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The Pursuit of Monetary Policy in Developing Countries


THE PURSUIT OF MONETARY POLICY IN DEVELOPING COUNTRIES

1. INTRODUCTION
This paper aims at examining and analyzing the conduct of monetary policy in developing countries (with particular reference to those in Anglophone West Africa). With a view of educating the constraints and charting a more appropriate and effective decline, many developing countries adopted measures aimed at macroeconomic stability, low inflation and the attainment of a sustainable growth trajectory in the late 1980s and 1990s. in most cases macroeconomic instability had its root in expansionary monetary policy, which fuelled and perpetuated macroeconomic decline. The use of direct monetary policy instruments, coupled excessive government intervention in the conduct of monetary policy exacerbated the problem. Consequently, economic reforms effort in these countries reflected a remark in the focus of monetary policy. There has been a shift to indirect monetary policy targets for growth and inflation.
However, the choice and sequencing of monetary policy in developing countries deserve particular attention, in view of the peculiarities of markets and institutions in these countries. Levels of market economic/financial peculiarities in these countries pose special challenges to policy makers. Additionally, apparent conflicts between fiscal and monetary policy further complicates the picture. Thus, the choice and sequencing of policies and instruments must be weighed very carefully against these considerations as failure to do this may have significant repercussions for economic management both in the short and long-term.
In spite of these problems, developing countries that adopted monetary policy reforms in the 1980s succeeded in reducing inflation, improving their domestic interest, minimizing exchange rate volatility and enhancing their external balances. Financial liberalization, institutional/capacity building, improvements in the regulatory framework and the more effective use of open market operations combined to strengthen macroeconomic performance. It is however, worth noting that if such progress is to be consolidated or sustained, monetary policy must be made more relevant to the environment within which is operates. This paper will explore these difficulties and make requisite proposals. Potential pitfalls that may arise from failure to adequately account for these difficulties will also be analysed and educated.
In the very simplest or terms, the stock of money in an economy is representative of productivity in that region. Where the rate of growth of notes and coinage outpaces that of productivity, the value of the currency drops and too much money chases too few goods. As a result, the general price level would rise. The stock of money may rise for a number of reasons; perhaps the most significant of these is the need to finance domestic government expenditure. Governments may increase the stock of money to meet budget deficits by mandating the issuing authority (usually the Central Bank) to issue more domestic currency. Such an expansionary policy stance is normally accompanied by an administered exchange rate regime, designed to cosmetise the loss in international competitiveness.
The development described in the preceding paragraph sow the seeds of macroeconomic instability and general economic decline. In order to correct (or forestall) this trend, governments and monetary authorities seek to ensure consistency between the growth of the stock of money and the targets for key economic fundamentals. The developing world is no exception in this regard. Although there is some agreement as to the importance that should be accorded monetary impulses in explaining changes in price level, there is general consensus about the need to keep monetary supply growth within non-inflationary levels.
Throughout the developing world, fiscal discipline is the most common cause of monetary expansion. Given the limited menu of financing options available to these governments, deficit financing almost always involves recourse to the central bank. There are four mains ways in which this is done: (a) monetizing at zero cost through high reserve requirements, (b) sale of government securities to a captive market, (c) foreign borrowing in the open market. Distortions arising from the first three lead to “financial repression”. This concept is summarized in the familiar McKinnon-Shaw thesis which argues that distortions of financial prices (particularly interest and exchange rates) retards economic development by reducing savings and consequently, the real growth rate {see McKinnon(1973 and 1991) and Shaw (1973) Recent work by Agenor and Montiel(1996) and Fry, Goodhart and Almeida (1996) provide empirical support for this assertion. While neostructuralist such as Taylor (1988) and Jha (1994) are in agreement with the general thrust of this argument, they rightly pointed out that the absence of repression without requisite institutional and structural reform would only be counterproductive, but also could exacerbate the problem. They explained that such an environment could raise general price level via a cost-push effect, while at same time inhibiting growth by reducing the supply of credit on account of monetary contraction.
Regardless of intellectual or ideological conviction, it is clear that as developing economies are becoming increasingly monetized and liberalized, the choice of monetary policy regime is assuming greater importance. The advice of Thomas Gresham to Britain’s Quen Elizabeth 1 in the 16th Century (after Henry VIII had debased the currency to finance his extravagance) is still valid. Monetary expansion to correct fiscal indiscipline not only debases the currency but also destroys credibility (Burgon, 1839). Monetary policy must, therefore, seek to uphold the integrity of the currency, ensure consistency with other macro-economic variables and constitute the bedrock for sustainable economic growth.
