1 Monetary Economics And The Malaysian Financial System

DP01
Monetary Economics And The
Malaysian Financial System
10 MAY 1999
1. Time allowed : Three (3) hours
2. Total number of questions : Six (6) questions on 2 pages
3. Number of questions to be answered : Four (4) questions
Part A : Compulsory question [40 marks]
Part B : Three (3) questions [20 marks each]
4. Candidates must obtain a minimum of 20 marks in Part A as well as pass the paper as
a whole.
5. Begin each answer to a new question on a fresh page.
6. Answer all questions in English.
2 Monetary Economics And The Malaysian Financial System
PART A
COMPULSORY QUESTION
1. (a) Define the meaning of financial intermediation. Discuss briefly the advantages and costs of financial
intermediation. [6]
(b) Explain briefly the roles of the capital market in the economic development. [6]
(c) Discuss any two banking measures implemented by Bank Negara Malaysia in 1997. [4]
(d) Discuss the major features of the new base lending rate (BLR) framework introduced by Bank Negara
Malaysia in 1998. [4]
(e) Describe briefly the following:
(i) Financial deepening [2]
(ii) Excess reserve ratio [2]
(iii) Currency-deposit ratio [2]
(f) Discuss briefly the goals of asset and liability management of a commercial bank. [5]
(g) (i) Using a schematic diagram, show a simplified transmission of monetary policy on the economy.
[5]
(ii) Briefly explain why changes in a central banks assets cause the money supply to change in the
same direction. [4]
(Total:40 marks)
PART B
ANSWER THREE (3) QUESTIONS ONLY
2. (a) Distinguish between a bank panic and a bank failure. [5]
(b) Explain why financial authorities are concerned with a bank failure. [5]
(c) Commercial banks face credit, liquidity and interest rate risks in their daily operations.
Briefly highlight any two of these risks and explain the strategies adopted by commercial banks to
mitigate these risks. [5]
(d) (i) List the components of liquid assets for financial institutions. [2]
(ii) State any three reasons for a central bank to impose liquid assets requirements for financial
institutions. [3]
(Total:20 marks)
3. (a) Briefly discuss the monetary stance of Bank Negara Malaysia in 1997. [8]
(b) Can a central bank control both the money supply and interest rate at the same time? Explain your
answer. [8]
(c) Briefly discuss the impact of sterilisation of foreign exchange on money supply. [4]
(Total:20 marks)
4. (a) Discuss three major factors that affect money supply in Malaysia. [7]
3 Monetary Economics And The Malaysian Financial System
(b) (i) Explain the terms monetary base and money multiplier. [2]
(ii) Assume that the external reserves of Bank Negara Malaysia (BNM) increased by RM50billion,
while the banking system recorded a decline in the net external reserves by RM20billion. If there
are no changes to the other determinants of money supply, compute the net impact on money
supply in the economy. [2]
(iii) Explain the terms narrow and broad money. [3]
(c) Compute the value of M1, M2 and M3 from the table given below:
Items RMbillion
Demand deposits of private sector 20
Fixed and savings deposits of private sector placed with
BNM and commercial banks 30
Currency in circulation 10
BNM certificates 10
Negotiable certificates of deposits 40
Fixed and savings deposits of private sector placed
with BNM, commercial banks, finance companies,
merchant banks and discount houses 80
[6]
(Total:20 marks)
5. (a) Discuss briefly five monetary goals of a central bank. [5]
(b) Discuss how a central bank conducts monetary policy to achieve its monetary policy goals. [5]
(c) Briefly highlight the reasons in favour of reserve requirements as a monetary tool. [5]
(d) Highlight two factors that may hamper the effectiveness of a monetary policy. [5]
(Total:20 marks)
6. (a) Briefly discuss the roles of any one of the following international agencies:
(i) World Bank [7]
(ii) International Monetary Fund [7]
(b) Explain briefly the following:
(i) European Monetary System [2]
(ii) Floating exchange rate regime [2]
(iii) Fixed exchange rate system [3]
(c) Explain any two of the following:
(i) The reasons for adopting capital control measures (you may use a Malaysian case as an example)
[3]
(ii) Balance on the current account and capital account of the balance of payments [3]
(iii) Offshore currency trading [3]
(Total:20 marks)
4 Monetary Economics And The Malaysian Financial System
PART A
Question 1
Generally, most candidates scored marks of 20 and above for this question. Nonetheless, many of
them showed a poor understanding of some of the concepts examined, e.g. financial deepening
and Central Banks assets to money supply relationships.
