.An . . important lesson of industrial country experienceis that oratig current account positions, relatvely highInfla- there is no guaranteed method for attaining monetary tion rates, and appreciatingreal exchangerates. In this policytargets (direct methods included).Officials must situation, it is important that governmentsbe ableto use avoid regarding econometricrelationships with uncon- fiscal policy to restrain inflationary pressures, since ditionalbelief and insteadbe preparedto adjust to behav- monetary policyhas been sacrificedto maintain the ex- ioral changes associatedwith financialreform. change rate peg. In many countries with a floatingexchange rate, in- Governments in several countries are recognizing terest rates have becomethe more important intermedi- that monetary policy deliberationsshould be insulated ate target, as they were before the rise of monetary from political pressures and that therefore it is impor- targeting. But the authorities are now more alert to the tant to increasethe independenceof central banks. A so- long and variable lags of monetary policy. Professor ciety can choose to peg its currency to one that is Goodhart explainshow lags probablycontributed to the managedby an independentand firmlyanti-inflationary difficulty of targeting money aggregates in the early monetary authority, or to erect legalbarriers around its 1980s. own central bank.A discussionensued regardingthe dif- Questionsarose concerning the use and design of re- ficulty in establishing a proper incentive structure for serve requirements. Severalcountries-such as Canada central bankers; some feared that monetary incentives

65 66 Introduction to Part 11 favoringonly low inflation might bring about such a re- times of crisis, willcontinue to be a featureof developing sult at a high price. country policy. While Lindseyand Goodhart describemonetary poli- Dr.Mathieson also describesthe macroeconomicand cy practicein industrial countries,Don Mathieson(Chief structural preconditions for successful transition to of the Financial StudiesDivision in the ResearchDepart- market-basedmethods of monetarycontrol. One may be ment of the IMF)concentrates on developingcountries allowed the optimisticopinion that careful attention in in asking why there has been a traditional reliance on advanceto ensuring that these preconditions are satis- credit controls and why they are coining under pressure. fied (includingthe changes in net credit demand noted Exogenousshocks tend to be relativelylarger for many by Johnston in his paper) would minimize the need for developingcountries than for industrial countries. The policyreversals. former do not have the depth of financialmarkets to ab- Centralbanks can only hope to be independentwithin sorb and spread out the effectof such shocks. It is partly a government, rather than independent of the govern- as a result of this that developingcountries rely on "fi- ment. When shocks are sufficientlylarge, be it a stabili- nancing"large losses,caused by such economicshocks, zation program in a LatinAmerican country or a driveto through the central bank's balancesheet, and thus effec- currency union in Europe,a central bank will ultimately tively through the inflation tax and other forms of re- have to make some compromiseor see its independence pression ofthe financialsystem. Rather than allowcrises limited. The true art of central banking, then, concerns to lead to greater instabilitythrough their effecton sky- the nature of the trade-offsbargained by the monetary rocketing interest rates, the authorities in developing authorities. Goodhart noted that the importance of dis- countries have had recourse to direct controls. Mathie- cretionary changes in policywill persist as long as gov- son adopts the pessimisticview that such recourse, in ernments maintain their monopolyof the right to issue money. 5

Monetary Targeting:Lessons from the U.S. Experience

DavidLindsey

I will attempt today the ambitioustask of weavinga con- of Governorsand the Federal Open Market Committee ceptual discussionof U.S.monetary control techniques determine that they cannot or should not be achieved into a chronologicaldiscussion of four separate periods because of changing conditions ... provided ... the in recent U.S.monetaryhistory: 1970 through October Board of Governorsshall include an explanationof the 1979, October 1979 through the fall of 1982, the fall of reasons for any revisions to or deviationsfrom such ob- 1982 to the fall of 1987,and the fall of 1987 to date.I will jectives and plans." address changes both in the tactics of operating proce- The Federal Reserve's record in attaining the an- dures and in the strategy toward intermediate targets nounced annual ranges for Ml and M2 from 1976 to used by the Federal Reserve Open Market Committee 1979was somewhatmixed. The ranges for each calendar (FOMC)over the four periods. The outstanding issues year are shownby the lines in the top panel of Figure 5-1 related to monetary targeting in the U.S. will, I hope, and the actual growth rates of Ml and M2are shown by emerge clearlyfrom the discussion. dots, using the definitionsof these aggregatesin force during these years. Over each of these calendar years, 1970 through October 1979 only one of the aggregatesgrew within its range, while the other exceededits upper bound. In addition, Ml ex- Over the 1970s, the Federal Reserve gradually ceededits upper limit during the first three quarters of strengthened its reliance on monetary aggregates. Step 1979. by step, the monetaryaggregates-mainly Ml and M2- For most of the decade,the FederalReserve relied on supplanted interest rates as the primary intermediate the federal funds rate-the interest rate that banks targets for monetary policy.In the early 1970s,the Fed- charge one another on overnight loans of reserves-as eral Reserve began focusing internally on the growth its operatingtarget in attempting to attain its monetary rates of monetary aggregatesas indicators of monetary objectives.When money growthwas fasterthan desired, stimulus or restraint. The Federal Reserve started an- the FOMCraised its operating range for the funds rate, nouncing publiclyits desired ranges for annual growth shown by the solid bands in Figure 5-2. The FOMClow- rates for selected monetary aggregatesin response to a ered the range when money growth was undesirably joint resolution of Congresspassed in 1975.Later, Con- weak. The trading desk at the Federal ReserveBank of gress legislativelymandated this practice. NewYork altered the supplyof nonborrowedreserves to The current provisionsof the Federal ReserveAct, as keep the supplyof total reservesequal to the demand for amended by the Full Employmentand BalancedGrowth total reservesat the desired funds rate. This kept the ac- Act of 1978,require the Board of Governorsof the Fed- tual funds rate, shown by the crosses, generally within eral ReserveSystem to report to the Congresstwice each the operating range. year on the "objectivesand plans of the Boardof Gover- Through these procedures, the Federal Reserve nors and the Federal Open Market Committee with re- sought to influence directly the quantity of money de- spect to the ranges of growth or diminution of the manded by the public. It tried to select a level of the monetary and credit aggregates."This section of the Act funds rate that would make the public want to hold an also states that "nothing in this Act shall be interpreted amount of money equal to the targeted value. Whenthe to require that the objectivesand plans [for the mone- trading desk raised the funds rate, other short-term in- tary and credit aggregates] ... be achievedif the Board terest rates tended to rise in sympathy.The public then

67 68 David Lindsey

Figure 5.1 Adopted Ranges and Actual Growth Rates for Ml and M2, 1976-1979

MI (currency and demand deposits)

Actual

X - 1976 1977 1978 1979 X Tairget*I z ZX Rcitge Ata M2 (Ml plus savings and small time deposits at commercial banks)

1976 1977 1978 1979 found market instruments more attractive relative to tary aggregates[by] ...... placing greater emphasis on the moneybalances, which weresubject to interest-rate ceil- supply of bank reserves and less emphasis on confining ings or outright prohibitionson the paymentof interest, short-term fluctuations in the federalfunds rate." The resulting transfer of funds from monetary to other Holdingto a nonborrowedreserves target path essen- financialassets was reflectedin a reduced stock of mon- tially gives the short-run total reserves supply curve a ey. Over time as well, the higher interest rates and ac- positive slope, as in Figure 5-3. The stock of total re- companying tighter credit conditions tended to damp servesis on the horizontal axis and the federalfunds rate spendingand hence transactions demandsfor money.In is on the vertical axis. The supply curve is positively practice,when money demand strengthened, the FOMC slopedmainly because an increasein short-term interest did not alwaysalter the funds rate promptly enough or rates relative to the discountrate induces depositoryin- sufficientlyto keep monetary aggregates consistently stitutions to increase their borrowing at the discount within their ranges, even over the longer run. window.With nonborrowedreserves fixed, total reserves suppliedwill be higher, and hence the stockof reservable October 1979 through the Fall of 1982 depositsthat can be supportedby the outstanding nonborrowedreserves will be larger. On October6, 1979,facing above-target monetary ex- The increase in borrowing induced by a given rise in pansion,worsening inflation,and their consequencesin the fundsrate has a limit, though, becausedepository in- domestic and international financial markets, and dis- stitutions are expectednot to make repeatedor continu- satisfied with the old procedures, the Federal Reserve ous use of the discount facility for adjustment credit switchedits operating target from the federalfunds rate under normal circumstances. Thus banks experience to nonborrowedreserves as a sign of its commitment to some rising implicit cost to added use of the discount longer-run restraint on money growth. The Federal Re- windowas they anticipate more administrativepressure serve announced that it had switched procedures "to to adjust reservepositions in some other way.Banks will support the objectiveof containing growthin the mone- increase their borrowing until the implicit cost on the MonetaryTargeting: Lessonsfrom the U.S.Experience 69

Figure 5.2 Short-run Tolerance Ranges and Actual Levels of Federal Funds Rate

16*

12-

10 - ~~~~~~~~~~~~Actuallevel of averaigefederailfunds raite'

6 'W~~~~~~~~~~~~Short-runtolerantce ranige

41976 1 1977 1 /978 1 1979 last dollar of discount borrowings has risen by an Figure 5-4 shows how this automatic mechanism amount equal to the initial change in market interest worked during the three years after October 1979. The rates. In equilibrium, the marginal cost to a bank on two panels indicatemonthly levelsof Ml and M2relative each of its managed liabilitiesis equalized,including the to the upperand lowerbounds of their annual ranges. A sum of the explicit discount rate and the implicit mar- strengthening of money relative to target raised re- ginal cost of discountwindow borrowing. quired reserves. Since nonborrowedreserves were held A nonborrowedreserves operating target, therefore, to a fixedpath by the trading desk, reserve positions of providesan automaticself-correcting mechanism acting depositoryinstitutions were automaticallytightened as partially to resist divergencesof the money stock from institutions in the aggregate were forcedto borrow the its targeted value that could be mimicked only through extra reserves at the discount window. These adjust- judgmental adjustments under a federal funds rate ments plus seasonal borrowings are shown in Figure guide. Under the nonborrowed reserves procedure, a 5-5. surge in nominal money demand relative to target- Institutions were induced to borrow additional re- owing to an increase in real income,a rise in the price serves at the windowonly after they had first attempted level, or a positive random disturbance-will cause re- to acquire the needed reservesfrom other institutions. quired reservesto increase and shift the demand curve In doing so, they bid up the federalfunds rate relativeto for total reservesto the right. As banks increase bor- the discountrate. This responseof the funds rate may be rowedreserves to fillthe gap, the implicitcost of the bor- seen in Figure 5-6. Higher short-term interest rates in rowingrises and they bid up the funds rate. Asthe funds turn encouraged depositoryinstitutions and the public market movesup and to the right on the total reserves to make secondaryadjustments to balance sheets that supply curve, the funds rate rises. The surge in money curtailed deposit expansionand helped to bring money will be partially checked by the induced rise in short- back to path. This process occurred automaticallyin the term interest rates. absence of additional deliberate actions by the Federal 70 David Lindsey

Figure 5.3 Reserves Market servesvaried over a wider range than their supplycurves did. Moreover,there is evidencethat the Federal Reserve Federal in fact confronted a more unpredictable demand for Fiends money after the inception of the new procedures. At the start of 1981,negotiable order ofwithdrawal accounts (NOWs)were authorized nationwide,boosting ac- Total tual Ml demand. Working in the other direction, cash Reserves Demand:s management techniques evidently spread to medium- Required size corporations, and some demand depositors also + Excess( *) Total shifted into money market mutual funds.As in the mid- Reserves 1970s,the high market interest rates that accompanied Supply: high rates of inflation prompted money holders to econ- Nb oBrrowed(d) omize on conventional checking account balances sub- Discouznt Broe\ ject to interest-rate ceilings,and promptedthe Congress Rate - - \ and the financial regulatory agencies to allow the creation of newaccounts payinghigher returns. By 1982, the growth of fixed-ceilingNOWs had evidently raised the interest elasticity of Ml demand. The sizabledeclines in rates in the second half of 1982 began to engender a larger increasein desired money holdings Nonborrowed" Reserves than suggested by conventional money demand functions. Figures 5-7 and 5-8 show that declines in the (*) This schedule shifts withchanges in the demandfor three-month bill rate relative to the NOWrate (Figure reservable deposits or in the willingness of banks to 5-7) narrowedgreatly the opportunitycost of Ml (Figure hold reserve sitrplitses. 5-8). The NOWaccount component, and Ml as a whole, (**) This schedule shifts with changes in open market operations, had becomemore elasticwith respect to market interest in the discountrate, or in banks' willingnessor need to borrow rates than was true of demanddeposits or currency.After all, using hypotheticalfigures, a fall in short-term mar- Reserve. However,the Federal Reserve also frequently ket rates from 15 percent to 10 percent represents a de- opted to amplifythese automatic effects.For example,in cline of one-third in the marginal opportunity cost of the case of a monetary overshoot,it might have lowered holdinga demand deposit (evenone payinga positiveav- the nonborrowedreserves target or raised the discount erage implicitreturn via servicesindependent of account rate. size). By contrast, the marginal opportunitycost of hold- From October 1979 to the fall of 1982,divergences of ing a NOWaccount paying a 5 percent explicitrate of re- money,especially Ml, from long-run targets were closely turn is reduced by one-half. For 1982 as a whole, Ml associatedwith changes in borrowed reserves and the growth substantiallyexceeded its upper bound, while the federalfunds rate in the same direction. Such variations measured velocityof Ml, shown in Figure 5-8, posted a in short-term interest rates were part and parcel of the nearly 6 percent decline, unprecedented in the postwar process that returned money to longer-run objectives period. In light of these circumstances,and with further over time in the faceof divergences.For those three years impending deregulationhaving uncertain effectson Ml, the nonborrowedreserves operating procedurespermit- Chairman Volckerannounced on October 9, 1982, that ted short-term interest rates to move over a much wider for the time beingthe FOMCwas placing reduced empha- range in the intermediate run than under the previous sis on Ml as a guide to policyrelative to broader mone- procedures. tary aggregates. Overthose three years, the Federal Reserveslowed the trend rate of money growth, and while real economicac- The Fall of 1982 to October 1987 tivity stagnated and unemployment rose to a postwar record, the rate of inflationessentially was halved. But as The de-emphasis of Ml in the fall of 1982, together monetarist critics noted, money growthas well as inter- with the more flexiblestrategy that followedregarding est rates showed more intermediate-term variability. the monetary aggregatesmore generally,was mirrored What explains this behavior? That money and interest by a shift in operating procedures.The nonborrowedre- rates moved in the same direction establishesa prima fa- serves operating procedure,with its automaticityderiv- cie case that the demand curves for money and total re- ing mainly from variations in required reserves on MonetaryTargeting: Lessons from the U.S.Experience 71

Figure 5.4 Ml and M2 Growth Relative to Annual Ranges, 1980-1982

Ml $500

$450 - Actual monthly leve'l

X£n$400_ $4009,' An Annual range

$350_ 1979 1980 1981 1982 1983

M2 $2,200

. $2,000

.Z $1,800 Actual monthlv level $1,600 - Annual range

$1,400I I, l I l l l I, l l 1979 1980 1981 1982 1983 transaction deposits, has to be modified if Ml is de- federalfunds rate operating target. Instead, the nonbor- throned as the primary intermediate monetarytarget (or rowed reserve strategy and its automaticitygave way to if a more judgmental approachis taken in reactingto Ml a technique that allowedthe funds rate to be determined movements). The Federal Reserve did not return to a by the market, through the targeting of discount win- Figure 5.5 Discount Window Borrowing, Adjustment Plus Seasonal Borrowing, 1979-1982 (monthly)

3 -

0 1979 1980 1981 1982 1983 72 DavidLindsey

Figure 5.6 Federal Funds Rate and Discount Rate, 1979-1982 (monthly)

25 Fede2a5fiindsrate Discountrate pluts 20 Federal-fundsrate surchargerate

10 ~~~~~~~~iscountrat

5 1979 1980 1981 1982 1983

dow borrowing from one reserve maintenance periodto er degree other money markets,while still enabling the the next, implemented by allowing a flexiblenonbor- funds rate to fluctuate in responseto changesin market rowed reservespath. Over longer periods,"the degree of expectationsof policy actions and other forces affecting restraint on reservepositions," as reflectedin the levelof money markets generally,as well as to disturbances in adjustment plus seasonal borrowings at the discount the supplyand demand for reserves.There was a system- window,was altered morejudgmentally in responseboth atic, if somewhat loose, association betweenthe spread to movementsin monetary aggregatesrelative to short- of the funds rate over the discount rate and the willing- term objectivesand to other economicand financialde- ness of institutions to draw on adjustment plus seasonal velopments. borrowings. Greater discount borrowing in the aggre- Theshift in operatingprocedures weakened the earli- gate tended to be associatedwith a wider spread of the er correspondencebetween movementsin monetaryag- funds rate over the discount rate-which encouraged gregatesrelative to their ranges, on the one hand, and in more institutions to rely on the windowmore frequently discount borrowingsand the federal funds rate, on the and for larger amounts. This associationbetween actual other. As the top panel in Figure 5-9 shows, the funds borrowing and the spread remained discernible from rate from the fall of 1982 to late 1987 displayeda much 1982 through 1987,as may be seen in the lowertwo pan- smoother pattern than it did during the previous three- els of Figure 5-9. year period. Although a borrowing guide providedan anchoring The use of borrowing as an operating guide afforded mechanism that generally acted to confine unexpected the FOMC,through the desk, considerable influence movements of the funds rate, upon occasion the two- overconditions in the federalfunds market and to a less- week average funds rate varied significantly from the Figure 5.7 Three-Month Treasury Bill Rate and NOWRate

Percent

16-

14 -3 Month T-bill rate

12-

10 : \

6- NOW rate . , . . ., ~~~~~~...... 4

I I I I I I I I I I I 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 Monetary Targeting:Lessons from the U.S. Experience 73

Figure 5.8 Ml Velocity and Opportunity Cost

Ratio Scale Logarithmic Scale 7.5- -18 Is ,' ys ~~~~~~~MIVelocitv 1

7 u(Left Hand Scale) - 12

MI Opportunity Cost(*) *. 6 (Right Hand Scale)

1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 (*) Two quaner moving average. Assumes zero return on demand deposits. area expectedto be typicallyassociated with a given dis- and a halfyears to prevent unexpectedfunds rate move- count rate and a given intended levelof borrowing. ments, rather than to allowthe funds rate to divergeper- Severalepisodes of more sustained shifts in the funds sistently from expectations. The FOMCmay not have rate-discount rate spread relative to borrowing can be revertedall the wayback to the funds rate targeting pro- seen in the lower panels. In the summer of 1984,in the cedure of the 1970s,but it has come close. aftermath of the troubles of Continental Illinois Bank, The desired funds rate has been adjusted fairly fre- the spread widened while borrowing stayed around quently since late 1987, as was the borrowing objective U.S.$1billion, as large institutions became more reluc- from late 1982to the fall of 1987.But these adjustments tant to be seen borrowingat the window.Subsequently, havebeen more judgmental than in the early 1980s,and this reluctance disappearedand the relation returned are made on the basis of a wide range of incoming data, more to normal. Then, in early 1986, borrowing de- not just M2 and M3.The reason partly stems from the clined,but the spread fellby less than wouldbe expected. swingsin GNPgrowth relativeto the growthof the broad This greater reluctance seemed permanent, perhaps re- aggregates, that is, from variations in their velocity. flecting more caution in reserve management after the Movementsin M2velocity in the 1980sare shown in Fig- Bank of NewYork's publicized computer breakdownon ure 5-10;the three-month treasury bill rate is compared November21, 1985. with the averagerate on M2in Figure 5-11. M2has not proven to be a reliable short-run indicator of GNP or October 1987 to the Present thus a reliable short-run guide to policy. Thechart suggeststhat this problemis attributable to Afterthe stock market break on October19, 1987,ad- a sizableinterest sensitivityof M2demand, though it has justment borrowing droppedstill more, relative to the less sensitivity than Ml demand over annual periods. spread, in several steps. Recently in 1990, adjustment Swingsin M2'sopportunity cost, in Figure5-10, are fair- borrowinghas averagedonly US$100million. The weak- ly well mirrored over time by swings in V2. Thus, the ness in adjustment borrowinghas been overlaidby wider FOMChas been forced to consider the likely interest swings over the calendar year in seasonal borrowing. rates associatedwith prospectiveM2 paths, and the ef- The predictabilityin the relation betweenthe funds rate- fect of those rates on spending,production and inflation discount rate spread and adjustment plus seasonalbor- pressures. rowinghas all but disappearedin the last three years. The article on "MonetaryPolicy" by Henry Wallich Under circumstances of such evident shifts in bor- and myself notes the problems in some circumstances rowing behavior,the FOMChas chosen to alter its bor- for macroeconomicstabilization when the central bank rowingoperating objectivemore flexiblyin the last two adheres rigidlyto a predeterminedtarget for the money 74 David Lindsey

Figure 5.9 Money Market Conditions Federal Funds and Discount Rates and Borrowings

Federal Funds and Discount Rates Percentagepoints 20 Monthly Surcharge

* -~~~~~~~~~~~~~~~~~~~~~~~~16 _*w |: n r\ FederalFunds Biweekly * ,Thru 5/2/90 - 12

