The Transmission Mechanism of Monetary Policy in Emerging Market Economies - Part: 4
[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]

Capital flows and monetary policy

In the absence of capital controls, the efficacy of domestic monetary policy is in theory determined by the exchange rate regime and the degree of substitutability between domestic and foreign financial assets. Under a floating exchange rate, monetary policy works through two channels. First, since the money supply is exogenously controlled by the central bank, monetary policy can work through conventional interest rate and liquidity effects. Secondly, monetary policy influences aggregate demand and prices through its impact on the exchange rate. The greater the substitutability between domestic and foreign assets, the greater the response of the exchange rate to policy-induced changes in interest rates and hence the larger the impact of monetary policy through that channel.

In a fixed exchange rate regime, the influence of asset substitutability on the impact of monetary policy is reversed. When domestic and foreign assets are perfect substitutes, any monetary policy action is immediately offset through capital flows, so that monetary conditions remain unchanged. The lesser the degree of substitutability, the more scope the monetary authorities will have to move domestic interest rates independently of foreign rates. As will be discussed in greater detail below, the evidence suggests that asset substitutability is less than perfect, indicating that governments fixing their exchange rate have some scope, albeit limited, for pursuing independent monetary policy.

An important feature of increased capital mobility has been the growing ability of many firms in emerging market economies to get finance abroad. For instance, international capital markets have become the main source of capital raised by Israeli firms. The Singapore economy is dominated by multinational corporations with access to financing from abroad. External financing of Thai enterprises grew from 16% of GDP in 1989 to 27% in 1995. Offshore borrowing effectively reduces these firms' exposure to domestic credit-market conditions, and acts to limit the impact of monetary policy on aggregate demand. A monetary tightening that raises domestic loan rates will cause firms to switch to foreign borrowing, thereby limiting the incidence of the monetary tightening and constraining the ability of domestic banks to raise loan rates. To the extent that a change in the differential between the domestic and foreign rate is not offset by an equivalent expected change in the exchange rate, the impact of monetary policy on spending (other than the important effect operating through the exchange rate change itself) may thus be constrained in a floating exchange rate regime.

In practice, only a small number of large firms - often those with foreign currency revenue streams - are able to tap international credit markets directly. Some central banks restrict enterprise access to offshore finance or subject it to reserve requirements (e.g. in Chile and Thailand). The aggregate impact of monetary policy on aggregate demand will not be much affected. Instead, the incidence of monetary policy will fall primarily on smaller firms and households. Whether or not this is desired, it may make the transmission of monetary policy more uncertain, since the firms that are most affected might be those with the weakest balance-sheet positions and most vulnerable to credit rationing.

Many countries having experienced high inflation - particularly in Russia and Latin America - have seen a substantial rise in the use of foreign currency. The term "dollarisation" has been employed somewhat indiscriminately to refer to the use of dollars as a unit of account, a store of value, a means of transactions, or all three. This paper focuses on the provision of dollar-denominated loans and deposits by the domestic banking system, an activity which embraces both the store-of-value and, to a lesser extent, the transactions function of money. Table 12 compares the shares of bank assets and liabilities denominated in foreign currencies among various emerging market countries. Foreign-currency-denominated shares in some of these economies are much higher than in the industrialised countries shown in the table and, given the legacy of unsettled macroeconomic conditions over the past decade, have risen since the early 1980s.

Assets can be denominated in foreign currency ("dollars") or in the domestic currency ("pesos"); the other dimension is that assets can be local or foreign. The transmission of monetary policy in a dollarised system will depend not only on the substitutability between domestic peso and dollar assets, but also on the substitutability between domestic dollar assets and foreign dollar assets. Because of the presence of default and convertibility risk, domestic and foreign dollar-denominated assets are likely to be regarded as less than perfect substitutes. As evidence of this, dollar interest rates in dollarised financial systems have generally exceeded international levels.

Consideration of the case where the markets regard domestic peso and dollar assets as close substitutes but view domestic and foreign assets as being not substitutable serves to illustrate the importance of asset substitutability. Assuming limited exchange rate changes, policy-induced increases in peso interest rates will induce borrowers to switch to domestic dollar loans and savers to shift their assets into peso deposits, leading to increases in domestic dollar deposit and loan rates as well. Therefore, monetary policy is effective in this case. Conversely, where domestic and foreign dollar assets are highly substitutable, the monetary transmission channel will more closely resemble that in a non-dollarised system with perfect capital mobility, except that access to dollar loansmight be more widespread in a dollarised system than in a non-dollarised one.

There is considerable evidence that relative holdings of peso and dollar deposits respond to changes in relative rates of return. However, little research has focused on the degree of substitutability between domestic and foreign dollar-denominated assets. The conduct and transmission of monetary policy in a partially dollarised financial system remains a relatively unexplored topic.