OUTLINE ANSWERS
(a) Financial intermediation is the process by which a financial intermediary plays the role of an ultimate
borrower and an ultimate lender, serving each of their interests. All financial intermediaries issue
their own liabilities to the public such as saving deposits, saving and loan shares. The funds will be
used to purchase assets such as bonds and mortgages.
Advantages
Allows savers to purchase assets that are relatively safe and more liquid. These assets will earn
interest. Financial intermediaries would take advantage of economies of scale by pooling funds
depositors to reduce the costs of transactions. Thus, individuals are able to earn higher returns on
their savings and borrowers can realise a lower cost of funds.
Financial intermediation offers savers a well-diversified portfolio rather than investing in a single
asset. Indeed, a limited number of assets increases the risk of default and losing the entire asset
portfolio. A financial intermediary such as a commercial bank can offer the small saver a reduction in
risk through diversifications. This is conducted by pooling the excess funds of many savers in order
to purchase a larger variety of assets from many borrowers.
Costs
Expenses of servicing deposits and loans return to capital, the intermediary business and reserve
requirements that earn no interests.
(b) The capital market is a market in which securities with a maturity of one year or more are exchanged.
Capital market activities are primarily that of raising long-term funds in the primary capital market
as well as trading the funds raised in the form of securities in the secondary markets. The stock
market is included as part of the capital market. The share of stock is a long-term security since it has
no maturity period. The instruments traded in the stock market are the shares issued by private
companies or corporations. In addition, the other instruments include: mortgage market corporate
bond and long-term government securities. The interest bearing debt instruments comprise commercial
papers and bonds. The notes that are traded in the capital market are of maturities between one year
and five years and are often referred to as medium-term notes. It is often necessary for the issuing
companies to obtain a credit rating from one of the commercial rating agencies when issuing debt
instruments.
Importance to Economic Development
Since it mobilises long-term funds of more than a year, it provides the financing for long-term
investments and capital expenditure in the public and private sectors. In other words, the capital
market promotes private enterprises by providing intermediary services to raise funds for corporate
investment and expansion. It also assists in the changing of ownership structure of companies.
(c) (i) Bond Information and Dissemination System (BIDS)
This was launched on 1 October 1997. The purpose was to provide comprehensive market
information on domestic debt securities to market participants. The BIDS is a computerised
system which centralises the collection and dissemination of information on Scripless
Securities Trading system securities and private debt securities. The information provided
includes the terms and conditions of issuance, details of deals done and relevant news on the
debt securities market. The members of the BIDS are commercial banks, merchant banks,
discount houses, Cagamas and rating agencies. The establishment of BIDS will provide
ready access and transparency of information and improve liquidity and widen the type and
5 Monetary Economics And The Malaysian Financial System
number of market participants. This will promote the development of primary and secondary
markets.
(ii) Classification of Non-Performing Loans
With effect from financial year beginning 1 January 1998, the period in arrears for classifying
a loan as non-performing by banking institutions was reduced from 6 months to 3 months.
Banking institutions were also required to claw back and suspend the interest accrued but-
not-received to day one of default on any loan which becomes non-performing. Similarly,
the standard yardstick for loans of million RM1 and below to be classified as sub-standard
had been reduced from a period in arrears of 6 months to 3 months; doubtful from 12
months to 6 months; and bad from 24 months to 12 months.
(d) The framework for the computation of the Base Lending Rate (BLR) was adjusted in November
1995. Under the new adjustment, commercial banks and finance companies are allowed to quote
their BLR below the ceiling set for the industry. The purpose is to foster greater competition
among the banking institutions. Moreover, this would allow greater flexibility for banks to pursue
their own lending strategies. On 6 August 1998, the framework of the BLR was again adjusted which
would lower the BLR for both commercial banks and finance companies. The revision for the BLR
results in the computation is:
Commercial Banks : BNM intervention rate*80% (1 SRR) + 2.25%)
Finance Companies : BNM intervention rate (1 SRR%) + 2.25%
Moreover, the BNM intervention rate now refers to the current rate. Essentially, the higher BLR for
finance companies (in this case, commercial banks), the computed value is reduced by 20% to reflect
overall funding costs.