DiscountRtee ,

4 1980 1981 1982 1984 1984 1985 1986 1987 1988 1989 /990

Spread between Federal Funds and Discount Rates Percentagepoints 8

* ~ ~ ~ ~~2

1980 1981 1982 1984 1984 1985 1986 1987 1988 1989 1990

Adjustmentplus Seasonal Borrowings(*. Millionsof dollars 3200

-2400

-1600

~~~ -800

!~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~' ;, S>SDi

1980 /981 1982 1984 1984 1985 1986 1987 1988 1989 1990 (*) Excludesspecial situation borrowing. Monetary Targeting: Lessons from the U.S. Experience 75

This easingin financialconditions will provide only little Box 5.1 Recent FOMCStatements of offset to the weakness in economic activity,absent an Objectives upward adjustment to the target for money growth. The FOMCthus has needed to be flexiblein approachingits Portions of the Long-run Paragraph Adopted annual or quarterly objectivesfor M2 or M3. It comple- at the February 6-7, 1990, FOMCMeeting ments monetaryindicators by monitoring direct indica- tions of real activity and price trends, and by examining anTheFederal Open Market Committee seeks monetary indirect evidenceprovided by movementsin other finan- andfinancial conditions that will foster price stability, cial variablesin domesticfinancial and international ex- promotegrowth in outputon a sustainablebasis, and change markets as well. contribute to an improved pattern of international transactions.... Box 5-1 indicatesthe long run objectivesthe FOMC Thebehavior of the monetaryaggregates will continue has set for itself, in the most recent publiclyavailable to beevaluated in the lightof progress toward price level record of policyactions. The secondparagraph indicates stability,movements in their velocities,and developthat monetary aggregateshave a policyrole, but are not mentsin the economyand financial markets. rigid guides. Their behavior is evaluatedin the light of progress toward price stability,movements in their ve- Operational Paragraph Adopted at the locities,and developmentsin the economyand financial February 6-7, 1990, FOMCMeeting markets. The operational paragraph's second sentence makes In the implementationof policy for the immediatefu- clearthat movementsin moneygrowth relativeto annu- ture, the Committeeseeks to maintainthe existingde- al ranges or quarterlygrowth paths specifiedin the third gree of pressure on reservepositions. Taikingaccount of sentence are not accorded top priority. Behavior of the progresstoward price stability, the strengthof the busi- monetary aggregatesare third among the factors to be ness expansion,the behavior of the monetary aggregates, and developments in foreign exchange and domesticfinancial markets, slightlygreater reserve restraint or slightly lesser reserve restraint would be ac- Box 5.2 ceptablein the intermeeting period.The contemplated Underlyig Monetary Relatons reserve conditions are expected to be consistent with growth of M2 and M3 over the period from December Lowercase variables are the logarithmsof the upper case throughMarch at annualrates ofabout 7 and 3.5 per- variables. cent respectively.The Chairmanmay callfor Committee consultation if it appears to the Managerfor Domestic Quantity Equation Operationsthat reserveconditions during the periodbe- forethe next meetingare likelyto be associatedwith a (1) MxV = P x Q = GNP federal funds rate persistenlyoutside a range of 6 to 10 percent. M = money V= incomevelocity of money Votes for the paragraph on short-term policy imple- P GNPdeflator mentation: Messrs. Greenspan,Corrigan, Angell, Boe- Q = real GNP hne, Johnson, Kelley,LaWare, and Stern. Votesagainst this action: Messrs.Boykin and Hoskinsand Ms.Seger. Long-RunPrice Concept (2) P* = M x V* stock when its demand is relatively interest sensitive Q* (Lindsey and Wallich 1989). For example, suppose spending had clearly weakened and the central bank has V*= long-run velocity responded by adding to reserve availability in the face of Q*= real potential GNP a very interest-sensitive demand for the targeted monetary aggregate. The resulting fall in interest rates has led IdentityBetween Price, Output, and VelocityGaps to a sizable overshoot of money from target. In this cir- cumstance, it may turn out better for the economy if the (3) (p - p*) = (q* - q) + (v - v*) central bank accepts the full overrun of money above tar- price gap output gap velocitygap get. With a highly interest-sensitive demand for money, only a small reduction in interest rates is implied by keeping money on target when spending turns down. 76 David Lindsey

Figure 5.10 M2 Velocityand Opportunity Cost

Ratio Scale 1.9 - _ 15

1.8 - M2 OpportunityCost(*) -10

1 7 - / V < H a~~~~~hHnd Scale)

, . ~~~~~M2Velocin \t^ 16 | ~~~~~(LeftHandScale) \ 3 2 1.6-

1.5 -

1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 (*) Twoquarter movingaverage. considered in making adjustments to the operating continued in 1987.The ranges for M2,M3, and domestic stance of policyduring the inter-meetingperiod. nonfinancialdebt were widenedin 1988,with the domi- As a consequenceof the more eclectic approach to nant considerationfor M2 being its significant interest policyguides, monetary growth ranges since 1982were elasticity.M2 ranges were attained in all the years since made less confiningand, even so, have not alwaysbeen 1982 except 1987. But M3 ranges were attained only in attained. This is shown in Figure 5-12. The MI ranges 1985, 1986, and 1988. This year both aggregateswere werewidened and twice the basewas shifted to midyear, within their ranges through March. To be sure, M3 was reflectingits de-emphasisin policy.Nonethe- less, they close to its lowerbound, and as Figure 5-12shows, M3 is were missed in two of four years beforeranges were dis- estimated to have fallen just below its lower bound in Figure 5.11 Three-Month Treasury Bill Rate and Average Rate on M2

Percent

16-

14 - Three-Month T-bill rate

12-

6 M2 Ownrate(*) ...... '. .

I ,I , , , 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 (*) Rate on componentsweighted by sharesof componentsin M2. Monetary Targeting: Lessons from the U.S. Experience 77

Figure 5.12 Monetary and Debt Aggregates

Ml Billions of Dollars Debt Billions of Dollars 850 10,400

- Actual Level Actital Level - - - Estimated Level 82 10,000

_ ' _ -800800 //-6.5~~~~~~~~~~~~~6.% __r - / m/ ~~~~~~~~~~~~~~~~~-9600 -775

- - ~~~~~~~~~~750

I I i I I I I I II I I I I I I I I I I 725 I I I I I I I I I I I I I I I I I I I I 8800 O N D J F M A M J J A S O N D J F M A M J O N D J F M A M J J A S O N D J F M A M J 1989 1990 1989 1990 M2 Billions of Dollars M3 Billions of Dollars 400 4300

- Actiual Level 350 Actual Level 7.5% . - Estimated Level / 7% . . . Estimated Level 4200 7% ~~300 65

250 - - 4100

- 200 / 2.5%

>~~~~~~~~~~~ 150 - ->4000

0 3900 -50

O NDJ FMAMJ J AS O ND J FMA MJ ONDJFMAMJJASONDJFMAMJ 1989 1990 1989 1990 Figure 5.13 M2 Velocity

1.80 -

1.75- Mean (1955:QI - 1988:Ql) 1.70-

1.60-t | V65/,X------

1.55

1955 1960 1965 1970 1975 1980 1985 1990 78 David Lindsey

April.The weaknessin M3since the spring of 1989 owes can be readilydetermined. Based on the long-run stabil- mainly to the downsizingof the thrift industryand the ity ofM2 velocity, V2, shown in Figure 5-13, it appears to lessened need of these institutions for managed liabili- be much easierto specifya long-run velocityestimate for ties in M3. this aggregatethan for any other aggregate.While V2 is Despitethe shorter-run loosenessbetween monetary sensitiveto the movements in its opportunity cost, flex- aggregatesand GNP,some justification for continuingto ibilityin M2deposit rates tends to stabilizethese costs in announce ranges for the broader aggregatesand for giv- the long run. Evidently,V2 eventuallyreturns to a level ing them weight as a longer-run guide to policy can be close to its historical average,shown by the long dotted advanced.That rationale involvesM2's successful prop- line in this exhibit. In what follows,V* will be set equal erties as a long-run indicator of price trends. This indi- to its longer-run historical averagein the construction cator propertymay be seen making use of the conceptof of long-run prices. M2 per unit of potential GNPand ofan equilibriumlevel The price level, as measured by the GNP deflator, is of M2velocity. My discussion draws on some work that plotted with the value of P* in the top panel of Figure has been done by Boardstaff (Hallman,Porter, and Small 5-14, which uses a ratio scale. The four-quarteraverage 1991). rate of inflation is shown in the lowerpanel of this fig- Box5-2 reviewsthe key concepts and relation-ships. ure. Nine vertical lines are shown in both panels at the Equation 1 is the equation of exchangeMV = PQ,which point where the price levelcrosses the curve for P*. states that the stock of money M times its incomeveloc- In general, this chart shows that when the long-run ity,V, equals the product of prices, P, and real output, Q. price measure is abovethe current deflator,inflation will If we consider a long-run situation where velocity may accelerate, and, conversely,it will decelerate when the be presumedto havesettled downto an equilibriumlevel long-run price measuremoves below current prices.The V* and real output is at its potential level identifiedas chart also shows that the change in the inflation rate Q*, the quantity equation can be rearranged to deter- usually lags the change in the gap between P and P*. In mine the long-run price leveltoward which actual prices the latest episodein which P* rose abovethe deflatorin presumablyare headed,for any given levelof the money early 1985,prices did not showmuch tendency to accel- stock. This long-run price concept, which is calledP*, is erate on a four-quarteraverage basis until 1988. In 1989, definedformally in Equation2. The equation states that, P* fell to approximate equality with the current price in the long run, priceswill be proportionalto the money level, suggesting a roughly stable rate of inflation over stock per unit of potential real GNP,with the proportion- 1989, which, in fact, transpired. I have simulated the ality constant givenby V*. model over 1990 and 1991, assuming M2 growth over From the quantity equation for actual pricesand the both years at the midpoint of the announced range for equation for P*, we can derivean identity for the gap between actual and long-run price levels from the differ- thls year: 5 percent. The model suggests a gradual de- ence betweenequation (1) and equation (2). Specifically, hiningtrend in inflation,to about 3.75 percent. Equation 3 in the bottom panel of the first exhibitstates This evidenceindicates that M2'sgrowth, when aver- that for the logarithmsof the variables,the gap between aged over extended periods, minus the accompanying P and P* is equal to the sum of the output gap, the dif- growth of potential real GNP,may not diverge too much ference between potential real output Q* and current from the long-termaverage rate of inflation.According- real output, and the velocitygap, the differencebetween Ily,some role, though clearly not an exclusiveone, espe- the current value of velocityand its long-run value V*. cially overshort-term horizons, for M2in the making of If, for example,prices were below their long-run level, monetary policyseems warranted. this situation would be consistent with the economy running abovecapacity, with velocitybelow its trend, or References both. Asa result, priceswould then be expectedto rise to reach their equilibriumlevel. Lindsey,David E. and HenryC. Wallich, 1989. "Monetary Finally,the separate terms on the right hand side of Policy,"The New Palgrave edited by John Eatwell, Equation 3 can be identifiedwith different viewsof the Murray Milgate,Peter Newman.New York, NY: W.W. inflationprices. The output gap is commonlyassociated Norton. with the expectations-augmentedPhillips curve, while Hallman, Richard D. Porter, and DavidH. Small, 1991. the velocitygap has more of a pure monetarist orienta- "Price LevelTied to the M2 Stock of Moneyin the tion. Long Run" Forthcoming American Economic Re- To implement P* empirically, we need to select a view, September. monetary aggregate with a long-run velocity levelthat MonetaryTargeting: Lessons from the U.S.Experience 79

Figure 5.14 Inflation Indicator Based on P(*) Logarithmic scale

Current price level (P)

te0' , ~~~~~100

equilibrium price level (P*) > Lt 50

1960 1970 1980 1990

Percent

8 Inflation 6

I ~~~~~~~~~~~~2

I I -~~~~~~~~~~~~~~~~0 1960 1970 1980 1990 Inflation (bottom panel) is the percentage change in the implicit GNP deflator from four quarters earlier. For 1990. Q2 to 1919:Q4 P(*) is based on M2 growth of 5 percent over 1990 and 1991, and P is simulated using the price gap model developed by Hallman, Porter and SmalL 80 David Lindsey

Discussion

Question:There is often a questionabout the levelsof wedge between a market rate, like a three-month bill optimal reserve requirements. I think that severalyears rate, and the offeringrate on the monetarydeposit liabil- ago, some people argued for uniform reserve require- ity of the institution. This means that, as market rates ments when M2was itself a target for monetary policy.I rise, the wedgemay stay constant as a percentage,but it believeit was argued that shifts of the portfoliowould be opens up a widergap in terms of basis points. Since this neutralized or offsetthrough the system of uniform re- tends to reduce the demand for the aggregate, it gives serverequirements. If these assertions are true, why ar- the central bank the ability to control the growth of the en't reserve requirements in the United States uniform? aggregateon the demandside via an interest rate handle. As a hypothesis,suppose required reserves are com- Mr. Lindsey: Prior to the Monetary Control Act of pletely eliminated,so that institutions can pay virtually 1980, the Federal Reserve argued fairly strongly that the same amount on their MMDA(money market depos- uniform reserve requirements on transactions balances it accounts, which pay market-determined interest wouldbe helpfulin tightening the link between total re- rates) that they return on their assets-their holdings of servesand MI. In part because ofthese conceptualargu- treasury bills, for example. I would argue that in this ments for uniform reserve requirements behind case the rate of return on moneywill movevery close to transactions depositsand MI, the MonetaryControl Act, the rate of return on market instruments. There will be as passed, embodiedan almost ideal structure for con- a kind of Keynesianliquidity trap that would fill the en- trolling Ml through reserves. tire money demand spaceon a chart of interest rates and There are some ironies here. In the late 1970s,Paul money demand. Then it would not matter where the Meekand I debated whether, to control Ml, one would central bank set the short-term interest rate, in the ab- find not only uniform reserve requirements helpful but stract at least, becauseoffering rates wouldfollow. Banks also contemporaneousreserve accounting. So shortly af- could make up for their cost by charging explicit fees; ter the passageof the MonetaryControl Act,the Federal they could carry the same rates on MMDAas they return ReserveBoard staff went to work and pushed through on their assets. It seems to me that the depositorswould the FederalReserve System a procedure for contempora- be more or less indifferent between the MMDAand a neous, rather than lag, reserve accounting. Asa result, treasury bill.The demandfor money wouldbecome very in the UnitedStates we reallyhave a very good systemfor unstableand the utility of money as an intermediate tar- controlling Ml through a reservesoperating target. The get would,I believe,be even more questionablethan it is irony of the situation, of course, is that in 1982we aban- already. doned Ml as an intermediate target and in 1987 even Apartfrom this argument, which I admit has a hypo- stoppedgiving ranges for MI. But we also abandonedus- thetical tone, the case for reserverequirements is not ex- ing reservesas the operating instrument. We fell back ceptionallystrong if there is a tendencyfor sluggishness first to discount windowborrowing as the operating in- in the adjustment of offeringrates. We have seen this in strument and now, in effect,use the federalfunds rate. the United States,in contrast to my hypotheticalcase. If So I would say to Paul Meek,looking back over these I were making decisions for a developing country, I years, that I may have won the battle but lost the war. In would think twice before imposing reserve require- reality,when an aggregate reservesmeasure is not being ments.The case for them is not all that strong. I knowof used as the central bank's operating instrument, I think no central bank in the world that uses their total re- there is onlya very weakintellectual case for having any serves or even their nonborrowedreserves or monetary reserve requirements.As Charles Goodhartcan tell you base as operating targets to control the monetary aggre- from experienceat the Bank of England, if an interest gate. The possibleexceptions are Switzerlandand Ger- rate is being used as the operating instrument, interest many,but neither do it all that rigorously. rates can be controlled just fine without required reserves. Question: It seems that because uniform reserve re- The only theoretical concessionI would make (and I quirements have often been promoted by both the IMF knowsome disagreeeven with it) is that reserverequire- and the World Bank. I was never convinced that we ments do prevent depositoryinstitutions from payingan should have uniform reserve requirements in the first offeringrate that is fully comparableto the rate of return placeand, in the second place, that they should be set so on their assets less some service charge fee. It drives a high. Monetary Targeting: Lessons from the U.S. Experience 81

Mr.Lindsey: Well, uniform reserve requirements are As a conceptual matter, I would argue that if this is helpfulif you are trying to set a path in advancefor total what worries you about reserve requirements,then just reserves.It meansthat any switchesof depositsfrom one pay interest on them. Ifyou reallywant to control money institution to another will not affectthe "moneymulti- via total reserves(which no one wants to do), then keep plier," that is, they will not affect the relationship be- the reserve requirements but pay interest on them. You tween total reserves and money. Therefore, if you are still run into the problem in my hypotheticalcase that controlling the money supply by controlling total re- the own rate comes close to the market rate. The de- serves, uniform reserve requirements are helpful. But mand for the aggregate may become highly unstable. that is a big "if."Few central banks are eager to walk up But at least you don't have the problem of the reserves to the precipice of what they saw the U.S. Federal Re- "tax."If you think there will be this problem with insta- serve do between 1979 and 1982: letting market rates bility of demand anyway,there is no point in trying to move over a very wide range just to keep money under control the monetary aggregate closely.You might just short-term or intermediate-term control. Also,a 15 per- as well take off the reserve requirements. cent reserverequirement is a pretty big tax that, I would argue, tends to be passed back to the depositor.If there Question: But in the 1950s or 1960s,deposits with are other nondepositoryintermediaries, such as money thrifts were not included in M2,were they? market funds, that can start offeringtransactions-type or savings-typedeposits and do not have this reserve re- Mr. Lindsey:They were not then. Indeed, they were quirements "tax" imposedon them, they certainly have not until 1980. At the same time that we put NOWac- quite an advantage.It's not a levelplaying field if depos- counts in Ml, we redefinedour conceptof M2to encom- itories are stuck with reserve requirements but other pass deposits at thrifts. This measure of M2 is the one players who can enter the field, such as money market used in Figure 5-13. However,Figure 5-1 does not use mutual funds, do not have those requirements. this definitionof M2 but the one in force at the time.

Mr.Honohan: Reserve requirements of 15 percent are Question:Isn't there substantialevidence that in the even more penal when the country has double-digitin- 1970speople were using depositsat thrift institutions at flation or even 80-90 percent annual inflation,as occurs that time as a substitute for bank accounts and that in some of the countries affectedby these requirements. these depositswere not then included in M2? The penaltybecomes really severe. Mr.Lindsey: When we worked on that redefinitionof Mr.Lindsey: Yes, in terms of percentagepoints, that is M2,we did look at that evidence.Some of my own re- right. search suggestedit wouldbe a mistaketo drawthe divid- ing line of M2before you got to the small time deposits, Mr. Caprio:We will see this issue again on Friday in then have another money aggregatethat included small the case of Italy. It is discussedin the paper,which is in time deposits. As interest rates vary up and down, we the conference readings, by Padoa-Schioppa.It details have seen a significanttendency for shifts betweensmall very clearlythe problemsthe Italians had with dramati- time deposits on one hand and savings accounts, NOW callydifferent reserverequirement levelsand the result- accounts, and money market funds on the other. When ing controllabilityproblems like those to which David M2is definedbroadly enough to encompassall those de- [Lindsey]has alluded. posits, the shifts are internalized in that aggregate. We actually had considered the other definition be- Mr. Lindsey:Charles Goodhart has made the point fore, but it was pretty clear there was not much differ- that this competitivedisadvantage of depositoryinstitu- ence, in the United States at least, between the ways tions can occur in such a way that your measure of the savers use their savingsaccounts at thrifts and those at Ml money aggregate is compromisedby shifts of trans- banks. Thrifts were just beginning to offer NOWac- actions services out of the depositorysystem and into counts in New Englandat that time, so the decisionwas componentsthat are not included in your transactions- made to look at all depository institutions. Although deposits.In a limited way,we saw it in the United States there was a little nostalgia within the Reserve Bank of with NOW(negotiable order of withdrawal)accounts. At San Francisco for the old definitionof M2for a coupleof first these were not included in Ml, but our fleet-footed years, that was the end of it. No one has really second- central bank soon altered the definition of Ml to include guessed that decision. them. So that's a potential issue that needs to be consid- In evaluatingthe P* model and the constancy of the ered as well. M2velocity in Figure 5-13, one reaction might be, "Is it 82 David Lindsey not remarkablethat the velocityof M2 is so stable over necessaryto bring the quantityof Ml demandedback to- time?" On the other hand, when we defined the aggre- ward its intermediate target." gate in 1980,we certainly were awareof its movements I think that washelpful for the country.It wasa break; with respectto nominal incomeand interest rates at the it providedan anchor for a time. There are manyways in time. I think that, in a sense, we stacked the cards in fa- which it was not a perfect anchor. We certainly did not vor of a sensibleaggregate when we defined M2that way come that close,month to month, to hitting the targets. in 1980. It has held up reasonablywell since. But when all is said and done, I think it served pretty I think one can exaggeratethe reliability one should well, if only as a kind of excusefor doingwhat we needed grant the P* modelas a mechanismthat explainsU.S. in- to do to get a handle on inflation. flation,given the fact that M2was very carefullydefined, WouldI movetoward M2today? That is not an entire- early in the decadeof the 1980s,to be as sensiblean ag- ly hypotheticalquestion. It is true that things have gone gregateas we couldcome up with. The P* modelcertain- fairlywell in the 1980s.We have not come close to price ly would not work as well for other aggregates;we knew stability-although the projection from the P* model that, when we defined it that way.Still, I would argue the with money growth in the 5 percent range over the next evidencedoes suggest it made sense to put thrifts and two years (see Figure 5-14)would tend to bring the rate banks together as depositoryinstitutions. of inflation down gradually.But that is not a foregone conclusion, nor is it a foregoneconclusion that M2will Mr.Honohan: You say the Federal Reservehas, since grow at only a 5 percent annual rate. We'vedone fairly 1982,moved reallytowards an eclecticapproach to mon- well;we haven't brought inflationdown, but we'veman- etary management. Now it may be that this has worked aged to stabilize the economy reasonablywell through well enough because conditions-at least at the infla- the 1980s.Is there a guarantee that we'll continue to do tion-output side-have been fairly steadyin the United that? I don't think there is. States since 1988. In short, it may not be that hard to One can envisageall kinds of exogenousshocks, fail- fine-tune things that are pretty much goingall right. ures ofwill, unexpectedpressures on aggregate demand, However,in many of the countries with which we or what have you, which could moveus back into esca- deal,things are alreadyvery far wrongor are likelyto be- lating inflation.I am not predictingthat, but it is possi- come veryfar wrong quickly.Would you agree that some ble. And it is possiblethat in retrospect the FOMCwill anchor might be needed if a lot of things are going look back on its behavior over the 1980sand conclude wrong? And if things started going badlywrong, would that, once again as in the 1970s,it moved too little too you jump for M2or for some other kind of main anchor late. "If only we had focusedon M2 during that period in a storm where so many anchors have failedto hold? more than we did, we might have prevented that from happening." Mr. Lindsey:The Federal Reservejumped to Ml in If we ever get to that situation, I think there would be late 1979,and I think that servedus well.It providedpro- a case for going explicitlyto an anchor to try to get a tection from political pressures that otherwise would handle on the inflation process and bring things back. have kept interest rates from rising to the levelnecessary Perhaps this should be the final point of my talk: There simplyto bring downaggregate demand and, in time, in- is a case for keepingyour eyeon long-termM2 growth- flation.At that time, the FederalReserve could essential- and for that matter on longer-termnominal GNP growth ly say,as it could not today,"Given the seriousnesswith and other nominalvariables-just to make sure you are which we are pursuing the Ml target, we are not control- not drifting up and awayfrom the objectiveof price sta- ling short-term interest rates. They are free to move as bility rather than toward it. 6

Monetary Targets:European Experience

CharlesGoodhart

I want to start with a digressionprompted by David Lind- interest rate changesaffect the demand functions.We all sey's excellent paper. In particular he addressed the know that such lags exist. In Equation 1, I've simply question ofwhat happenedin the United States in 1979- written an equation down with the demand for money 1982. That will be a period in monetary history which (M)as a function of nominalincomes f(Y,i),with interest economichistorians will rake over again and again, rath- rates laggeda number of periods. er like 1929-1933in United States monetary history and M d = f (y_ it, t it 3) (1) various occasions in Britain, such as the suspension of tu=o( that the moneysuppl (1) convertibilityin the Napoleonicwars. I thought that suppose that the money supplyrises but becauseyou David'spresentation of that period, though admirable as policy-makerhave not yet observedthe rise, you are was still what one might describe as the Federal Re- holding interest rates at their initial level.After a month serve'snormal position.This positionholds that both in- or so, you observethat the money supplyis rising rather terest rates and the relativelyshort term movementsof faster.In the first month, you reallydon't know whether the monetary aggregates, notably Ml, were extraordi- the trend is real, so you wait another month. Themoney narily variable over that period because the demand supply goes up again. After two or three months, you functionsfor the relevant monetaryaggregates were also start to raise interest rates. extraordinarilyvariable. Just for the record, I think that If there is a lag in the effectof interest rates on money it needsto be said that at least two other sets of explana- demand, the first month that you push up interest rates tions exist for that period. very little will happen. So the followingmonth, money One of these, which I will call the second set of expla- supply growth looks even worse; you push up interest nations, is the one favoredby the monetaristshere in the rates again. If the lag requires six months beforeinterest United States. They describe it as simply a control fail- rate increasesaffect the demand for money,you contin- ure. The Federal Reservewas using the wrong tech- ue pushing interest rates up in each of those months un- niques and the wrong instruments for monetarycontrol. til rates are very high. Given that the interest rate effect It had a laggedaccounting basis, it did not impose pen- on demand is significant but lagged,once it starts to alties for borrowing at the discount window,and so on work it works more and more. It also introduces indirect Allan Meltzer,Robert Rasche, and others are identified effectson income (Y),which starts going down.So a lot with this view. of things start going in reverse.It is not difficultto show Then there is the third sort of explanation,which that if you have lags in the demand-for-moneyfunctions, Charles Freedman from Canada and I have presented. particularlywith respect to interest rates, the more you Under this view,what happened in 1979 and 1982 was try to maintain stable control of M on a monthly basis, predier.thisview, predicthaed it; wo1979 pretd exacy the more you run into what is known technicallyas in- predictable. We predicted it; we would predict exactly strument instability.You end up in a total quagmire.In similar eventsfor any similar country that tried to intro- ment ista hat happend in 1979 q982. An duce tight, relativelyduc tiht,reltivlyshort-term, hor-tem, controlontol oververa a mone-mne^ wouldmy view, happen that againis what in anyhappened other country in 1979-1982. attemptingAnd toit tary aggregate in a situation where ultimatelythe effects do hame thin in try ot on attemting to on the monetaryon thaggregatesggregtes moneary were, ere, andnd hadhd to come,ome, sis;do the it cannot same thing. be done. Don't try to do it on a continuousba- through interest rate changes. The problemsimply arises as a result of lags in the demand-for-moneyfunctions, particularly the lags before

83 84 Charles Goodhart

