Interest Rate Liberalization and Money Market Development

Hassanali Mehran, Marc Quintyn, and Bernard Laurens

• Publisher: INTERNATIONAL MONETARY FUND
• Year: 1996
• eBook ISBN: 9781557755636

NONE

1 Introduction

HASSANALI MEHRAN,
BERNARD LAURENS,
MARC QUINTYN,
VICTOR CHANG

Monetary and exchange system reforms in China since the beginning of economic reform in late 1978 emphasized institution building in general and institutional and market development in the foreign exchange system and the capital market in particular.¹ The development of nationally integrated money markets—that is, markets for short-term funds—is becoming a priority. This would enhance the effectiveness of monetary policy, support the capital markets in providing liquidity and funding for portfolios, and allow further progress in the operation of the foreign exchange market. Inherently related to all aspects of money market development is interest rate liberalization, an area where reforms are also lagging in China. Moreover, achievements in reforming the foreign exchange system—the exchange rate was unified as of January 1, 1994, and much progress was accomplished toward convertibility of the renminbi—make domestic interest rate flexibility highly desirable as a tool to support the exchange rate.

The seminar on interest rate liberalization and interbank market development was held in the context of a new impetus given to financial reform. This was supported by the decision of the Third Plenum of the Fourteenth Central Committee of the Communist Party, which, back in November 1993, outlined and approved a comprehensive reform strategy in which financial reforms are described as a key element in the macroeconomic management in a market environment.²

In contrast with the experience in many other countries, the liberalization of interest rates is the last item in China’s reform agenda, coming after the liberalization of the exchange rate and the establishment of a securities market. The People’s Bank of China’s tentative plans to liberalize interest rates and to establish a nationally integrated interbank market were discussed during the seminar on the basis of presentations by officials from the People’s Bank of China (PBC).

This introduction summarizes the seminar discussions and brings together the common themes, focusing on the policy implications that flow from the experiences of the different countries—Italy, Korea, Malaysia, Thailand, and Turkey—as described in the papers presented during the seminar. Certain aspects of the financial reforms in the United States over the past 35 years, addressed by Victor Chang in his presentation at the seminar, were also brought into the discussion and served as background in considering the lessons that could be drawn from other countries’ experiences.

Policy Implications of Country Experiences

Interbank Market and Financial Reforms

The establishment of a domestic interbank market is critical for the conduct of monetary policy. It allows the central bank to implement liquidity management, which is required whether the central bank uses genuine open market operations or refinance instruments such as a discount facility. The importance of a nationally integrated interbank market for the efficiency and effectiveness of monetary policy is recognized in China and was made part of the financial sector reform program for 1996. The reform of the interbank market in China raises four main issues: the involvement of the central bank, the participants in the market, the degree of centralization of the market, and the role of the interbank market in the conduct of monetary policy. Country experiences were discussed along these lines, although the papers that were presented on country experiences also included references to a number of other issues.

Involvement of the Central Bank

A common feature in many countries embarking on financial reforms is that the development of the interbank market is a stage-by-stage process. Experiences from Italy, Korea, Thailand, and Turkey show that the central bank can play an active role, not only from the general point of view of capital market development, but also in using the interbank market as a “playground” where monetary operations can be conducted and in which it could become an important player.

In Turkey, owing to a variety of factors, some of which are more of a political nature than economic, the banking system was highly segmented. Public sector banks were reluctant to lend to private banks not only because of their assessment of commercial risks but also, and perhaps more important, because of political considerations. Similarly, private banks tended to minimize their transactions with other commercial banks owing to competition. In particular, many of the private commercial banks in Turkey belonged to different industrial groups. Competition and rivalry between these industrial groups often led to a reluctance by their banks to deal with each other directly, and almost completely prevented lending between banks. As a result, the interbank market did not exist in Turkey. However, banks were willing to participate if their counterpart was the central bank. This situation prompted the central bank to develop a framework for an interbank market in which it was acting as a blind broker, that is, as the counterpart of all transactions. Thus, the market was organized around the central bank as the intermediary. The parties to a transaction did not know each other’s identity and, therefore, from a practical as well as a legal standpoint, their counterpart was the central bank. The central bank operated as a broker in that it borrowed only when it could on-lend the proceeds at the same interest rate. In order to cover for the credit risk, all transactions intermediated by the central bank had to be backed by acceptable collateral, such as government securities.

In Thailand, a repurchase market within the central bank was created in 1979 with a view to further developing the fledgling money market and providing the central bank with a mechanism to monitor and, if necessary, intervene in the market. Participants are allowed to place buying and selling orders with the central bank, indicating the amount, interest rate, and maturity of the desired transactions. The central bank then tries to match the orders and determine a single “market” repurchase rate (that is, a fixing). If needed, the central bank intervenes to absorb or inject liquidity.