(e) (i) Financial Deepening refers to the evolution of the financial system from a simple structure
to more sophisticated institutions. Thus, it involves the transformation of the financial system.
For example, the Malaysian financial system has undergone radical transformation from a
relatively simple structure since the 1950s to a more sophisticated industry with specialised
institutions and products. Thus, today the Malaysian financial structure is much deeper,
broader and more diverse. The transformation and innovations over the past three decades
are called financial deepening.
(ii) Excess Reserve Ratio refers to reserves that financial institutions hold in excess. The
principal decision to do so is the expected return from holding excess reserves. The
opportunity cost of holding excess reserves is the market interest rate. Hence, a higher
interest rate will tend to lower the holding of excess reserves. In other words, it is inversely
related to market interest rates. An even more important reason for holding excess reserves
is that they serve as a cushion against expected deposit outflows or significant variability in
deposit outflow. The theory of portfolio allocation predicts that an increase in the expected
level or variability of deposit outflows increases excess reserves and vice-versa.
(iii) Currency Deposit Ratio refers to the decision made by non-bank public about how to
allocate liquid assets between currency and deposits. Such decisions are collectively called
the currency-deposit ratio. It is an important part of the money supply creation process. The
portion of wealth held in terms of currency does not depend on the wealth of a person. In
fact, the ratio declines with increases in income and wealth. When the economic growth
increases, the ratio tends to decline. The expectation on the returns from holding assets also
determines the amount of holding of currency. The other determinants include the liquidity
of the asset, and the available information to assess the value of currency versus deposits. In
conclusion, the ratio falls on account of increases in wealth, expected returns from deposits,
riskiness of deposits, increase in liquidity of deposits, and increase in information or
anonymity value of cash.
(f) The goals of asset management are to address exposure to liquidity risk by lending money to other
banks through interbank market. The other option is to lend repurchase agreements for government
securities, lending securities to business and other banks overnight. However, such longer maturity
government securities involve some risks since interest rates will fluctuate. Overall, there will be a
6 Monetary Economics And The Malaysian Financial System
trade-off between lower expected returns and default risks and the higher expected returns and the
risk of interest rate fluctuations in government securities.
The goals of liability management are to manage liquidity since bank liabilities are usually of
shorter term than their assets. Banks have to keep sufficient cash or assets on hand that is easily
converted to cash to meet depositors withdrawals. However, this must be done without sacrificing
too much operating income by holding cash instead of loans or securities. When banks have more
loans than deposits, they may decide how to borrow additional funds to make loans. The options
include certificates of deposits, REPOs, and so forth. These alternatives have different maturities and
costs to the bank. Thus, relying on overnight loans is generally unwise.
(g) (i) The Central Banks conduct of monetary policy can affect production, employment and
price level in the economy. Schematically, a simplified transmission of monetary policy on
the economy is shown as follows:
BANK NEGARA MALAYSIA
Volume of Bank Reserves
Interest Rates
Volume and Direction of Credit
REGULATES
INFLUENCES
Advance, Loans
and Investment
Deposit and
Money Supply
Advailability and Cost
of Credit
Liquidity
Situation
EXERTS IMPACT
ON
INFLUENCES
Output, Employment, Prices
Private Consumption and Investment
(Savings)
Impact of Monetary Policy on the Economy
7 Monetary Economics And The Malaysian Financial System
(ii) Changes in the Central Banks assets cause the money supply to change in the same direction.
When the Central Bank buys an asset from the public, the payment whether cash or cheque
will directly enter the money supply. The increase in the Central Banks liabilities associated
with the asset purchase will cause money supply to expand. Likewise, money supply shrinks
when the Central Bank sells an asset to public since the cash or cheque that the Central
Bank receives in payment goes out in circulation. This will reduce the Central Banks
liabilities to the public. As such, changes in the level of Central Banks asset holdings
would cause money supply to change in the same direction since they require equal changes
in the Central Banks liabilities. In conclusion, any Central Bank purchase of assets results
in an increase in the money supply, while any Central Banks sale of assets automatically
causes the money supply to decline.
(a) (i) Bank Panic
All financial institutions have to honour their obligations to convert their demand and saving
deposits into currency immediately. On the other hand, they do not hold enough cash or
liquid securities to provide for the simultaneous conversion of all deposits into currency.