On MonetaryTargets themselvesfrom the world financialsystem by using exchange controls. That was the digression;now to my theme proper. I First then, why did central bankers start with mone- am goingto ask you to rememberwhy we are concerned tary targetry? One considerationwith respect to central with monetarytargets at all. I shall argue that among the bankers which you must never forget,and more so now requisitesfor monetary targets are relativelystable rela- than ever,is that central bankershave a club. I know be- tions between the monetary aggregate and nominal in- cause I used to belong to it. They all talk to each other. comes in the short run and between the monetary That means that they tend to behave rather like the aggregateand prices in the longer run. I shall then indi- sheep on my farm; they all tend to move together. There cate that, in the European context,these relations have are fashions, and undoubtedly there was a tremendous not been sufficientlystable over recent years. For the fashionfor monetarytargets in the mid to late 1970sand majority of countries involved,this has not mattered at the early 1980s.That fashion has now changed; mone- all for a number of years. The exceptionsare the Federal tary targets are out of fashion. Even though, as David Republic of Germany and the United Kingdom,whose Lindseywas saying, the United Stateshas a perfectlyrea- philosophy and experience I shall discuss. In practice, sonablemonetary target in M2,why isn't the Federal Re- the others havenot been on a monetary aggregatetarget serve using it? In part, it is because this is an ideawhich at all. Instead, their nominal anchor has been the ex- is unfashionable.In economicsyou can see ideas going change rate mechanism:their membershipin the EMS around and around. There is a splendid quote, which I (EuropeanMonetary System). got from Dennis Robertson,that intellectualsare rather What I most want to bring to your attention this af- like hares;as with any other formof hare coursing, if you ternoon are the changingviews about the waythis exter- stand in one place they alwayscome back to you in due nal nominal anchor, the exchangerate mechanism, has time. So if you like monetary targets, don't worry,in due been changing. This analysis is known as "the new time they will come back. EMS."Then I shall turn to the issue ofwhat happensfor Whydid we actually have monetary targets?The first those countries without this external nominal anchor, point to note is that no one reallyis interested in M2 or either becausethey are the hegemoniccenter ofthe EMS M3or Mx,as such. When NigelLawson established mon- (Germany)or are outside the EMS (the United King- etary targets, it wassaid that in the working men's clubs dom). Since they lack this external anchor,what should in Newcastle,the talk was of nothing but Sterling M3. they do if they no longer can, or no longer choose to, But the ultimate reason for concern with monetary tar- adopt a monetary target, whether because of the insta- getry is that it is supposedto have a stable link with eco- bility ofvelocity or another of the reasons why monetary nomic events and developmentsthat affect economic targets are no longer maintained virtuallyanywhere? welfare,which does concern us. The supposed link is to I shall also talk about a constitutional idea whose either price levelor real incomes,via that dear old stan- time has come. This idea is to give the central bank dard, the quantity identity (Equation2). much more independence.In effect,the legislatingau- MV= PY (2) thorities say, "Wedon't know exactlyhow one controls inflation.But if we give the central bank the mandate to => PY (3) do so, particularlyif we give them an incentivestructure If money velocityis predictable-which is even more in terms of salaries and reappointments so they will try important than its being stable-then a given M will to do so, we believe they will use their interest rate in- equate, in the short run, to a given nominal income. In struments to achieveit. Although nobodyknows exactly the medium to longer term, where one hopes to be able what is necessary, we believe it can be done." This, I to assume that real incomeswill revert to some equilib- think, is the current state of thinking about central bank rium, the relation between money and price level im- independencein quite a number of countries. plies that monetary growth and the rate of inflation are If I have time, which I probablyshall not, I shall also closely related. This relation is considerablystronger talk about the effectivenessand range of various central than relation (3) that the central bankers had relied on bank policy instruments in conditions where exchange in earlierperiods, which wasjust to vary interest rates in controls have been removed.This is enormouslyimpor- a way thought appropriate to bring P and Y back into tant. The one term that I did not hear in all the previous line. discussionof required reserveratios was "exchangecon- The problem with reliance on the interest rate rela- trols." Youcannot impose discretionaryburdens, which tion is that the effecton expenditures,and therefore on required reserve ratios effectivelyare, on independent the ultimate generalprice of output, is in fact influenced countries unless those independent countries isolate by real interest rates rather than nominalrates. Whereas Monetary Targets: European Experience 85 nominal interest rates can be measuredexactly, expectation. There can be quite a period of time betweenthe ef- tions of price inflation are highly variable. Therefore, fect on M and the consequencesfor PY. If you see M one does not know real interest rates with any clarity, moving first, you may see PYmoving later. This leading and nominalinterest rates are a misleadingindicator. On indicatorargument, then, is an important one. Whylook the other hand, as long as velocity remains relatively at the noisy indicatorof what reallyconcerns you, which predictable,control of Mgives you a good idea ofwhat to is inflation,rather than directlytargeting what concerns expect of P and Y. you? Well,if M is a leading indicator,and if it is causal- David Lindsey commented that if velocity, even if the reason for the increase in P and Y is essentially though predictable,is veryvariable because the interest monetary-that is an argument for targeting M. elasticityof the money aggregate is high, then you can't These arguments did exist in my own country and run a monetary target; you will not be able to explainto many European countries. The receivedposition held people at large the re-entry problem, which he de- that V (velocity)was stable and predictable,that Mwas a scribed,and problemsof that kind. I am not entirely per- leading indicator, and that targeting M would lead to suaded by his reasoning.Certainly, such variabilitydoes more automatic, rule-driven,changes in interest rates, make monetary targetry more difficult.It would be nice rather than discretionary changes. When we compare to have velocitybe both predictableand stable, but pre- these expectationswith what actually happened, I think dictable alone would probablyget you most of the way. the main problem has been a decline in the stability of Another advantage of using monetary aggregates the velocityfunction. Tosee why, let's considerthe indi- rather than interest rates is that a monetary target al- vidual aggregates,starting with the United Kingdom. lows for almost rule-basedadjustment. Interest rate ad- The first aggregate is Ml: narrowmoney. A combina- justment, which is clearly discretionary,is subject to tion of high inflationand deregulation,together with in- politicalcontrol and politicalinfluence. There is also the creased competition, led banks to provide interest considerableconcern that the authorities would always bearing checkable-typedeposit accounts. These are ei- be tuning too late and vary interest rates too little if they ther going to be in Ml or close to Ml. Whenthis occurs, were allowedto use their discretion.Targeting monetary the Ml aggregatejust goescrazy. That has certainly hap- aggregatesis supposed to reduce the risk of that. pened in the UnitedKingdom. In the last couple ofyears, Yet another factor is the use of monetary aggregates the clearing banks have introduced all kinds of check- as a leadingindicator. As I said before,our interest is not able sight deposits,interest bearing demand deposits.As in Sterling M3or M2for its own sake; we are concerned a result, the non-interest-bearingcomponent of Ml has with P and Y.If we could actuallyobserve P and Y,imme- collapsed,while the interest bearing component (and to- diately and accurately,why worry about M?M is simply tal Ml) have risen out of sight. The structural changes an indicatorwith noise-it certainlyhas a lot of noise. If have been so dramaticthat Ml has becometotally mean- a rule can be introducedthat is tied to M,why not intro- ingless. duce a rule that is tied directly to P? Take,for example, What has happenedto broad money, which was the the discussionsearlier about nominal anchors. Accord- government's preferred target initially?That is rather ing to this view of M as just a noisy indicator,what some more difficult. Remember that Sterling M3 regularly of these countries should do is to collect data for an eco- grew more slowlythan nominal incomes.That is, its ve- nomic series on wages.Once you have that, require the locity was rising throughout the 1960s and up to the central bank to raise interest rates by 1.5 times the in- time that a medium-term financialstrategy with a mon- crease in wage earnings in the previous 6 months, or etary target wasadopted in 1979.Ever since that strategy something like that. was adopted, velocity has turned around. Sterling M3 Whatyou reallywant is to ensure that, everytime you has growna great deal faster than nominalincomes, and start getting an inflation, interest rates go up fast velocityhas fallenvery sharply. enough and far enough. Nowif you can observeP and Y What brought about this dramatic and tremendous accurately,why bother with M? This would be a form of shift in velocity,which, I might add, none ofus predicted "Tobin"approach on nominal incomes. in advance?Well, we are not absolutelycertain, but there There are severalcounter-arguments to this noisy-in- are probablytwo or three causal factors. First, at the dicator case against monetary targets. First, it may be same time that the Conservativegovernment went for that M, though noisy, is a leading indicator.The causal monetarytargetry, it introduceda considerabledegree of chain linking money with nominal incomes and prices deregulation, particularlyderegulation of the banks.All may be indirect.As has happenedin manycountries, you direct constraints on bank lendingwere removed,in part can first get credit expansion,monetary expansion, asset because exchangecontrols were removedin 1979.Once price inflation, and then on to commodityprice infla- you get rid of exchangecontrols, if you have direct con- 86 Charles Goodhart trols on your own banks a large part of your banking in- strained. The one monetary aggregatethat does not pay termediation simply moves offshore.We could see that interest is MO,which is cash in the hands of the public, happen. (although it could in principle pay interest). MOwas the One can never tell what the actual effectis of direct monetary aggregateto which the British authorities re- controls and banking system regulation. But one factor treated when all the other monetary aggregates lost that was important wasthe effecton bank strategy.After their stabilityand went haywire.Barry Johnston, who is deregulation, the banks changed the kind of lending not here at the moment, wrote a paper for the U.K.Trea- they did. Prior to 1979, banks did very little mortgage sury showing that the demand for MO was reasonably lending in the United Kingdom;it was all left to the spe- stable and has remained so. This provides a fig leaf for cialized building societies, which are our more stable, the Chancellorof the Exchequer;he can say that mone- profitable, and better-run equivalent of the American tary targets have not been completelyabandoned; when Savings and Loans (S&Ls). (We do not have an S&L they have been. problem for all kinds ofreasons; deposit insurance isjust Whyin practice doesMO not matter? It doesn't matter one of them.) In any case,the banks went into mortgage in practice because nobody believesthat it is a leading lending, and the increase in the rate of lending after de- indicatoror causal factor.Everybody knows that anyone regulationaltered dramaticallyas the banks shiftedtheir can get currency on demand. It would be inconceivable strategicpolicy. So their lendingwent up; the rate of infor the Bank of England not to allow anyone to obtain crease in bank lending, after deregulation removedthe cash when they try to cash a check.The convertibility re- supplementaryspecial deposit system in 1979, has aver- quirement on the banks must remain. This meansthat a aged well over 20 percent per annum in the 1980s. change in MOneither causes nor predicts a change in This was financed in large part by issuing more at- nominal incomes or consumers' expenditure.It is sim- tractive interest bearing depositsof variouskinds. David plya coincidentindicator. It is not a bad one, although it Lindsey'snightmare occurred;most of the money supply is a bit noisy; it is a coincident indicator of consumers' was effectivelyoffered at market-related interest rates. expenditure. Furthermore, the increasedcompetition meant that the However,we alreadyknow consumer's expenditures; margin, or the spread betweenlending rates and deposit we get data promptly.MO does not tell us anythingwe do rates, went down.If you ask, "Whatis the cost of inter- not knowalready. Accordingly, insofar as the Chancellor mediation?" the answer ought to be, "the spread." If of the Exchequer, the Treasury, and, to a degree, the there is zero cost of intermediation and intermediation Bank of England are concerned about consumers' ex- providesany servicefor you, the amount of intermedia- penditure, they will raise interest rates anyhow.But they tion that you ought to undertake ought to be infinite. If do not reallylook at MO;nobody looks at MO.It is a pure you get some particular liquidityfrom holdingdeposits, fig leaf. while the cost of borrowingis the same as the cost of de- Let us move on to Germany,where the concernsand posits, you borrow an infinite amount and you have an problems are different. Germany has not had so much infinite amount on deposit.There is no charge and you high inflation, has not had so much structural change. are totally liquid. It's a wonderfullife. Therefore,for a long time, there was far less disturbance The lowerthe spread,the more intermediationpeople to the demand-for-moneyfunctions and the velocity of willdo. In the United Kingdom,the total volume of bor- money than in the UnitedKingdom. The Germansmain- rowing by persons and companieshas shot up, and the tained, and attached a great deal of importanceto, their total amount of depositsthey hold has shot up. The de- Central BankMoney (CBM) target. CBMwas simply the gree of intermediationis inverselyrelated to the spread. total liabilities of the central bank. But they never con- This is in large part where reserve requirements come sideredit as a simple monetarybase aggregate;they con- in. The reserve ratio requirements increase the cost of sidered it as a weightedbroad monetary aggregate. intermediation.They are important in this respect. I am Neverthelessthe weight in currency was far higher that not sayingthat it is particularlydesirable, simply in pur- the weight of the other constituent elements, which suit of some monetary aggregate that may or may not were weightedby the reserve ratio applicableat a partic- have a stable relationshipwith nominal incomes,to less- ular point in history. en the efficiencyof the banking system in a developed In recent years,the amount of deutsche mark curren- country, which needs proper financial intermediation. cy, particularly that held in Eastern Europe for savings But that is another story. and other purposes,started to increase.For this and oth- In large part then, the stability of a monetary aggre- er reasons, about two or three yearsago the relationship gate is likelyto be a function of the degree to which its between currency, CBM,and what was happening to own interest rate is artificially or institutionally con- German nominal incomes just went haywire.One of a Monetary Targets: European Experience 87 number ofproblems with currencyis that it is frequently The European MonetarySystem held abroad in large quantities; this is true of the U.S. dollar and the deutsche mark. In addition, a large pro- The first stage of the EMSwas between 1979 and the portion of what is held is either held for nefarious pur- time in 1983 when Mitterrand switchedhorses and re- poses or whenever a survey is done, nobody knowswhy versed the whole thrust of French policy.In these first it's held, or both. So the Germans moved from a CBM fewyears of the EMS,there were frequent realignments target to a broad monetaryaggregate. through which the nominal exchange rates were re- That broad monetary aggregate is about to be deval- alignedto accommodatethe wageand price adjustments ued even further because the German monetary union, that had occurred since the last realignment, thereby or GMUas it is now known,means that "Ostmark"(mark maintaining the stabilityof real exchangerates. In other of the German DemocraticRepublic) will be exchanged words, during its early years the EMSdid not reallyhave for deutsche mark in some ratio. Nobodyhas the slight- any long-term discipline. It was merely a short-term est idea of what the East Germans are going to do with pegging of nominal rates until they were realigned in their new deutsche mark holdings. The complexityof light of differinginflation rates. monetary changes will be of the same order as those The French change of strategy, which occurred in which I have been talking about in the United Kingdom. March 1983, was the crucial occasion in the history of The Deutsche Bundesbankwill not know how to apply the EMS.This began the periodof what is known as Ger- their monetary target to make sense of what is happen- man hegemony. During this period, the Deutsche ing there over the next couple of years. So they will go Bundesbankset monetary policy,implemented through back to adjusting policyin responseto concern with the monetary targetry, to try to achieve domestic price sta- non-monetaryaggregates: inflation and a whole series of bility in Germany,without significantor seriousconcern other factors. for what was happening in the other EMS countries. Finally let us turn to Italy and Spain, where the re- movaofexcang cotros in199 wil cusesuc Havingchanged their strategy, the other countries were primarily concerned with holding the nominal peg to structural change that again the demand-for-money Germanyand trying to achieveconvergence. Initially the functions will go out the window.The marginal-indeed private sector, having observedthe earlier realignments the average-reserve ratios in Italyare on the order of 25 to maintain the peg, did not believetheir monetary au- percent. Although some interest is paid on reserves, thorities. Because the private sector did not believe there is something like a 10 percent differencebetween them, the nominalinterest rates in the peripheral coun- the interest paid on reserverequirements and the inter- tries had to rise to somethin like the inflationdifferen- est availablein money markets. Now 10 percent on 25 tgies a rise to balkethe feariof an percent is in effecta 2.5 percent burden in addition to tial plus a risk premium to balance the fear of an the spread. I can tell you that bankers in London are adjustment. lookingforward with enormous enthusiasm to interme- Since 1987, the situation has changed again. Private diating in lire at the moment that exchangecontrols are agents in the various countries have increasinglycome lifted. to believe that the peripheral governments can achieve The Spanish have already started to dismantle their and maintain fixednominal parity.An influentialrecent reserve ratios. This has nothing to do with monetary paper by Giavazziand Spaventa(1990) analyzes the cur- union; it has everythingto do with the removal of ex- rent situation through the followingset of equations: change controls in the run-up to the single Europeanfi- y = - Pr + lAs - 6u (4) nancial system. Onceexchange controls go, bank clients (p - pt) a(pt - pt-i) + fy (5) will move to the cheapest possibleintermediary center. If there are significant differencesin the burdens on s = e + p* -p (6) banking systems,they will movevery rapidly. rh =i -E(pt+l -Pt) (7) In any case, Italy and Spain and all the peripheral countries in the ERM(European exchangerate mecha- XbE(pt+i-Pt) }(8) nism) have reallynot been concernedwith monetarytar- ri = mi p getry over the past years. They have had an external + E(et+i- et)- E(pt+1 - Pt anchor in the form of maintenanceof the exchangerate Equation 4 expressesthe real output y in a particular mechanism. The EMS,or ERM,has moved through at country as a function of the real interest rate r, the real least three stages since it was introduced.Never think of exchangerate s, and fiscalpolicy u. Equation 5 is a par- the EMSor the ERMas somethingthat is static; it is very tially backwards-lookingdetermination of inflation, dynamic and changeable. while equation 6 definesthe real exchangerates, where 88 Charles Goodhart

the nominal exchangerate, e, is defined as the domestic mously. If they cannot sterilize the inflows, their currency price of foreignexchange. domestic nominal interest rate goes down, which rein- The last two equations are the truly important part forces the expansion. for the authors' analysisof peripheral economies.In par- In this situation, a peripheral economy's exchange ticular, the peripheral economiesunder discussion are rate goes to the top of the EMS band. At the moment, the Europeansouthern cone economies,including Italy, whose exchange rates are at the top of the band and Greece, Portugal, and Spain. One may also include Ire- whoseare at the bottom?Those at the top of the band are land and England as honorary membersof Southern Eu- Spain, Portugal,and Italy.At the bottom are the Nether- rope. The authors dividea peripheral economyinto two lands and Germany.Because these peripheral countries groups. Those in the householdgroup can borrow only are booming, there is no monetary discipline.A great within the domestic economy.For them, the real inter- deal of pressure builds on the wage front. For example, est rate, as expressedin Equation 7, is the local interest wage increasesare now a source of concern in Spain. rate i, less the expected rate of inflation. The second TheEMS discipline is beginning to disintegrateunder group comprises firms, which can borrow either at these particular influences. If the discipline disinte- home or abroad. If they borrow at home, they face the grates, the real exchange rate of course starts to go real interest rate, which again is the local domestic in- wrongand increasinglywrong. But if the relativesize of terest rate less the expectedrate of inflation.If they bor- the real interest rate effectis greater than the relative row abroad,they borrow at the foreignrate i*, which for size of the real exchange rate effect, the whole system this analysis, is the German rate, less two expectation can becomeunstable. This may leadto very severeprob- factors (Equation8). The first is the expectedexchange lems and turbulence. These effects can be offset and rate depreciationover the next periodof borrowing.The dealtwith, but they should be offsetand dealt with by fis- second is the expectedlocal inflationrate. cal policy.In other words, if a peripheral country in the The authors' point is that after 1987, the expectation EMS (or one entering the EMS as a more inflationary has been that, for the foreseeablefuture, the govern- member) finds that the credibilityaccorded to its ex- ments of countries such as Italy, Spain, Portugal, and changerate will leadto capital inflowsand monetaryeas- Ireland will not devaluebut will maintain the peg. Be- ing, that country must introduce a much more cause of their relative success in doingso, they need not deflationaryfiscal policy, or things will go badlywrong. devalueeven if their inflation is higher than Germany's. In a sense, the messagethat I want to leavewith you Thus the expected rate of depreciation is much lower is that, as the EuropeanCommunity approaches irrevo- than the expectedrate of inflation.Firms in Spain, Italy, cably fixedexchange parities, there will increasinglybe Portugal, and so on, finding a German interest rate a just one Europeanmonetary policy.This appliesboth to great deal lowerthan the domesticrate and havinga low the current EMSand the even more ambitious develop- expectationof a change in the exchange rate, have bor- ment towards European MonetaryUnion, expressedin rowedabroad heavily,because their effectivereal inter- the Delors Committeereport. At the limit, with a single est rate is thereby substantially reduced. In addition, currency,there would be no national monetary policies foreign investors, for examplefrom Germany,will put at all. The interrelation betweenfiscal policiesand mon- money into these countries because doing so offers a etary policiesis of the essence.When national monetary considerable economic advantage,as long as one does policy becomes predicated upon the maintenance of a not expectthe exchangerate of deutschemark for the lo- fixed exchange rate, operating fiscal policywithin that cal currency to be reduced.Accordingly, the real interest conjoined system, in an EMSor European system, will rate in Spain, Italy,and Ireland-and in the UnitedKing- become increasingly important. Unfortunately,one of dom, if it were to enter the EMS-goes down with a the great difficultieswith economicanalysis of EMUhas bang.' been that much of it has assumed freelyflexible and per- The immediateeffect on these peripheral countries of fectly adjusting markets. There has not been nearly maintaining their EMSposition (or of entering the EMS enough analysisof how fiscalpolicy should be coordinat- system) now becomes much more stimulatory than in ed with monetary policyin all this. the period of periodicdevaluations. It producesa highly effective expansionary monetary policy because local Central Bank Independence firms are borrowingabroad and not expectinga devaluation. The countries experience huge capital inflows. Wehave not yet addressedthe questionsof what mon- This creates a tremendous problem for the Italians, the etary policyought to be in the hegemonic center or of Spanish,the Portuguese, and others in sterilizingthe in- what monetarypolicy should be in the United Kingdom flows.Their foreign exchangereserves have risen enor- if it stays outside the EMS.We are in a world in which, Monetary Targets: European Experience 89 as I have said, monetary targetry is out of fashion. The coordination argument is an important one, and must instabilityof the velocityfunction has made it effectively be addressed. unusable. If you are either the "center" country or too The last topic I was goingto talk about was monetary big to link to somebodyelse's currency, or for some oth- policyinstruments. Can we introduce direct credit con- er reason you want to maintain national autonomy,what trols in a worldwithout exchangecontrols? The answer do you do? This brings us to the idea of central bank in- is probably"No." Do we want to maintain exchangecon- dependence,towards which I think a lot of countries are trols in our various countries? Not in the medium term moving.This idea has become increasinglyfashionable. if you can get away from it. Concerning interest rates, What does central bank independencemean? It does there is an interesting paper in the latest Bank of En- not mean giving the central bankers the independence gland QuarterlyBulletin (Bank of England 1990).It in- to print money to pay themselves large salaries. The indicates that, as a concomitant benefit of reducing dependencewill be qualified.As part of the central bank's spreads and having a far greater gross increase in both constitutional mandate, its overridingpriority will be to borrowing and deposits, interest rates in the United maintain price stability. This has occurred in New Kingdomnow impingeon a far widercommunity. Many Zealand and to a degree in Chile and probably other of the English young are so overborrowedwith huge countries. Tosome large extent it is intended for a "Eu- mortgagesthat when interest rates go up, if they are to roFed," a Europeansystem of central banks. Indeed, the pay their mortgage they cannot go on holiday,they can- idea may possiblyexpand to provide an incentive struc- not buy consumer durables, they can barely eat. So you ture for compensatingthe central bank governor and se- can understandwhy politicalpopularity is affectedby in- nior officialslinked to that priority. terest rates. When your personal sector is heavilybor- My suggestion is that the central bank governor rowed, it has an effect. should be paid some lowlyregular salaryirrespective of Finally there is monetary base control. Is monetary outcome, perhaps a salaryequivalent to that of a profes- base control anything other than an alternative way of sor of economics.As the governorgets increasinglyclose bringing about interest rate variability,which you could to the desired rate of price increase over an appropriate bring about directly?Or is there some direct, supplyside period, he or she receivesa bonus. In the United States, effect that it has, in addition to its effect on interest I would recommend this should rise, in total, to some- rates? In the United Kingdomrecently, Gordon Pepper thing on the order of a million dollars; in the United has stirred some interest by arguing that there is a dif- Kingdomto something like halfa millionpounds. So the ference. Mostof the rest of us do not believethat there central bank govemor becomes a very rich person if is, but it is still an issue of some interest. price stabilityis achieved. There are arguments against my suggestion. If the Note onlyincentive for the central bank governor is to achieve price stability and the central bank does not care about 1. Editors' note: Sterling entered the ERMin October anything else, one can alwaysachieve price stabilityby 1990 (five months after the conference),and interest shovinginterest rates up to 30 percent. If I willget a mil- rates did initiallycome under some downwardpressure. lion dollars to achieveprice stabilityin the United States in three yearsand nothing else matters to me, I willpush References interest rates up to 30 percent todayto bring about a major depressionover the next fewyears, then lowerinter- Ciavazzi, Francesco and Luigi Spaventa 1990. "The est rates down gently and run away with my million 'New' EMS," Centre for Economic Policy Research dollars after three years. So there are problems about DiscussionPaper No. 369, London,January. trying to set out the central bank objectivesin a waythat Bankof England 1990. "The Interest RateTransmission does not actually encouragesuch behavior. Mechanism in the United Kingdom."Bank of En- Another major argument against a simple incentive gland QuarterlyBulletin, May. structure concerns coordinationwith fiscal policy.The

Comment: Policy Constraintsin Developing Countries

Donaldi. Mathieson

I wasasked to discuss the relevancefor developingcoun- sectors. Whatever their form, credit ceilings have been tries of the previous speakers' points on the use of mar- perceivedin many developingcountries as a useful in- ket-based monetary instruments. I would like to touch strument for macroeconomiccontrol, regardless of the on four basic issues. First, why have developingcoun- exchangerate structure that is in place. This statement tries traditionally favored credit controls rather than should be qualifiedslightly, since it assumes that the market-basedmonetary instruments?Secondly, why are overallfiscal position of the economyis not wildlyout of these credit controls coming under increasingpressure control. If there is a large fiscal deficit financed by the in developing countries? Third, what are some of the provision of central bank credit to the government, preconditions for a successful transition from credit there is no hope for any control. Moreover,attempting to control to a market-basedmonetary instruments?Final- maintain some sort of overall credit ceiling in such an ly,why is it unlikelythat developingcountries willcom- environment would mean a sharp shift in the distribu- pletely abandon the use of credit controls and directed tion of credit from the private sector to the government, credits. with all the attendant effectson privateactivity. In discussingthese issues,I want to make two caveats Let's assume, therefore, that the authorities do have clear. Developingcountries are a rather heterogeneous some fiscalcontrol. If credit is not availablefrom foreign lot, and I shall be considering only a middle-income, markets (in contrast to the case that Charles Goodhart middle-sizedeconomy. My second caveatconcerns the wasconsidering), it is difficultfor the country'sresidents objectives of monetary policy.I shall assume that the to escape the constraints imposedby credit ceilings, at fundamental objectiveof monetary policyis price stabil- least in the short run, even if there is a fixed exchange ity. I don't care whether "price stability" is defined in rate. Domesticfirms, for example,would find it difficult terms of a price index or a nominal aggregate such as to quickly adjust output in order to increase their ex- nominal GNP.I want to stress this objectivebecause I ports to the rest of the worldand thereby acquireforeign don't think it has been pursued by most developing exchange.As a result, credit controls have often been countries. For most of them, price stability has been viewed as quite effective in restraining aggregate de- only a second or third order objective. mand. Let me turn first to why developing countries use Creditceilings have also been important becausethey credit control systems.Although a number ofdeveloping complement the credit allocation rules and self-con- countries,particularly in Asia,are beginning to moveto- tained tax-subsidyprograms that are oftena part of a sys- ward market-basedmonetary policyinstruments, this is tem of financial repression. The tax-subsidy systems still not a widespreadtrend. I see two reasons why most reflectthe ceilingson lending and depositinterest rates developing countries have relied so heavily on direct and the credit allocation rules that direct credit to fa- credit control programs throughout the past two or voredborrowers or activities.The overallcredit ceilings three decades.One reason stems from the desire to have specifiesthe total levelof credit;whereas the tax-subsidy some control over macroeconomicdevelopments; the scheme allocatesthe credit across users. second reflectsfiscal policyconcern. Why have these monetary systems based on credit Credit ceilingscan be appliedto lending by all finan- ceilings been under pressure? There are two reasons. cial institutions to the private sector or they can be ap- First, as everyonehere is well aware,the effectsof finan- plied to lending to both the private and government cial repression on economic efficiency have become

