Transcript Monetary policy in incomplete markets

A Presentation at Conference on Central Banking, Financial Stability
and Growth: Celebrating 50th Anniversary of Central Bank of Nigeria
Njuguna Ndung’u
Governor
Central Bank of Kenya
April 04, 2009
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Introduction
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Monetary Policy Framework in Kenya
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Financial Market and its Structure
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Market Incompleteness
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Challenges of Monetary Policy and
Uncertainity
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Resolving the Challenges
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Conclusions
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Monetary Policy contribution to economic activity
and growth is largely indirect, through a stable
macroeconomic environment.
o
A stable macroeconomic environment is a
necessary but not sufficient condition for
economic growth.
o
Goal of Central Bank (of Kenya)
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To formulate and implement monetary policy
directed to achieving and maintaining stability in
the general level of prices
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How is this done? Control money supply?
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Other goals;
1) Supervise commercial banks
2) National payments systems, etc
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Monetary policy formulated on a Monetary
Targeting Framework.
The Framework ensures that monetary policy
targets are consistent with the Government
economic policy strategy.
Key Assumptions of Framework under a
Flexible Exchange Rate Regime
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There is a predictable relationship between money and
nominal GDP.
The targeted monetary aggregates are under the
control of the Central Bank.
There is no trade-off between inflation and output in
the long run.
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Efficiency of Financial markets determines the
effectiveness of monetary policy: Efficient markets assist
the transmission mechanism
A well functioning financial market are central to
sustained economic growth, by facilitating the smooth
exchange and provision of credit
In financial repression system (McKinnon-Shaw type), the
transmission mechanism channels are dependent on the
regulatory environment.
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In liberalized bank dominated financial system
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the transmission channels work through credit supply;
the endogenous credit rationing is via the price effect,
facilitated by the openness of financial markets.
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In developed financial system,
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banks and markets for securities are well functioning
the transmission is through prices: (interest rate,
asset values and real exchange rate).
Financial markets determine channels through which
monetary policy stimuli is transmitted to the rest of the
economy
Dysfunctional financial markets will undermine monetary
policy transmission
o Distortions/multiple pricing/arbitrage
o Controls
o Information asymmetry-between banks themselves
and banks and their clients
o Lack of supporting institutions
o Segmented markets – difficult to communicate across
segments
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Different layers of banks- different information processing
Borrowers are less transparent when
 they lack well established reputations (no credit reference
bureaus),
 accounting and disclosures are lax and poorly enforced (e.g.
in Kenya, since banks do not share customer information,
there is a tendency for customers hopping from one bank to
the other taking loans with no intention of paying).
Opportunistic behavior
 borrowers have a stronger incentive to behave opportunistically
when they possess limited collateralisable net worth relative to
the size of their loans
 rural lands title deeds - collateral cannot be realized
 Political loans
 Sector loans (e.g. loans advanced to farmers)
Adverse selection among banks themselves- in different
segments
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Small Open Economy with large informal/Agricultural
(subsistence) sector
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A traditional non-monetary sector and a large informal sector
Impact of Monetary Policy is weak and the direction uncertain
Segmented markets
o
Large banks vs small banks (no credit lines between them)
o
Large banks able to access interbank markets, have credit lines with
others – price of that credit?
o
Small banks keep large excess reserves, since no access to interbankinefficiency.
o
MFIs and SACCOs - operating mainly in rural areas.
Financial Deepening? – weak despite policy initiatives:
o
Narrowly defined instruments
o
Few players: Dominance of a few large banks – adverse selection
between banks
Information Asymmetry - No private agent to break this
asymmetry (information capital should be a public good)
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The Five large banks: Multinationals/publicly
quoted banks – large capital base (US$ 1 billion
and above)
The next tier - medium banks, medium capital
base
The small family banks at the bottom– trade with
each other and a few individuals, service family
companies, low capital base (between US$ 5 - 60
million)
Adverse selection is actually based on this market
structure
This structure also defines financial product
pricing behaviour – responsive to CBK signals or
the wider market.