Indeed, even with the sound loans and securities, financial institutions can get into trouble
in the event that too many customers want their cash at the same time. In the event that
everybody wants to cash their deposits at the same time, there is an occurrence of a run on
the bank. Sometimes, a bank responds by temporarily suspending the privilege of
converting deposits into currency. When this happens simultaneously at many banks or
financial institutions, then we say a banking panic has occurred. The hallmark of a banking
panic is a sudden increase in the demand for currency. As a response, banks and other
financial institutions tend to increase their demands for excess reserves and other liquid
assets to meet their customers possible demand for cash. Banking panic occurs even in
economies with an established banking system. In response to a banking panic, the Central
Bank as the lender of last resort could lend liberally to the affected financial institution at
discounted rates, which would be set below market interest rates.
(ii) Bank Failure
Bank failure refers to an event whereby a bank is unable to pay its depositors in full. A
bank fails when it is unable to meet its obligation to its depositors. Banks use depositors
funds to make loans and to purchase other assets, but some of a banks borrowers may find
themselves unable to repay their loans, or the banks assets may decline in value for some
other reasons. In these circumstances, the bank may find it unable to pay off its deposits. A
bank faced with the wholesale loss of deposits is likely to close its doors, even if the assets
are sound. When the regulators deem that the net worth of the bank is too low, it may close
the affected bank. Generally, a bank with higher holdings of reserves will be less likely to
become financially distressed.
(b) With the potential consequences of a banking collapse that are harmful to the economy, governments
attempt to prevent bank failures through extensive regulation of their domestic banking system. The
concerns are as follows:
(i) Inflict harm on individual depositors;
(ii) Harm the economys macro economy stability;
(iii) General loss of confidence in banks undermines the payments system of the economy; and
(iv) Reduction in the ability of the banking system to finance investment and consumers on
durable spending. This could lead to slower economic growth. There is evidence that the
string of U.S. bank closings in the early 1930s helped to start and worsen the Great Depression.
Question 2
Generally, most candidates understood the concepts and principles examined in this question.
PART B
8 Monetary Economics And The Malaysian Financial System
(c) (i) Credit Risks
Banks face credit risks or the risk that borrowers might not repay their loan principal and
interest rates. In the event that a borrower defaults, the bank would suffer a loss due to bad
loans. Thus, banks have to deal with credit risks through various means, including gathering
of information about the borrower, monitoring borrowers and also diversifying their loan
portfolios. Banks do adopt credit rationing as a strategy to manage credit risks. This would
also address the costs from adverse selection and moral hazard. Credit rationing refers to
denying the borrower a loan at the prevailing market interest rate. Moreover, the bank may
either grant a borrowers loan application but would limit the size of the loan. The bank
may also deny a loan application of any amount at the prevailing market interest rate. Credit
rationing may take place when the borrowers have little or no collateral to offer to banks.
In the event that interest rates are raised to compensate for high-risk borrowers, then the
low-risk borrowers would drop out. Hence, the bank would only have a pool of high-risk
borrowers in its loan pool. Indeed, this is costly to the economy when the low-risk
borrowers are denied access to credit for productive purposes.
(ii) Liquidity Risks
Banks face liquidity risk since bank loans are less liquid compared with bank liabilities. If
this happens, banks are forced to liquidate their relatively illiquid loans and probably
receive less than their full value. Thus, the banks challenge is to reduce risk exposure
without sacrificing too much profitability. Strategies to resolve this problem involve holding
of reserves in the form of cash and or short-term marketable securities. Since this is not a
simple approach and also not profitable, banks do use various techniques of asset and liability
management to reduce liquidity risks.
(d) (i) The components comprise:
cash
clearing balances with the Central Bank
money at call
Treasury bills
government securities
government investment securities
Cagamas Bonds
bills discounted of purchases.
(ii) The reasons for imposing liquidity asset requirements are:
A high liquidity ratio will reduce the amount of deposits and loans for a given
supply of reserves (contractionary);
The liquid assets do earn a return though not necessarily the highest in the market;
The liquidity ratio requirement would raise the effectiveness of credit restraint
as it limits the scope for bank liquidation of Treasury bills and other short-dated
liquid assets to support an expansion of loans;
As a prudential measure so that the banking institutions are liquid at all times to
meet withdrawals of their customers; and
As a monetary requirement to influence liquidity situation in the banking system.