91 92 Charles Goodhart clear, and this has stimulated efforts to liberalize finan- one reason why many developingcountries have had in- cial systems. In such liberalized systems, the market flationarybiases. rather than the authorities determinesthe leveland dis- A fourth requirement for successfultransitions contribution of credit. This has removed one of the pillars cerns the issue of whether there will be any stable rela- supportingthe use of direct credit controls, which is to tionships maintained among the authorities' policy ensure consistencyof the overall distribution of credit. instruments, any intermediate targets, and the nominal The second reason has been developmentof "pseudo" income or price level targets they have selected. In the capital mobilityin many developingcountries. I do not United Kingdomand the United States, there have been mean by this that a country's residentscan borrow in the difficultieswith the stability of these relationshipsas a international markets; most domestic borrowers do not result of what I would call, by developingcountry stan- have access to these markets. Rather,it reflects the fact dards,second-order structural changes. that, over the previousdecade or two, the domestic resi- Finally,let me explainwhy I do not think direct credit dents of many developingcountries have accumulateda controls, or what I would call directedcredit, will disap- large stock of externalassets. Thesecan be effectivelyre- pear from the set of tools used by central banks in devel- patriated through various means during a periodwhen oping countries. There is a fundamental structural credit is severelyrestricted. No one, however,would say differencebetween the size of the shocks experiencedby that this is a good wayto reverse capitalflight; it certain- industrial and developing countries. While a major ly is not a way to get capital back on a permanent basis. terms-of-tradeshock or a move ofthree or four hundred Even so, one often sees this phenomenon and, when it basis points by international interest rates may be diffi- occurs, it undermines the effectivenessof a credit ceil- cult enough to absorb for the industrial countries, they ing. can have first-ordereffects on almost all enterprises and So from both the "fiscalpillar" side and the monetary the entire financial sector in a developingcountry. In control side, the effectivenessof the credit control pro- such situations, central banks in developingcountries system that is grams that have been so heavily ueaDused by aveopndeveloping etnctvecan find themselvesinsolvent.allfaced with a financial countries is being eroded by structural changes.One re- effectivelymsolvent. sponse has been to move to market-basedmonetary pol- While the losses associatedwith these shocks could icies as a way.to regain control (or totrysomething be absorbedimmediately by the private sector,most de- iewsIashaiway toereghaibeenan cotrlem(r to tryt aswell) veloping countries prefer to absorb the loss over time But there are a number of requirements for making this through the fiscalprocess. However,there is a real differ- transition, including the freeing of interest rate and the ence between how this can be done in developingcoun- devlomeno bradbasd ndliquid securities mar- tries as opposed to industrial countries. For example, develNopmetevery ofnbroad-bsredll aillind to meetthese re- considerthe way in which the UnitedStates is handling kets. Not everycountry is reallywilling to meet it.aig thesenre- La rss h crsi wa,i fet quirementsquirement orormk make theh transitionrniin attti this stage.tg.I In largets Savings financial andshock Loan andcrisis. there The have crisis been was, dead-weight In effect, a addition, any fiscal control problemmust be addressedif loses that havet tee syst eTish theo ranstiosccee. isFom vrios stdie of i- osses that have to be absorbed into the system. This has the transition is to succeed. From various studies of fi- not been done by having the central bank purchase the nancial liberalization,we know that a net loss of reve- Savingand Loan'sbad assets; nor is a large proportionof nues can result when the financialliberalization occurs. the losses being brought into the current fiscal ac- These revenueshave to be replaced. counts. Instead, the bad assets are being taken into the Thirdly,I do not think enough attention has been giv- accounts of the ResolutionTrust Corporation,which is en to the requirement, which CharlesGoodhart stressed, financing itself through the issuance of long-term gov- for a nominal anchoring in the system. In developing ernment-guaranteedbonds. It is only as the interest and countries that are contemplating a move to market- principalpayments on these bondsare made that the full basedinstruments, one often hears a lot of discussionof losseswill be realized over time. the technical aspects of the move,such as how to intro- Developingcountries don't have this option. They duce markets for central bank securitiesinto the system. don't have domestic bond markets where they can These are important issues. However,the fundamental spreadout the costs of a financialshock over time. They problem of movingto the newsystem is the one that the cannot go to the external markets to borrow because, previous three speakers addressed:what is the nominal when the shocks hit, their creditworthinessusually de- anchor? Is there going to be an exchangerate anchor or teriorates. So how do they handle this shock?Basically, a monetary aggregate anchor? Or is another choice go- they take it into the accounts of the central bank. It is as ing to be made?This problem was never adequatelyad- if the United States were to combine the balance sheets dressed under the direct credit control system,which is of the Federal Reserveand the ResolutionTrust Corpo- I Monetary Targets: European Experience 93 ration. If you look at the central bank's balance sheet central banks in most developingcountries. Since there (with its assets and liabilitiesmarked to market) in a pe- are no domestic bond markets or external markets in riod after major shocks,you will see negativenet worth, which developing countries can obtain long-term fi- which represents an implicit future tax liabilitythat is nance in a crisis period, the only shock absorber they associated with distributing the cost of the shock have is the central bank. One part of the process of ab- through time. sorbing a shock will indeed be direct credits to specific One of the problems in developingcountries is that industries and specificclasses of borrowersthat are pre- the authorities have tended to impose most of the taxes sumed to be viable if they can get through the current that are needed to pay for erasing this tax liabilityfrom period.Whether the presumption is true or not is anoth- the central banks accounts on the holders of domestic er issue. assets. This has often involved,especially in Latin Amer- To close, I would like to considerwhat type of mone- ica, either the inflationtax or taxes on financialwealth tary system most developingcountries are likelyto be and financialincome. The realizationthat holdersof do- using in the future. Again,I must stress that I am gener- mestic claims are likelyto pay for most of the cost asso- alizing in an area where generalizationis hazardous at ciated with large shocks to the economyhas become, I best. I would saythat a two-tier system of instruments is wouldargue, part ofthe "receivedwisdom" that is passed graduallyemerging in most developingcountries. One on from one generation to the next, at least in Latin tier will consist of the use of market-basedinstruments America.It is deeplyingrained in the public's perception to handle the day-to-dayoperations of monetary policy. of the risks of holding domestic assets, and I think it is These instruments may also be used to control expan- one of the principal reasons why capital flight from this sionary trends in the monetary base,although, as an al- region has been so large. Moreover,even with good pol- ternative, countries may very well choose to peg the icies and good financialreturns in normal periods,this exchangerate. But there will continue to exist a second perception may persist. It may be hard to dispel this per- tier of crisismanagement tools focusedon direct credits ception until such time as another shock occurs and the and institutional aids. government demonstrate that the holders of financial Whether this is good or bad deservesa lot of analysis, assets will not be taxed (or taxed disproportionately)to and I willnot attempt to reach a judgment on it. But I do pay for it. think that the institutional and structural differences The difficultiesinvolved in dealing with large finan- between industrial countries and the developingcoun- cial shocks also explainswhy directed credits and credit tries will contribute to fundamental differencesin the ceilings are likely to remain a part of the "tool kit" of structures of their monetary policyregimes. Discussion

Question:As you said, there is a problem of coordinat- bank's wishes. For another thing, particularlywith flexi- ing monetary and fiscal policy.But there is also a prob- ble exchangerates, the movementof the exchangerate is lem of coordinating monetary policy and exchangerate closelyrelated to the monetary policy.If there is to be a policy,or managementof exchangecontrols. How do you pegged exchangerate, then the central bank has got to see that relation? Would you suggest that the central vary monetary policyin order to maintain the peg. bank manage both monetary policy and exchange rate In the NewZealand case, the act says that the Federal policy?Or should it be more like the Bundesbankin Ger- ReserveBank of NewZealand shall aim for price stability, many,where the responsibilitiesfor exchangerate policy with the assumption that the exchangerate will be flexi- are not that clearly in the hands of the central bank? ble. If, on the other hand, the authorities introduce an override to try to peg the exchange rate with another Mr.Goodhart: The answerto this question,in myview, country, then of course the central bank should-its re- is certainly"yes." You would run into difficultyif you had quirements must-shift to maintain that peg. Then it a central bank that wasgiven independencefor monetary cannot at the same time control the rate of inflation,be- policy while the exchangerate was determined by some- cause,as long as the peg is maintained,the rate of infla- hlse.There exchae ratnumberwa de ined by some-i. tion will depend on the inflation rate of the currency to bodypolicy, else. There would be a number of points of conflict, hc e eln spged hte.ti egdt For one thing, if the central bank were given the priority whlichNew Zealand IS pegged,whether Itis pegged to of achieving price stability,it would be difficultif some- body devalued the exchange rate against the central 94 Charles Goodhart

The same thing applies, for example,in Hong Kong, similar policychanges. I wonder,does it have something which has its currency linked with the U.S. dollar.The to do also with the publicity about 1992, which also Hong Kong monetary authorities have no control over started to get goingaround that time? the domesticrate of inflation.In a sense, then, if you are going to give the central bank independenceto achieve Question:If I have it right, it seems that the problem price stability,you must effectivelyallow it a degree of for southern European countries is basicallyone of the exchange rate flexibility.If you want an exchange rate real equilibrium exchange rate. The inflation coming peg, then you cannot require the central bank to achieve from the inflowof reservesis basicallya mechanismthat price stability.You either have the externalanchor or the puts upwardpressure on the exchangerate peg. If that is domestic nominal anchor. Central bank independence so, then I don't see how a con-tractionaryfiscal policy reallyonly makes sense when you are looking for an in- would help. ternal anchor. If you have an externallink or an external anchor, then the central bank's instruments are entirely Mr. Goodhart: Regarding the southern European dedicatedto maintaining the external link. cone, I think the concern is that the inflows of money will result in much less discipline on wages than had Question:I confess I do not followthe EMSproblem. been hoped. So there will be less convergenceand, con- Perhapsyou can help me by explaininghow this problem sistent with a fixednominal exchange rate, the real ex- would be different, and how the possible adjustment change rate will appreciate.That leadsto a worsening of mechanisms would be different, if it were occurring imbalancesin the current account. It willtend to worsen within a country.For example,suppose it occurredwith- quite sharply,with a shift out of the tradeablegoods sec- in two very distinct regions of a country that had these tor into the nontradeable goods sector.A fiscal contrac- two different sets of characteristics. Could the same tion could help in two ways. It would put downward kinds of problems develop?Could the adjustment mech- pressure on interest rates and thereby slow capital in- anisms within a national boundary perhaps differ from flows,and it would directly affectthe labor market and those which exist across national boundaries? slowwage inflation. If correctivefiscal action is not taken, the growingin- Mr.Goodhart: It is in part a transition problem,in the ternal and external imbalanceswill ultimately provokea sense that countries like Spain, Portugal,and to a degree revision, perhaps sharp, of expenditures, precipitating Italy, are entering a system to which they had not previ- fairlydrastic measures. ouslybelonged. Within a single country,the rate of infla- You can have large currency realignments occur tion isn't all that much differentfrom region to region. again, which defeatsthe purposesof those who desire to The wage levels can differ,but the price inflation rates bring the exchangerate system ever closerto irrevocable are not all that much different within a country. When parities. Or it will require a major change in policy.Ei- the previouslyfloating currencies of two countries are ther of these will increasethe potential for a fairlydrastic pegged,however, different inflationrates will persist for change or shift in the policyarrangements at some stage a while despite the peg. One will see capital inflows, in the next couple of years. And they might have fairly monetary expansion,wage inflationand a worsening of devastatingeffects on, for example,Stage 1 of the Delors the current account in the countrywith the higher infla- committee proposalsor the next stage of the European tion rate. monetary union. This correspondsto a number of stylizedfacts about the EMS at the moment. Which are the countries into Question: Generallyspeaking, in Latin Americathe which there are large capitalflows? Which are the coun- lowest rates of inflation occurred before 1920, when tries which have had very large increases in reserves? there were no central banks. Is there anything one can Whichare the countrieswhich are at the top of the band? learn from this for the future? Which are the countries which have the greatest inflation rate? Which are the countries whose current ac- Mr.Goodhart: Oh, yes, absolutelyindeed. The radical counts are worsening rapidly?Which are the countries ideawhose time has come is central bank independence. whosereal exchangerate is appreciatingwhile the nom- The radical idea whose time has not yet come, but may inal exchangerate remains pegged?The answer to each come, is to get the government out of the monetary sys- question is "the southern cone countries of Europe." tem altogether. The reallyradical libertarianssay that there has been Mr.Honohan: It seems very like the euphoria that has a closecorrelation betweenendemic inflation and the in- occurred in other countries, including Chile,at a time of volvement of the government, through central banks, Monetary Targets: European Experience 95 with monetary creation. They say the sole appropriate terms of output. In other words, it would allow us to function of the government is to define the monetary jump down the long-run Phillipscurve. unit-the pound, peso, peseta, or whatever-as being With respect to what occurred when the new mem- the equivalentof a particular basket of commodities,of bers of the EMSjoined up, the point that was raised ear- real assets; or of some foreign asset, such as one escudo lier was about credibility. Suddenlythe new members is equal to one U.S. dollar. Then it should be left com- had credibilitythat they would lose their inflationcosts. pletelyto the privatebanking sector to maintain the cur- We would love to have that. The reason countries like rency's reputation by maintaining convertibility with Australiahesitate is that we think we are very different private bank notes, private deposits, and so on. There from the countries that we might join onto. should be no central bank, no lender of last resort. The It has been suggested at times that we should hitch government defines the currency unit, but otherwise ourselvesonto Japan. However,given that our compara- gets out of the monetary creation system altogether. tive advantages are exactly the opposite of Japan's, we That idea's time will come if central bank indepen- would find our exchangerates doing exactlythe wrong denceturns out to be ineffectiveand we go on having en- thing for us. Theterms of trade wouldbe movingin a di- demic serious inflation. But for the moment it's not rection unfavorablefor us but favorablefor Japan. So the practical politics. It is the idea of a fringe of libertarian adjustment, the softening effect, that we currently can thinkers like GeorgeSelgin, KevinDowd, David Glasner, get by changingour exchangerate would not only be lost and LawrenceWhite, whose ideas are fascinating,but for but reversed.It is not because these ideas are a million the moment are not practical politics. Central bank in- miles awayfrom the viewsof central bankersthat we do dependenceis practicalpolitics. Getting the government not act on them. It is because, at least for the moment, out of the monetary system isn't for this decade. we think that on balancethis is not the wayto go. There are softer waysof adjusting. Mr.Honohan: If may use my privilegeas chairman to Of course, these considerationsreturn us to the old make a glosson the point, I believeI have observeda sys- idea of optimal currency areas. Optimal currency areas tem very similar to this. It is a "real bills" system in op- are geographicregions that have a lot of similarity.I sup- eration in Central Africa, in the Banque Des Etats De pose that the counter-argumentto that idea is Charles L'AfriqueCentrale (BEAC)zone, where the central bank Goodhart'sexample of the United States,which has very has, until recently, more or less unconditionallyredis- differentzones and yet managesto operatewith one cur- counted all bills satisfyingcertain arbitrary criteria. This rency. So there are a lot of issues here that don't quite means the private bankers decide how much credit to hold with theory. give out. The result is essentially "free banking." This system fell afoul of the trap foreseenby the nineteenth- Mr. Goodhart: One consideration that does surface century monetary theorists. Namely,it does not have a from time to time (and I would think it surfaces more nominal anchor; and there is a fallacyof compositionin frequentlyamong WorldBank countries) is the option of that the so-calledreal bills are not clearlyidentifiable in removingthe central bank from the system as much as advance. possible.One can take the Panama route to this, which was also consideredseriously by Israel. Youjust change Mr. Goodhart: But the libertarians' proposal is not from having a local currency to a currency in U.S. dol- "real bills." It is the gold standard, but with the added lars. In effect,then, you have local fiscalpolicy, but you gimmick that gold is too variable as a commodityrela- don't have monetary policy. tive to general prices. So, instead of making gold the In a sense, that's what has been attempted in Hong standard, a generalbasket of goods is the standard. Kong. The problem is that, if you haven't gone too far downthe hyperinflationroute, the only thing you can do Mr.Grenville: I agree that central banks could move is to relate the currencybase strictly to the availabilityof in the direction of greater independenceand then con- U.S.dollars. Even going too far downthe hyperinflation centrate on price stability.A small country can choose path will usually lead to being a dual currency economy, between various anchors, including the currency of a in any case. There are some countries that could have larger country (as the smaller EMS members have gone on a dollar base some time ago, and they would done). Speakingas a little country, as an Australian,we have been much better off. But relating the currency have informallythought about the joys of anchoring to base strictly to U.S. dollar availability,and holding to it, another currency becausewe have seen the great power gets the central bank out of localmonetary policy. It gets of this "saferisland" to get us from high rates of inflation you onto a credible, reasonable, monetary basis and back downto low rates ofinflation with very little cost in leavesthe fiscal authorities to do what they can. 96 Charles Goodhart

Mr.Honohan: Is it not difficult,though, to keep the being introducedor considered.Brazil and Argentinaare central authorities out of the system?I think of the case two that come to mind. Questionshave arisen as to how of Liberia, which started with the Panama system and they might restructure the relationship.One such ques- then decidedto mint Liberiandollar coins. Nextit decid- tion, as an example,is what exactlyshould be done about ed to mint Liberian five-dollarcoins. Very soon there the extra-judicialliquidation function, which is usually were more Liberian coins than U.S. notes, in effectbe- housed in the central bank. Should one keep that func- cause the authorities would not leavethe system alone. tion within the central bank or take it out of the central bank and let the central bankworry about monetary pol- Question:Although I agree with the independenceof icy, exchangerate policy,and so on. I am curious as to central banks and central bankers, I would like to raise a what your thoughts are on this point. question. Basically,someone has got to set performance criteria for the central bank-a job description-and Mr.Mathieson: I supposethe issue is what advantages then assess performance against those criteria. Who is this separate institution would have over the central going to do that and on what basis? bank. What would be its source of funding?If you think We can set price stability as one criterion, but it is in terms of the ResolutionTrust Corporation, it is able to generally recognizedthat another of the central bank's get resources because its bonds carry the guarantee of tasks is to maintain the stability of the banking system. the U.S.government and can therefore issue bonds onto For example,if, in order to restrain inflation, interest the world markets. rates are raisedby 30 percentagepoints and banks fail as I don't see that any agencywill have that capacityin a consequence,the central bank may have fought infla- developingcountries. In most developingcountries, go- tion but has created other problems.So we come bank to ing to the externalmarkets during a major crisis is typi- the issue of designinga role for the central bank and set- callyjust out of the question. So the problem faced by ting its objectives. developingcountries is, "howdo you absorbthis type of shock or meet this lender-of-last-resortfunction, when Mr.ell oodhrt: thoe isues re ctualy bing you don't have the same tools of financeavailable to the addressed.If you read the ReserveBank of New Zealand indtrial tres?" they ar aina the realmof Act or the various paragraphsin the report of the Delors snd-st coies. committee, or what will no doubt come out of the Eco- second-bestchoices. nomicnoi Comnt'Community's intergovernmentalinegvrmna discussionsdicsin.a. at centralIn most bank developing absorbs this countries, function, the because outcomeno is other that the in- the end of this year, those exactissues are currently be- -stitutioni ablodos Fiscal plcyus not ibl ing seriously addressed.There are legislativeacts that includestatements of the objectivesof the central bank. enough to generate the resources neededthrough, say,a Now,the relationship between financialstability and large hike in taxes or a sharp cut in expenditures. So macroeconomic control-and there may be a conflict more or less by default, the shock is absorbed by the cen- between them-is indeed a serious one. A number of tral bank. peoplehave argued that the more seriousyou think it is, In the near term-which means about the next five the more you might want to separate the role of lender years-I don't see the situation changingfor most of the of last resort from the macroeconomicactivity of the developingcountries. Ideallythe capacityyou would like central bank. In the United States, this is done by sepa- these countries to have is what the United States can do, rating the FDIC (Federal Deposit Insurance Corpora- which is to financeits shocksthrough time: spreadthem tion), which provides stability against runs on banks, out, take some cost up front, take some over time. While from the Federal Reserve.Conceivably you might have most of the industrial countries can do that, developing an independentinstitution to make lender-of-last-resort countriesjust simply do not have that ability. loans under certain criteria; the central bank would offset the macroeconomiceffect of such loans through its Mr. Caprio: But this liquidation function will be open market operation. It would have one arm deciding housedwith the bank supervisoryfunction. Someargue on a specificloan and another arm decidingto maintain that, both becauseit is difficultto create independentin- the monetary base and interest rates to affirm overall stitutions, and because there are some complementari- price stability.In any case, this is a real problem that has ties between conducting monetary policy and bank to be faced,although there are various waysof facingit. supervision,it is sensible to combine the two powers in one institution. But no hard and fast rules emerge from Question: We have been working on some countries cross-countryexperiences. where legislationrelated to the central bank's role is now Monetary Targets: European Experience 97

Question: I have a question on this point of spreading But my point is that this is a question of financing costs over time. If a banking system or a bank fails in a technique. Right now, it is the only financingtechnique developingcountry, if the government then issues debt for a large shock. If these countries really had accessto instruments which that bank holds on the asset side and international markets, then presumablythis would give these instruments provide a spread to that bank over them an alternative way to finance a shock over time. their deposit rates, does that help to address the issue? But for most of them, the accessis just not there, and I doubt it will be there for most of the 1990s. Mr. Mathieson:When I say the central bank absorbs the shock, what it reallydoes is to take over the bad as- Mr.Caprio:It is probablyworth adding that, although sets of the financialsystem. In reality, these assets often industrial countries have deeper capitalmarkets that al- do not earn anything, or they earn some small fraction low them to "stretch out" more easily various shocks, of their contractual return. That is the basic problem; they continued in the 1970sand 1980sto resort to direct the central bank has issued liabilitiesof some facevalue, controls when they thought that indirect methods but-if you want to think of it in the terms you used-it would take too long to operate or prove insufficientto has taken on assets that, although they have the same the job. Thus we saw"the corset" in the United Kingdom facevalue, their real value is much less. in the 1970s,various credit control schemes in Italy in So the central bank has already taken a loss. If its as- the 1970s and 1980s,and a short-lived credit control sets and liabilitieswere marked to market, it would end scheme in the United States in 1980. In either develop- up with a negativenet worth in its balance sheet, which ing or industrialcountries, such programsmay be a mis- is goingto be workedout of the system in some sense. It take in that they inhibit the efficientallocation of credit. may be done through the inflation "tax," which erodes Thus Dr. Mathieson's point that developingcountries may bealdonue trou thoseoutstandinfliation " whi.s erods- will for a long time continue to use such tools does not the real value of those outstanding liablities. Theminis- ipyta nietmtossol o edvlpd ters of finance and presidents of central banks in devel- imply that indirectmethods should not be developed. oping countries are quite good at thinking up different Rather, the inefficiencies of direct controls should waysto accomplishthis "workingout" process.Unfortu- hemghtenonet s resolveto assst in the movementtoward nately,most of it ends up affectingthe whole range of fi- market-basedmethods of monetary policy. nancial instruments. But I really don't see them having Mr.Queiroz: If you have real central bank indepen- much flexibilityhere. For large shocks-to terms of dence, absorbinga fiscalshock will remain the responsi- trade or something like that-they just do not have the bility of the fiscal authorities and the government, absorptive capacity except to take it onto the central because the central bank would not be financing the bank's books. government in any way.On the other hand, if the central bank is not independent,it willtend to assume responsi- Mr.Honohan: When you say "taking it on the central bility for absorbing the shock. So the govemment in bank's books,"I take it that you do not necessarilymean general has a great interest in not having an indepen- the actual accountingtreatment but more that the cen- dent central bank. tral bank is goingto have to take care of the problem? It Theextreme case of central bank independencewould can do so through any of a variety of measures. It can be a bank that never financed any government paper, print money; it can lower reserve requirements; it can only private paper. This creates an adversarialrelation, set interest rate ceilings. These are the only actions with the central governmenton one side and the central availableto it. In other words, there must be some taxes bank on the other side. This is a war, a terrible war, the but, because the fiscalauthorities do not have the means worst war betweenthe two that could occur.In this case, to raise taxes, the residual course of action is to go there wouldbe no inflationin any country in the world. through the central bank. So my questionis, which is the country,who are the politicians, the congress, the president, the first minister, Mr.Mathieson: What you describeis not the only pos- that would like to have an enemy of this kind?Nobody. sible outcome. There could be a gradual transfer from the fiscal authorities over time. They could generate tax Mr. Goodhart: Well,the Deutsche Bundesbankis in- revenuesthat couldbe used to buy up the bad debts from dependent. Although,we've seen in recent months the the central bank. This would, in a sense, unwind the limits of that independencewhen you have somethingat shock through future taxes. So it does not necessarily stake that is as important politicallyas German mone- have to come through an inflation"tax." Although it of- tary union. Where I do think you are right is that there ten does, it need not. is a feelingamong commentatorsand economists-now 98 Charles Goodhart quite fashionable-that central bank independencewill currency was consistentlythe most stable monetary ag- help to delivergreater price stability,in part becausethe gregate in the United Kingdom. Bundesbankhas been the most successfulcentral bank. There werevery good reasons for this result. Allof the I think that your argument can also be reversed:one broader aggregates,including Ml, had been distorted by tends to get central bank independencewhen the popu- significant financial innovation. In Ml, for example, lation as a whole, and the politiciansas a whole, put the there had been the growth of interest-bearingsight de- highest priority on price stability. If they did not, they posits. The broader aggregateshad been affectedby the would not make the central bank independent.So what developmentof the building societies. In the U.K.con- is reallycreating the price stabilityis the shift in priori- text, the liberalizationof restrictions on creditexpansion ties of the public as a whole, not the constitutional increasedthe demand for holding broad money. change to the central bank. Ultimatelythere will always As I suggested in the presentation, the demand for be some kind of politicaloverride of central bank inde- money,at least for broad money,depends not just on in- pendence. There is a political override in the Reserve come but also on broader portfolio restrictions. When Bank of New ZealandAct. And I have difficultybelieving access to credit increases, the demand for money in- that most of the Europeancountries willaccept a "Euro- creases as well as the demand for other assets. This will Fed" (EuropeanFederal ReserveBank) that is subject to shift the demand for money.This was indeedshown em- no politicalcontrol under any circumstances.But that piricallyby the U.K.experience, the details ofwhich have degree of independence is what the Delors committee been published. actually advocated. Mr.Grenville: As I understandwhat wassaid yesterday An Elaboration by Mr.Goodhart, as an empirical,informational variable to showwhat income is doing, a narrow monetary mea- Editors' note: The followingexchange took place during sure might be fine. But for a monetary aggregate to be the questionand answersession of BarryJohnston's pre- operationallyuseful, there needs to be a causalsequence sentation. It is reported here becauseit directlyrelates to that begins with M and finisheswith Y (in the quantity the content of this session. identity), not the other way around. What the tests of stability show is simply the informational content. I Question: Under the heading of helping the captain know that the reason we get such good relationshipson steer the ship, Charles Goodhart suggested yesterday the narrow aggregatesin Australiais that we do not op- that narrow monetary aggregates are not particularly erate policiesthrough them; when people demand cur- useful in guiding the ship. I would like to give you the rency,we simply give it to them. The critical thing is not opportunityto rebut him, becauseI know that you have whether they are stable now but whether, if we try to done a lot of work on that. push on them, they would remain stable.

