Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]

Module: 3 Monetary Policy In An Open Economy

Globalisation and Monetary Policy

Sterilisation of Capital Flows

Sterilisation - whether through Government securities or central bank's own securities - has its own limitations. It is important to know as to whether capital flows are temporary or permanent. In case such flows are believed to be permanent, sterilisation may not be an appropriate policy response. For economies with imperfect asset substitutability resulting from impediments to free cross border movements of capital and with a fully/partly regulated interest rate regime, sterilisation can be effective to an extent. Sustained sterilisation operations may, however, keep domestic interest rates high. This could attract even larger short-term inflows and thereby increase the overall volume of capital inflows rather than reducing them. By keeping domestic interest rates high, sterilisation could also alter the composition of capital flows, away from stable long-term FDI inflows and towards volatile short-term and portfolio inflows. The intensity of the open market operations has varied substantially across countries and across time. For example, capital inflows were almost fully sterilised in Chile during the first half of 1990, Indonesia during 1991-92, Malaysia from mid-1991 through early 1993 and Sri Lanka in 1991-93. Most of the East Asian developing countries have been able to employ sterilised intervention effectively.

Since domestic securities sold by the central bank in its OMO sales typically earn higher interest rate than that on foreign securities acquired by the central bank, sterilisation operations involve costs, termed as quasi-fiscal costs (QFCs), and these QFCs could turn out to be substantial with adverse implications for the central bank balance sheet per se and future conduct of monetary policy. For Latin American countries, these QFCs have been estimated to be between 0.25 and 0.5 percent of GDP. Although QFCs may not be large per se, these could increase significantly during brief surges in capital flows and may influence the future course of central bank sterilisation. In case, capital flows continue to persist, these QFCs can become quite large and these may render further sterilisation operations unsustainable. In such a scenario, central banks are quite likely to reduce the scale of their sterilisation operations and will be forced to let burden of adjustment to be borne by exchange rate. Kletzer and Spiegel (2004) find support in favour of this hypothesis for a group of 22 countries using quarterly data between February 1984 and April 1992. On the whole, however, opportunity cost of reserves seldom exceeds 0.5 per cent of GDP (IMF, 2004). Apart from losses on account of interest rate differentials, central banks may be exposed to capital losses in case their exchange rates were to appreciate sharply. According to Higgins and Klitgard (2004), a 10 per cent appreciation of the domestic currency could lead to domestic currency capital losses ranging from 3 per cent of their GDP for Korea and China to 8 per cent for Taiwan and 10 per cent for Singapore.

Countries have, therefore, often supplemented sterilisation measures with a number of other steps -the "belts and braces" strategy, which combines indirect instruments of monetary policy with some capital controls. The choice of instruments for sterilisation is often critical, especially as the degree of market orientation and the associated incidence of the cost on the central bank and the banking system varies a great deal. Policy responses have been conditioned by a number of factors, viz., the country's anti-inflationary track record, the openness of the economy to foreign trade, the depth of the domestic bond market, the degree of irreversibility of trade reforms, the health of the financial sector, the presence of non-banks in the financial system, the flexibility of fiscal policy and the health of public finances, the strength of the regulatory and supervisory framework, and the market's perception about the credibility and consistency in macroeconomic policies.

Apart from sterilisation through OMO sales, increase in cash reserve requirements and imposition of Tobin-type tax measures have been used by a number of countries. Recent examples include a two-step increase in reserve requirements by China and a differential reserve requirement system. Countries have also imposed differential reserve requirements between domestic and foreign currency liabilities and/or resident and non-resident deposits. A key limitation of across-the-board reserve requirements is the dead weight cost borne by the market in the form of an indirect tax on the banking system. Reserve requirements widen deposit-lending rate spreads and promote disintermediation as new institutions and instruments arise to bypass controls, thereby hampering efficient allocation of credit. For a sample of 20 episodes, Reinhart and Reinhart (1999) found that spreads widened in as many as 17 episodes. Both depositors and lenders share the tax: while deposit rates fell in 14 episodes (out of 20 sample episodes), lending rates increased in 12 episodes as banks passed on the costs of reserve requirements to their customers. The limited effectiveness of reserve requirements in the face of a large non-bank financial sector was clearly illustrated in Korea during the episode of capital inflow surge in the early 1990s. The share of deposits held by banks fell from 70 per cent in 1970s to 36 per cent in 1992, partly on account of sterilisation measures and this reduced the intended efficacy of reserve requirements. Despite sterilisation measures, Korea still experienced a large degree of real appreciation.