(a) In the conduct of monetary policy in 1997, Bank Negara Malaysia (BNM) faced the difficult task of
maintaining domestic and external stability in the context of the unprecedented turbulence in the
regions financial markets. The contagion impact and prolonged regional uncertainties, which
Question 3
Very few candidates attempted this question. Many of them failed to elaborate on the impact of
sterilisation of foreign exchange on money supply.
9 Monetary Economics And The Malaysian Financial System
accentuated the depression of the Ringgit, aggravated inflationary pressures and adversely affected
confidence, thereby, increasing the complexity of monetary policy implementation.
While the implementation of monetary policy was complex in 1997, the objectives remained
unchanged. Price stability remained as a primary goal of monetary policy. In the first half of 1997,
monetary policy had focused on asset inflation. After July, monetary policy responses were directed
at restoring stability to overcome the disruptions to economic activities caused by uncertainties in the
foreign exchange and stock markets. However, towards year-end, monetary policy was directed to
address the tight liquidity situation and inefficiencies in the intermediation process that had emerged
in the banking system.
The focus of monetary policy, thus, was to dampen inflationary impulses. Thus, the objective was to
slow down overall credit growth to levels that were more reflective of the moderation in GDP and to
encourage available resources into productive uses. Moreover, further interest rates increases were
also reinforced with further prudential measures in the form of credit ceilings. This was aimed to
limit further exposure of the banking system to these sectors in order to minimise its vulnerability to
any reversal in price movements in the asset markets. Interest rates were raised to support the Ringgit
as it came under several bouts of speculative attacks.
(b) The Central Bank can control either money supply or interest rates but not both at the same time.
When the objective is to maintain the prevailing interest rate, the Central Bank will enter the open
markets to buy or sell specific amount of securities needed to achieve the targeted interest rate. When
the objective is to prevent interest rate from rising above its target, the Central Bank will buy securities
and vice-versa when the goal is to prevent interest rates from declining. As such, the Central Banks
policy will reflect its interest rate policy and what it should do with money supply.
(c) Central Banks do carry out equal foreign and domestic-asset transactions in opposite directions to
nullify the impact of their foreign exchange on money supply. This is known as sterilisation of
foreign exchange intervention. As an example: the Central Bank sells US$10 million of its foreign
assets and receives a cheque for the sales. Thus, its foreign assets as well as its liabilities will decline.
This will lead to a decline in the domestic money supply. In order to negate this impact, the Central
Bank will buy equal amount of domestic assets such as government bonds, which will increase the
Central Banks domestic assets and its liabilities by US$10 million. This will completely offset the
money supply effect of the original sale of US$10 million. Any sterilised foreign-exchange sale will
have no effect on the money supply.
(a) The rate of growth in the money supply is an important indicator to the Central Bank due to its likely
impact on its monetary policy. The credit creation process will determine the level of expansion of
money supply in the economy. Whenever a loan is made by a financial institution, a deposit of an
equal amount is being created in the financial system. A large portion of money supply comprises
deposits of financial institutions and these in turn can affect the level of money supply in the economy.
(i) Bank Credit to Private Sector
Every loan will create a deposit and therefore, will expand money supply. The limit to
which banks may extend credit will depend on the size of the statutory reserves at the
Central bank. In the Malaysian economy over the years, credit to the private sector has
always been expansionary. This has even exceeded the growth of money supply (M3). A
more restrictive monetary policy will slow down lending to the private sector.
(ii) Net Government Operations
The level of money supply will be influenced through financing a budget deficit through
borrowings from the private sector, financial institutions, the Central Bank and even from
abroad sources. Financing the governments overall deficits by the banking system will
have the same effect on money supply as the banking system will have the same effect on
Question 4
Many of the candidates who attempted this question did well.
10 Monetary Economics And The Malaysian Financial System 10 Monetary Economics And The Malaysian Financial System
money supply as the banking sectors loan to the non-bank private sector. These two modes
of operations are very alike since both work through bank reserves to inject liquidity into
the private sector. The government operations are reflected by the average differences over
time between the level of government deposits with the banking system and the holdings of
government debts by the banking sector, mainly in government papers. A higher governments
deposits with the banking system compared with holdings of governments debt by the
banking system will have a contractionary impact on the level of money supply and
vice-versa.