In Italy, although an over-the-counter interbank market was operating for a long time, the central bank was prompted to take action because oligopolistic behavior led to segmentation of the market. Also, the subsequent excessive volatility of the market was an impediment to using interest rates as a channel of transmission of monetary policy. In 1990, the central bank promoted the establishment of a screen-based interbank market. This was accompanied by a thorough modernization of the payment system, enabling a real-time and direct movement of funds on banks’ centralized accounts with the central bank. Participation in the system is voluntary and participants agree to abide by a set of clear and binding procedures. All interbank transactions among participants on contracts quoted in the system are carried out on the screen-based market and are cleared through the clearing house or by entries in the centralized accounts with the central bank. Transactions outside the system are allowed, and nonparticipant banks can freely trade among themselves in all types of deposits on the over-the-counter interbank market.

In Korea, the central bank promoted the establishment of brokers and dealers for call transactions in order to enhance the adjustment function of the interbank market and break the segmentation of the existing call market between bank and nonbank financial institutions (NBFIs).

Participants in the Interbank Market

Generally, participation in the interbank market is confined to financial institutions with a current account at the central bank since the interbank market is that part of the money market where financial institutions can trade their deposits held at the central bank. Therefore, interbank markets may or may not include NBFIs, depending on whether or not they are authorized to maintain current accounts with the central bank. Among the countries represented at the seminar, Korea is the only country in which NFBIs that do not maintain a settlement account with the central bank participate in the interbank market. Participation of these institutions, which could have contributed to enhancing market liquidity, resulted in a segmentation of the market between banks and NBFIs, because of differences in the pattern of transaction behavior. The integration of the interbank market with the over-the-counter market between NBFIs was eventually achieved at the end of the 1980s with the nomination of brokers and dealers for call transactions as mentioned above.

However, as a consequence of financial innovation, the boundaries between banking institutions, which were allowed to participate in the interbank market, and other entities has blurred. A money market has emerged that provides economic entities, such as financial institutions, business firms, government, and individuals, with various kinds of instruments to intermediate in the short-term demand for, and supply of, funds. The money market comprises the interbank market (or call market), secondary markets for securities (treasury bills, commercial paper, negotiable certificates of deposit), and the repurchase market, which is from an economic perspective a secured means of short-term borrowing and lending.

The development of repurchase transactions brings about important consequences in terms of financial reforms. Since it is not necessary to have developed financial markets to undertake them, repurchase transactions can take place at the onset of financial reforms, even while interest rates on deposits or on interbank transactions remain controlled. When repurchase transactions are treated as collateralized lending, interest rate regulations may apply, whereas when they are treated as a sale with an agreement to buy back they may not. Thus, repurchase transactions can be used as a way to circumvent central banks’ regulations on interest rates that may apply on interbank transactions as well as on deposits, since repurchase transactions are not circumscribed to participants in the interbank market. The development of repurchase transactions thus blurs the boundaries between the various segments of the money market.

The United States offers a model of such market structure. There are two overnight money markets, the federal funds market and the repurchase market. The federal funds market is strictly an interbank loan market; in that market, banks with clearing accounts with the Federal Reserve make uncollateralized loans of reserves to each other, at the federal funds rate. The repurchase market is mainly a financing market for dealers of government and other securities. Dealers, with huge inventories, finance their securities by borrowing from banks and institutional investors, using the securities as collateral.

Repurchase agreements were introduced in Korea in 1977 to provide securities companies with an instrument to finance their portfolios. Gradually all financial institutions were allowed to engage in such transactions. Repurchase agreement rates are freely determined subject to a ceiling set by the Chairman of the Securities and Exchange Commission, but interest rates on the large denomination repurchase agreements are free. The main borrowers of funds are financial institutions, including securities companies and business corporations, while the main investors are individuals and nonprofit corporations. The repurchase agreements have functioned mainly as an alternative form of interest-bearing demand deposit. Recently, however, the financial institutions have gradually begun to use them as a means of adjusting their short-term liquidity positions for longer periods than those of call transactions.

Degree of Centralization of the Interbank Market

Although central banks play a catalytic role in interbank market development, typically they do not intend to centralize transactions on their books. When it occurs, as is the case in Turkey with the establishment of the “official” interbank market intermediated by the central bank, direct transactions among banks are nevertheless permitted. Moreover, in Turkey the establishment of a centralized interbank market was seen only as a temporary arrangement to “educate” participants and thus facilitate direct transactions. In the case of Italy, participation in the centralized market is on a voluntary basis. Moreover, it operates outside the central bank, which only provides settlement arrangements in support of market transactions. In Thailand, Korea, and Malaysia, the interbank market is over the counter, that is, participants are free to trade between themselves. In these countries, interbank brokers play an active role as facilitators for the transactions and thus in promoting smooth adjustment of surpluses or shortages of short-term funds among financial institutions. In Korea, for instance, measures implemented to integrate the segmented market between banks and nonbank financial institutions included the appointment of brokers for call transactions. In February 1992, a “Blind Brokerage System,” designed to ensure perfect competition between participants, was introduced. The importance of brokers in Korea can be assessed through the volume of transactions they intermediate. In May 1995, the daily average transactions volume in the call market amounted to W 2.8 trillion, of which W 1.8 trillion was transacted through brokers.

