Policy Papers No. 5 - Monetary policy operating procedures in emerging market economies

March 1999

This work provides an overview of monetary policy operating procedures in emerging market economies. Most of the discussion reflects the situation in mid-1998. The emphasis is on general principles although in practice country-specific factors condition actual procedures. Yet there has been a certain convergence in monetary policy instruments and procedures in recent years, not only in industrial countries but also in most emerging market economies. Major forces for change have been the rapid development and deepening of a variety of financial markets and instruments, the diversification of financial institutions and the globalisation of intermediation.

As long as the financial sector was relatively closed and dominated by commercial banks, monetary control was exercised by the setting of only two parameters: reserve requirements against demand deposits at commercial banks and the discount rate on bank borrowing from the central bank. This is what is defined in the South African paper as the classical cash reserve system. Adjustments in either parameter would induce banks to change the terms of their loans and deposits, leading to changes in the economy-wide stock of money and in turn aggregate spending. Even more rudimentary techniques based on quantity controls rather than on price signals proved effective as long as financial markets remained underdeveloped and insulated from foreign influences.

Once new financial markets developed and market integration progressed, bank intermediation became less dominant. Households placed part of their savings outside the banking sector, enterprises started tapping non-bank sources of funding and banks, too, had to gain a foothold in the new markets, on both the supply and the demand side. In this new environment, the setting of bank interest rates came to depend on conditions in financial markets. Moreover, aggregate spending became sensitive to more than just bank-determined interest rates. In order to control the new channels of financial transmission new procedures had to be developed, focused on influencing the behaviour of all market participants and price formation in a variety of short-term money and interbank markets. As paraphrased in the Bank of Israel's paper, "It is not enough to clear the landscape, one also has to construct new modes of travelling through it".

Although the experiences and the choices made in individual countries vary widely, a number of common trends in the modernisation of operating procedures can be detected. First, the deepening of financial markets and the growth of non-bank intermediation have induced, if not forced, central banks to increase the market orientation of their instruments. In most cases (but with a few notable exceptions identified below), a higher proportion of reserves is now supplied through operations in open markets, with the use of standing facilities limited to providing marginal accommodation or serving as emergency finance. This, however, does not imply an erosion of the power of standing facilities in affecting liquidity conditions; indeed, it is often the marginal changes in bank liquidity which have the greatest impact on interest rates. Secondly, the increased importance and flexibility of the price mechanism in the new market environment have induced many central banks to focus more on interest rates rather than bank reserves in trying to influence liquidity. A third trend is that, reduced market segmentation, and thus the greater ease and speed with which interest rate changes are transmitted across the entire spectrum of yields, has enabled central banks to concentrate on the very short end of the yield curve where, given payment and settlement arrangements, their actions tend to have the greatest impact. The move to real time gross settlement systems in several countries may increase the short-term focus of policy implementation even further. Fourthly, the greater market orientation of the central banks' instruments has been associated with a preference for flexible instruments. In the highly volatile financial environment marking several of the emerging market economies, flexibility in the design of the policy instruments may be particularly important. Much of this greater flexibility has come from the growing use of repurchase operations. Finally, awareness of the important role of market psychology and expectations has increased markedly. This has implications for the degree of transparency which central banks need to influence interest rates, their reliance on market information in formulating policies and their own tactics in signalling policy changes to the market.