The initial financial position of households, firms and banks is likely to interact with monetary policy in three important ways. First, the impact of monetary policy on consumption and investment will depend upon the extent to which these expenditures are financed through the financial system. Secondly, changes in asset prices resulting from monetary policy action will have different effects on net worth depending on the composition of financial portfolios. Finally, the initial strength or weakness of balance-sheet positions will influence how monetary policy action will induce changes in borrowing and spending aimed at achieving asustainable or acceptable balance-sheet position.

In economies where financial intermediation is underdeveloped and investment (both housing and corporate) usually is financed from internal sources (such as personal savings and retained earnings), the impact of monetary policy actions on aggregate demand may be relatively modest. Limited reliance on external financing sources could be a reason why enterprise investment in India is only slightly affected by interest rate changes.

As economies develop, the availability of intermediated savings tends to rise, and a greater share of investment and, in some cases, consumption expenditures is financed by bank lending. In the past decade, this long-term evolution has been amplified by the process of financial liberalisation, which has improved the financial sector's efficiency and ability to channel savings - both foreign and domestic - to borrowers. Often, too, fiscal adjustment has released resources for private sector use that previously had financed government budget deficits. These developments are likely to have increased the sensitivity of aggregate demand to monetary policy.

Tables 13 and 9 display flow-of-funds data on the personal and the non-financial corporate sector's liabilities to the financial sector, respectively. The rather incomplete data are consistent with the view that dependence upon intermediated savings has risen in emerging market countries in the past decade. For instance, two-thirds of investment by enterprises in Thailand was financed by external funds in 1991-96, compared with only one-third in the period 1980-90.

The pattern of financing of household and enterprise expenditures also plays an important role in the sectoral impact of monetary policy. In industrialised countries, the construction sector is especially sensitive to interest rates, since buildings and real estate are too large and "lumpy" to be financed in ways other than by borrowing; for much the same reason, consumer durable expenditures are also quite interest-sensitive. Similarly, sectors in which requirements for fixed capital or working capital (because of the cyclical behaviour of demand or supply) are high are likely to be heavily dependent on bank credit and sensitive to bank interest rate changes. There has been less research on the sectoral response of demand to monetary policy shocks in developing countries; but there is some evidence that in such countries construction and consumer durables expenditures are also especially sensitive to monetary conditions. Colombian studies also suggest high sensitivity in certain other sectors, such as agriculture and manufacturing.

In several emerging market countries, financial liberalisation and capital inflows have given rise to particularly marked growth in mortgage lending and consumer credit, including credit cards. In Argentina, for instance, consumer loans have led credit growth in recent years. As indicated in Table 14, the share of consumer credit and mortgage lending in total bank loans has grown considerably in the past decade, although it still remains below levels in industrialised countries. Given the interest sensitivity of residential investment and consumer durables purchases, this promises to further strengthen the effects of monetary policy in developing countries, as well as to accentuate its uneven incidence across different sectors. In Mexico, heavy consumer lending in the years prior to the peso's 1994 devaluation was followed by a near-elimination of new credit availability thereafter, making the subsequent contraction even deeper than it otherwise would have been.

As monetary policy can change the valuation of assets and liabilities, the impact on aggregate demand depends crucially upon the initial composition of portfolios. In economies in the early and middle stages of financial development, most savings are intermediated through the domestic banking system, and relatively small proportions of household and corporate portfolios are invested in securities whose value varies with market conditions. More important may be the share of foreign currency assets and liabilities.

As financial markets develop, the diversity of portfolios and their sensitivity to policy actions affecting asset values may be expected to grow. Table 15 compares movements in the share of securities in the total assets of banks. Unfortunately, very few data for the household and the non-financial corporate sector are available, making it difficult to discern to what extent this share has grown and come closer to the levels observed in selected industrialised countries.

Holdings of foreign currency assets and liabilities may represent a particularly important source of balance-sheet exposure to asset prices - in this case, exchange rate changes. Data on the foreign currency exposure of households and firms are not readily available. The data on the foreign currency exposure of the banking system are shown in Table 12, but they must be interpreted carefully. In most countries, regulations restrict the size of net foreign currency exposure by banks. However, insofar as bank borrowers may hold open positions in foreign currency, the quality of bank portfolios and banks' ability and willingness to provide credits may be affected by changes in exchange rates. In Mexico, for example, foreign exchange exposure was limited as a share of capital (and foreign liabilities as a share of total liabilities), but the 1994 devaluation seriously eroded the financial situation of many domestic customers with dollar-denominated debts, contributing to a rise in non-performing loans that has seriously damaged bank balance sheets. Banks, in turn, have responded by tightening lending, which may have further reinforced contractionary tendencies. The depreciation of a number of Asian currencies since mid-1997 may have similar effects, especially where there has been large foreign-currency-denominated borrowing to finance the acquisition of domestic assets.