Mr.Johnston: On the first point, I think Charlesand I Mr.Johnston: I think the fundamental differencelies havehad some long-standingdisagreements on the mer- in the waythe monetarypolicy operates. If the policyop- its of different monetary aggregates.Charles has always erates through discriminatory restrictions, then your felt that broad money was the only reasonablysensible aggregateswill not remain stable. The experiencein the aggregatein the economy.I believethe main reason for United Kingdom is that if policyoperates on an instru- this view is that broad money can be broken down into ment that is not restricted or discriminatory,such as in- credit counterparts; one can analyze broad money in terest rates, then the narrow aggregatesdo not become terms of the absorption of funds by the government, by structurallyunstable. Indeed,the experiencein the Unit- the banking system,and so on. ed Kingdomhas been that, although MOhas been target- Myapproach has alwaysbeen more empiricallybased. ed since 1984, the results still show that aggregate has It addressessuch questions as the underlyingstability of maintained its propertiesdespite having been the princi- the aggregatesthat are being examinedand the informa- pal monetary target. tion content, in any sense, of those aggregates. The I think the real problem with the broad aggregates movement to MO in the United Kingdom, to which was that they used things like the corset, which really Charles referred, was based on an extremely extensive made aggregatesrather meaninglessand led to a large study of all the monetaryaggregates. This study also in- amount of disintermediation. While there has been a cluded measures of money not usually studied or pub- trend or structural change in the currency aggregate lished,because we were trying to find what measurewas (MO),it has been taken into account by includingvarious the most stable.The results showedthat the demand for variables. Monetary Targets: European Experience 99

I should also point out that the choice of MOwas etary policy is all about, pressing.... some aggregate- basednot just on stabilityof demand but also on findings then peoplewill find waysaround it. of very extensive causalitytests. The work looked at a very widerange of moneycomponents. I ran them in ev- Mr. Johnston: But how do you press on currency? ery conceivableway that we could think of. We ran very Certainly you do not stop people from coming to the large statistical testing over subperiodsand for different bank and withdrawingit. I wouldagree with your point definitionsof the equations. Nevertheless,again the re- if pressing on the aggregate meant that you said to the sult was still that currency systematicallyturned out to populace,"You cannot have any more currency today." have the best information content of all the aggregates But raising interest rates works on the demand for mon- we examined. ey function, which is stable and does not deteriorate. What you said about the Granger causality is precisely Question: One explanation for your results may be why it is MOthat is targeted. The transmission mecha- that as interest rates go up, the economyslows and the nism is the effectof interest rates on the economy.No- narrow aggregates also slow. The narrow aggregates body ever believedthat cutting back currency actually slow becausethere are financialflows into interest-bear- affectedanything; it was designedsimply as an interme- ing securities. So one can find lots of reasons why the diate target. This, I think, is the crux of my difference Grangertest might be passed.The point that strikes me with Charles.He feelsthat money should do something, is that there are such good substitutes for currency. If not just be an indicator. you reallywant to press on that-and that is what mon-

PART III

BUDGET DEFICITS AND MONETARY POLICY

Introduction

Of the pressures which can cause central banks to lose ens the resolveof governmentsto control inflation.(Also control over their balancesheet and thereforeover mon- controversial have been debt-equity swaps, of which etary conditions, perhaps the most common is the need Chileis the leadingexponent. Fontaine explainedwhy, as of governments to finance large budget deficits. How operated by Chile, these swaps need not have an infla- monetary policy has functionedwhen confronted with tionary impact.) large public sector deficits is the subject of this section. Recentmonetary policy in Brazil,as describedby Car- Speakers recounted the experience of Italy, Chile, and los Alberto Queiroz, Chief of the Open Market Trading Brazil. Department at the Central Bank of Brazil, has had the The late CesareCaranza, former ExecutiveDirector of more limited objectivesof stabilizingbond market con- the World Bank and previouslywith the bank of Italy, ditions and avoidingfinancial distress of intermediaries. summarized the lessonsfrom Italy.Double-digit deficits The use of floatingrate instruments with daily revision (as a percentageof GDP) have been the rule in Italy since of yields has helped tide the Brazilianfinancial system the mid-1970s, and government debt-most of it held until budgetary control is restored enough to allow internally-is equivalentto one year'sGNP. The author- monetarypolicy to resume the role of stabilizingprices. ities' abilityto market governmentpaper (helpedby high Theindependence of central banks facedwith govern- household saving)has greatly helped to maintain a suc- ment deficits has dependedon a widevariety of consid- cessful anti-inflationary monetary policy. They have erations. Despite the 1981 "divorce,"which ended its been able to broaden the debt market by using instru- role as automatic purchaser of unsold treasury bills at ments of a variety of maturities and in small denomina- each auction,the Bancad'Italia is endowedwith relative- tions. Indeed, this "structural" approach to monetary ly limited de jure independence,inasmuch as monetary policy,which is argued to have been essential to the policyis set by an ministerialcommittee chaired by the Bankof Italy'ssuccess in restraining inflation,should be TreasuryMinister. Yet its high professional reputation of interest to those officialswho believethat onlycaptive and its relative stabilityin the rough seas of Italian poli- markets can be relied on to finance large deficits. tics haveaccorded it considerablede factoindependence. Togetherwith the shift from a pay-as-you-goto a fully Dr. Fontaine underlined the role of greater central fundedsocial securitysystem, the indexationof all finan- bank independencein the Chileancontext, with the en- cial contracts accounted for much of the success in de- actment in 1989 of a new law prohibiting the central velopingmedium-term and long-termfinancial markets bank from lending to government;the law could proba- in Chile, according to Juan-AndresFontaine, who was bly be evadedbut only at a cost. The Braziliansituation formerly Director of Researchat the Banco Central do leavesthe central bank with less independence,at least Chile. Indexationis controversial;some believeit weak- for the present.

103

Impact of Government Deficits on Monetary Policy: The Case of Italy

Cesare Caranza

Italy makes an interesting case for study because of all cade, it grew at slightlymore than 3 percent. More im- the potential for conflict between fiscal and monetary portantly, the productive sector of the economy policy.With a public debt that roughlyequals GDPand a recoveredduring the 1980s from the dark years of the fiscal deficitof about 11 percent of GDP,this conflictis a 1970s.Private enterprises regained productiveefficien- fact of life. cy,competitiveness, and financialstrength. I shall beginwith somebasic facts and figuresthat are Meanwhile,the status of public finances deteriorated essential for understanding the Italian experience.Then sharply.A few numbers will convey the basic scenario. I shall describethe policy responseof the monetary au- The public sector borrowing requirement (PSBR)aver- thorities, the strategy they followedto finance these aged 13 percent during the 1980s. From 14 percent in growing fiscal deficits while maintaining a reasonably 1983, it decreasedto the present level of about 11 per- sound monetarypolicy. Thirdly, I shall reviewthe results cent. For the next fiscal year, the governmentis aiming of these policiesand the problemsstill unsolved.Finally, to reduce the deficit to about 10 percent, but that goal I shall sketch the prospectsfor the future. may proveelusive. As a consequenceof these continuing high fiscal deficits,the stock of public debt grew rapidly. The Economic and Financial Picture This year it will roughly equal GDP.Interest payments on public debt grew from 5 percent of GDPin 1980to 9 Webegin, then, with the facts and some figures. Dur- percent this year. Therefore,of the 11 percent I quoted ing the last two decades,Italy has experiencedhigh and earlier as the PSBR,9 percent represented interest pay- continuouspublic sector deficitsand a ballooningpublic ments. Primary deficits (that is, net of interest pay- debt. At the same time, it has had a restrictive monetary ments) climbed to 6.5 percent of GDP in 1983, then policyaimed at maintainingthe exchangerate ofthe lira decreasedgradually to 1 percent this year. The primary within the EMSband. Althoughthe lira has been deval- deficit,which is a key element in the story, has been cut. ued from time to time with respectto the German mark, Yetthis improvementhas been too slowand half-hearted those changes did not compensate for the inflation dif- to break the vicious circle of high deficits,higher debt, ferentialwith our major trading partners in Europe. In higher interest rates, and still higher deficits.That, in effect,Italy maintaineda relativelystrong exchangerate brief,is the scenarioof the 1980s:a dramaticallyimprov- policyto reduce inflation to the level prevailing in our ing private sector; satisfactoryreal growth; a sharp re- major Europeantrading partners. duction of inflation;but deteriorationin public finances. This objectiveof reducing inflation has been largely achieved. Consumerinflation peakedin 1980at 21 per- A New Strategy for Monetary Policy cent. From that extremelyhigh levelat the beginning of the decade, it has declined to an average over the last Bywhat strategy have the monetary authorities tried three years of between5 and 6 percent. The latest figure to reconcilethe financingof this growingdeficit with an is 5.8 percent, but some slowing is expectedover the acceptablemonetary discipline?The monetary authori- next fewmonths. ties, and the central bank in particular, did not imple- At the same time, real growth improved.In the first ment just a quantitative monetary policy, aimed at half of the 1980s, GDP grew at an annual average of control of the monetary base and control of aggregates. slightlyless than 2 percent; in the second half of the de- They tried to implement a structural monetary policy,

105 106 Cesare Caranza one that would develop the financial structure of the public securities in the economychanged dramatically. country in order to cope with the huge demandfor funds In the late 1970s,only about 20 percent of publicsecuri- from the public sector, while also modernizing the in- ties in circulationwas held in private sector portfolios; struments of monetary control. They sought, of course, by the late 1980s, this increased to more than 70 per- to keep the creation of base money under control. At the cent. same time, they sought to change the rules of the game Of course, concomitantwith this increase in the pri- for the financialsector. They tried to deepenand broaden vate sector holdings was an equallydramatic decrease in the financialmarkets, to channel savings,and household the share of public securities held by commercial banks savings in particular, into public securities. and the central bank. This redistributionmeant lesscre- A positive peculiarity of the Italian situation is the ation of base money and broad money.And in fact,mon- high savingspropensity of its households.It is important ey creation deceleratedthroughout the decade.In 1984 to assess those high fiscaldeficits of 11 or 12 percent of the Bankof Italybegan to announce moneytargets, such GDP against the high savings in the other sectors, sav- as growthtargets for M2and for creditto the private sec- ings of between 20 and 21 percent of GDP.If a channel tor. Although the credit target was usually overshot,the can be activated to transfer a major part of these savings M2 money target was almost alwaysattained. The pre- into funding of the public debt, money creation can be dominant tool for controlling money growth was inter- reduced and kept under control. est rate policy, as credit ceilings on bank loans were In pursuit of more depth and breadth in the markets, removedin 1983. the authorities introduced an enormous amount of fi- Real interest rates had, for the most part, been nega- nancial innovation.They floatednew kinds of securities: tive in the late 1970s. After the credit and monetary financiallyindexed securities,short-term and medium- crunch at the beginning of the 1980s,real interest rates term securities.Many new instruments appeared in the jumped to relativelyhigh positive levels. Over the re- financial markets, as well as new intermediaries. Some mainder of the decade,real rates remained at a high lev- years ago, Carlo Cottarelli and I wrote an article on fi- el, although they showeda slight declining trend from nancial innovationin Italy in which we calledit a lopsid- the early highs. Even today real interest rates in Italy re- ed process. Although there was all this financial main a bit higher than in other major industrial coun- innovationduring the 1980s,it was lopsidedbecause the tries. This differential,by the way, explains the huge public sector was the major, and almost the only, inno- influxof capital into Italy during the most recent years. vator. The reason was simply because its appetite for Theserelatively high real interest rates notwithstanding, funds was so huge that it had to find new sources of Italy continued to enjoya very good performanceof pri- funds. vate investment. So this broadening of the markets, to channel more I have already mentioned that inflationwas reduced. privatesavings into public debt, was the first major ele- And last but not least among the major results of the ment of the monetary strategy.The central bank in par- strategyhas been the gradual liberalizationof foreignex- ticular also tried to improve the instruments of change controls. We took the final step just this week; monetarycontrol, to regainsome maneuveringroom for since May14, 1990,capital controls havebeen complete- interest rate policy.One ofthe more significantdevelop- ly removed,even on short-term capital movements.The ments in this direction was the "divorce" in 1981 be- EMShad agreed to remove these controls by the begin- tween the Treasuryand the Bank of Italy, whereby the ning of July. France made the last step at the beginning central bank discontinuedthe commitment to act as the of this year. NowItaly has taken this last step. This liber- residual buyer of treasury bills at auctions of public se- alization is a crucial element of the story;from now on, curities.This divorce,which strengthenedthe role ofthe our financialmarkets will not be protected fromexternal central bank in setting short-term interest rates, competitionby artificialbarriers. wrought a crucial change in the conduct of monetary This increasingfinancial openness of the Italianecon- policyin Italy. omy has thus far brought huge capital inflows.The reason, simply enough, is the higher real interest rate, Results of the New Policy relativeto other countries,combined with the prevailing expectationof exchangerate stability.For foreign inves- These were the broad directions of policy; now we tors, Italian financial markets providegood buys. There come to the results. The effortto channelprivate savings is a plentifulsupply of bonds,treasury bills,and treasury into public debt wasa major success.The distribution of certificates,all with relativelyhigh yields. Impact of Government Deficits on Monetary Policy: The Case of Italy 107

The Remaining Problems the annual deficits grew in the late 1970s and early 1980s;in fact, for the last twenty-fiveyears interest pay- The results summarizedabove represent the positive ments on the public debt have been coverednot by taxes aspects of the Italian situation. But the coin has a dark but by the issue of new securities.In this situation, pub- side as well. Of the two problems I want to discuss, one lic debt is no longer "irrelevant"in the Ricardo-Barro is more technical, the other is more general. sense. The private agents in the economyconsider their The technical point concerns the implicationsof the holdings ofpublic debt as net wealthand its stream of in- shortened average maturity of Italy's public debt. To terest payments as part of their disposableincome with market that enormous amount of debt to the privatesec- expansionaryeffects on their spending decisions. tor during a period of high and variable inflation rates, The Keynesian description of interest payments as the Treasuryhad to accept a major shortening of matu- measuring the conflict between producers and rentiers rities. This occurred not only as a direct shortening, by does not hold in this situation. The absenceof a conflict which I mean an increasingamount of treasury bills, for of interest between the taxpayersand the recipients of instance, but also as an indirect shortening. The Trea- interest paymentsweakens the pressure of public opin- sury issued large quantities of so-calledtreasury certifi- ion on Governmentand Parliamentto cut the deficitand cates with maturities of between four and seven years. act for the consolidationof public finance. However,their yield is linked to short-term rates, to the treasury bill rate, so the interest payments on them re- Potential Solutions flect the movement of short-term rates. Todaythe average maturity on public debt is some- What solutions to these problems are possible?For a thing less than three years. That is not drasticallyshort, number ofyears now,the central bank has been insisting although it is much shorter than the average maturity that the primary deficitmust be cut. Indeed, the deficit some years ago. Still, a shorter average maturity of the should be reversed into a primary surplus, as other Eu- publicdebt createsspecial pressures on monetarypolicy. ropean countries with high ratios of debt to GDP did At the same levelof debt and of annual deficit, a shorter during the 1980s.Belgium moved to a primary budget averagematurity means that the debt stock must be re- surplus in 1984; Ireland in 1987. If this first step is cycledmore frequently.Each month, Italy'spublic issues achieved,one can expecta reinforcing circle of improve- equal 5.0 percent of GDP,which is ten times the average ments. Lessdemand pressure on the financialmarkets, stock of bank reserves.This high rate ofturnover consti- because of the reduced deficit,would lessenpressure on tutes a major threat to monetary policy.If a treasury bill interest rates. Since interest payments at short-term auction is not completed satisfactorily,a serious prob- rates are a major component of the deficits,lower inter- lem of monetary control ensues. If not enough bills or est rates would further lower the overall deficitand so bonds are sold in a month, bank reservesare out of con- on. It is easy to say that the starting point for readjust- trol. So refinancing becomes a continual and delicate ment should be cutting or even reversing the primary game. deficit,but it is difficultto do. In the end, the issues are For the economyas a whole, this situation represents sociopoliticaland require a sociopoliticaldecision. If the a high degreeof financialfragility. The systemis acutely country reallywants to do this, it must choose to pay exposed to external shocks coming from abroad and more in taxes or to cut public expenditure. from changingexpectations in domesticmarkets. This is Italyhas latelymade someprogress in the right direc- one cost Italy has paid and will continue to pay for this tion. Thegovernment plans to reducethe primary deficit delicate equilibrium,which has so far been maintained to zero for the next fiscalyear. That forecast seems rea- but remains a cost and a threat for the future. sonable.In any case, the only way out is to move ahead The second and more general point is that Italy has in that directionand to move reasonablyfast. had a primary deficitsince 1965.I remarked earlierthat

Impact of GovernmentDeficits on Monetary Policy: The Case of Chile

Juan Andres Fontaine

The Chilean experience is interesting because of the ments in countries with high inflation or with high manychanges that have been introducedover the last 15 uncertainty are reluctant to followthis route. years in financialmarkets and monetarypolicy. We have In Chile in the mid 1970s,the alternativeof removing movedfrom a repressedfinancial sector with substantial all exchange controls was not even considered.Liberal- govemment intervention to something much more lib- izing the financialmarket by openingup the capitalmar- eral. Financial markets have grown and become much ket to international financial flows was much more deeper.Chile has movedfrom high inflation-nearly 400 controversialthen than now,after the experienceof Eu- percent per year in the mid 1970s-to about 20 percent ropean countries such as Italy, Spain, and France. In- a year,which is moderate by LatinAmerican standards. stead,we took a rather long route that has created sort During this process, the country has undergone some problems but, so far at least, is working. traumatic experiences.The fact that I am talking here That route had two basic elements. One consisted of now showsthat a country can survivethose experiences. some legal changes in the status of the Central Bank. One such traumatic experiencewas a severefinancial The other was the creation of an efficient indexation crisis in the early part of the 1980s.It was solvedwith a mechanism. rescue plan in which the Central Bank took high losses. The legal changes in the Central Bank law prohibited These losses have created a quasi-fiscal deficit in the it from lending money to the government,to the public Central Bank, and I shall explain how this quasi-fiscal sector enterprises, or to any entity connected with the deficitis being managed. government. That prohibition was enacted in the mid Asa starting point, I shall describea few institutional 1970sand has remained in place.Although ways of going features of the Chilean financialmarket that are closely around this type of legal restriction can alwaysbe found, linked to this process of financial liberalization. These I think it playsan important role because those waysare features should be of interest, since many developing typicallycostly. Someone has to figure out how to do it countries have financialsystems similar to the Chilean and take the risks, including the legal risks, of getting systembefore the mid 1970s. around the prohibition. So I favorthis solution of simply closing the legal window to Central Bank financing of Factors in Chile'sFinancial Liberalization the government.Of course, once that windowis closed, either the fiscal deficitmust be reduced or it must be fi- The keyto successfullyliberalizing a financialmarket nanced by other means. This prohibition was taken to is creating confidence.All financial markets depend on the constitutional level in the 1980 constitution. Now confidence.The fundamental problem in the Mexican the Central Bankis constitutionallyforbidden to finance situation, which was raised in the previousfloor discus- the public sector. sion, is exactly a lack of confidence.One way to create Just last year, a new law governing the Central Bank confidence is to lift all exchange controls. Doing so was enacted. It gavethe Central Bank independenceon means granting free exit to those confident enough to the model of the GermanBundesbank. This is a contin- risk their capital on the domestic markets. Typically, uation in the same directionas the earlier prohibitionon however,lifting exchangecontrols implies a substantial public sector financing. Although the law is quite new devaluationof the domesticcurrency and a correspond- and the Central Bank is just starting to work indepen- ing reduction in real wages. For this reason, govern- dently,things appearto be on the right path.

109 110 Juan Andres Fontaine

The secondchange to which I referredwas the index- prises not only M2 but also governmentbonds and sim- ation system. Whether this is a good solution or not is ilar instruments, grew from 27 percent of GDP just still highly controversial. Chile had the problem of a beforethe reform in 1980to 60 percent of GDP last year. long history of very high inflation.A wayhad to be found This changewas induced in large part by the pensionre- to create a financialmarket in that environment.So we forms, although there were also other factors that con- decidedto try to make financial markets function as if tributed. The stock of financialassets held by the newly inflation did not exist. The indexationmechanism that created private pension funds now amounts to 15 per- was created was based on a unit of value, called the UF, cent of GDP.The funds have become long-term institu- in which almost all financialassets and loansare denom- tional investors whose emergence has helped a great inated. The UF changes its value daily,according to the deal in developingthe market. inflationof the previousmonth expressedas a daily rate. This change would probably have been impossible In essence,this nearly perfectmechanism created a new without the UFindexation, There had to be someway to currency,the UF,whose real value is constant. It is now maintain a fully funded pension system in a high infla- widely used for most medium-term and long-term con- tion environment. tracts. Creation of this mechanismmade possiblethe devel- Managing Monetary Policy in Chile opment of the medium-term and long-term financial markets. Nowthe Treasuryand the Central Bank issue Howis monetarypolicy conducted within this frame- paper,which is indexed,with a maturity of ten to twelve work?The Chileaneconomic policyof the last ten or fif- years. Privatebanks issue mortgage bonds with maturi- teen years has gained a reputation for orthodoxy and ties of twelveto twenty years to finance housing loans of monetarism. In actual practice, monetarypolicy has not equivalent maturities. Private firms are issuing long- been monetarist at all, even though most of the econo- term bonds. So the market is functioning as if inflation mists in the Central Bank-myself included-have stud- did not exist. ied in Chicago.For the past fiveyears, monetary policy Of course, one must be aware of the risks of this sort has basicallybeen conducted through interest rate tar- of institution. It may create some "inertial" inflation as geting, which is somewhatheretical in the monetarist manycontracts start to be denominated in this new cur- world. rency. However,I do not agree with Mr. Caranza'sposi- Our guiding principlehas been that the role of mac- tion that this indexationnecessarily reduces the political roeconomicpolicy, and specificallyof monetary policy,is pressures to fight inflation. The Chilean experience to provideinformation to the private sector.It is basical- shows just the oppositeas there are many debtors who ly an informationalrole whoseaim is to guide the spend- are affectedby the indexation.For example,when mort- ing decisions of private economic agents so that gage debtorshold housing loans denominatedin UF,the aggregate spendingwill be consistent with the produc- monthly payment on the loan is indexedto the consum- tion capacity and the availabilityof foreign financing. er price index.In this situation, any increasein inflation Our view has been that real interest rates convey more becomespolitically a very difficultsituation. So in Chile information than nominal monetary aggregates. This I think we have created a built-in mechanismto fight in- seems especiallytrue when financial markets are rela- flation, because so many individuals are personally af- tivelyyoung and it is difficultto determine the right rate fected. of growth of monetary aggregates. This mechanism of the UF has another effectthat is Everybusinessman understands very well what a real more risky. It has made the demand for money, for MO interest rate means. The messageis clear.We have done and MI at least, very volatile.I shall addressthis in more this within the frameworkof a highly indexed financial detail below. system, in which market-determinedreal interest rates A third institutional factor worth mentioning con- are evident.The criticisms of interest rate targeting tend cerns changes to the social security system.In the early to be arguments against targeting of nominal interest 1980s,the pensionsystem in Chilewas transformedsub- rates. Thesearguments may well applyin markets where stantially.It went from a standard pay-as-you-gosystem there is no indexation,but our UF-denominatedassets to a fully funded private pension system.So the payroll allowagents to see the real interest rates clearly.This en- taxes that previouslyhad been collectedby the govern- ables the CentralBank to target real interest rates. This ment to finance pensions are now being channeled to may be a capabilityunique to Chile. the capital market. There is a second reason why we have focusedon in- Becauseof this far-reachingreform, financialsavings terest rates.As I mentioned,the variationsof the UFtend increased dramatically.Financial savings, which com- to render the demand for MOand Ml very unstable. Impac t of Government Deficits on Monetary Policy: The Case of Chile II1

Whenthe market incorporatesa nearly universal index- the Central Bank quasi-fiscaldeficit is a consequenceof ation system,nominal interest rates, which are the argu- decisionstaken in the past. What appears at the present ment in the demand for money functions, behave are just the financial implications of those decisions. according to a modified Fisherian equation. Instead of Thus, these amounts are not comparableto the current the nominal interest rate being equal to the real rate subsidies,taxes, and other economic decisionsthat are plus expectedinflation, the nominal rate equals the real typicallymanaged in the nonfinancial fiscal sector. In interest rate plusthe changein the UF.The change in the other words, the standard fiscal deficit is directly rele- UFis determined by the previousmonth's inflation,and vant for ascertaining fiscal influence on aggregate de- month-to-month inflation rates fluctuate a lot. So the mand. In terms of effects on aggregate demand, the nominal interest rate, which is also the cost of holding quasi-fiscaldeficit, which comes from decisions taken demand deposits or currency, also tends to vary a lot. perhaps ten years ago, cannot be simply addedonto the And this renders the quantity of money demandedvola- standard fiscal deficit. tile too. Under these circumstances,targeting a mone- This high quasi-fiscaldeficit in the Central Bankdoes tary aggregatebecomes impossible. create some problems for monetary policythat are sim- The way we do our interest rate targeting can be ilar to those describedfor Italy in the last presentation. viewedas a combination of the Pakistani and Canadian It generates a large stock of Central Bank debt in the methods, as these were explained by Paul Meek. The market, on the order of 19 percent of GDP.Most of it Central Bank issues paper in a fixed-ratetender, so it is used to have a maturity of 90 days, so amortization of prepared to sellwhatever amount of paper is demanded. those debts posed a difficultproblem in terms of mone- The reverse action of adding liquidityto the market is tary management.For example,there wasa time several decidedcase by case.We do not have an openwindow. In- weeks before the 1988 plebiscite in Chile when banks stead, we enter the markets and provide liquidity were reluctant to take a 90-dayposition. Becauseof the through short-term and medium-term loans, a method political uncertainty,they wanted to remain liquid.As a similar to the use of depositsin the Canadiansystem. result, there was a huge expansionin the monetarybase, These aspects of monetary policy in Chile all have since this mismatching automatically shows up in the some bearing on the quasi-fiscaldeficit I mentioned in monetarybase. the introduction. As I said, Chile experienceda deep fi- That sort of liquidityproblem tended to recur until nancial crisis in the early 1980s.It was deep enough to the beginning of this year. We decided to address the arouse fears that the whole financialliberalization process would be derailed. The Central Bank adopted and problemby placinglong-term bondsat a high premium. caredswoutd aestratlegy ofe resug Banksandodebtos In Wehave been able to swapmost of the short-term paper carried out a strategy of rescuing banks and debtors. In folngtrbnd.Tiaconsvethlquiy pursuit of this strategy,the Central Bank took on large for long-term bonds. This action solved the liquidity lossesfrom three sources:(1) liquidationof some banks; problem, although at a significantprice in terms of a (2) recapitalizationof the remainingbanks through sub- higher rate. ordinatedloans payinginterest at less than market rates; Other considerations with this kind of quasi-fiscal and (3) acceptanceof the exchangerate risks associated deficitare whether the increasein public debt impliedby with Chile'shigh foreign debt, at a time of major deval- the deficit is reasonableand the extent to which it will uation of the peso. cause problems in the future. In Chile'scase, a counter- In short, the strategy succeeded but was extremely weight to the deficitwas the change in the socialsecurity costly for the Central Bank. It created a Central Bank system,which I describedearlier. Fortunately,the social deficitwhose preciseamount has been difficultto com- security reform created a high growth rate of financial pute because it dependson such things as the probability savings,on the order of 14 percent per year in real terms. of those subordinatedloans being paid.Anyway, this def- Of course, this is not money dropping from heaven. icit has been estimatedat around 3 percent of GDP. When a social security system changes from a pay-as- What is the implicationof this deficitfor the macro- you-gosystem to a fully funded pension system, the so- economicsituation in Chile?In the past, this issue of the cial security benefits of those who are already retired Central Bank's quasi-fiscaldeficit was disregarded;now must be paid. Those current benefits are being paid by it is receivingconsideration. And yet, perhapsthe pendu- the government.The net result of all these changes has lum has swung too far. For two reasons, the Central been a significantincrease in nonfinancialpublic sector Bank deficitcannot simply be added onto the standard savings.These savings in the nonfinancialpublic sector fiscal deficit. First, there is an accounting problemwith offsetthe quasi-fiscaldeficit in the Central Bank. I be- whether costs are taken on an accrual basis or upon relieve this counterweight explainswhy the Central Bank alization. Second,the economic point is that much of deficithas not created problems. 112 Juan Andres Fontaine