Brokers are also an important feature in all the segments of capital markets in the United States. Of special relevance for monetary policy conduct are the government securities brokers, which serve as facilitators for transactions between the primary dealers. Brokers work on an agent basis to protect the “anonymity” of both the buyer and seller. They occupy a very important place in the daily distribution of government securities. On any given day, over $200 trillion are traded on government securities in the secondary market. Typically about 50 percent of this volume is transacted through the government brokers. While today’s brokers are well capitalized, this has not always been the case. Twenty years ago, many brokers began to operate with almost no capital and relied on their relationship with dealers and traders in order to get business from them.

Interbank Market and Conduct of Monetary Policy

The interbank market is a natural playground for central banks. Their involvement in market development has increased with the shift to indirect instruments of monetary policy, more particularly to open market operations. The interbank market rate is often used as an operational target or a main indicator for the central bank. This is typically the case in the United States, where the Federal Funds rate (that is, the rate at which non-interest-bearing deposits held by banks at the Federal Reserve are traded) serves as indicator of monetary conditions, whereas the discount rate is perhaps the most decisive signal that the Federal Reserve uses to confirm the direction of interest rates and monetary policy (it usually follows changes in the level of the Federal Funds). This model, however, requires a sufficient degree of liberalization of interest rates and liquid and efficient markets. In Korea, for instance, the behavior of the interbank market does not yet provide adequate information on market conditions and the most immediate indication of the current relationship between the supply of and demand for funds. In other words, because deregulation of interest rates is not yet complete, the interest rate does not yet function satisfactorily as an information variable.

In countries where secondary markets in government securities are liquid, central banks tend to operate through outright sales and purchases of securities to influence banks’ liquidity rather than through interventions on the interbank market. This is typically the case in the United States and Italy. However, in these countries central banks’ repurchase operations also affect banks’ reserves in the short term.

The United States has had long experience with open market operations through outright sales or purchases of government securities. In the early 1950s and 1960s, when secondary markets for government securities were not as liquid as they are now, discussions took place on the kind of securities that should be sold or bought. From the point of view of the control of the money stock, the question is not significant; the effect on the monetary base depends solely on the amount of open market operations. But from the point of view of the “credit” effects of monetary policy, that is, the determination of the pattern or structure of interest rates, the kind of securities is important particularly because of the influence of long-term interest rates on investment decisions. What is known as the “bills only” policy, whereby the Federal Reserve would conduct open market operations on short-term government securities to avoid undue influence on long-term rates, was discussed in the early 1950s. In taking this course, the Federal Reserve would have implemented the concept that markets should be as free as possible to allocate available funds among alternative uses through competition. Open market operations by the Federal Reserve would have one purpose only, to control the amount of bank reserves to promote economic stability and growth. This option was also based on the fact that the market in the short end was more liquid and thus open market operations were less likely to impact interest rates. The “bills only” policy became a topic of discussion for many years and was officially abandoned in the early 1960s. It was generally considered by economists to be a mistake because it unnecessarily restricted the powers of the central bank. Moreover, this episode illustrates the importance of a liquid secondary market to conduct outright sales or purchases of securities for monetary policy purposes. In any event, the U.S. government securities market has grown so much in the last 15 years that outright open market operations now have little impact on the market.

Current operating procedures implemented by the Federal Reserve in the United States were presented at the seminar as they set a sort of model for open market operations for central banks around the world. Open market operations in the United States are the primary tool for adjudicating monetary reserves in the system. The Federal Reserve conducts open market operations exclusively through a network of 36 primary dealers who report to the Market Division of the Federal Reserve Bank of New York. The primary dealers have earned the right to have a direct line to the open market desk of t...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Content Page
• Preface
• Glossary
• 1. Introduction
• 2. Interest Rate Deregulation and Money Market Development in Korea
• 3. Government Credit Facilities and Interbank Market Developments in Italy
• 4. Interest Rate Administration and Liberalization and Money Market Development in Thailand
• 5. Financial Liberalization in Turkey
• 6. Development of the Money Market, Interest Rates, and Financial Reforms in Malaysia
• 7. Toward a Market-Oriented Interest Rate Policy in the Transformation of China’s Economy
• 8. Basic Outline for the National Interbank Market in Renminbi
• List of Participants
• Footnotes