Scope and Coverage
Given the heterogeity of the developing world, attempting to discuss monetary policy in such a general context would be both unwise and unhelpful. It is for this reason that this paper focuses on the sub-region. However, general policy guidelines for the developing world may be discerned from the ensuing discussion. Also, in the spirit of this seminar, aspects relating to banking supervision in the sub-region will be emphasized.
Furthermore, every attempt will be made to avoid esoteric and complex ecometircs. This should facilitate policy dialogue in a broader context, which is all the meeting seeks to achieve. Additionally, this paper does not aim to answer all the questions; on the contrary, it seeks to ask questions that would improve our understanding of the role and functioning of monetary policy in our countries and, hopefully, lay the basis for further research to identify an appropriate framework for monetary policy in the sub-region. Understandably, this paper presents the issue through the eyes of a central banker. In spite of this, due cognizance has been taken of the views and perspectives of the four other players in the conduct of monetary policy, namely, central government, commercial banks, other financial institutions, and private institutions/individuals.
The non-attainability of pareto optimality in the real world has led to the endearment of the concept of second-best to economists. This is especially true of macroeconomic policy in developing countries. Market imperfections, distortions and structural rigidities make it difficult for many theories to hold true in these environments. This has led to growing interest in relevant research on both sides of the ideological divide. Work by neo-structuralists is pioneered by Taylor (1988), while a number of IMF research publications espouse the revamped monetarist approach. Unfortunately, the peculiarities of West African economies in this regard have not attracted sufficient attention; and even when they have they are not widely circulated.
This paper attempts to illuminate this relatively uncharted course by synthesizing the main points of this debate as a useful first step towards developing in appropriate macroeconomic framework for economies in this sub-regional efforts at policy necessary and timely, particularly in view of the sub-regional efforts at policy harmonization, as agreed by ECOWAS heads of state at recent fora. This preliminary attempt should investigate the nature and effectiveness of a range of monetary policy options, while identifying institutions, instruments and market structures that best suit them.
II. THE EVOLVING EMPHASIS OF MONETARY POLICY
Objective so Monetary Policy
Governments use monetary to regulate the stock of money in an economy, either upward or downwards. When the stock of money is revised upwards monetary policy is termed “expansionary”. This is usually done to finance capital expenditure, close the fiscal gap and reflate the economy. On the other hand, “contractionary” monetary policy refers to downward revisions in the stock of money. This is usually done to contain the overheating of domestic demand, as well as to ensure consistency in the growth rate of all macroeconomic variables.
The over-riding objectives of monetary policy are to guarantee macroeconomic stability and ensure economic competitiveness. At this juncture, it must be emphasized that in order for monetary policy to succeed, it must be implemented in tandem with supportive structural and institutional reforms.
Direct Monetary Policy
In this context, direct monetary policy may also be termed “directed” monetary policy. This is because the policies are implemented in a controlled or directed environment. Following independence, many African governments felt compelled t adopt expansionary monetary policies for a number of reasons. The desire to implement extensive capital expenditure progammes within their democratic mandates necessitated expansionary policies. Also, with budding private sectors government was the largest economic operator; government departments and parastatals made colossal demands on very narrow tax bases. This also fuelled and perpetuated the expansionary trend.
Indirect Monetary Policy
The consequent macroeconomic destabilsation, plummeting growth rates and increase in poverty in the sub-region forced a rethink of economic policy in the late 1980s; most governments recognized the need to reduce financial repression as a precondition for macroeconomic stability in the first instance and sustained growth subsequently. Hence the move to indirect monetary policy. Since the second half of the 1980s, most countries have devoted time and resources to the development of institutions and structures that would enable monetary policy to be carried out in the open market, without direct government intervention (and its attendant distortions). This heralded the transition from direct to indirect monetary policy. Whereas at the beginning of the 1980s less than 5 percent of all government debt in the sub-region was subject to indirect monetary policy, today the figure has risen well above 25 percent.
III THE INSTRUMENTS OF MONETARY POLICY
As already mentioned, monetary policy aims to regulate the ability of government and the banking system to influence the stock of money in the economy. The government influences the stock of money through creation and the issuance/withdrawal of its securities. For their part, banking institutions influence the stock (a) the desire of the general public to hold cash outside the banks, (b) the statutory reserve requirement and (c) the level of excess liquidity in the banking system. The money multiplier, which is reflective of the proportion by which the banking system increases its deposit base through on-lending, is dependent on the following considerations or manipulations of monetary policy instruments by the monetary authorities in the given economy.