Debt-Equity Swaps The benefits of these conversions are clear. First, there is the capture of a portion of the discount at which I wouldnow like to turn for a fewminutes to the issue the paper is priced in the international markets. During of debt-equityswaps. The first thing to bear in mind is this period, the average discount on Chilean debt was that we in Chile did not invent debt-equityswaps or oth- about 40 cents per dollar.The averagediscount actually er mechanisms of debt conversion.They did not result captured by Chile through the two conversion mecha- from careful planning or discussions among govern- nisms, Chapters 18 and 19, has been on the order of 30 ment officialstrying to devisean ingeniousplan to solve cents. So we have been able to get most of the discount. the debt problem. They were basicallya market result, And 30 percent of US$9billion is US$2.7billion, which which arose spontaneously because there was a differ- representsa net gain to Chileof an amount slightlymore ence between the abilityor willingnessof debtors to pay than 10 percent of GDP.A program or policythat yields and the creditors' perceptionsof what the debtorswould 10 percent of GDPis not easyto find, so I think the re- be paying. A common perception is that these are tools sults have been impressive. of "debt management";actually, they are just ways oflet- There is discussion now, in Chile and elsewhere in ting the market work. Of course, had we thought sec- Latin America,of whether this debt conversionroute is ondary market prices for Chilean debt were "too high" better than the alternative of working with the creditor (in the sense of overestimatingour ability to pay) we banks' steering committee to agree on a debt conversion would not have gone ahead with debt conversions. scheme with a specificdiscount. Big plans of this type The questionwas whether to regulate or restrict this havebeen negotiatedby Mexico,Venezuela, and the Phil- market phenomenon or to allowit to run its own course. ippines.My impression is that the market mechanism is Within the Central Bank,we did discussat length how to much more efficient for the debtor country. When a design appropriate regulations to avoid some of the debtor country sits down with a creditor committee in problems these operations might cause. Washingtonor New Yorkto negotiate a discount, in ef- In Chile,the processwas greatlyfacilitated by the fact fect a "bilateralmonopoly" is formed.When debt conver- that most of the foreigndebt wasowed by the privatesec- sions are worked through the market, the debtor tor, the private banks,and some large companies.There country has more options for regulating the amount of was also some public sector debt, primarily in the Cen- conversionand for dealingwith small creditorswho may tral Bank.Although we did engage in some debt conver- be willing to sell at different prices.The debtor country sion on that public sector debt, priority was given to can better exploitthe market through mechanisms like allowingthe private sector to carry out that kind of op- those used in Chile,as shown by the capture of the dis- eration. count in our operations. Early in 1985, we analyzedthe costs and benefits of As a secondbenefit, these debt conversionoperations these operations. On the cost side, we were more or less allowedus to reshape the country's "balancesheet." The able to predict the kinds of problems that might arise if Chapter 18 operations brought flight capital back into the debt conversionswere allowed.On the benefit side, the country.In the Chapter 19 conversions,a portion of however,we erred substantially in our estimate that debt liabilities was converted into equity. Over all, we these would be small-scaleconversions. The figure we have been able to reduce significantlythe stock of exter- had in mind wasabout US$1billion. Since then, the total nal debt.At the start of the program,the total amount of value of conversionshas been US$9billion. foreign debt was slightly larger than GDP.Now it has We put in place two basic mechanismsfor debt con- been reduced to 60 percent of GDP.The ratio of foreign version. One,which is referred to as Chapter 18, allows debt to exportswas 4 to 1; it is now 2 to 1. I think the dis- Chileanresidents to buy debt paper abroad and convert advantage of a high levelof debt, comparedwith equity it into pesos through the debtor of that paper. The sec- liability,is that a high debt increasesthe country's risk ond mechanism,known as Chapter 19, providesfor stan- of interest rate or terms of trade shocks creating wide dard debt-equity swaps, in which foreign investors are fluctuations in domestic output and consumption. allowedto register as foreign investmentthe equivalent There is another benefit of these debt conversions in pesos of the equity they receivefrom convertingdebt that is not readily quantified.Typically, when a country paper.Of the total ofUS$9 billion of converteddebt, one- has a high levelof foreigndebt, private economicactivity third is the standard debt-equity swap; the remaining is very low,due in part to expectations.Private economic two-thirds are operations carried out by Chilean resi- agents feel there is no solution to the problem,and that dents, plus some relativelysmall operations by the Cen- attitude tends to depress the economy.A few months af- tral Bank itself in buying back its debt abroad,with the ter this conversionprogram started in Chile, the private agreement of the commercial banks. sector started to move again. People could see the light Impact of Government Deficits on Monetary Policy: The Case of Chile 113

at the end of the tunnel. They sawa way to reduce their Inflation is another macroeconomic effect that is debts; they saw opportunities, which got the economy sometimesmentioned as a potential cost of debt conver- moving again. sion. This concern arisesfrom the assumptionthat debt Of course, there are also costs to be considered,as conversionmust operate through the central bank itself, well as benefits. To capture those 30 cents on a dollar, which buys and converts the debt by issuing domestic you must pay the other 70 cents. Waysmust be found to currency.But the conversion mechanismsdo not work finance that 70 cents. that wayin Chile. Rather,there is usuallya privatenego- Then there is the issue of the additionalityof the for- tiation betweenthe debtorwho issued the paper and the eign exchangeused to pay that 70 cents. Both in Chile newcreditor who has bought the paper on the secondary and abroad, there have been long discussionson the ex- market. No monetary expansion is associatedwith the tent to which the foreign exchangeinflows attributed to prepayment of that debt in local currency.There could these debt conversionschemes were additionalor would only be an effecton the money supplywhen the debt behave occurred anyway.In Chile's case, the balance of ing converted is owed by the Central Bank. In that situ- paymentsimproved significantly, so it seems the inflows ation, however,rather than paying by issuing currency, were for the most part additional. Not only did the bal- the Central Bank issues a long-term bond denominated ance of paymentsimprove generally but cash investment in local currency. The transaction is actually a swap of increasedsubstantially, despite the success of the mech- foreign debt for the long-term bond, which sterilizesthe anism for investing through debt conversions.At the impact on money. least, there wasno cost with respectto foreignexchange. A third macroeconomiceffect to consider is pressure We managed our conversion mechanisms to avoid on real interest rates. Certainly there is some effect, linkages that would affect our foreign exchange nega- since the substitution of domestic for foreign financing tively.With respect to Chapter 18-the program that increases demand on domestic savings. There may also used residents' foreign exchange-a monthly quota was be an effecton real asset prices. When the debt conver- established. We auctioned off portions of that quota. sion operations began in Chile, real asset prices in- With respect to Chapter 19, we screened each project to creased significantly. Foreign investors and Chileans determine whether it created linkages-for example,by with foreign exchangeabroad were using the two mech- increasing imports-or wouldsubstitute for investment anisms to buy real assets. So the initial effectwas more alreadyin the country. on real asset price than on interest rates. In the past year Macroeconomiceffects are also an issue when debt or so, we have seen interest rate increases rather than conversionsare discussed.On the fiscal side, it has been real asset increases. said that converting cheap foreign debt into expensive Weighingthese various costs against the benefits, I domestic debt deteriorates the fiscal position of the believe the benefits outweigh the costs. To sum up, I country. This is a validpoint, so the discount on the debt think our mechanismsfor debt conversionhave been ex- should be used as the basis for determiningwhether the tremely efficient in reducing problems that in 1985 conversionmakes fiscal sense. For example,in Chile at seemed impossibleto solve. We have now reduced the present interest rates have increased to the point that foreignbank debt to US$5billion, which is manageable. there is little incentive to convert foreign debt. The de- Wewill probablycontinue to reduce it. Although it cre- cline in demand is putting pressure on the price of Chil- ates some problems for management of monetary and ean debt in the international market. When the price fiscalpolicy, those problems are manageable. declines enough to make the discount attractive, the market in debt conversionwill pick up again.

Monetary Management with High Inflation: The Brazilian Experience

CarlosAlberto Queiroz

I will begin by explaininghow the money market has As a result, a change in the price of financial assets evolvedin Brazil and how monetarypolicy has been con- could easily create a situation where private financial ducted in that market. I will then look at Brazil'sexperi- markets would collapsewithout government interven- ence during the super-high inflation of 1989, in which tion. On severaloccasions, the Central Bankhad to enter prices rose by as much as 84 percent in a single month. the market simply to provide a hedge for the market. In that kind of environment,open market operations of Over the years that the Central Bank has lived with this any kind becomedifficult. situation, it has tried to avoid large-scalerescue operations of this kind. Attempts to improve the situation Development of the Money Market and were made in 1986,when Central Bank Bills,or LBCs, Monetary Policy were created,and later on when FinancialTreasury Bills, or LFTs,were established.LFTs are variableinterest rate A market for governmentsecurities began in Brazil in securities; their daily interest yield equals the average the second half of the 1960sand grew during the 1970s interest rate for that day on all repurchase agreements and 1980s. Beginning in the 1970s, this market grew for government paper.In effectthe dailyyield on an LFT proportionately more than any other financial market, is equal to its own overnight repurchase rate. LFTsare including the stock market. The growthwas primarily in issued in public auctions every Tuesday,with transac- the spot market; only in the 1980sdid the first, and not tions cleared the followingday. The selling price, ex- very successful,attempts occur at a forward market in pressed as an annual discount rate, is determined by interest rate futures. competitivebidding. In a developingcountry like Brazil, there is a prefer- Introduction of a security that yields its own over- ence for short-term investment of savingsbecause long- night rate has greatly diminishedthe capital value risks er-term expectationsface large uncertaintiesabout both from unexpectedfluctuations in the interest rates. The inflationand income.The mechanism that made trading LFT made monetary control much easier in a setting of of long-term securities possible was the repurchase high inflationrates coupledwith no control of fiscal def- agreement.' It enabled financialinstitutions to leverage icits. a long-run position on financial assets with funding It is important to clarifythat the LFT does not solve from the short-term market. the problem of financingthe fiscaldeficit. Because of the Financing the publicdebt of Brazil during the last de- ever-growingneeds of the public sector for funding, an cade has come to depend on this mechanism of repur- increasingamount of governmentpaper must be sold at chase agreements and the associated system of auction.The market requires higher rates to clear the is- leveraging.Yet this situation imposesenormous restric- sues, so the discount rate for the LFT becomes deeper tions on the conduct of monetary policy.Because the and deeper.All that the LFT yield mechanism has ac- short-term market supports large and highly leveraged complishedis to insulate the effectof unexpectedly high- positionsin governmentsecurities, any unexpectedvari- er inflation on the stock of LFT already held by the ation in short-term interest rates could engender a li- private sector. quidity crisis. The possibility of hedging against such When open market operations started in the late variations through futures on short-term interest rates 1960s,the government introduced a monetary budget has been unavailable. by consolidatingthe balancesheets of the Central Bank

115 116 Carlos Alberto Queiroz and the Banco do Brasil, which is a commercial bank to a recession from which an early recoverycould be ex- owned by the government. Since then, this monetary pected. budget has been the basis for monetary policy. Duringthe inflationdynamic, there can be a periodof Lendingby the Bancodo Brasilto the nonbank public time when the real sector continues to produce goods has alwaysbeen a major source of monetarybase expan- and services,despite high monthly or even high weekly, sion in Brazil. This credit was registered in the budget rates of inflation. Certainly,this high inflation rate re- and funded through subsequent saleof governmentbills tains the negativeaspects of an inflationaryprocess, with and bonds. all its allocativeand distributiveproblems. It is in fact an In effect, the government was spending first, then intermediate stage that over time will lead to the hyper- borrowingto fund the expenditure.Interest rates would inflationarycollapse as describedabove. This intermedi- fall at first, from the credit expansion.Then the govern- ate stage is what I mean by a "super high rate of ment would sell securities to balancethe monetarybud- inflation,"and this is what Brazil experiencedin 1989. get. Overall, interest rates did not rise, so the private With this backgroundI turn to the funding ofgovern- sector did not identifythe latter action as crowdingout ment debt and monetary policy in circumstanceswhen other borrowers.However, after severalmonths' lag, the inflation has reacheda monthly rate of 70 percent. inflationrate wouldjump "unexpectedly."Only then did By the end of the "Summer Plan" in May 1989, the the private sector realize the extent to which govern- government admitted that nothing could be done to ment spending wasexpanding the money base.And only control government spending. The goal was simply to when the monthly inflation rate, which is public infor- find a way to support the politicalprocess leading up to mation, began to rise did the monetary authorities press the two rounds in the presidential election (the first for interest rate changes.They began to worryabout loss round in November,the second in December), while of control over the monetaryaggregates. However, inter- avoidinghyperinflationary collapse. est rates could not be allowedto rise very far, since the The monetary policy that was adopted in this situa- financialmarkets were so highly leveraged.Also, the de- tion was based not on the effect of prices on interest mand for investments might have been adverselyaffect- rates, as in the past, but on control of interest rates to af- ed. fect prices. The nominal interest rate became the main This situation held for most of the time that the open target for monetary policy.The real ex post interest rate, market was evolvingin Brazil.During the 1970s,the in- i.e., as measuredafter the fact, had been the operational flow of external capital made things easier. During the target; it was now dropped from consideration.The ra- 1980s,particularly after the Mexicanbankruptcy, the in- tionale for this change was a Fisherian concept of the flowof external capitalhalted. From that time on, the is- nominal interest rate as having built into it the future sue of how higher interest rates would affectinvestment inflationrate. Thus the new policywould take the real ex becamean important constraint on monetary control. ante interest rate, i.e.,as estimatedbefore the fact,as the Monetarypolicy was therefore being conductedindi- operationaltarget. rectly.Increases in publicspending were justified by reg- The operating procedure was to set the monthly in- istering future funding in the monetary budget. terest rate so that the expectedinflation rate in the next Compensatingchanges in interest rates were too little month would leavea real rate on governmentsecurities and too late. Built into this mode of CentralBank action that would be favorablerelative to less liquid real assets is a causal directionfrom variation in prices to variation or speculativefinancial assets such as gold certificatesor in the monetary aggregates.In other words, the causali- foreign currency.The hopewas to delaythe public'scon- ty was from P to M, not from M to P. sumption decisionsas long as possibleby presenting an opportunitycost sufficientto encouragedecisions not to The Year of Super-High Inflation spend. Auxiliaryindicators for the real interest rate target In many high inflations a point is reached (often were the price behaviorof the gold market, the parallel termed hyperinflationarycollapse) where the supply of market in foreign currencies, and the stock market. The goods and services shrinks well below what had previ- behavior of the monetary aggregates (base money and ously been available,resulting in a severeworsening of MI) becameuseless. Therewas little sense in targetinga economic conditions and a generalized shortage of monetary aggregatewhen the inflationrate was so high goodsand services.Typically currency is no longer func- and the government would not reduce spending. In tioning as a medium ofexchange and the economyslides these circumstances,controlling money supply directly into a costlysystem of barter. The reduction in national could lead to interest rate variations-and resulting output leads to exacerbationof poverty,and not merely fluctuations in prices of financial assets-so large that Monetary Management with High Inflation: The Brazilian Experience 117 the Central Bank would be obliged repeatedlyto enter The fiscalpolicy goal is to create a fiscalsurplus. It is the market with rescue operations. Such rescue opera- obviouslydifficult to transform a chronic public deficit tions would only amplifythe uncertainties for the pri- into a surplus. Unfortunately,it is not possibleto reduce vate real sector, with further negative effects on the spending or generate more revenue overnight. In an production of goodsand services. economyas complex as Brazil's, which is developedin The real sector of an economywith inflationrates of the south but very poor in the north, achievingthis fiscal 40, 60, or 70 percent monthly experiencesconsiderable goal will require a long periodof hard work. uncertainty.As a result, there tend to be -brupt shifts in The new plan also acted to reduce demand in the savings preferencesas between real stocks and financial short run, through the compulsory use of private sav- assets. Investment decisionsare delayedas the ability to ings. The financialreturn on these savings is basednot anticipate decisions is eroded, since all the factors that on the old hyperinflationaryconditions but on the ex- influence investment and production activitiesare sub- pectation of future price stability.The intent is to recov- ject to drastic revisionat any time. er a more stable framework in which traditional In this situation, the stabilityprovided by the Central monetary policywill again be effective. Bank became essential to economic life or death. With- After March 15, a new monetary base was created, out some source of stability, the real economic sector consisting at the outset only of cash in the hands of the could have explodedat any moment. The trading desk of nonbank public. All other "new cruzado" (the old cur- the Central Bank providedthis stability in two key as- rency) assets became nonmonetary assets. Thus there pects: liquidityof the market and an adequatereal return has been an abrupt reduction of the stock of money and on financialassets. free reservesto 20 percent ofwhat it had been. The stock Toachieve the desired nominal interest rate, the trad- of cruzadoswill graduallybe convertedto cruzeiros over ing deskbought and sold repurchase agreementsand re- a period of eighteen months. verse repurchase agreements. It stood ready to provide During this periodof a year and a half, the public def- adequate liquidityat the target interest rates to a highly icit willbe managedby reductions in governmentspend- leveraged financial market. In managing liquidity the ing and permanent increases in government revenues. trading desk of the Central Bank made outright transac- Public enterprises and government real estate will be tions in governmentsecurities: buying those the market sold as well. Therefore,we hope to have recoveredthe did not want and selling those the market desired to classicalinstruments of both fiscal policyand monetary hold. At times the market demanded long-term paper; policyby the end of this transition period. on other occasions,long-term paper wassold back to the CentralBank. Similarly, demand for short-term notes Note was met by the buyingand sellingoperations ofthe trading desk. 1. The interbank market for reserves-one of two Thesetrading operations in support of monetary pol- main short-term markets in Brazil-is entirely basedon icy made it possiblefor the private real sector to contin- repurchase agreements in government securities or on ue conveying its uncertainties to the financial sector. outright trading in those securities. Therefore the key Even so, the situation could not be sustained indefinite- interest rate for the national financialmarket is the over- ly.Actions that are basedonly on monetarypolicy to con- night repurchase rate for government securities. (The trol interest rates, without adjustment of government other market, called the administrative check market, spending, eventually lose their efficacy.The stability trades funds availablefrom the floaton checks that have achievedby the policybecame merely a stabilizationof not yet been cleared,and is collateralizedwith private se- the rate of growth of inflation. curities. Becauseof the one-daydelay in clearing, inter- Inflationaryprocesses arise from public deficits.With est rates on the two markets are linked through inflationrates reaching 70 percent per month, a govern- expectations:the rate on the administrativecheck mar- ment can achievelong-term success only by cutting its ket is effectivelythe market's expectation of the next own deficit.In March 1990,the governmentof Brazilin- day'srate on the market for reserves. troduced a new program built on the three pillars of fiscal policy,monetary policy, and income policy. 118 Carlos Alberto Queiroz

Discussion

Question:What Mr.Caranza has describedreally does Question:This is whyI say that Italymay be a miracle. seem to be an Italian miracle, at least compared with If I were an Italianin 1965and saw that the government Mexico,where the public debt is only 20 percent of GDP. was borrowing to pay interest and to cover the budget Mexicois running a budget surplus of around 7 percent deficit, the situation would look unstable. The Mexican of GDP.Yet the real interest rate on the public debt is governmentis trying to address the problemof inflation- about 25 percent.This is creatinga tremendousthreat to ary expectationsby issuing indexedbonds, which cover the stabilizationprogram in Mexico.We are lookingfor the inflation risk. Becausethis risk is removed,the rate financialinnovations that will extendthe maturity of the on indexed bonds is lower than on nonindexedbonds. debt, because the public debt is almost entirely short But there is still a substantial premium in the real inter- term. The averagematurity is less than two months. In est rate because of the default risk. The problem seems effect,every two months or less the entire debt must be to be not the risk of inflationbut the lack of stable de- renegotiated. mand for these indexedbonds. We think that this situation may be the result of expectationsof hyperinflationin the near future.Those ex- Mr.Caranza: During the 1970sand 1980sin Italy, we pectations may be grounded in the fear that at some discussed all the possibilities, including the pros and point that demand for the public debt willbe too weak to cons of issuing price-indexedbonds. We decidednot to carry out the bimonthlyrefunding of that debt. issue price-indexedbonds because indexationto prices is With respectto the financialinnovations in Italydur- a wayto livewith inflation;it is not the wayto fight in- ing the 1980s,did you investigatethe stabilityof demand flation.Price-indexing the debt anesthetizes the system. for long-term bonds issued by the public sector? Are It is like a drug; one liveswith the inflationbut loses the there other cost-saving schemes, such as contractual stamina to fight it. savings,retirement funds,and pension plans, that could You raised another point concerning the results we create a stable demand for long-term debt? Or are there had in Italy in creating a stable demand for longer matu- other reasons why householdsin Italyare willingto hold rities. In recent years, we have achievedthat result. Here 70 percent of the debt of the public sector? again, inflation calls the tune. Particularlyafter the fall in oil prices in 1986, Italy had rapidly falling inflation; Mr.Caranza: The link between your two questions is then inflation stabilizedat a lower level.At that point, inflation. Last summer, I spent several months in Sao the demand for longer-termbonds increased.By longer Paulo, Brazil,for I was fascinatedby certain similarities term, I mean four to seven years, which is not all that betweenthe Italian and Braziliansituations. Brazil, like long, but there wasa large demand for such bonds. Mexico,has extremelyhigh real interest rates and a very short maturity on its public debt. The averagematurity Question:Were those bondstied to the short-term in- is practically24 hours, becausethey must go to the over- terest rate? night markets. Why are real interest rates so high? The level of real Mr. Caranza:No, these new bonds are fixed-interest interest rates reflects the past inflation history of the bonds. In the past, from the late 1970suntil early in the country.Mexico and Brazil are paying a huge risk premi- 1980s,we did use that kind of financialindexation in the um to the savers.After years of high inflation-not hy- treasury certificates.We did not adopt price indexation, perinflation in the technical sense, but an ongoing but those financially-indexedcertificates were used as a "mega-inflation"-how can the authorities convincepri- passageto more orderly financialconditions. vate savers to hold bonds or even bills? They must pay tremendously high real interest rates, which have a bal- Question:With the reduction in the primary deficitin looning effecton the debt, whosegrowth continues the Italy, what has been the impact on the private sector? cycle. In this situation, monetary policy alone is useless. Mr. Caranza:That was one of the positive aspects of Monetary policy cannot be used without a sound fiscal the story. Notwithstandingthe rise in real interest rates, policy. If the monetary authorities try to push interest the private sector did not suffer much. In particular,real rates higher, the deficitballoons and the debt grows even investment did not suffer much. To be more precise, more. The result is a loss of confidencein the country. construction activity slackened somewhat; there was probablysome reallocationof savings awayfrom the tra- Monetary Management with High Inflation: The Brazilian Experience 119 ditionalinvestments in housingand dwellingsand to- enterprisesector and the foreignsector were more or ward financial investments. Yet real, productive lessin equilibrium,in termsof the trend,although there investmentwas not affectedmuch. When we lookat the were significantfluctuations at times. On the other ratio of investmentto GDPgrowth, there is no signof hand,the surplusfrom the householdsector and the fi- significantsuffering. nancialdeficit in the budgetsector form two diverging Weprobably were able to achievethis resultby having trendsthat overtime represent an increasingpercentage interestrate and exchangerate policiesthat servedas of GDP.These two trendscomplement each other,but strongstimuli to the enterprisesector to cut costs and usingthe surplusof oneto financethe deficitin the oth- improvecompetitiveness. er requireda tremendousamount of financialinterme- The most importantfactor was that the enterprise diation.That intermediationhad to be suppliedby the sectorgenerated sufficient internal funds to financenew bankingsystem and the financialmarkets. investment.That sector underwent a tremendousrecov- eryin the early1980s. By the middleof the decade,their Question:In terms of monetarypolicy, how did you financialsituation was so comfortablethat a numberof handlethe inflowof resourceswithin the contextof a enterprisesbegan to investtheir extrafunds in the finan- strengtheningof the lira in the EMS? cialmarkets. The results were quite good because of the high levelof interestrates. Mr. Caranza:The problemItaly has had in the past So this was part of the bright side of the coin. We two yearswith capital inflow has beena newexperience. soughtto managethe situationwithout dampening the In the past, the treasurywas typicallycreating a good real growthof the economy. deal of money,while outflows through the externalsec- tor resultedin net moneydestruction. The last fewyears Question:Did the Italianrecovery benefit from capi- havereversed the situation.There has been a lot of in- tal inflowswhen European banks moved away from LDC flowfrom abroad,and we havehad someproblems ab- lendingin the wakeof the debtcrisis? sorbingthis liquiditythrough open market operations. Yetthis is just oneaspect of the newreality that Italy Mr.Caranza: Not verymuch, actually. An interesting willbe facingeven more in the future.I endedmy pre- featureof the Italian experienceis that the treasury, sentationwith the present situation,but one can also whichwas the big borrower,did not relyheavily on ex- lookahead to the newframework of Europeanmonetary ternalborrowing. As a matterof