(iii) Balance of Payments Performance
A surplus balance of payments position will result in an inflow of funds. This would increase
money supply and vice-versa when there is a deficit in the balance of payments position.
The movements of foreign assets between the Central Bank and the banking system
will not affect money supply since there is no net impact on private sector deposits.
Most noteworthy is that the relative importance of these determinants will vary from time to
time. Other factors may also influence the level of money supply in an economy, including
revaluation losses or gains, increase in banks non-deposit liabilities (increase in share capital
and reserves) and privatisation. In the case of privatisation, the sale of private sector assets
reduces the size of the budget deficit financing. With the reduction in government spending,
this will reduce money supply in the economy.
(b) (i) Monetary base
Monetary base is also known as base money or reserve money and sometimes as high-
powered money. It is called high-powered money because of its ability to create a multiple
amount of money. The monetary base comprises all reserves that are held by the Central
Banks and currency in circulation. While many factors affect the monetary base, the most
significant determinant is the action of the Central Bank through open market operations.
Basically, changes in the net foreign asset and stocks of domestic credit of the Central Bank
will change the monetary base. A surplus balance of payments will increase the monetary
base and in contrast deficit will shrink the monetary base. The linkage of the monetary base
and money supply is through the size of the money multiplier.
Most noteworthy is that the Central Bank cannot have full control over the monetary base
for these reasons:
The Central Bank affects the monetary base by selling and buying securities and
making discounted loans to banks. The most direct route that the Central Bank can
use to change the monetary base is through open market operations. An open market
purchase will raise the monetary base and vice-versa, while an open market sales
will reduce the monetary base. An open market purchase of securities from financial
institutions will increase the Central banks assets and its reserves. This will increase
the monetary base; and
The Central Bank can control the volume of open market operations. The Central
Banks control over discount lending is much less complete since banks will decide
whether to borrow from the Central Bank. Both the decisions of the Central Bank
and banks are required to determine the volume of discounted loans. Another factor
is the balance of payments position which affects the net assets of the Central
Bank and therefore, the monetary base.
Money Multiplier
In simple terms, the money multiplier is the number of times the money supply will change
in response to a given change of the monetary base. As an illustration, a multiplier of 2 and
a monetary base of RM10billion will result in money supply of RM20billion. The Central
Bank, non-bank public as well as banks determine the size of the money multiplier. There
are other factors including reserves ratio, currency-deposit ratio and the excess ration relative
to deposits.
(ii) RM20billion
11 Monetary Economics And The Malaysian Financial System 11 Monetary Economics And The Malaysian Financial System
(iii) The stock of money (M0) is generally defined as the amount of financial liabilities issued
by banking institutions. The narrowest definition of money is M1, which comprises currency
in circulation, travellers checks, demand deposits and other checkable deposits. The broader
definition is M2 and comprises M1 and other short-term investments, including small
denomination time deposits, saving deposits, money market deposit accounts and overnight
REPOs. A broader definition is M3, which includes M2, and large denomination time
deposits, institutional money market balances, term purchase agreement and even term Euro
dollars (as in the case of the Federal Reserve Bank).
(c) M1 = Demand deposits + Currency in circulation = RM30billion
M2 = M1 + BNM certificates + NCD + Fixed and saving of private sector placed with BNM and
commercial banks = RM110billion
M3 = M2 less Fixed and savings deposits of private sector placed with BNM and commercial
banks + Fixed and savings deposits of private sector placed with BNM, commercial banks,
finance companies, merchant banks and discount houses = RM160billion
(a) The six monetary goals of the Central Bank are:
(i) price stability;
(ii) high employment;
(iii) economic growth;
(iv) financial markets and institution stability;
(v) interest rate stability; and
(vi) foreign exchange market stability.
(i) Price Stability
Inflation erodes the value of money as a medium of exchange and a unit of account. Thus,
policy makers have emphasised price stability as a policy goal. In a market economy, where
prices contain information about costs and demand, inflation would make prices less useful
as signals for resource allocation. Overall, it would make decisions more difficult for
households and firms. More importantly, the occurrence of hyperinflation would lead to a
contraction of the economy as experienced by Germany in the 1920s. As such, price stability
is a desirable monetary policy goal.
(ii) High Employment
The maintenance of a low rate of unemployment is an important monetary goal.