Reserve Requirements
Monetary authorities prescribe statutory reserve requirement for potential reasons. In addition to serving as a form of deposit insurance, the reserve requirement reduces reserve money (on which the monetary multiplier is applied). By so doing, the stock of money is reduced. Some central banks use this instrument to regulate money supply. In contrast to the developed world where reserve requirements scarcely exceed 15 percent, requirements imposed by monetary authorities in most developing countries average roughly 45 percent. Not only does this guarantee government zero-cost financing for its deficit, it also effectively crowds out credit to the private sector.
Domestic Credit
Reduction in domestic could also reduce the rate of monetary expansion in the banking system. Governments have approached this issue in three ways: firstly, domestic credit ceilings have been imposed in a bid to achieve specific macroeconomic targets; secondly, directed credit has been channeled to priority sectors of the economy; and, thirdly, controlled interest rates may be used to channel selected credit.
Interest Rates
Theoretically, savings rate should be reflective of the opportunity cost of holding money while lending rates should be indicative of domestic rates of return on investment. This should have a direct bearing on the quantum of deposit and credit in the banking system. In controlled economies, authorities attempt to control money supply by determining interest rates administratively. It is also noteworthy that the shallowness of financial markets in the sub-region as well as the predominance of the government in the securities market rates more to fiscal imperatives, than private sector opportunity costs or rates of return. To the extent that the financial system takes its cue from these markets in the determination of savings rates, levels could be justifiably said to relate more to fiscal demands.
Open Market Operations
Open market operations (OMOS) refers to the trade in government (and other) securities. The initial or primary issue occurs in what is called the primary market. Here, specially designated market-makers trade in Government securities with a range of institutions and individuals. Operations; in the primary market is not freely accessible and market makers are offered some incentives to encourage participation and re-sale of the instruments. Securities are re-sold by market-makers on the secondary market, which is the true open market. The use of OMOs to finance deficits is less inflationary and imposes some level of discipline on the Government because it transmits the market cost of its borrowing. This indirect method is also effective in reducing reserve money through the issuance of securities.
IV MONETARY POLICY OPERATIONS IN DEVELOPING ECONOMICS
Problems with Direct Monetary Policy
The previous sections described how, in the past, Government in the sub-region used monetary policy as a vehicle for deficit financing, almost exclusively, this led to severe distortions and regarded growth. Arguments for directed monetary policy usually point to directed credit in south East Asia for justification. Empirical evidence (World Bank, 1993) reveals the transitory nature of this policy in south East Asia as well as the market-based framework within which is operates.
On the whole, the undesirability of direct monetary policy is evidenced in the sub-region’s progressive move to indirect monetary policy. The main problems associated with direct monetary policy may be summarized as follows:
It could be distortionary, leading to severe resource misallocation.
Deficit monetization by increasing reserve money is inflationary.
Controls are either costly or impossible to enforce and
The resultant financial repression has a debilitating effect on economic growth.
For reasons listed above, Governments have though it expedient to shift their policy implementation from direct to indirect policy instruments. In spite of substantial progress made in this regard, policy makers are faced with a number of dilemmas which threaten the efficacy of poor fiscal performance could undermine the effectiveness of monetary policy. This is particular concern since the same instruments are used for the conduct of both fiscal and monetary policy. Secondly, the shallowness of markets and limited number of players increase the possibility of collusion and hamper the smooth transition of market signals. Thirdly, the limited coverage of monetary policy further limits its effectiveness. In most countries only large formal financial institutions participate in indirect monetary policy operations. A significant urban bias is also displayed. Limited coverage is a severe constraint in demand management.

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Some Peculiarities of West African Economies
In addition to those dilemmas, which are largely generic among developing countries, West African economies have some peculiarities which further constrain indirect monetary policy. These peculiarities are predominantly structural in nature and must be taken account of at the policy formulation stage. The judicious sequencing of structural and institutional reforms on the one hand, and the deepening of financial reforms on the other, is of the essence. This is an often overlooked aspect of monetary policy design. The following elements which characterize West African financial environment bear emphasis in this context:
A significant proportion of the money supply is held outside the banks. This constrains the effectiveness of indirect monetary policy since the major players are formal financial institutions. Special education, public awareness and publicity campaigns will have to be mounted to increase public participation.
The level of monetization in most rural areas is still low. Volatility (both seasonal and ad hoc) in this regard affects the demand for money function, which would affect the stock of money in the economy.
The banking sector is small in most countries. This gives scope for the emergence of a virtual oligopoly (particularly among the larger foreign-based banks). Collusion at auctions could distort the interest rates.
The existence of vibrant parallel markets in most economies also influences the effectiveness of monetary policy reducing the quantum of transactions in the formal sector. The interest rate structure and money demand function could also be distorted.
Inadequate institutional and infrastructural support could frustrate market deepening. The example of India’s premature introduction of a repo market in 1992 collapsed for similar reasons.
