Over many years the effectiveness of monetary policy in many Pacific island countries has been constrained by large subsistence sectors, shallow financial markets, limited private investment opportunities, sticky interest rates, limited financial arbitrage, oligopolistic commercial banking sectors, excessive levels of liquidity and, in some circumstances, pressure on central banks to finance budget deficits (monetisation).
Pacific island financial markets are not strongly or directly integrated into, or exposed to, international financial markets. The banking and financial sectors of Pacific island microstates2 are relatively small, largely domestically funded and unsophisticated. The absence of bond and equity markets3 and strongly traded currencies means that during the global economic crisis Pacific island microstates were not subject to substantial changes in debt and equity cross-border capital flows. As well, the stability and continued strength of Australian commercial banks during the crisis meant that there were no substantial crisis-related financing, debt or credit implications for the offshore branches and subsidiaries of the Australian banks operating in the Pacific island region4. Reflecting these conditions, most Pacific island microstates surveyed in this article were largely immune from the worst transmission impacts of the second external economic shock, the global financial crisis.
Monetary policy authorities in most Pacific island countries adopted a generally cautious approach to monetary policy management during the global economic crisis. In line with the contemporary charters of central banks in Pacific island countries, the principal objectives of monetary policy during much of this period were to maintain an adequate level of foreign currency reserves and to contain and lower inflation. The scope to attempt a counter-cyclical monetary stimulus to lift economic activity - an objective not usually listed in central bank charters in these small island states - was largely precluded in 2008 and into 2009 by the need to address both of these higher priority problems (declining reserves and high inflation).
In pursuit of their objectives, central banks worked to change the growth in monetary and credit aggregates by selling or purchasing central bank securities in open-market operations, changing requirements for commercial banks to hold funds in statutory reserve deposit and liquid asset accounts at central banks, and by imposing and removing credit ceilings. Some of these policy adjustments were designed to constrain aggregate demand and, through that channel, the demand for imports, taking pressure off the declining level of foreign currency reserves.
Changes in foreign currency reserve levels (see Box 1) not only have consequences for exchange rate pressures but they also have direct implications for the liquidity of the banking system5 and its management. In a managed exchange rate system foreign currency proceeds are sold to the central bank, with the domestic currency equivalent credited to the commercial banks’ exchange settlement accounts, expanding the pool of funds available for lending. During the global economic crisis foreign currency receipts contracted and reserves fell in a number of Pacific island countries. As a result, the balances of exchange settlement accounts also fell and, in turn, fewer funds were injected into the banking system and demand deposits, resulting in lower liquidity. Injecting liquidity when reserves fell, and draining-off excess liquidity when it accumulated, proved to be a substantial function of monetary policy in Pacific island countries during the global economic crisis.
The management of interest rates also contributed to economic adjustment during the global economic crisis.6 However, the relatively large gap between lending and borrowing interest rates in some Pacific island countries complicates the task of using a policy interest rate as a means to impact inflation and smooth economic cycles, encourage savings, influence private investment and address large current account deficits.
By way of illustration, Solomon Islands has one of the widest spreads between lending and deposit interest rates in the Pacific islands region, around 10 to 13 percentage points.7 During 2009, while nominal lending interest rates remained static (around 15 per cent), real lending interest rates increased substantially (not conducive to borrowing and investment) as inflation fell sharply. Nominal deposit rates have for a considerable period been around one per cent and lower: currently they are around 4 per cent. Real interest rates on savings products were strongly negative during 2008 and into 2009 (not conducive to savings).8
While definitive conclusions cannot be drawn, high interest rate spreads in Pacific island countries are likely to reflect influences such as the small number of commercial banks, weak (bank and non-bank) competition and high after-tax profit margins, absence of secondary markets in government bonds and other savings options, high administration and intermediation costs, poor quality of loans, lack of collateral and high loan-loss provisioning, and relatively high financial and political risks.
