The Transmission Mechanism of Monetary Policy in Emerging Market Economies - Part: 3
[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]

Interest Rate Controls

Very few countries still impose limits on loan or deposit interest rates. Only in China are a significant number of loan and deposit rates non-market- determined. In Brazil, the authorities continue to exert some direct control over interest rates: the so-called "Reference rate" which guides several deposit and loan rates deviates from the freely determined rates in the interbank market by a fixed margin exogenously set by the central bank. In Chile, the interest rate on short-term demand deposits is regulated. In India, limits are imposed on interest paid on savings deposit accounts and on interest charged for a selected number of types of credit (mainly export credits and small value loans). A ceiling on lending rates (which, however, permits competitive pricing) exists in Malaysia. Below market interest rates are charged on agricultural loans in Venezuela.

Not only does the monetary authority (either government or central bank) impose direct targets or limits on bank lending, but it may also exert influence through moral suasion and the use of prudential regulations. In China, credit controls remain the most important instrument of monetary policy. Brazil, India and Venezuela retain credit allocation prescriptions. Moreover, Brazil imposed credit ceilings in 1995 to stem the rapid growth of credit triggered by the Real Plan; taxes on credit operations continue to be levied. In Malaysia, lending guidelines to priority sectors and selective, short-term credit controls (mainly on loans for automobile purchases, credit cards and real estate) are applied; cyclical conditions have on occasion led to the discretionary adjustment of such guidelines. In Korea, Russia and Thailand, credit controls are not used at present, but recourse to some form of credit ceilings is possible. In Thailand, financial institutions are required to submit credit plans for the next half-year, allowing the central bank to better monitor lending growth. Annual credit plans had to be submitted by Indonesian banks in 1996; this practice was continued in 1997. In several Asian economies (such as Hong Kong, India, Indonesia, Malaysia, Thailand and, to a lesser extent, Korea) the central bank at times uses moral suasion to steer credit (growth) in the right direction. In Singapore, the Monetary Authority can make recommendations to banks concerning credits and investments. In Israel and Peru, the last controls on credit were lifted as recently as the early 1990s. Controls on private sector credit were one of the main instruments of monetary policy in Venezuela before 1990.

In some countries it is recognised that prudential regulations could also play a supporting role in the conduct of monetary There are of course major objections - both of principle and of practicality - to gearing prudential regulations to the (often cyclical) demands of monetary policy. However, rules about bank loan exposures to particular spending categories, about loan-to-value ratios, or about collateral valuations (e.g. preventing assets being valued at an overpriced peak) can limit the risk of swings in bank lending fuelling boom-and-bust cycles. In addition, a change of monetary regime may require a change in prudential standards. Moving from ceilings on bank credit to interest-rate based mechanisms of control will require tighter prudential controls. In a fixed exchange rate regime which limits the scope for independent monetary policy, prudential rules may need to be stiffened.

Finally, the government may itself provide much of the non-financial private sector's total credit, either directly through official development institutions or indirectly through subsidisation of certain credits extended by commercial banks. Special development institutions receiving and lending funds at preferential rates or conditions can still be found in Brazil, India and, to a lesser extent, Israel (special mortgage banks). Development institutions in Malaysia receive substantial long-term funding from the central bank and the Federal and State Governments, usually in the form of equity participations and low interest loans. Special credit institutions in Venezuela grant subsidised loans to small enterprises, funded from the national budget. In Russia, up to one-fifth of enterprises' capital investments are still financed from federal and local government budgets, to a large extent on favourable terms. Another significant share comes from extra-budgetary investment funds. In all these cases, the role of credit availability in the transmission of monetary policy is likely to be strengthened relative to other channels, particularly interest rate effects. Although the role of the government as a source of credit also has diminished substantially over time, a high proportion of the banking sector was still owned by the government in several countries (for example, Argentina, Brazil, India and Indonesia) at end-1994 (the year of comparison shown in Table 4). In the last couple of years, however, several institutions in Argentina and Brazil have been privatised and further privatisations are in course.

A summarised view of overall trends in the relative importance of different sources of financing for the private non-financial sector indicates the share of financing provided by commercial banks has remained very large in most of the emerging economies for which data can be found In industrial countries, the share of alternative sources of financing tends to be much more pronounced.

In a liberalised financial environment, a key feature of the monetary transmission process is the responsiveness of the interest rates faced by borrowers and savers to the short-term money market rate most directly influenced by the central bank. Several factors have an important influence on this: the degree of competition within the banking sector; access to alternative financing sources; and the depth of the various financial markets.