In most countries in the sub-region, Government is still the main economic player. Attempts to reduce its influence too rapidly could have serious repercussions for economic growth. For instance, rising real interest rates could increase the Government’s debt service obligations.
Recent Performance
Despite these difficulties, monetary authorities in the sub-region have made the sterling progress in their efforts to shift to indirect monetary policy. This has been achieved within the context of sweeping economic reforms and firm commitment to fiscal discipline.

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V LESSONS OF THE PAST AND OPTIONS FOR THE FUTURE
A summary of constraints
Previous section have provided an overview of the development of monetary policy regimes. Furthermore, the constraints of indirect policy in the interventionist policy regimes in the sub-region relating to institutional inadequacies, market structure and the efficacy of indirect instruments have also been analyzed. In spite of these constraints, monetary authorities have made some progress in attaining some measure of macroeconomic stability after shifting to less interventionist and less expansionary monetary policies. However, in order for these gains to be sustained and consolidated, substantial efforts must be made to address the constraints. It is important to note that no progress could be made on this front in the absence of comprehensive economic reform to achieve macroeconomic stability.
Market Deepening
This requires effective sequencing, institutional building, appropriate legislative framework and relevant monetary instruments. Optimal sequencing of policies is precondition; both procedural arrangements and human resource endowments must be enhanced adequately. This should lay the foundation on which improved instruments can operate efficiently. Attempting to improve policy implementation without first strengthening the institutions would be counter-productive; not least because resultant inefficiencies would undermine confidence in the system thereby jeopardizing future credibility. Effective market deepening must be preceded by improvements in the intuitional and regulatory environments.

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Effective open market operations require robust institutions that would ensure efficient operations, monitoring and regulation. These include banking institutions, supervisory institutions and regulatory bodies. As highlighted earlier, operational modalities appropriate technology and human resource endowments must be upgraded. These institutions must conform to internationally acceptable operating/regulatory standards.
Requisite legislative arrangements must be put in place; out model provisions must be revised and newer, more relevant ones introduced, where necessary. Additionally, appropriate judicial reform should also be introduced to ensure the speedy and effective implementation of the legislation, where necessary, efforts should also be made to facilitate and expedite the judicial process.
The design and delivery of monetary policy instrument accessibility, maturity and relevant to market demand. This refers to instrument accessibility, maturity and pricing. Particular attention should be paid to increasing non-bank participation in OMO, especially in the rural areas. This improved coverage would augur well for the efficacy of monetary policy.
Monetary and Fiscal Consistency
Inconsistency between fiscal and monetary policy has plagued monetary policy efforts in the past. Regular meetings to ensure consistency in their implementation jeopardizing efforts on the monetary front. Moreover, the conduct of fiscal and monetary policy must be divorced. It is inadvisable to use the same instruments, and auction, to achieve both goals. Experience suggests that the fiscal considerations predominate in such cases. Divorcing the conduct of fiscal and monetary policy should enable both fiscal and monetary targets to be met with minimal inconsistency.
IV RECOMMENDATIONS AND CONCLUSIONS
In the light of the following, the following recommendations/conclusion may be highlighted:
Monetary policy must not be implemented in isolation; it must be part of a comprehensive strategy for sustainable economic growth.
Rather than attempt to reform institutions, instruments ad markets simultaneously, development on this front should be phased judiciously. Mehran et al. (1996) documents the success of this regard. Also, the demonstration effect succeeded in incorporating the non-bank sector over time.
Increased education and public awareness campaigns should target potential participants. This would broaden the market and,hopefully, the establishment of information Centers may be considered.
In order to overcome market size limitations, serious thought should be given to regional participation in OMOs. Among other things, this would augur well for sub-regional economic integration and overall market deepening in the sub-region.
The introduction of prudential guidelines on the treatment of excess reserves in the banking system could help overcome the problem of excess liquidity in the system. Consequent improvements in liquidity management would enhance the participation in OMOs.
The legislative and regulatory environment must be strengthened considerably and made adaptable to the introduction of new instruments and technology over time.
Efforts to resolve and pre-empt systemic crisis will enhance this sectors credibility and, in the long run, attract global participation.
Monetary and fiscal policy co-ordination must be prioritized. The introduction of transparent auctions will let governments know the true opportunity cost of borrowing, avoid recourse to inflationary financing and provide reliable price signals for policy formulation.
This shopping list of recommendations is not exhaustive; it is intended to serve as a guide for policy deliberation. The sub-region is clearly on the right tract in the area of monetary policy; what is required at this juncture is more attention to the peculiarities of this sub-region in order to make policy choices more practical, effective and robust. This is an achievable goal.


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