policy,we preferredto unificationwithin which Italy will be operating.During sellthe publicdebt in the domesticmarkets. Only in the the lastdecade, the typicalsituation was that ofone lead- morerecent years has there beena significantinflow of ing economy,Germany, whose money was the linchpin capitalfrom abroad, but that hasbeen completely auton- of the monetarysystem. The leader was the countrywith omous.So I do not think Italy benefittedparticularly the sternestanti-inflation discipline. The other coun- fromthe debt crisis.There was a majorinflow of finan- triestried to followby linkingtheir exchangerates to the cial investmentfrom abroad in the last fewyears, espe- moststable currency.During the 1980s,the followers ciallyfor purchasesof treasurysecurities. The crucial had the samefinal objectives as the leader:to reducein- point was the expectationof a reasonablystable ex- flation.There were costs, and much pain in certain changerate, the EMSeffect. countries,Italy in particular.But they were all determined to reducetheir domesticinflation rates towards Question:You mentioned that the governmentwas the Germanbaseline. borrowing11 or 12percent of GDPand the savingsrate Also,a numberof the largerfollowers-France, Italy, was 20 to 21 percent of GDP.For investment,there and later on, Spain-were countrieswhose economies would also have been foreignsavings added from the were relativelyclosed through application of exchange current accountsdeficit. How much wasthe difference controls.Now, however, the economiesof Franceand It- betweenthe total savings,both foreignand domestic, alyare entirelyopen, and Spainis graduallyliberalizing availableto the economyand the governmentdeficit? its controls. Didthat differencechange over time? It is difficultto imaginethe newframework continuing to workas it has duringthe past decade.Although Mr.Caranza: During the secondhalf of the 1980s,we the largefollowers have not achievedthe lowlevel of in- maintaineda smallcurrent accountdeficit. It was less flationenjoyed by Germany,their inflationrates are rea- that 1 percentof GDP.On balance, then, the externalef- sonable.And now their economiesare totallyopen. I fectwas moreor lessneutral. When one looksat the fi- doubt that Germanycan continueto play the role of nancial balances for Italy during this period, the leaderfor the followingreason. In a scenarioof contin- 120 Carlos Alberto Queiroz ued German leadership,the frameworkwould resemble tion. Although it is not a completesolution for the debt the old Bretton Woodssystem, but with a crucial differ- problem, it would be an important step forward.Major ence. Germany lacksthe economicand financialweight portions of the public enterprise sector could be sold to to have the mark play the role that the U.S.dollar played the private sector. But there is a lot of political resis- under Bretton Woods.At that time, the dollar was the tance, particularlywith respectto the banking industry, currency of the economy of overwhelmingimportance much ofwhich is publiclyowned. in the world. The situation is peculiar.Many of these banks do be- The problem is not one of competingnationalisms; it have likeprivate banks;they do not respond much to po- is a purely economic issue. The German economy can- litical pressure, at least so far. The problem lies in who not defenditself from instabilitycoming from other ma- would be the new owners of the privatizedbanks. Italy jor Europeaneconomies. Even within the last fewyears, lacks a sufficientlydeveloped sector of institutional in- Germany has begun to experienceproblems related to vestors. Perhaps foreign interests could play a part, but these pressures. When they have had major inflows of we do not want to sell our bankingsystem to foreign in- capital from other European countries, they have had terests entirely.The potential domesticbuyers are indus- trouble in controlling their money supply. trial enterprises or privateinvestors. There are pros and Furthermore, price stability in Germany should not cons that can be argued, but the monetaryauthorities in be taken for granted. What,for example,may be the con- Italy oppose industry taking majority positions in com- sequencesfor price stabilityof German reunification?I mercial banks. am not implying that there will be higher inflation in More generally,though, the issue of privatization is Germany,just that we do not knowwhat may happen. important. While not a complete solution to the debt A preferable outcome to revisiting Bretton Woods problem, it could be an important step forward. would, I argue, be a strong effort by key participants to coordinate their monetary policies. At least the major Question: I wasjust thinking back to when the Ger- European countries should coordinate monetary policy mans privatizedVolkswagen. They had a system through ex ante and set mutually consistent monetary targets. which they distributed shares to a very wide public, Then they must followdevelopments and make adjust- thereby avoidingconcentration. Presumably something ments to keep things on track. similar could be used in Italy, if the public authorities This appears to be the direction in which the EMS is were not hostile to it. heading. Beginningin the autumn of 1990,the four major continental economies-Germany, France,Italy, and Mr.Caranza: Yes, that is another possibility.An addi- Spain-and the two smaller economiesof the Nether- tional problem in Italy is that we traditionallyhave had lands and Denmark will announce coordinated mone- an underdevelopedequity market. Of course, an injec- tary targets for the followingyear. They will attempt to tion of new securities, such as those resulting from a implement a system to monitor developmentsso that a privatization program, could help to revive the equity consistent monetary policy can be maintained within market. the EMS.In the end, this is the only wayto achieve rea- This weakness of the equity market is a problem in sonablystable exchange rates in Europe. Of course, the other countries as well. I am thinking in particular ofre- whole exerciseassumes there is agreement on the final cent talks on privatization in the Eastern European objective of monetary policy.Clearly, that remains the countries. They have problems with how to market the control of inflation in Europe. new shares to small investors. So there are technical problems, but the privatization issue is fundamentally Question:To what extent can privatizationbe a poten- linked to the politicaldecision whether to move in that tial solution of the debt problem in Italy? directionor not.

Mr. Caranza:That is a very hot issue. Our treasury minister is campaigningvigorously for that kind of solu- PARTIV

THE INTERA CTION OF EXCHANGE RATE AND MONETARY POLICY

Introduction

The other main source of volatilityin the central bank's It should be noted that Malaysianauthorities in the balance sheet is foreign exchangeflows. Charles Freed- early and mid-1980shad a distinct preferencefor defend- man and Lin See Yan looked at this problem from the ing the exchange rate, letting interest rates bear the perspectiveof the central banks of a small open industri- brunt of the adjustment to various shocks. Canadianau- al economy(Canada) and a middle income country (Ma- thorities, in contrast, chose to moderate interest rate laysia),respectively. The speakers are deputy governors movementswith greater flexibilityin the exchangerate. of these respectivecentral banks. A variety of factors may govern this choice, including Central banks can insulate their balance sheet from countries' history, with Canadabeing an earlier experi- international flowsonly by adoptinga purelyfloating ex- menter with floating rates in the 1950s.In Freedman's changerate regime, that is, by avoidingany purchasesor terms, these preferencesmay reflect relativelyless con- sales of foreign exchangefor its portfolio.'At the oppo- cern on the part of Canadianauthorities with importing site end of the spectrum, irrevocablyfixed rates entail the credibility of their main trading partner. These the sacrificeof all monetary policyautonomy; even with choices might reflect as well the particular shocks to somewhat less permanent arrangements, small coun- which each economyhas been exposed,as well as the de- tries are forcedto adopt the monetary policyof the larger gree of priority givento combatinginflation. country to which their currency is pegged.In between Authorities of developingcountries should consider these two extremes, Dr. Freedman argued that the in- their choices regarding (short-term) interest rate and struments of monetary policy are more powerful than exchangerate volatility,given that in a liberalizedenvi- exchangerate intervention in influencingthe path ofthe exchang te vili gnt in a liberalized e exchangerate. Indeed, interventionis likelyto have only eclectic approach to monetary targeting suggested by a very short-run role. With less than perfect substitution Lindseyand Goodhart is consistent with an eclectic ap- among assets, central banks can sterilize reserve flows, proach toodharate a nclectin that is, limit their impact on the domesticmoney stock proach to the exchange rate as well. Officialsmight in on interest rates. the end focus more on their ultimate objectivesfor infla- Dr. Lin emphasizedthe extent to which a small open tion and less on near-term targets for exchangerates if economy can have its reserveswiped out if the central an independentmonetary policyis being pursued. Alter- bank does not act quickly.Occasional speculative runs in nativelythey can sacrificeall independenceand peg irre- Malaysia'sopen capital market have been stemmed only vocably to a "stronger" currency. But either choice is by short periods of liquidity squeeze in which money compatible with the move to market-based monetary market rates have jumped as high as 100 percent (as policy.Having established their credibilityregarding in- against single-digitinflation). In an exampleof the be- flation, and being faced more with incipient capital in- haviordescribed by Dr.Mathieson in Part II, the author- flows,Malaysian authorities recentlyhave in fact moved ities have, on such occasions, acted to protect to a more eclectic approachto both interest rate and ex- nonspeculativeborrowers with a closelycontrolled pro- change rate policy. This lesson-that central banks gram of subsidizedcredits. Some participants were skep- should pay most attention to restraining inflation, and tical that such selectiverelief from the liquiditysqueeze thereby reduce uncertainty facinginvestors-has much could be effectivelyimplemented without creating seri- to recommend itself to other developingcountries. Ma- ous distortions. laysia'slong-term growth performance suggests that the

123 124 Introduction to Part IV growth effectsof such a policyorientation may be posi- 2. Industrial country experience certainly suggests tive and, indeed,could well be significant. that long-term interest rates cannot be controlled by monetary authorities. Notes

1. Steven Grenville (in Part I) discusses the various waysin which a central bank can lose control of its balance sheet. 10

ExchangeRate Policy

CharlesFreedman

This paper is in four sections. The first is definitional: policy elements and is much less powerfulthan mone- what is meant by exchange rate policy.As will be seen, tary policy. there are three types of policy that directly affect exchange rates: (i) the choice of fixedversus flexiblerates FixedVersus Flexible Rates (withand without managed floating); (ii) monetary policy;and (iii) intervention policy.In the second section I There is a voluminous literature on this subject, discuss the choice offixed versus flexiblerates in a rather mostly for developedcountries, but some for developing broadbrush way.I then go on to discuss in more detailed countries. There are a number of major strands in this fashionthe conduct of monetarypolicy and of interven- literature, some of which I would like to touch upon in tion policy.Finally, I discuss the issue of sterilization of this paper.Among the important topics in the literature reserve changes in a system of fixedexchange rates or a are the relativepotency of monetaryand fiscal policyun- managed float. der fixed and flexibleexchange rates with various levels of capitalmobility and asset substitutability,' the mech- Some Definitions anism via which policieshave their effectsin the two regimes, the insulation properties of the different The term exchangerate policy is somewhat slippery exchange rate regimes in response to various kinds of because it focuseson the variablebeing affectedby a va- shocks,and the role of policycoordination and concert- riety of policies, rather than on the policiesthemselves. ed interventionby the G-7countries. In this respect, it differsfrom terms like "monetarypol- Broadlyspeaking, a worldwidesystem of irrevocably icy,""fiscal policy," or "commercialpolicy," which tend fixedexchange rates (i.e., one currency)would have sig- to focus on the instrument ofpolicy (respectively, money nificant efficiencybenefits. Mostnotably there wouldbe or interest rates, taxes and transfers or government ex- no transactions costs and no need to expend resources penditures,tariffs or quotas). Hence,rather than talking on coping with the risk of exchange rate changes. The about exchangerate policy,it is more useful to talk about presumed advantages of flexibleexchange rates tend to the elements of policythat have a direct influenceon ex- arise from macroeconomic and adjustment consider- change rates: the choices of exchange rate system, ations, in particular,the abilityof a country under a flex- monetary policy, and interventionpolicy. This is not to ible exchangerate regime to achievea better inflationary argue that other policies, as well as exogenousshocks, performance than its potential partners and its en- do not affectexchange rates, e.g., fiscal policy,commer- hanced abilityto respond to real shocks that are specific cial policy,or exogenouschanges in the relative price of to it. raw material on the world market. They do, but it is the Let me begin a detailed discussionof some of the is- three policiesthat are under the control of the authori- sues surrounding the choice of fixedversus flexibleex- ties and that have a more direct effecton exchangerates change rates by a bald assertion. In a world with perfect which are typicallyencompassed by the term "exchange asset substitutability,no exchangecontrols, and fixedex- rate policy."Note also the hierarchyof these choices.The change rates, there is virtually no autonomy in mone- choice of the exchangerate system is fundamental and tary policy for a small country. There are two key has a crucial implicationfor the scopeof monetary poli- implications. First, a small country that fixes its ex- cy.Intervention policy is the least important of the three change rate to the currency of a singlelarge country or

125 126 ChatrlesFreedman to a basket of currencies ofa number of countries by and flexible exchange rates the adjustment is not all that large ties its inflation rate to that of its partner or to a easy.There is alwaysthe risk that a currency deprecia- weighted average of its partners. Second, in the face of tion in response to a negativeterms-of-trade shock will real shocks to the terms of trade, adjustment of the real feed into a wage-pricespiral. And flexibleexchange rates exchangerate must take placethrough differentialprice willsometimes move away from equilibrium,not toward movementsrather than through nominal exchangerate it. Indeed,the misalignmentsin exchangerates in recent changes. years have been the source of considerablediscussion A country that fixesits exchange rate (permanently) about currencyzones, concertedintervention, EMS,and trades off its ability to influence domesticnominal vari- other ways of moving back towards the fixed exchange ables in return for the rate of inflationof its larger part- regime. Nonetheless,in the case of a country subject to ner. This decision is more sensible, the greater the periodic sizeable external shocks that are specificto it confidencea country has in the central bankof the coun- and do not affect its potential partners, it is difficultto try to which it is tying its currency and the greater the argue that fixedexchange rates will dominate flexibleex- similarityof the shocks facedby the two countries.In the change rates. case of the EMS,for example,other countries havebeen In this connection,it is worth noting the literature on able to import the credibilityof the Bundesbankby tying optimal currency areas, which focuses on such matters their currenciesto the German mark.And, indeed,there as the mobility of labor, the size and openness of the has been a convergence of inflation rates over time economy,the nature of shocks,and the flexibilityof real among those European countries that have associated wages. This literature reminds us that the decision re- their currencieswith the mark. Thecase ofthose franco- gardingfixed versus flexibleexchange rates is a multifac- phone Africancountries that have maintained their ties eted one, particularly for small countries. to the French currency area servesas another example. I argued earlier that, if there is perfectasset substitut- Note that to obtain the full credibilitybenefit of the ability and no exchange controls, a country choosing fixedrate in such circumstances,the country has to con- fixedexchange rates willhave no monetarypolicy auton- vince the market that the fixed rate is close to irrevoca- omy.I now turn to the situation in a fixedexchange rate ble. Havinga fixedbut adjustable exchange rate, in my worldwith imperfectsubstitutability, exchange controls, view, does not yield the benefit of an irrevocablyfixed or both. rate. The country does not get the full advantageof the Imperfect substitutability does permit a country to credibility,and it may be faced periodicallywith attacks have some degree of autonomy in monetary policyeven on the currency followedby large discrete adjustments though its currencyis fixedto another country'scurren- of the exchange rate peg, with concomitant effects on cy.The same holds true for exchangecontrols. However, prices of traded goods (or subsidies). although the central bank in such circumstances can As mentioned earlier, the choice of an irrevocably followa somewhatdifferent policy in the short run from fixed exchange rate implies that, in the face of real its partner, it has relativelylittle longer-run autonomy shocks to the terms of trade, adjustment of the real ex- except if it is prepared to adjust its exchangerate from change rate must take place through differential price time to time. movements rather than through nominal exchange Consider,for example,a situation where small coun- rates. This impliesthat, where possible,a country should try A choosesto followa somewhatlaxer monetarypolicy tie its currency to a large crediblecountry facingsimilar than large country B to which it has tied its currency. shocks to those it faces. This will permit it to float The lowerinterest rates in A can coexistwith higher in- against other countries with differingexternal shocks. terest rates in B since the capital outflow is not over- Supposethere is no country that both faces similar whelminglylarge (becauseof imperfectsubstitutability external shocks and has a credible anti-inflationary or exchange controls). Over time, however,if A's infla- stance.That is, supposea country faces sizable external tion rate is higher than B's, its currency becomes more shocks which are specificto it and which do not affectits and more overvalued.This will leadto pressures for cap- potential partners. A common shock of this type is the ital outflows from A as the public becomes more and shift in raw materials prices relative to manufactured more convincedof the inevitabilityof a future devalua- goodsprices. In such a case, the movement in the nom- tion. Even if A'sgovernment is successfulin preventing inal exchangerate can act to offsetin part the resulting the outflowvia the use of controls2 the overvaluedcur- changes in aggregate demand, to spread the costs and rency can have deleteriouseffects on the economy.It de- benefits of the change in product prices throughout the presses returns in the tradeable goods sector of the economy,and to facilitatethe movement in the real ex- economy, artificially increases the real wage rate (by changerate toward its equilibrium.Of course, even with keeping import priceslow), makesthe inevitableadjust- Exchange Rate Policy 127 ment harder to absorb, and raises the value of the ra- an extremelylarge changein reserves,a reflectionof the tioned foreign exchange (increasingthe return to rent- general point that there can be no autonomous mone- seeking behavior). tary policyin a fixedexchange rate system with perfect In sum, the pure logic of the arguments thus far leads substitutability. one to support either an irrevocablyfixed exchange rate Returning to the case of imperfectsubstitutability, I (or one close enough to irrevocableso as to enable the would repeat and amplifyon the point made in the pre- authorities to obtain all the credibilitybenefits) or a flex- vious sectionthat although somewhatautonomous pol- ible exchangerate (withor without management of the icy is possiblein the short run, it is not possiblein the float), rather than an adjustablepeg. The latter seems on long run without a parity adjustment.The easier mone- the surface to have a variety of disadvantageswithout tary policyin A results in a capitaloutflow and a current many compensating advantages.This particular judg- accountdeterioration. If A persists in a more expansion- ment is stronger, the greater is asset substitutabilityand ary monetarypolicy, there will probablybe some further the less the reliance on controls. Havingsaid this, I rec- capitaloutflow (lagged adjustment to the earlier interest ognize that most small developingcountries have opted rate change) and a continuallydeteriorating current ac- for this intermediate outcome. There are a number of count, as domestic price inflation exceeds foreign reasons for such a result. Political considerations (in inflation,with a resulting decline in domestic competi- particular, concern about the perceptions of indepen- tiveness.The continuing and growing current account dence) may prevent a country from entering into a mon- deficitwill eventually exhaust the finiteamount of inter- etary union, while economic considerations(its lack of national reservesavailable to A. Moreover,well beforeA's credibility)may lead it awayfrom exchangerate flexibil- reserves are exhausted, the market will recognize the ity. Also, the experience under flexibleexchange rates nonviabilityof A'spolicies and the inevitabilityof a fu- has made some countries wary of opting for this structure devaluationif they are not changed.The resulting ture. The second-bestoutcome in such a case might be capital outflow,driven by the expectationof a devalua- to try to mimic monetaryunion by fixingthe currencyto tion of A'scurrency, can be considerablylarger than the that of a crediblepartner and holding tightly to that link. earlier interest-rate-drivencapital outflow because the Moreover,a country may be nervous about tying irrevo- expectednet returns from getting out of investments in cablyto another currency,because the country to which a currency that one expectswill be devaluedcan be very it is tying may become less responsiblein the future. high (since the discrete changes tend to be very large). Monetaryunion also precludesthe adjustment of the ex- In addition, if there is concern that the authorities will change rate in case of a severe shock.Finally, the desire impose capital or exchange controls in such circum- to capture the seigniorage tax may prevent monetary stances, the outward movement of capital will be even union. greater.3 Experiencesuggests that residentsplay a prominent role in such capital outflows;it is not just foreign Monetary Policy and Intervention Policy investorsthat react. In sum, in a fixed exchange rate structure a small This section considers more closelythe conduct of country's monetary policy has to convergeto that of its monetary and interventionpolicy under fixedand flexi- partner country in the long run, even if asset substitut- ble exchangerates. Considerfirst the short-run situation abilityis low,and in the short run if asset substitutability in a fixedexchange rate world.A is the small country on is high. which we are focusingand B the larger country to which I turn now to the case of a small country with flexible it has tied its currency. Supposethat A decidesto relax exchangerates. Monetarypolicy can be used in autono- its monetarypolicy and ease interest rates. This willhave mous fashionby the authorities of the domestic country. both direct and indirect effects on its international re- In the long run this autonomy enables the country to serves. The direct effectvia capital outflowsis generated choose its own inflation rate and facilitates the adjust- by the change in interest rate differentials (through ment to real (termsof trade) shocks. However,the ability transactions of both residents and non-residents).The to choosean inflationrate can be used for good or for ill. indirect effectsoccur via the current account deteriora- Furthermore, at times the market has pushed exchange tion as output and prices rise in country A. It is obvious rates too far in one direction or the other, resulting in that the higher the degree of asset substitutability,the adjustment costs for the tradeable goods sector. These larger the changein internationalreserves (i.e., the larg- erratic and bandwagoneffects providethe rationale for er the amount of interventionneeded) for a givenchange intervention in a flexibleexchange rate system. in interest rates. In the limit, with perfect asset substi- Howdoes monetary policy get transmitted in a flexi- tutability,even a small changein interest rates results in ble exchangerate world? In a small open economywith 128 Charles Freedman flexibleexchange rates, monetary policy is transmitted More generally,in a world of flexibleexchange rates via both interest rates and exchangerates. And as econ- with high asset substitutability,exchange market inter- omiesbecome more open to foreign financialinfluences, vention is not likelyto have long-run or even medium- the greater will be the importance of the exchangerate run influence on the exchangerate, although it may be channel. In the typicalclosed economy model, the tight- useful in the short run. Thus, for example,the Canadian ening of monetary policy operates to increase interest authorities tend to think of intervention as, first and rates; the higher interest rates in turn reduce interest- foremost, a tool for promoting orderly markets and sensitive expenditures.Typically, the focus is on invest- moderating exchange rate movements in response to ment expenditures, residential construction, and con- shocks and temporary disruptions. The technique of sumer durables.In addition, spending on other forms of leaning against the wind is used to dampen short- run consumer goods is reduced via the wealth effect,at least volatilityand to offset random movements.Even in the in a world where long-term fixed-rateassets predomi- case of more persistent shocks and more fundamental nate. (Andin a world with regulation-Qtypes of ceilings, pressures,intervention is usedas a meansof buyingtime there wouldbe disintermediationand creditrationing by in order to permit monetary policyto go to work. The financialinstitutions.) In the correspondingopen econ- Jurgensen report, prepared some years ago for the G-7, omy model with flexibleexchange rates, the tightening also reached the conclusion that intervention policy of monetary policytends to increasethe value of the do- could have some short-run effecton exchangerates but mestic currency as well as to raise interest rates. The re- could not be expectedto have any lasting influence.4 In- sult is to shift expendituresby domestic residents from tervention can be sporadicor more continuous, the lat- domesticallyproduced goods to imports. In addition, the ter being the case in Canada. currency appreciation has a direct effecton prices, par- The use of exchange market intervention may also ticularly in the case of the small open economywhere have some significanceas a signaling device of forth- the prices of both exportablesand importables respond comingmonetary policy action, either automatic (in the fairly directlyto exchangerate changes. case of unsterilizedintervention) or discretionary(in the It is important to note that the central bank has very case of sterilizedintervention). This role for intervention little influenceon the split betweeninterest rates and ex- can be of particular importancewhen a beliefhas devel- change rates of a given change in policy stance. Thus a oped in the market that speculativeforces have resulted given tightening of policymay produce a sharp appreci- in a considerableovershooting of the exchangerate. If ation and little interest rate change or little appreciation market participants are alreadyconcerned about the vi- and a significant interest rate increase. In large part the ability of the currency at the prevailingexchange rate, split depends on expectationsin the foreign exchange strong intervention, which signals that the authorities market, including most notably expectationsregarding hold the view that the currency is overpricedor under- the length of time the tighter policyand higher interest priced and that they are likelyto engage in more funda- rates are expectedto last. To assist it in the conduct of mental actionsto movethe rate, is likelyto have a direct policyin these circumstances,the authorities can use a effecton market behavior.In the absence of clear evi- "monetaryconditions index" that tries to weight both in- dence of speculativeovershoot, the signalingaspect will terest rate and exchange rate changes in terms of their be less effective. relative effecton aggregate demand. Beyondthe concern with its effecton aggregate de- Sterilization of Changes in International mand, the exchange rate is also important in the con- Reserves duct of monetary policyfor a coupleof other reasons.At a time of inflationarypressure, one wouldwant to avoid This last section dealswith the technical issue of ster- a sharp depreciationof the currency, because it would ilization of reserve changes. The details of sterilization feed into price changes fairly rapidlyand have deleteri- will differfrom country to country dependingon the in- ous effects on expectations of future rates of inflation. stitutional structure (which,itself, is usually the result Andthere is sometimesa concern that markets willover- of the historical development of markets and institu- shoot and push exchangerates too far, especiallyif they tions). The basic principleis, however,very simple.Ster- believethe authorities are taking a hands-offattitude to ilization involvesaction (or nonaction in certain cases) the exchange rate ("benign neglect"). Both monetary by the authorities to prevent changes in internationalre- policyand intervention policycan be used to influence servesfrom having secondaryeffects on domestic mon- the exchange rate in such circumstances, although etary conditions through their influence on the cash clearly the former is by far the more powerfulinfluence. reservesof the domestic banking system. Exchange Rate Policy 129