The greater and more rapid the response of loan and deposit rates to changes in money market rates, the more rapid and effective will be the transmission of monetary policy measures to the real economy. Loan and deposit rates are linked to policy or money market rates to a considerable extent. The re are rates most subject to central bank control or intervention. A key determinant of this responsiveness is the degree of competition within the banking sector. When there are several banking institutions (a development that could be promoted by lowering barriers to new entrants, in particular to foreign banks) and market conditions are competitive, changes in the cost of funds are likely to rapidly affect loan and deposit rates. Conversely, in a highly concentrated banking sector, oligopolistic pricing may be possible, making the response of loan and deposit rates to changes in money market rates sluggish and asymmetric. In addition, the presence of stateowned or state-subsidised banks under little pressure to maximise profits could diminish the responsiveness of loan and deposit rates to monetary policy. (A number of measures of competition in emerging country banking sectors were also seen.)

The impact of banking sector competitiveness on the responsiveness of deposit and loan rates can be illustrated by a number of country experiences. In Colombia, competition among banks in the deposit market is much greater than in the loan market (partly because Colombia is still rather underbanked). The Colombian loan market is much more concentrated as many banks belong to conglomerates: interest rates charged to preferred customers within these conglomerates tend to be adjusted only sluggishly to changing market conditions. In Indonesia and Thailand, too, commercial banks tend to adjust lending rates less frequently than deposit rates. Sometimes adjustment throughout the banking sector depends on the initiative of the most important banks in the deposit and/or loan segment of the market. In Hong Kong, smaller banks usually follow the best lending rate charged by the bigger banks. In Indonesia there is evidence of price leadership by the largest state banks.

The interest rates on deposits and loans set by the domestic banking system may also depend on the access of households and firms to alternative domestic funding sources, including securities markets and/or informal "curb" markets. Table 9 shows the reliance of enterprises in emerging economies on various sources of financing, including securities markets. Moreover, in several countries (e.g. Israel and Thailand) access to foreign sources of funds has increased widely, an issue addressed separately below. The key determinants of the impact of these alternative sources of financing on the efficacy of monetary policy are their degree of integration with the domestic banking market and their state of development. In principle, the presence of domestic securities markets should accelerate the transmission of monetary policy shocks. Well-developed and competitive capital markets often tend to respond more flexibly to changes in policy rates than do bank-administered loan and deposit rates. The Israeli paper notes the importance of institutional investors and recent financial deregulation in the transmission of monetary policy. Since the portfolios of such investors contain various maturities of government bonds, including short-term notes (which are an important monetary policy instrument), a change in the central bank's policy rate can quickly spread throughout domestic securities markets. Some of the rates in these markets may be more relevant for spending decisions than those onshort-term bank deposits or loans.

Moreover, if the banking sector and the securities markets are well integrated, banks may be forced to enhance the responsiveness of the interest rates under their control. The Israeli case is also illustrative in this regard. As institutional investors also hold bank deposits, they represent an important element of the linkage between individual financial market segments, ensuring that a change in the policy-controlled rate reverberates through the entire spectrum of interest rates.

Restrictions on the financial sector have led in many countries to the emergence of informal "curb" markets for credit. In some countries, these curb markets have become large enough for the monetary authorities to actively monitor them. For example, developments in the curb market remain even today an indicator for guiding the policies of the Bank of Korea. To the extent that the formal banking sector and curb markets are highly segregated (e.g. if each market has its own small group of distinct depositors and borrowers), the impact of monetary policy will be diminished.

Contractionary monetary policy, for example, will raise interest rates and reduce credit availability in the formal sector, but may have little impact on conditions in the curb market.

The transmission of monetary policy is more complex when formal and curb markets are integrated to some degree. Tighter monetary policy which raises bank deposit rates may cause households to shift their savings from the curb market to formal bank deposits. Because borrowers in the curb market are likely to lack access to formal bank lending, this shift in loanable resources may cause disruptive declines in credit and spending in those sectors served by the curb market. The uneven nature of the incidence of monetary policy in a partially segregated market suggests that its effects may be harder to predict than in a more unified one.