Where it occurs, the combination of high levels of liquidity9, inadequately developed secondary markets for central bank and government securities, wide and largely unchanging interest rate spreads and slow pass-through of changes in policy interest rates to commercial interest rates, suggests that commercial interest rates may not be driven strongly by changes in economic conditions, the supply of money or the policy interest rate. With constrained transmission mechanisms10, macroeconomic variables may not be strongly responsive to changes in monetary policy. It follows that the ability of monetary policy to quickly offset the effects of economic shocks (such as the global economic recession) on economic activity by counter-cyclical monetary policy is likely to be limited.
Authorities in a number of countries sought to influence borrowing and lending interest rates during the global economic crisis. In Papua New Guinea, high inflation saw real lending interest rates fall substantially, from around 10 per cent in late 2007 to 4 per cent in September 2008. In order to tighten monetary conditions and to address high inflation and strong credit growth, the policy interest rate was raised from 6 to 8 per cent in the second half of 2008.
Vanuatu, with relatively well-developed financial markets, sought (in September 2008) to raise commercial interest rates by using market forces (that is, by raising the rediscount rate) to address inflation and strong credit growth. The rediscount rate was lowered shortly thereafter as liquidity tightened.
In order to support credit growth and stimulate economic activity, Tonga reduced the repurchase facility interest rate from 10 per cent to 4.5 per cent during 2009 as inflation slowed and foreign currency reserves increased. Samoa lowered the lending interest rate from 7.8 per cent to 5 per cent to address flagging demand, sliding confidence and falling real GDP.
A reversion to moral suasion11 occurred in Fiji when in April 2009 the monetary authority mandated that commercial banks lower lending interest rates and interest rate spreads.12 However, this mandate created new financial risks for the commercial banks. As a co
nsequence uncertainty increased, the profitability of banking operations was adversely impacted, credit growth slowed, lending was reprioritised toward lower risk borrowers and overall bank lending declined.
In summary, partly as a result of monetary policy adjustments, foreign currency reserves in Pacific island countries were generally maintained above target levels during the global economic crisis (see Box 1) except for Fiji and Solomon Islands. Liquidity swings were addressed, and credit growth slowed over the course of 2009, particularly in Solomon Islands, Samoa, Tonga and Papua New Guinea where credit growth had been excessive. Inflation fell back across the region during 2009, sharply so in some cases (see Chart 1), due to reduced credit growth and firm monetary policy, the retreat in food and fuel prices and weaker domestic demand.
Box 1: Foreign Currency Reserves
- Table 1 below reports actual and target levels of foreign exchange reserves measured as months of import cover over recent years. International reserves may be accumulated for a number of reasons including for precautionary self-insurance purposes, to pursue monetary policy and exchange rate policy objectives or as a consequence of policy designed to create an undervalued currency. Reserves create a buffer that may be used to cushion the domestic economy from adverse external shocks, service foreign debt, manage volatile current and capital account transactions, reduce the costs of external borrowing, intervene in exchange rate settings and defend exchange rates.
- Reserves declined in most Pacific island countries during 2008 and into 2009 suggesting that they played a cushioning role in the face of external shocks when exchange rates remained fixed. However, reserves fell below target levels in Fiji and Solomon Islands. Fiji subsequently raised its reserve target from three months of import cover to five months of cover. During August and September 2009 the IMF allocated new special drawing rights (SDRs)13 to IMF member Pacific island countries (equivalent to US$ 370 million)14, effectively raising their holdings of foreign currency reserves. Import compression, higher remittances and increased tourism receipts contributed to the build-up in reserves during 2009 in some countries. Solomon Islands and Tonga continued to build reserves into 2010.
Table 1: Official Foreign Currency Reserves (Months of Import Cover)
|Reserves target||End 2007||End 2008||2009||2010|
|Fiji Islands||5||4.4||2.9||1.3 (Apr)
|PNG||No target||13.0||10.9||9.7 (Mar)
|Solomon Islands||3||3.7||2.5||3.2 (May)
Sources: Asian Development Bank (ADB), Taking the Helm: A Policy Brief on the Response to the Global Economic Crisis, 2009; Pacific Economic Monitor, ADB, August 2009; Tonga Ministry of Finance and National Planning, At a Glance, June 2009; Various Monetary Policy Statements; Sada Reddy, Presentation to the Public and Private Sector Consultative Forum on the 2010 Budget, Fiji, September 2009; Central Bank of Samoa, Monetary Policy Statement 2009/2010; National Reserve Bank of Tonga, Monetary Policy Statement, September 2009.
