Thursday, September 27, 2012

Monetary transmission in developing countries

Usually, when we talk about monetary policy, it is customary to link this with standard econ theories. For instance, it is well established that increase in money supply increases inflation. But then in countries like Nepal, money supply (or central bank’s interest rate) has hardly any effect on inflation (even correlation is very weak). Why? Because of exchange rate pegged to Indian rupee, almost 60 percent of total imports originating in India, slowly adjusting oil prices, huge informal economy, supply-side constraints and very limited reach of financial institutions (just 20 percent of households take loans from banks). The theoretical relationship between money supply and inflation is not that straight forward when it comes to applying it on the ground in developing countries with under-developed financial sector.

Montiel and Mishra argue that the application of conventional monetary transmission would require “an economy with a highly developed and competitive financial system in order to be effective.” Two strong messages that are relevant to Nepal come from their research:
  • Inflation targets set during the announcement of monetary policy should be modified to take the imperfect monetary transmission into account. (They recommend to the extent of postponing setting inflation target!).
  • Weak monetary transmission weakens the argument for floating exchange rates and capital account restrictions.
Below are excerpts from their article in Ideas for India (btw, an excellent website for easy-to-read, evidence-based articles focused on the Indian economy): 

That includes: a strong institutional environment, so that loan contracts are protected and financial intermediation is conducted through formal financial markets; an independent central bank; a well-functioning and highly liquid interbank market for reserves; a well-functioning and highly liquid secondary market for government securities with a broad range of maturities; well-functioning and highly liquid markets for equities and real estate; a high degree of international capital mobility; and a floating exchange rate. These features are typically taken for granted in the OECD but the same assumptions cannot be made for developing countries.
[…] First, the complete absence or poor development of domestic securities markets suggests that both the short-run and long-run interest rate channels will be weak. Second, small and illiquid markets for assets such as equities and real estate will tend to weaken the asset channel. Third, in countries that are imperfectly integrated with international financial markets and tend to maintain relatively fixed exchange rates, the exchange rate channel will tend to be completely absent, or relatively weak.

[…] If the banking industry is non-competitive, changes in banks’ costs of funds may be reflected in bank profit margins, rather than in the supply of bank lending. If a poor institutional environment increases the cost of bank lending, banks may conduct lending activity in a manner that weakens the effects of monetary policy actions on the supply of loans by using reserves as a buffer to sustain their lending to low-cost customers when the central bank tightens credit conditions and to avoid lending to high-cost customers when the central bank loosens credit conditions.

[…] We find a much weaker link between the policy instrument (central bank interest rates) and money market rates in poorer economies than for advanced and emerging economies, both in the short and in the long run. We find a similar result for the link between money market rates and bank lending rates in the short term, and while differences in long-term effects are not as pronounced, they remain weaker in low-income countries. Most importantly, changes in money-market rates explain a much smaller proportion of the variance in bank lending rates in low-income countries than in either advanced or emerging economies.

[…] We interpret the evidence presented in our research, as well as that of the broader literature, as creating a strong presumption that in the financial environment that tends to characterise many developing economies, monetary policy is likely to have both weak and unreliable effects on aggregate demand. If this is true, the stabilisation challenge in developing countries is acute indeed, and identifying the means of enhancing the effectiveness of monetary policy in such countries is an important challenge for policymakers and researchers alike.

When domestic monetary policy is weak and unreliable, activist policy is less desirable, and the adoption of policy regimes that raise the stakes associated with attaining publicly-announced monetary objectives, such as a target rate of inflation, should be postponed or their design should be modified to take the uncertainty about monetary policy effects into account. In addition, weak and unreliable monetary transmission weakens the arguments for floating exchange rates as well as for capital account restrictions under fixed exchange rates.

The full paper is here.