In the context of large capital flows, countries have used a wide range of instruments. One such instrument consists of explicit taxes or tax-like measures on inflows. The simplest example of an explicit tax is a tax on foreign exchange trading or on short-term cross-border bank loans, commonly known as the Tobin tax. Tobin tax, first proposed in 1972, was originally intended to deter short-term currency speculation. The burden of a Tobin tax is inversely proportional to the length of the transaction, i.e., the shorter the holding period, the heavier the burden of tax.

Variants of Tobin tax are available in the cross-country experience. An interest equalisation tax that equates the rate of return on domestic and foreign assets was imposed on capital flows in Brazil in 1993 on some classes of foreign exchange transactions. These were expanded in 1994 but scaled back, in 1995, in response to the Mexican crisis. Chile and Colombia have resorted to a system of unremunerated reserve requirement (URR) to discourage short-term capital inflows.

Chile has relied on URR on two occasions: 1978-82 and 1991-98. In both episodes, foreigners wishing to move funds into Chile were required to make non-interest bearing deposits at the central bank - a system equivalent to a tax on capital inflows. During the 1978-82 episode, inflows with maturities below 24 months were prohibited while those with maturities from 24 months to 66 months were subject to reserve requirements of 10-25 per cent of the value of inflows. Chile reintroduced restrictions on capital inflows in June 1991 in the face of a surge in capital inflows. Originally, all portfolio inflows were subject to a URR of 20 per cent. For maturities less than one year, the deposit was required to be maintained for the maturity of inflows; for inflows with maturities above one year, deposit was to be maintained for a period of one year. In view of attempts to avoid the URR by mis-stating portfolio inflows as trade credits or as direct investment inflows, the coverage of URR was extended to trade credits as well as FDI loans in July 1992. Moreover, the URR was raised to 30 percent, and its holding period was set at one year, independent of the length of stay of the flow. In an effort to close additional loopholes, the controls were extended, in 1995, to Chilean stocks traded on the New York Stock Exchange and to international bond issues. In order to reduce the risk of contagion from the Asian financial crisis, URR was reduced to 10 per cent in June 1998 and finally withdrawn in September 1998.

Colombia also introduced capital controls in the form of a URR on external borrowing in September 1993. In an effort to target short-term inflows, the URR was limited to loans with maturities up to 18 months. The URR was subsequently modified several times to better target short-term inflows (with higher rates applied to shorter maturities). As in Chile, following the Asian crisis, the URR was substantially reduced to contain exchange rate pressures.

The effectiveness of these tax measures remains a matter of debate. As these measures are subject to evasion, authorities are forced to widen the coverage repeatedly to make them effective. In Chile, the controls became effective in discouraging short-term flows only after 1995, when the implicit rate of taxation imposed by the controls increased significantly. However, the reduction in short-term flows was fully compensated by increases in long-term capital inflows and the aggregate capital moving into Chile was not altered by the controls. As there was no significant effect on overall capital flows, the measures could not check real appreciation although controls had some, albeit small, effect on domestic interest rates. As regards their contribution to financial stability, these controls may have been able to protect Chile from relatively small external shocks but were not effective in preventing "contagion" from very large shocks stemming from East Asia in 1997-1999.