Particularly where financial markets are shallow and money demand functions are relatively stable, changes in money and credit aggregates and reserves held with central banks may be appropriate instruments to use when seeking to influence foreign currency reserves, liquidity, inflation and economic activity. To the extent that markets for securities are sufficiently deep and mature, and intermediation and arbitrage are effective, greater reliance may be placed on open-market operations and a nominated policy interest rate to determine commercial interest rates and influence macroeconomic variables15. Monetary policy effectiveness might generally improve over time as financial markets are subject to further development. Desirable advances would include:
- development and deepening of inter-bank markets and secondary markets for government and central bank securities;
- the introduction, where appropriate, of new central bank short-term bill facilities to assist commercial banks stabilise liquidity;
- greater competition in the banking sector;
- greater offshore investment, further investment diversification and greater integration with domestic financial sectors by provident funds;
- greater financial inclusion and increased access by borrowers and lenders to financial services, including through the further development of deposit facilities, micro-finance opportunities and related innovation; and
- avoidance of the direct administration (mandating) of borrowing and lending interest rates.
Box 2: Monetary policy flexibility
During the global economic crisis monetary policies have needed to adjust to rapidly changing circumstances.
- During 2008 and into 2009 monetary policy was tightened in a number of countries (Tonga, Papua New Guinea, Solomon Islands and Vanuatu) to address rising inflation resulting from the food and fuel price hike, respond to strong credit and domestic demand growth, and to drain off excess liquidity.
- A number of countries maintained their tight monetary policy stance through 2009 to contain inflation and to address falling foreign currency reserves (Tonga and Solomon Islands), and to deal with high fiscal spending, excess liquidity and devaluation-induced imported inflation (PNG).
- In Vanuatu the global economic recession impacted exports and lowered foreign currency reserves. An acceleration in lending and relatively stable deposits caused liquidity in the banking system to tighten. Monetary policy was eased in December 2008.
- In early 2009, as the global economic recession impacted on foreign currency inflows, Fiji faced serious economic problems: a contraction of economic activity, an overvalued exchange rate, falling foreign currency reserves and tightening liquidity. Faced with conflicting objectives the Fiji authorities devalued the Fiji dollar, tightened foreign exchange controls, eased monetary policy and mandated that commercial banks lower their lending interest rates and the margins between borrowing and lending interest rates. The easing of monetary policy sat awkwardly with the need to control inflation and to constrain the demand for imports in order to achieve an improved balance of payments position.
- During the course of 2009, monetary policy was eased to increase liquidity and stimulate economic activity in Samoa, Solomon Islands and in Tonga; following a period of weakening GDP, declining inflation and weak credit growth.
- Toward the end of 2009 liquidity was increasing strongly in Fiji. The statutory deposit (SRD) ratio was raised from 5 per cent to 7 per cent in December 2009, and the Fiji authorities announced that credit ceilings would be removed, interest rate directives issued in April 2009 would be lifted and
that some currency controls would be eased. On May 3 2010, minimum capital adequacy requirements were raised from 8 per cent to 12 per cent for banks and from 10 per cent to 15 per cent for licensed credit institutions. The SRD ratio will be raised again to 8.5 per cent on 7 June 2010.
2 Tonga, Samoa, Vanuatu, Fiji and Solomon Islands are classified as microstates, with populations less than 2 million persons, following P. Imam, ‘Exchange Rate Choices of Microstates’, IMF Working Paper, No. 10/12, 2010.
3 At end -2008, Papua New Guinea’s Kina Securities Index was about 40 percent below its June peak, similar to the decline in international equity markets.
4 In the case of Tonga a weakening of bank balance sheets due to a worsening of credit quality coincided with the global economic crisis. As a consequence, banks maintained a tight lending stance following the loosening of monetary policy in 2009-2010 in order to strengthen their balance sheets.