The depth of money and capital markets can also have an important bearing on how policy-controlled rates affect other rates and ultimately spending behaviour. A thin or uncompetitive financial market can cause major volatility of money market interest rates. Insofar as it is costly to adjust loan and deposit interest rates, both for administrative reasons and for reasons of customer relations, banks may not adjust these rates in response to movements in money market rates if these rates are highly variable and expected to reverse their movements quickly. (On the other hand, greater money market volatility may lead banks to develop mechanisms to link administered loan and deposit rates more closely to money market rates.)

Similarly, the response of interest rates in thin capital markets to changes in policy rates may be more-than-usually unpredictable. Although they have grown over time, bond markets in many developing countries indeed remain shallow and volatile. In the early stages of capital market development, therefore, the transmission of monetary policy measures may be particularly uncertain.

In sum, various factors, including the degree of competition within the banking sector, the availability of alternative sources of financing, and the depth and volatility of domestic financial markets, are likely to condition the extent and rapidity of the adjustment of bank deposit and loan rates to monetary policy actions.

There is some statistical evidence that the response of bank rates to monetary policy measures has been slower in some emerging market economies than in the larger industrialised countries, perhaps reflecting the more limited competitiveness, depth and flexibility of financial markets in emerging market economies. This difference is least apparent in the response of three-month money market rates to changes in overnight rates; possibly, it is easiest to ensure competitive conditions in the interbank market. On the other hand, the response of bank deposit and loan rates to same-month changes in three-month money market rates clearly has been slower in the emerging market countries than in the industrialised nations. The average long-run response of bank rates to money market rates also is smaller in the emerging market economies, though less markedly so. Terms of financial contracts As noted earlier, an important means by which monetary policy affects economic activity is by altering the cash-flow position of borrowers. This depends not only on the extent to which changes in the policy interest rate lead to changes in new short-term deposit and loan rates, but also on how quickly changes in these new rates lead to changes in average rates. One of the most important determining factors is the maturity of financial contracts. The shorter the maturity, the more frequently will loans and deposits be rolled over at new interest rates, and hence the more quickly will changes in policy rates lead to changes in average interest rates earned by depositors and paid by borrowers.

Table 10 shows that the share of loans with maturities exceeding one year in the major emerging market countries is considerably lower than in several industrialised countries. Loans in Latin America are typically of an even shorter maturity (but comprehensive data are not available). This reflects the greater degree of uncertainty over future inflation and interest rates in those markets. For instance, in Brazil, most enterprise loans have a maturity of less than three months and bonds of less than one year. No long-term instruments existed in Peru until the early 1990s. Monetary policy might therefore be expected to produce a more rapid impact on cash-flow positions in developing countries than in industrialised countries, and hence on aggregate demand as well.

A second factor determining the impact of policy rates on average interest rates is the extent to which interest rates on loans and deposits can be adjusted prior to maturity. The more frequently contractual interest rates are adjusted, and the more fully adjustments reflect changes in money market rates, the more rapid will be the impact of changes in policy rates on average loan and deposit rates. Table 10 indicates the share of loans with adjustable interest rates in emerging and industrialised countries: as a general rule, most loans carry adjustable interest rates.

A third feature of financial contracts that should be highlighted is the indexation of principal to some nominal variable, usually the price level or the exchange rate. In countries such as Chile and Israel with a history of high inflation, the majority of longer-term contracts are indexed; by contrast, indexation is insignificant in Hong Kong, Korea, Malaysia, Singapore and Thailand (see Table 11). The presence of indexed loans and deposits introduces several considerations. First, the interest rate on such contracts may be interpreted as a real interest rate, depending upon the specific manner of indexation. This may help clarify the signal that a central bank sends to financial markets through its monetary policy action; it may also help the central bank interpret movements in free market interest rates on indexed debt instruments. Secondly, when deposits and loans are properly indexed, swings in expected inflation and/or exchange rate depreciation will not lead to swings in deposit and loan interest rates, and hence will not affect cash flow as such developments will in non-indexed financial systems. In Mexico in 1995, for example, the Government encouraged the re-contracting of loan rates on a price-adjusted basis so as to eliminate the high inflation-risk premium built into nominal interest rates and thereby reduce the impact of debtservice on borrowers' cash flows.

A particularly important form of access to resources outside the domestic financial system is foreign finance. In contrast to many other aspects of the monetary transmission process in developing countries, there has been considerable research into the role of capital mobility in conditioning the effects of monetary policy. The textbook analysis of the implications of external capital flows for monetary policy transmission suggests several important conclusions. Two related phenomena - offshore borrowing by enterprises and dollarisation - require particular analysis.