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 1

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 Introduction  Monetary Policy Framework in Kenya  Financial Market and its Structure  Market Incompleteness  Challenges of Monetary Policy and Uncertainity  Resolving the Challenges  Conclusions 2

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o 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.  Goal of Central Bank (of Kenya)  To formulate and implement monetary policy directed to achieving and maintaining stability in the general level of prices  How is this done? Control money supply?  Other goals; 1) Supervise commercial banks 2) National payments systems, etc 3

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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  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. 4

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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.  In liberalized bank dominated financial system  the transmission channels work through credit supply;  the endogenous credit rationing is via the price effect, facilitated by the openness of financial markets. 5

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 In developed financial system,  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/arbitrageo Controlso Information asymmetry-between banks themselves and banks and their clients o Lack of supporting institutionso Segmented markets – difficult to communicate across segments 6

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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 7

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 Small Open Economy with large informal/Agricultural (subsistence) sector  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 interbank- inefficiency. o MFIs and SACCOs – operating mainly in rural areas.  Financial Deepening? – weak despite policy initiatives: o Narrowly defined instrumentso 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) 8

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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. 9

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MARKET INCOMPLETENESS  Lack of forward and futures market  Lack of forward foreign exchange markets (no price, no cover) Weakens policy transmission mechanisms  Presence of a larger informal sector  Operates with currency outside the banking sector Informal financing (e.g. shylocks)  Presence of segmented structure banks  Each segment has its own market structure Target own niche market Pricing depends on client bank relationship  Presence of “family” banks with a pre-defined niche  Do not respond to price signals in the market

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INCOMPLETE MARKETS & WEAKENED MONETARY POLICY TRANSMISSION  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 12

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MONETARY POLICY UNCERTAINT OUTCOMES: EXAMPLES  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  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. 14

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CONCLUSION  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

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CONCLUSION (contd)  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.

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