5 A range of other factors (including swings in expenditure) can influence liquidity. For example, during 2009 high government spending and the location of trust funds with commercial banks (at a low interest cost) raised liquidity in Papua New Guinea. The subsequent transfer of some public trust accounts from commercial banks to the central bank is seen as one effective method to reduce liquidity in the commercial banking system. In the case of Vanuatu stronger growth in lending relative to deposits reduced liquidity. Provident funds represent a large proportion of financial sector assets in many Pacific island countries. They are generally restricted in their capacity to invest offshore, and some invest heavily in domestic deposits. As a consequence, provident funds can contribute substantially to domestic liquidity. Some central banks permit provident funds to purchase foreign assets to help reduce their impact on domestic liquidity. This stimulates commercial bank competition for deposits and reduces the need for the issuance of central bank securities. If currency reserves fall to low levels repatriation of provident funds offshore assets can be undertaken to increase reserves and liquidity (as with Fiji in 2009). Looking forward, the Liquified Natural Gas project in Papua New Guinea can be expected to high government revenues which could drive liquidity higher and create economic instability unless a special offshore fund is established to regulate the pace at which the increased liquidity is injected into the domestic financial system.
6 There is little evidence to suggest that interest rate policy was used pro-actively to directly reduce cross-border capital outflows and protect foreign currency reserves.
7 In April 2010 the (lending/deposit) interest rate spread was 8.2 percentage points in Samoa and 7.7 percentage points in Tonga. In Papua New Guinea the spread was 8.0 percentage points in December 2009. In Fiji the spread was 6.7 percentage points in March 2010.
8 Particularly with limited access to commercial banks, unspent monies may be taken home and shared with persons of a shared community background, constraining private sector savings.
9 High liquidity reflects, inter alia, the lack of local investment opportunities, restrictions on capital outflows and compulsory savings in provident funds.
10 A number of academic studies suggest that the existence of stable monetary demand functions and inadequately developed capital markets in some Pacific island countries provide a basis to use monetary aggregates rather than interest rates as an instrument of policy. See T. Jararaman and C. Choong, ‘How Does Monetary Policy Transmission Work in Fiji?’, International Review of Economics, 2009. See T. Jayaraman and J. Dahalan, ‘Monetary Policy Adjustment in an Undeveloped South Pacific Island Country: A Case Study of Samoa’, International Journal of Monetary Economics and Finance, 2008. Also, see R. Singh and S. Kumar, ‘Some Empirical Evidence on the Demand for Money in the Pacific Island Countries’, MPRA Paper, No. 18703, November 2009.
11 Prior to December 2006 the Reserve Bank of Fiji conducted open-market operations in RBF securities with the 91 day yield to maturity rate being the policy indicator rate.
12 The Reserve Bank of Fiji directed that the weighted average lending rates of commercial banks be kept at the level prevailing at the end of 2008 and that the interest rate spread of banks be reduced to 4 per cent or less by the end of 2009.
13 The SDR is an international reserve asset allocated by the IMF to IMF-member countries. SDRs are recorded as part of a country’s official foreign currency reserves and are readily convertible into foreign currency held by another IMF member.
14 SDR allocations to Pacific island countries included Fiji (US$94 million), Solomon Islands (US$14.6 million), Kiribati (US$8.4 million), Republic of Marshall Islands (US$5.2 million), Federated States of Micronesia (US$7.6 million), Palau (US$4.7 million), Papua New Guinea (US$183 million), Samoa (US$15.7 million), Tonga (US$10.4 million) and Vanuatu (US$25.6 million).
15 In May 2010 the Reserve Bank of Fiji announced a decision to implement a new market-based monetary policy framework. Under the new framework the Reserve Bank will set an overnight policy rate to signal the stance of monetary policy. The overnight policy rate will serve as the target rate at which the commercial banks will lend to each other in the interbank market, influencing the commercial banks’ borrowing and lending interest rates. See Reserve Bank of Fiji, Press Release, 17/2010, 14 May 2010.