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MARKET INCOMPLETENESS
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Lack of forward and futures market
Lack of forward foreign exchange markets (no price, no cover)
 Weakens policy transmission mechanisms
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Presence of a larger informal sector
Operates with currency outside the banking sector
 Informal financing (e.g. shylocks)
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Presence of segmented structure banks
Each segment has its own market structure
 Target own niche market
 Pricing depends on client bank relationship
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Presence of “family” banks with a pre-defined
niche
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Do not respond to price signals in the market
INCOMPLETE MARKETS & WEAKENED
MONETARY POLICY TRANSMISSION
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Uncertainty about the effect/impact of monetary policy
Markets rely on price and that price should ‘clear’ the
market- that is the price is known
Narrowly defined instruments which only affect few
market players and sectors of the economy
Few players: Dominance of a few large banks operating
in the interbank market . Majority of banks do not
participate in interbank or Repo market – monetary
policy signals are missed
Information Asymmetry –between markets segments
and across the market
Lack of supporting institutions like credit reference
bureaus- to create information capital
Reliance on social network not prices in the market
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Incomplete markets makes monetary policy
transmission uncertain (and weak)
Monetary policy is ineffective/does not meet the
intended objective – for some segments or all the
market
Traditional channels of transmission are weakened
Credit market segmentation (which is a function of
the state of financial development) has
consequences on transmission of monetary policy
The signalling of CBK Monetary Policy may reach
only a small segment of the market that may not
coordinate the whole market
This affects not only information flow but also
information processing
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MONETARY POLICY UNCERTAINT
OUTCOMES: EXAMPLES
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Large banks (between 5-8) trade in the interbank market
every day. The rate is important for CBK
The trading tells CBK on a daily basis whether there is
credit crunch or not
But what about the other 35 banks left out? What price do
they use, is the interbank rate relevant?
Informal markets (shylocks) what prices do they use and
how do they set it
Interest rate is an important instrument for monetary
policy – but segments of the market may not be
responsive - so are some agents
But also the collateral technology used enforces severe
costs
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prevents large flow of bank loans and credits
Creates room for social networks to determine credit
allocation?
Large informal sector using informal finance and currency
outside the banking system.
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Segmented Markets:
 Horizontal Repos for banks to trade with each other
 Force banks to open credit lines (example;during Safaricom IPO)
 Reduction of threshold in short term securities (from Ksh1 million
(US$12,500) to Ksh100,000 (US$1,250)
 Reduction of requirements to open CDS accounts
Raise minimum capital to encourage consolidation
Credit Reference Bureaus – to reduce information
asymmetry (sharing of both positive and negative
information)
Disclosure issues (introduce APR for loans)
Financial Reforms to increase intermediation
Focus on Price instead of Quantity in Monetary Policy to send
clear signal to the market.
Research to inform and improve policy
The world of monetary policy is uncertain right now- but for
countries like Kenya, the market and economic structures
makes it very uncertain.
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CONCLUSION
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Monetary policy and its targeted outcome
uncertain due to the structure of the domestic
market
Banks dominate the market
The stock market is active but has a weak base
The bond market has relied on government
guaranteed bonds
Monetary policy transmission mechanism use
the price effects – but some segments of the
market look at other variables-like quantity
Most agents (households) and even informal
firms do not look at interest rate as a guide
Collateral technology keeps away potential
market participants
CONCLUSION (contd)
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Deposit rates in Kenya have remained low on
average around 5%, and a spread of 9.5% yet
deposits have almost doubled in the last 3
years
But this has followed the accounts: 4.7m
accounts in December 2007 with 43 banks
competing for them
Currently 6.8m accounts with 45 banks
competing for them and 900bn shillings of
deposit
The main motive – safe haven for saving
The global outcome may be uncertain, but the
domestic market structure has more
uncertainty.