The Transmission Mechanism of Monetary Policy in Emerging Market Economies - Part: 2
[An Overview of the Discussion Papers Submitted by the Basel Policy Group - Overview by Steven Kamin,
Philip Turner and Jozef Van 't dack - The Orgnal Article may be referred at - URL http://www.bis.org/publ/plcy03.htm]

Another means by which asset price changes triggered by monetary policy actions can affect aggregate demand is described by the so-called q theory of investment pioneered by James Tobin. With an easier monetary policy stance, equity prices may rise, increasing the market price of firms relative to the replacement cost of their capital. This will lower the effective cost of capital, as newly issued equity can command a higher price relative to the cost of real plant and equipment. Hence, even if bank loan rates react little to the policy easing, monetary policy can still affect the cost of capital and hence investment spending. Policy-induced changes in asset prices may also affect demand by altering the net worth of households and enterprises. Such changes may trigger a revision in income expectations and cause households to adjust consumption. Similarly, policy-induced changes in the value of assets held by firms will alter the amount of resources available to finance investment.

A decline in asset prices may have particularly strong effects on spending when the resultant change in debt-to-asset ratios prevents households and firms from meeting debt repayment obligations; it can have similar effects if it raises fears about the ability to service debts in the future. A substantial fall in stock and bond prices for instance, may reduce the value of liquid assets available to repay loans. As households and firms thus become more vulnerable to financial distress, they may attempt to rebuild their balance-sheet positions by cutting spending and borrowing. The effects of monetary policy actions on aggregate demand, working through asset prices and balance sheets, may become amplified as the pace of economic activity begins to respond. For example, increases in interest rates that depress asset prices and weaken balance sheets may lead to an initial decline in output and income. This initial decline in economic activity, in turn, reduces the cash flow of households and firms, further heightening their vulnerability to financial distress, and leading to a second round of expenditure reduction. In this way, changes in monetary conditions may lead to prolonged swings in economic activity, even if the initial monetary policy action is reversed soon afterwards. The severe recession in Malaysia in 1985-86 exemplified this effect. A steep drop in the prices of commodities, shares and real estate accompanied weak foreign and domestic demand. The result was a marked contraction of the cash flow of many enterprises, caught by falling income, collapsing asset values and rising debt servicing costs.

One particularly significant price monetary policy can affect is the exchange rate. Indeed, in many developing countries - particularly those with only rudimentary markets for bonds, equities and real estate - the exchange rate is probably the most important asset price affected by monetary policy. When the exchange rate is floating, a tightening of monetary policy increases interest rates, raises the demand for domestic assets, and hence leads to an appreciation of the nominal and - at least initially - the real exchange rate.

This appreciation can feed through to spending in two distinct ways. The first is the relative price effect: it tends to reduce the demand for domestic goods, which become more expensive relative to foreign goods, and thus aggregate demand. Secondly, changes in the exchange rate also may exert significant balance-sheet effects. In many countries, households and firms hold foreign currency debt, either contracted abroad or intermediated through the domestic banking system. Unless such debts are fully offset by foreign currency assets, changes in the exchange rate may significantly affect net worth and debt-to-asset ratios, leading to important adjustments to spending and borrowing. Where domestic residents are net debtors to the rest of world, as in many emerging market countries, a large appreciation of the exchange rate may lead to an improved balance-sheet position that may give rise to a marked expansion of domestic demand. Thus this balance-sheet effect tends to offset - and in some cases may even dominate - the relative price effect.