Considerthe followingsimple example. Suppose that country to impose a secondary reserve requirement, international reservesare held on the books of the cen- which would force banks to hold certain assets such as tral bank (not a universal practice,as we shall see). The domestictreasury bills, in order to influencethe demand other asset of the central bank is domestic bonds. The by banks for the type of assets used in the sterilization central bank liabilitiesare currency, the depositsof the operation. banking system (reserves), and government deposits. In some countries, such as Canada,international re- Supposethere is an increasein the desired holdings by servesare held on the booksof the governmentor a gov- foreignersof domestic currency assets, and that the au- ernmental entity and not on the books of the central thorities intervene to prevent an appreciationof the do- bank. This doesnot changethe logic ofthe abovediscus- mestic currency. The central bank issues a check upon sion but rather makes sterilization automatic rather itself in return for the foreigncurrency (typicallya check than discretionary.In the case of Canada,for example, on a foreign bank). Whether the foreigner buys a bond international reservesare an asset in the ExchangeFund from a resident or holds a deposit in a domestic bank,the Accountand are financedin the short run by a reduction domestic bankwill obtain the claim on the central bank in governmentdeposits at the banks and in the long run and its reservesat the central bank will rise. This will by an increase in treasury bills outstanding. TheBank of lead to downwardpressure on short-term interest rates Canada acts as an agent. Note that if a government fi- as the banks with excess reserves act to expand their nanced its increased holdings of international reserves portfolio of interest-bearing assets, and this downward by borrowing from the central bank, we would be right pressure may be inappropriate. back to the earlier example. What options are availableto the authorities to pre- I would note in conclusion that sterilizationprevents vent the secondary effects?They can do a number of certain automatic responsesfrom taking place.Thus the things: (1) The central bank can sell domestic assets on autonomous capital inflowjust discussedwould, if un- the domestic bill or bond market. (2) It can sell the for- sterilized,have led to an expansionof the balancesheets eign exchangeto the domestic banks on a swap agree- of the banks and put downwardpressure on interest ment. (3) It can shift government deposits from the rates. Hence it would have induced a partly offsetting banks to the central bank. (4) The governmentcan issue capital outflow.By engagingin sterilization,the author- debt instruments and depositthe proceedsin the central ities are trying to prevent the secondary repercussions bank. (5) The reserve requirement ratio can be adjusted on the interest rate and hence insulate the domestic upward. Note that the first and fourth options assume economyfrom the capitalinflow. Similarly, if the capital the existenceof a reasonablywell-developed market for inflowwere the result ofa tightening of monetarypolicy, domestic instruments while options two, three, and five the sterilization tries to prevent downwardpressure on do not. interest rates, which wouldoffset the originalaction. Re- It is sometimesargued that if the central bank or the call, however,that in the limit in a fixed exchangerate government sells domestic instruments to sterilize the system with perfect substitutability,fully sterilized in- capital inflow,there willbe upwardpressure on domestic tervention is not possiblebecause of the infinite elastic- interest rates, further capital inflows, further need for ity of capital flows, while nonsterilized intervention open market sales for sterilization purposes, further up- simply reversesthe original central bank tightening ac- ward pressure on interest rates, etc. This argument in- tion (leaving the central bank with more foreign ex- volvesa fallacybecause it does not take into account the change and less domesticassets on its balance sheet). destination of the original capitalinflow. One possibility is that the foreign investorwants to hold domestic inter- Notes est-bearingassets, with the result that the central bank indirectlyends up trading its own holdings of, say,trea- 1. Capitalmobility is defined as the absence of policy sury bills to the foreign investor in return for foreign restrictions on the movement of funds between coun- currency.A secondpossibility is that the foreign investor tries. Asset substitutability is definedas the willingness wishes to hold a deposit in the domestic bank.The cen- of investorsand borrowers to shift betweeninstruments tral bank or government can then supply an interest- denominated in differentcurrencies in response to very bearing asset for the bank to hold (treasury bill or small differencesin expectedreturns. swappedforeign exchange)or it can reduce other (i.e. 2. I wouldnote that no controlsare perfect.For exam- government) deposits at the bank or it can force the ple, black markets develop,and there are leads and lags bank to hold more required reserves (either interest- in current account transactions. bearing or non-interest-bearing),all of which actions 3. Foreign borrowingby the authorities can provide prevent secondaryrepercussions. It is also possiblefor a more reserves,but market forces will eventuallydomi- 130 Charles Freedman nate. Intervention on the forwardforeign exchangemar- indeed,might cause counterpartiesto refuse to engagein ket has virtually identical effectsto intervention on the further transaction with the authorities because of the spot foreignexchange market and appears on the surface perceivedrisk. to be potentially unlimited in magnitude. However,ex- 4. In a world with imperfectsubstitutability, interven- tremely large intervention on the forwardmarket would tion can have last effects but these are quantitatively result in the authorities' taking on a very large risk and, small. 11

Interaction of ExchangeRate Policy and MonetaryPolicy: The Caseof Malaysia

Lin See Yan,

After listening to Dr. Freedman, I think that what I am not to belittle but just to showthe differencein percep- going to say is very pedestrian. He has covered a lot of tions of the same thing. ground, especiallyon the theoreticalside. I would like to AsI said, the starting point is 1980;until then we had move awayfrom the theory and go into the nuts and been doing very well. Like all Western-trained econo- bolts of operations. One thing I have learned over many mists, I thought in 1980that the worldrecession coming years is that, whilethe theory is nice to have, in develop- through then wouldbe short. Everybody-the big brains ing countries where things are always imperfect, very all over the world including the World Bank and the imperfect, even simple statements of theory cannot be IMF-thought it would be a short recession. Likegood taken for granted. Asan example,just now Dr.Freedman Keynesians,we decidedto spend our waythrough the re- referred so easilyto the option of using governmentde- cession.That was a big mistake for us. By 1983, three posits in commercial banksto sterilize foreign exchange years later, we were running a government deficit of interventions.And yet, it took me four years to convince close to 19 percent of GNP and a balance of payments the governmentto allowthe central bank to handle that. deficit of around 14 percent. By then we had increased First, then, I shall talk brieflyabout the Malaysianex- our externaldebt four times, and the public debt at that perience,which has some unique aspects. Within that time was close to 130 percent of GNP. context, I shall then describehow we operate monetary By the way,when the recession began in 1980, the policy,with particular regard to exchangerate policyand prices of everything that Malaysiaproduces fell at the the problemswe face. same time. I recall that the WorldBank had advisedus that such a convergencewould be statisticallya near im- M1alaysia'sEconomic Background possibility.In 1980,we had everythingfalling for us at the sametime, and then it happenedagain in 1985. I am sure many ofyou have heard of Malaysia,but you Clearlythe situation wasnot sustainablefor us, so we may know little about it. A perspectiveis important, for decidedto pull back in 1983.This was done on our own mayssonknowslittle aboutit.Aprspmectiv iswimhwportante,fo volition, without any help from the WorldBank or the it is difficultto appreciatewhat we have done. The start- IMF.By 1984,dust beforethe onset of the secondreces- ingpoint for this perspectiveon Malaysiais 1980.For the percent of GNP to 8 percent. The balance of payments twenty-fiveyears prior to 1980,Malaysia had been grow- deficitfell from 14 percent almost to balance,with just a ing fast with practically no inflation. It is one of those small deficit. countries that some describeas allergic to inflation.We Then the secondwhammy came through. We had to regard inflation as being like toothpaste;once it's out, it manage it and so could not make further progress for a is difficultto push back in. At present, our inflation rate while.But within another year and a half, we turned the is 2.2 percent,and alreadypeople are talkingabout infla- govemment deficit around to only 2-3 percent of GNP tionaryexpectations. So, yes,we are allergic to inflation. and had a balance of payments surplus as large as the I just came back from Geneva,where I was talking to deficitwe had in 1980. Allthis time, inflationwas from my Latin Americanfriends. It is very difficultto keep in 3.5 to 4.5 percent. During this period, we also decreased step; I am alwaysunsure whether they are speaking of the external public debt significantly.The ratio of exter- hourly,weekly, daily, or annual inflationrates. I say this nal debt serviceto exports had been 20 percent. By the

131 132 Lin See Yan end of this year, we will have reduced debt service to 9 Withoutgoing into too much detail,I want to provide percent of exports. a taste of the dilemmas we face. For example,as I just mentioned we are now in our fifth consecutive year of ExchangeRate Policy and MonetaryPolicy rapid growth. Wewill have growth of about 8.5 percent in real terms. We hope inflation for the year as a whole To put these changes in perspective,you must re- will not exceed4 percent. However,the money supply is member that Malaysiais a small country but very open growing fast because of these four years of very rapid with respectto capitalflows. The only exchangecontrol, growth.There was much pent-up demand that had been ironically,is inward rather than outward.Malaysia has a held back in the early 1980sby the strict structural ad- floating exchangerate. It floats against a basket rather justments. So money growth is running now at 18-20 than one particularcurrency. percent, while a range of 14-15 percent is more to our More importantly,we turned the economyaround by liking. In this environment,I think it is important to try completelyrestructuring it. Wemade the private sector, to pull back. Monetary policy has to become more re- not the government, the engine of growth. In the pro- strictive. Creditpolicy has to be somewhatrestrictive, so cess, government expendituredecreased from a high of interest rates must rise. Exchangerate policyshould be 42 percent of GNPto less than 30 percent today,and it is at least neutral, even a bit below,so that the currency still falling. That means downsizing government and will appreciate. privatization. At the same time, we have a situation where the pri- The capital markets in Malaysia,the money market vate sector was brought in just a short time ago to take and the foreign exchange market, are not highly devel- over from government as the engine of growth. So we oped.In addition,this open economyis situated only250 must be verysensitive in managing monetarypolicy, es- miles from Singapore,which welcomes capital inflows peciallyinterest rates, to ensure that a rise in rates does with open arms. Hong Kong,which is just three hours not choke off these sharp increases in investment. On away, does the same. So money flows easily.Very few the other hand, if we do not raise them enough, capital monetary policy instruments are availablein such a sit- outflowsmay becomeso significantthat reservesare se- uation. Mostof those which we learn from the textbooks riously drained. are not easy to implementin such an economy. The export orientation of the economycreates addi- In Malaysiaas in most developingcountries, the me- tional dilemmas.This year exportswill account for close dium-term goal is clear: to have growth with stability. to 45 percent of total output. Onlyfive or six years ago, Yet,in the processof goingfrom here to there, one must they were just 22 percent of total output, and the share remember that the means to that goal are never clear to will rise to 65 percent in another three years. To ensure politicians, nor to many economists.In practice, there that exportscontinue to grow,this export-drivenecono- are multiple objectivesand insufficientinstruments to my requires policy to be relativelyeasy. Interest rates target them. cannot be too high, or they will choke off the strong in- Certainly though, the more fundamental objectives flowof foreign investment.We must also ensure that the include such things as low inflationwith high growth. strong balance of payments position that has developed During the last four years, Malaysia'sgrowth rate has over the last four to five years does not raise the ex- been 8 to 8.5 percent in real terms. As I said, we have change rate to the point that exports become noncom- handed the whole economy over to the private sector, petitive. with exportsas the main engine of growth. Wherever we turn, these conflicts and dilemmas A matrix can be drawn that charts these objectives arise. At present, we are trying to developa capital mar- against the availablemeans of achieving them. On one ket and a money market that give us sufficientflexibility side are the objectivesof low inflation,high growth, and and adequate instruments to succeed in this balancing dynamicexports. On the other sidewe list monetarypol- game. Even so, it is practicallyimpossible to maintain a icy,which for us works directly through liquidityman- balance. agement; credit policy,for which interest rates are the Overthe past fewyears, we have been sterilizing those main instrument; and exchangerate policy.With objec- large inflowsof capital,both portfolioand direct invest- tives like those and limited instruments, and given the ment capital, by prepayment of public debt. In conse- sharp structural adjustments in our environmentduring quenceour debt has declinedenormously; as I said,total the past ten years, exceedinglydifficult dilemmas are external debt serviceby the end of this year will be only bound to occur again and again. The real problem of the 9 percent of exports.But the capitalinflows are still com- central bank is how to keep all these things in balance. ing. Interaction of Exchange Rate Policy and Monietaiy Policy: The Case of Malaysia 133

At the same time, Malaysiahas had huge outflowsof We think of many things to do; we do swaps.But do capitalto take advantageof high interest rates abroad.To not forgetthat swapsare not easyfor our country.Malay- give you an idea, Malaysiatoday probablyhas the lowest sia is a small country that has been in the shadowof Sin- interest rates in the world; our money market rates for gapore for manyyears. Wetry to be independentof them 3-month or 6-month moneyare around 5.5 or 6 percent. and create our own swapmarket. We have a base lending rate of 6.75 percent, but busi- These things we can manage;we can balance some nesses can finance themselves through bankers' accep- wayor other. But the most difficultpart occurswhen the tances and export refinancingfacilities at 4.5 percent. market gets itchy. The exchangemarket begins to feel The current rate for 12-monthdeposits is 5 percent. that it is time to speculate against the ringgit and does So here again we have a delicate situation. We have so. Wehave not had this problem recently,but over the managed so far because the inflowsof capital have been last ten years it happenedmany times. Supposethe fun- so strong that the outflowfrom low interest rates was a damentals and the exchangerate are not moving in the blessing.The outflowsworked to sterilize a lot ofthe in- same directions for obviousreasons: capital flowsand so flow. Still, our markets are not as developedas in the on. Thebitter lessonwe have learned is that you must be West.There are not enough instruments to sterilize the veryagile, which the textbooksdo not teach. Youhave to inflows,so we need to createnew ones. At first when a lot do it in such a way that, if necessary,you have to accept of capital came in, we just deflectedit through prepay- expensivetrade-offs. ments of debt, but there is a limit to that. Not all debt can Let me give an example.At a time when we were go- be prepaid. And your creditors begin to complainwhen ing through that difficult structural adjustment, the you repay too much; they prefer to hold your paper.Nev- speculatorsthought it was time to take positionsagainst ertheless, our government long-term inflowshave been the Malaysianringgit. Becausewe were in a recession, negativefor four years. So we have to create other means interest rates were low, monetary policy was easy,and of dealingwith the capital inflow.For example,we may ringgit were easily available.So the speculators start- have to persuade our foreign direct investors to bring in ed-and they alwaysstart in New York,while you are only M$20million,' rather than M$100million, and to sleeping. borrow monei locallyso that the banks can restructure To put the situation in perspective,we have reserves balanceoheirsheets. Wehave to think of things like that. today of roughly US$8 billion. That is equivalent to Nevertheialaeshereis. We have toth ofliquiithings le that about four and a half months of imports. In one day of Nevertheless,there IS still a lot of liquidityin the mar- spcltoagitthcurnywcnlseablonf ket. So we do the same things that everyonedoes. We speculationagamst the currencywe can lose a bllion of raise required reserves or the liquidity ratios, and the For a country like Malaysia,with just US$8billion in re- banks complainbecause they have to raise interest rates. Forveco a si a, billion in re- But do not forget that all the time the balance must be serves,losing a billion of it is no joke. The only way to Buintainedontogthaltti thbacmse handlea speculativesituation like that is to hit the spec- maintained. ulators hard, very hard. What we do is make it extremely Sinceh egovenment wa insurs-th overn difficultfor them to get ringgit. We squeeze the money ment had money flowingout of Its ears-on occasion market, though obviouslyat the expense of domestic the treasury wanted to stop issuingbills. They askedwhy monetary policy,At that time our monetary policy was we were pressing them to issue more bills to mop up the easy,for we had to reviveconfidence. But in speculative liquidity;that is the central bank's problem. So instead bouts like that-and over the last ten years we have had of issuing bills,the next best thing we could think of was three or four such occasions-our experiencehas been to accept deposits.We began to mop up the liquidityby that unless you act very firmlyagainst them, the specu- acceptingdeposits from the banks. That is an easyway of lators will never leaveyou alone. And you will never be doing it, although it costs a lot. Our job is not to make able to conduct monetary policy. money. So even at the expenseof trade-offsagainst our mon- Yeta simpleidea like this seems terrible in the eyes of etary policy,today we would not hesitate to squeeze the a developing country. It is important that people have money market to a 100 percent per day rate of interest. confidencein the central bank. If they see your profits Our past four experienceshave been that if you do that, fall, they do not understand that your motivation is not if you make life extremely painful for the speculators, to make a profit; they think something is going wrong then they will never touch you again. In fact the best with the central bank. Outflowsof money will start be- outcome would be to make them default and come to cause of that opinion. Therefore,such actions must be you beggingon their kneesfor ringgit.We have not gone carefullymanaged to ensure that your profits do not fall that far. The furthest we have gone is to raise the money too heavilywhen you are moppingup reserves. market rate to 100 percent and make presidentsof spec- 134 Lin See Yan

ulative companiescome to me beggingfor ringgit. They to lend to them, either directly or through the redis- will never go after the ringgit again. count window,at rates that are more in line with normal Theseare drasticmeasures, but you have to improvise times. In our case, these priority investments included like that. Being a small economy with not enough in- manufacturing,plantations, and so on. In manyinstanc- struments, with openness in your economy,and dilem- es, we have set up funds like that. To ensure that our ex- mas like that, you have to act very firmly.And so, trade- treme tightening did not have an adverse impact on offs must be taken; you must be decisive.One result is investment,we thought of new ideas on how to help. that we now operate24 hours a day.I run my foreignex- During the period when you have to handle an exchange shop around the clock in three shifts, to make change rate problem,you have to find waysto make sure sure nobodytakes advantageof us. In that way,we do not life at home can go on as normally as possible.At the lose hard-earned reservessimply because someonetries right time, when the speculatorsare off for the day,you to make a quick buck on us. just go back to normal. Fortunately,this approachis not The point of this exampleis that in a small and open difficultto manage in a small economy. economyit is very difficultto conduct monetary policy, exchangerate policy,or interest rate policyby the meth- Conclusion ods the textbooksteach. Most of the time, the textbook approachesdo not work. You have to think of whatever Althoughwe have done many things in Malaysiathat way you can to work toward whatever objectives you someof you have probablynever heard ofbeing done behave. Youhave to innovate all the time. We do that, and fore, we do them because they work. With that general I can give more examplesthat show it can work. point, ladiesand gentlemen, I shall stop. Mymessage to Always,the key is to foster in the market, whether in you who operate in a small economyis that you do not the local or foreign markets, a respect for your policies. have the luxury to do many things my friend Mr.Freed- If something is working againstyou that you do not like, man can do in Canada, things that any central bank in if it is working against the effectiveattainment of your the developedworld can do. To reach our objectives,we policies,you must act firmly, even to the extent of ac- must make do with what we have. ceptingsevere trade-offs like those I mentioned. Wealso have found that whileyou may have to accept Notes these trade-offs,there are ways to ameliorate their impact. For example,when we had to squeeze the market 1. The author is DeputyGovernor, Bank Negara Ma- and raise interest rates very high to kill off the specula- laysia. tion, we set up new funds for what we call priority invest- 2. The currency ofMalaysia is the ringgit, which is ab- ments. To bring down the interest rate for investments breviatedM$. that willincrease capacity,the central bank stands ready Discussion Question:Why doesn't Malaysialet the currency ap- We don't think our current exchangerate is inappro- preciate more to dealwith the inflationaryconsequences priate. We moved back to this point when we went of the favorablecurrent account and the large capital in- through the structural adjustment. We went through a flows? periodof overvaluation,mainly because of Singapore.We were on a one-to-one peg to them for many years. Be- Mr.Lin: Don't forget there are no inflationaryconse- cause of Singapore'sstrong economyas a financialcen- quences at this point in time. Weare sensitiveto the exter, the political, and more importantly, the general changerate because for many yearswe had an overvalued feelingwas alwaysto maintain this one-to-one relation- exchangerate. Also,it is very difficultto explainto inves- ship. It took us fiveyears to convincepoliticians and the tors who have come to you on the expectationthat your general public that it was all right to have a weaker ex- exchangerate will be stablewhen suddenlythey are faced change rate. So it is fundamental for private sector con- with a 20 percent or 30 percent appreciationof your cur- fidence, in our context certainly, that we manage the rency. I think that would be an act of bad faith. Foreign exchangerate in such a wayas to avoidsharp gyrations. investment,which was crucial in tuming our economy Dr.Freedman earlierreferred to it as maintainingorderly around, accounted in 1987 for about two-thirds of total markets. investment,so the exchangerate is very important. Interaction of ExchiangeRate Policy and Monetary Policy: The Case of Malaysia 135

Question: In your exchangerate policy,am I correct sharply.On those occasions,you give subsidizedcredits that you are assigning a real exchangerate on the basis to priority investments.How can you ensure that these of a basket of currencies?And do you assign it weekly, subsidizedcredits are not also used for speculation? monthly or how often? Mr. Lin: Oh, those funds are for actual projects. You Mr.Lin: Yes[to the first question]. Daily[to the sec- can only borrow from the special funds for actual ond question]. Wehave a softwareprogram to handle it. projects. It is not difficultto developit. The problemis alwayshow to get your economicspeople, who turn out all these bas- Question:But how can you keep them from joining in kets and effectiveexchange rates, togetherwith your op- the speculationagainst the currency? erators. Although we are pegged to a basket, our intervention currency is the U.S.dollar. If, for example, Mr. Lin: I do not release my money until the investor the basket moves up too much [against the U.S.dollar], needs to pay a bill. For example,if the investor is build- moves up by a certain number of points; the operator ing a factory, I release the money when the machinery must know,by pressinga button, what he needsto do on comes. the U.S. dollar side to keep the rate stable. It is not too difficultto developthat software.It allowsthe econom- Question: Supposethey have their own resources to ics people,the research people,the monetarypolicy peo- apply to their activities, and they use the subsidized ple, to talk on the same wavelength as the operator. money you give them and speculate against you? What That'svery important. willyou do?

Question: Myquestion is on the instrument you use Mr. Lin: I will come down very hard on them. But to affectinterest rates. Is it through rediscounting? these people knowthat.

Mr.Lin: We affect interest rates through management Mr.Honohan: Haveyou ever consideredthis alterna- of liquidity,for which we use the normal range of instru- tive. Instead of increasinginterest rates dramaticallyto ments. For example,when we see the first signs of inter- hit the speculator,have you ever allowed the ringgit to est rate changes, we will raise required reserves to fall 3 or 4 percent, then suddenlyraise it 5 percent?That manage liquidity.However, with the capital inflowswe approach would feed back less severelyon your priority have had, not just in direct investment but also in port- projects. folio investment, these traditional instruments are far too inflexible.For example,to move required reserves, Mr.Lin: Yes,we have tried that. The problem is that we must wait for the middle of the month and dealwith when you operate an exchange,you are never sure how other complications.But in an open economy,actions far you can go, because the market willmove you. If you should be taken today or tomorrow. New instruments are not careful, the speculators will make money from that we have created are more convenient.For example. you.And that is the worst situation to ever get into. Once we just go into the market and mop up [liquidity]by bor- they have tasted blood,they never let go. So what you do rowing. Nothingis faster than that, and it is very conve- is to hit them reallyhard. Wehave tried other ways,but nient. Wejust movein and take out liquidity. as I said,the moment they make money out ofyou, they For many years, [our open market operations] have know they can do it again. faced difficultiesbecause the government is flush with funds.Yet contractionary steps taken by the central bank Mr.Queiroz: Malaysia is small,so you can knowthese tended to be offsetby Treasuryaction. It was very diffi- things. In large countries it is not as easy. cult to convince the government that the central bank should also manage the government's so-called excess Mr. Lin:Yes, I think our experiencewould not be ap- reserves.But now the central bank has much better con- plicableto everyone.Still, we don't make these decisions trol of liquidity.To be able to marshal all the excessre- ourselves,we do it through the banks. For the banks, it serves of the public sector into the central bank is a is part of standard procedure. In our banking system, powerful instrument. It is an extremely useful instru- when the banks lend out for projects, we require ment to have. through our inspection system that the money goes where it is supposed to go. Of course the system is not Question: When speculators take positions against perfect,but it is a systemimplemented within the banks. your currency, you have increased the interest rate 136 Lin See Yan

Mr.Queiroz: How can a central bank at the same time nated in U.S. dollars, see that portion of it lose 20 per- act as a developmentbank? Those two functions are well cent of its value? separated.If you introduce a specialwindow for project That is an interesting question.The "normal"central finance,but fund speculationonly at a differentinterest banks ride it out over the long term. Things will be all rate, overtime it all becomesone. So the strategy is very right. But the point is that things are not all right tomor- risky. row or the dayafter tomorrow.You must face the Minis- We used to do this in Brazil. In December1979, the ter of Financewho saysthat as a result of my decisionhis government had a maxi-devaluation,following which debt goes up 30 percent; why didn't I do something they reduced interest rates. The objectivewas to boost about it? exports because the devaluation would make exports Ever since the world went off Bretton Woods, the cheaper. The problem was that peoplestarted to specu- whole game of central banking has changed. It is well late, expectinganother devaluationbecause the govern- and good for people,including the WorldBank and the ment loweredinterest rates. That is just what you were IMF,to give advice.We appreciate the advice,but much doing on those occasionsyou described.So I don't think of that advice comes without responsibility.I, on the you have much chance of maintaining that strategy over other hand, have to livewith the responsibilityif I take time. Interest rates cannot be high for somebodyand low your advice.If it goes wrong, I livewith it. And I have to for someoneelse. Either interest rates are low for every- turn around a situation that has not worked or be trans- body or high for everybody. ferred to another department. For us, this is the school of hard knocks. Mr. Lin: We maintain that distinction only for the Centralbanks todayare not differentfrom other insti- short term, the very short term [during which specula- tutions. They have to be development-oriented.To the tion againstthe ringgit is active].We are an unusual cen- extent that some action achievesthe national objectives, tral bank. For many years, we were a standard central we willdo it, just as we have done it in the past. As I said, bank.We did everythingthat central bankers in the West we are very controversialtoday. The IMFdoes not like us do. I remember,when Eugene Blackwas president of the becausewe try to protect ourselvesfrom G-7 decisions. World Bank, my first governor went to him for advice. Wehave explainedour positionto them and I think they Eugene Blacksaid, "For heaven'ssake, you are a central understand.We are sorry, but we believe it is important bank, neverget into developmentfinance and planning." for a central banker to be able to say,"We want to control But that is exactlywhat we did, and for severalreasons. our destiny." In a developingeconomy, where there is little or no infrastructure, where everything must be developed Mr. Freedman:Except for the 1985 case, where some from scratch, the central bank cannot behave like a argue it was the market and not the G-5that drove the Western central bank. That is reason number one. The dollar down,I don't think there is a singlecase where the second reason may sound very hard, but I have been in G-7decisions had a major effecton the market.And even this game for twenty-eight years. I have learned that if in the 1985case the dollar was clearlyovervalued; every- you don't take care ofyourself, nobodywill. one knew it was. Martin Feldsteinargues that it did not Let me pose the followingclassic example,which is have anything to do with the G-7. certainly controversial.The Group of Seven (G-7) can Usuallythe G-7pronouncements are things like,"We make policy pronouncements any way they want. They would like .. ." or "It isjust about right, but if it goestoo get together one weekendand decidethat the yen should far we are goingto move."It is alwaysmuch more vague appreciate by 20 or 30 percent. People like us, sitting than [a decision on how much an exchangerate should miles away,hear about it on the television;suddenly our change.] In fact, it is the market that has been driving debt has increased by 20 percent. And yet the central the rate changes. banks say you must behavelike a normal central bank. Don't rock the boat. Mr.Lin: What you say is quite true, but there is more What doesone do? I learned from the game. If I know to it than that. Wedon't knowwhat goeson in G-7meet- that rates are going up, I take a position.That is not be- ings;we can onlyspeculate. Theymight not have done it having like a "normal"Western central bank, obviously. to date, but they could do it tomorrow or the day after. But for heaven's sake,you tell me what I should do. Ev- Mypoint is that within that group-and now the latest erybody knew that the yen was going to appreciate at writings talk ofa group of just three, the G-3now-they that time; what should the central bank do? Should we can gang together and do whatever they want with re- sit back and, since a large part of our assets are denomi- spect to interest rates and exchangerates. Whateverthey do has a directimpact on us. Wehave to defendourselves Interaction of ExchangeRatePolicy anddMonetaryPolicy: Tle Case of Malaysia 137

in the market. I am saying we have becomea streetwise Also,I supposethat if you are in that business,you are central bank, so to speak,over the years. part of the market. You are going to win some and lose some. Andyou are going to haveto take that responsibil- Mr.Freedman: My only point is that you are overstat- ity. ing the power of the central banks and their governments to affect these things. They are usually not Mr.Lin: Exactly;my point is that the traditional cen- * preparedto take the fundamentalactions that it wouldin tral bank just sits it out. fact take to have those effects.

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