China has emerged as a key driver of world growth. Its real GDP has recorded an annual average growth of almost nine per cent per annum in the recent decade. According to purchasing power estimates, China contributed almost one-third of global growth in the recent three-year period (2000-2003). At the same time, concerns are being expressed that the Chinese economy is getting over-heated due to excessive investment. Excess demand in sectors such as real estate, cement and steel where investment has been very strong is leading to overcapacity. This can cause a boom-bust cycle and may increase non-performing loans. These concerns mainly emanate from substantial external inflows and their impact on the money supply process.

China has recorded surpluses not only on its capital account but also on its current account in the recent decade. Although both capital and current account surpluses fell in the aftermath of the Asian financial crisis, these have subsequently recovered to their pre-crisis levels. Given the fixed exchange rate, the People's Bank of China (PBC) has been absorbing the excess supplies in the foreign exchange market. Consequently, China's foreign exchange reserves jumped multi-fold from US $ 22 billion in 1993 to US $ 515 billion in September 2004. The rapid increase in foreign exchange reserves has, in turn, led to a high growth rate of broader monetary aggregates. Initially, inflation in China remained subdued and in fact, China experienced deflation during 2002. The liquidity overhang coupled with robust economic activity, however, has led to emergence of inflationary pressures although inflation is, in part, due to supply shocks from food prices.

Since early 1990s, the PBC has been undertaking a number of steps to sterilise the impact of external inflows. Initially, capital controls were used as the main instrument. The PBC also relied on calling back relendings to sterilise the excess money supply. However, with dwindling relending amounts over the years, the scope to change relending for the purpose of sterilisation reduced significantly. Open market operations were initiated in 1996. In view of the negligible holdings of Government bonds by the PBC, it was not possible to carry out OMOs in any significant way to contract the money supply. The PBC, therefore, tried other sterilisation measures such as requiring commercial banks to open special deposit accounts with it, issuing central bank financial bonds, tightening the control over capital account transactions and ceasing high-cost foreign borrowings. It also implemented a series of measures aimed at encouraging capital outflows by easing restrictions on overseas investments by domestic companies, lowering ceilings and easing regulations on Chinese residents to take foreign currency abroad and allowing Hong Kong banks to offer personal renminbi accounts. International financial institutions have also been permitted to issue local currency RMB bonds in the domestic market.

More recently with external flows strengthening further, the PBC, effective April 22, 2003, started outright issue of its own bills with maturities up to one year. In 2003, base money injection of RMB 1146 billion yuan due to forex purchases was offset to the extent of RMB 269 billion yuan through open market operations. By the end of 2003, the PBC had made 63 issues of central bank bills, with a total issuance amount of RMB 723 billion yuan and outstanding amount of RMB 338 billion yuan. In the first half of the year 2004, PBC issued RMB 674.2 billion yuan of central bank bills. By end-June 2004, the outstanding balance of PBC bills had further increased to RMB 603 billion yuan (around US $ 73 billion). In the first half of 2004 PBC bills sterilised nearly one-half of the increase in its foreign exchange reserves.

OMOs have been supplemented with other policy measures. These include a two-step increase in reserve requirements from 6.0 per cent to 7.5 per cent between September 2003 and April 2004. In April 2004, China also took recourse to a differential reserve requirements system. Under this system, reserve requirements applied to financial institutions are dependent upon a number of criteria such as capital adequacy, asset quality and non-performing loans (NPLs). The lower the capital adequacy or the higher the NPLs, the higher the reserve requirement and vice versa. Other measures are : adoption of a floating rate system for central bank lending; using foreign exchange reserves to the extent of US $ 45 billion to inject capital into the Bank of China and the China Construction Bank. Moral suasion was intensified to guide credit orientation, improve credit structure and ensure the healthy development of the national economy.

These efforts have been able to contain broad money growth to an extent. The year on year growth rate of M2 fell to 16.2 per cent by end-June 2004 from 20.6 per cent a year back. Base money growth has, however, continued to remain in excess of that a year ago. More recently, effective October 2004, the PBC decided to raise the central bank benchmark rates for deposit and lending by 27 basis points each to, inter alia, build on the achievements of macro economic control.