In small open economies with flexible exchange rates, the exchange rate channel is likely to be particularly important because, in contrast to the other channels described above, it affects not only aggregate demand but also aggregate supply. A loosening of monetary policy, for example, may lead to a depreciation of the exchange rate, an increase in domestic currency import costs, and hence induce firms to raise their domestic producer prices even in the absence of any expansion of aggregate demand. Because exchange rate changes are viewed as a signal of future price movements in many countries, particularly those with a history of high and variable inflation, wages and prices may change even before movements in import costs have worked their way through the cost structure. When the exchange rate is fixed or heavily managed, the effectiveness of monetary policy is reduced but not entirely eliminated. Often (as in Israel) relatively wide margins exist within which the exchange rate can fluctuate. Moreover, if domestic and foreign assets are only imperfectly substitutable, there is some scope for domestic interest rates to deviate from international levels. Therefore, even if the nominal exchange rate is fixed, monetary policy may be able to affect the real exchange rate by acting on the price level. In this manner, monetary policy retains its ability to affect net exports, albeit to a much lesser degree and with much longer lags. However, where domestic and financial assets are close to perfect substitutes, as they may be under currency board arrangements (e.g. in Argentina and Hong Kong) or where there is a long tradition of dollarisation (e.g. in Argentina and Peru), the scope for monetary policy is severely limited.

In countries where private markets for credit either are poorly developed or are prevented by government regulation from operating freely, monetary policy is likely to affect aggregate demand more by altering the quantity or availability of credit than through the direct or indirect effects of changes in the price of credit. This will be true especially when binding controls or guidelines on the quantity of credit itself are present, as is the case in several major developing countries. In addition, binding ceilings on interest rates (or statutory rates as in China) will force banks to use non-price means of rationing loans and thus enhance the importance of credit availability effects. Finally, direct government involvement in the loan market, either through official development banks or through fiscal subsidies of commercial bank loans, will have a similar effect.

The liberalisation of financial markets does not necessarily eliminate credit availability effects. Recent financial market research has emphasised the importance of imperfect information and contract enforcement problems that alter the means by which credit markets clear. When monetary conditions tighten, for example, banks may wish not to rely exclusively on raising interest rates in order to ration available credit, since this would not only encourage riskier investment behaviour on the part of borrowers but also attract riskier borrowers as customers. Hence, in response to increases in the cost of credit, banks are likely both to raise loan interest rates and to tighten creditworthiness standards, leading to declines in the supply of credit along with increases in its price. Even borrowers whose creditworthiness has not been affected will face less favourable terms for their loans during periods of recession and at times of financial distress, because banks may be unable to distinguish fully between borrowers who have been adversely affected and those who have not.

Partly in response to the special role credit can play even in liberalised systems, several central banks (e.g. in India, Indonesia, Israel, Malaysia, Peru, Thailand and Venezuela) explicitly monitor credit growth in evaluating the stance of monetary policy. The Korean paper argues that "in formulating policy, the central bank should monitor an alternative indicator, such as the volume of bank loans, which has shown a close link to aggregate spending".

Credit rationing is likely to hit smaller borrowers particularly hard because of the high cost of gathering information about them. The Colombian paper shows that during past periods of monetary contraction the implicit cost of external funds for smaller firms rose significantly relative to that for larger firms, and the growth of their financial liabilities was significantly lower. Especially where financing sources other than bank lending are scarce (or access to them is limited to a few borrowers), the credit rationing effects may amplify the conventional interest rate effects of restrictive monetary policy.

The availability of credit also may be affected by shifts in loanable resources from one market to another. At the core of the view that a "bank lending channel" exists in addition to an "interest rate channel" is the proposition that when monetary policy tightens, banks lose some of cheaper sources of loanable funds. According to some analysts, this logic would apply particularly to smaller banks that depend primarily on deposits for funding and cannot tap as easily as larger banks other sources of funds (e.g. international capital market). The Korean paper presents econometric evidence that a tightening of monetary policy leads to a greater cutback in lending by small banks than by large banks, thereby supporting the existence of a credit channel for monetary policy. To the extent that certain firms depend heavily or exclusively upon bank financing, shifts in loanable resources from banks to other markets may exert an impact on aggregate demand that goes beyond the effects of increased interest rates alone.

Finally, monetary policy may affect the availability of credit more directly through effects on the value of assets of both borrowers and lenders. As changes in monetary conditions lead to changes in asset prices, the value of collateral for bank loans may be affected and changes in the access of borrowers to credit could be induced. For instance, residential housing loans in Singapore are not to exceed 80% of the cost or valuation of the house, whichever is lower. In addition, where a large proportion of bank assets is invested in equities or real estate, declines in asset prices, by lowering capital/asset ratios, could force banks to tighten the supply of credit.

Changes in the creditworthiness of bank customers and in the financial condition of banks themselves will induce changes in credit rationing only if the banks perceive themselves to be facing hard budget constraints. The Colombian paper suggests that, in the early 1980s, the perception that the Government would bail out ailing banks caused banks to tighten credit insufficiently in the face of monetary contraction: "A monetary contraction in the context of systems endowed with high levels of government involvement in the marketplace, and thus high degrees of moral hazard, might not lead bankers to implement the same type of behavioural adjustments (i.e. credit rationing) as would be the case in a more liberal environment. A banking crisis could well emerge as a consequence of bankers lacking incentives, failing to perceive and respond to policy decisions."

Two aspects are important in evaluating how fast monetary policy affects the real economy. The first is the transmission from the instruments directly under the central bank's controls - e.g., short-term interest rates or reserve requirements - to those variables that most directly affect conditions in the non-financial sector - loan rates, deposit rates, asset prices and the exchange rate. This linkage is determined primarily by the structure of the financial system. The second aspect of the monetary transmission process is the link between financial conditions and the spending decisions of households and firms. In this regard, the initial financial position of households, firms and banks is likely to play a key role, including the extent of leveraging, the composition and currency denomination of assets and liabilities, and the degree of dependence upon external financing sources, in particular bank financing.

Both aspects of the monetary transmission channel are likely to have been affected by the process of financial liberalisation in many countries in the past decade. The reduced role of the government in the financial system has lessened the importance of the credit availability channel of monetary policy compared with the interest rate channel (and related effects). But the increased fragility of the financial sector in the wake of financial liberalisation may have accentuated other aspects of the credit availability channel - particularly perhaps in the aftermath of crises. At the same time, the opening and deepening of financial systems in emerging market countries has caused both the assets and the liabilities sides of the private non-financial sector's balance sheet to become more diversified, thereby enhancing the role of asset prices, in particular the exchange rate, in the monetary transmission process.

Government intervention in financial markets may influence the monetary transmission process in three ways: by imposing interest rate controls or other limits on financial market prices; by imposing direct limits on ban lending; or by providing government-financed credit to selected areas. In the past decade, the trend almost everywhere has been towards liberalisation. Direct controls on the quantity and allocation of credit have given way in practically all cases to greater reliance on indirect mechanisms of monetary control such as open market operations. Studies conducted have compared the primary instruments of monetary policy used by various countries. Compared with the beginning of the 1980s, when the use of credit ceilings and changes in reserve requirements was pervasive, the studies conducted indicate greater reliance on open market operations and on central bank credit and deposit facilities in the 1990s. Some central banks (such as those of Brazil, Chile, Hong Kong and Israel) rely in the first instance on their own loan and deposit facilities to implement monetary policy; in the first three countries this practice leads to the setting of an interest rate corridor for money market interest rates. Other central banks (such as those of Colombia, Indonesia, Korea, Malaysia, Peru, Russia, Saudi Arabia, Singapore, Thailand and Venezuela) aim to change liquidity condition mainly by auctioning Treasury or their own paper, by performing foreign exchange swaps or by operating in the open markets.

Although the use of reserve requirements has declined significantly, they are still high in Brazil and Colombia and are relatively important in several other countries. Reserve requirements are often imposed in a differentiated way. Chile and Peru maintain a higher reserve requirement on foreign-currency-denominated deposits in order to limit the impact of capital inflows on the exchange rate. Several central banks (e.g. in Chile and Argentina) impose higher reserve requirements on more short-term instruments.