Unemployment leads to excess productive capacity, financial stress and lower self-esteem
for those who lost jobs. High employment does not mean a zero unemployment and this is
neither practical nor in the economys best interest. Variations in the high employment goal
and substantial uncertainty about high unemployment means could lead to serious mistakes
in monetary policy.
(iii) Economic Growth
One key macroeconomic objective of monetary policy is to promote the highest sustainable
rate of output growth in the economy that is consistent with domestic prices and exchange
rate stability. Steady economic growth and increases in the economys output of goods and
services would raise household incomes and hence, the revenue of the government. Economic
growth policies could provide the incentives for increase in savings to ensure a large pool of
investment funds and also direct incentives for business activities. Moreover, the stability of
economic growth is crucial since this allows for accurate planning and promotes long-term
investment in the economy.
Question 5
Another well-answered question.
12 Monetary Economics And The Malaysian Financial System
(iv) Financial market and institution stability
This would ensure that funds would be channeled from savers to borrowers. Moreover, this
would also involve growth in bank credit and money supply is adequate to accommodate
and fuel real economic growth without causing inflationary pressures. The Central Bank
would ensure that the economy has a sound and efficient banking and financial industry as
monetary policy operates through the financial markets.
(v) Interest rate stability
Like fluctuations in price levels, fluctuations in interest rates make planning and investment
decisions difficult for households and businesses. In some instances, the goal of interest rate
stability could be motivated by political pressure and also a desire for a stable saving and
investment environment.
(vi) Foreign exchange market stability
In the global economy, this is an important monetary goal of the Central Banks. A stable
foreign exchange market would make planning easier for both commercial and business
transactions. A fluctuation in the domestic exchange market would make domestic goods
less competitive in the international market. Thus, economists have argued that policymakers
should intervene in order to offset extreme fluctuations in the foreign exchange market.
(b) The Central Bank has full control over the instruments used to achieve monetary goals. The instruments
are targeted towards the financial institutions deposits as these comprise money supply, the control
of which the success of monetary depends on. The monetary control is conducted either through the
instruments that could either be directed towards limiting the supply side (curbing credit lending) or
directed towards the demand side (discouraging borrowing by the financial institutions from the
Central Bank). The monetary instruments available to the Central Bank could be classified as
selective and general instruments. Selective instruments are used to influence credit to a particular
sector or type of lending. Selective instruments are a set of complementary instruments rather than
alternatives or substitutes for general instruments. The choice of selected instruments covers the
following;
(i) priority sector lending guidelines;
(ii) hire-purchase guidelines on motor vehicles;
(iii) guidelines on credit card operations;
(iv) credit limit for purchase of stocks and shares and units of unit trusts; and
(v) credit guideline ceilings for financing of certain types of properties.
General instruments for monetary policy would serve to influence the level of bank reserves or
monetary base. Among the instruments available to the Central Bank are:
(i) Variations to the statutory reserve requirements;
(ii) Adjustments to liquid ratio; and
(iii) Money market operations.
(c) There are two arguments for reserve requirements, namely, the liquidity argument and the monetary
argument. Under the liquidity, the reserve requirement would create a pool of liquid funds to assist
illiquid but solvent banks during a banking crisis. For the monetary argument, the reason for the
reserve requirement is that they increase the Central Banks control over the money supply process.
The percentage of deposits held as reserves is one of the determinants of the money multiplier and
hence, the responsiveness of money supplies to a change in the monetary base. Thus, by controlling
reserves-deposit ration through reserve requirements, this would make the money multiplier stable
and thus, money supply more controllable.
(d) There are two possible obstacles in using monetary policy tools to achieve its goals. The presence of
information lags or the inability to note any changes in economic growth, inflation and other
macroeconomic parameters instantaneously. This delay would lead to major policy errors. The second
impediment is impact lag or the time required for monetary policy changes to affect economic growth,
employment, or inflation. Indeed, any changes in the monetary base translate into changes in the
money supply, and changes in the money supply affect the economy over time. This impact is not
immediate but with a time lag. As such both information and impact lags make effective policy-
making a rather difficult exercise.
13 Monetary Economics And The Malaysian Financial System
(a) (i) World Bank
The World Bank was founded in 1994 together with the International Monetary Fund. The
Banks mission is to help developing economies reduce poverty as well as sustain economic
development. The Bank comprises two key organisations, namely, International Bank for
Reconstruction and Development (IBRD) and International Development Association (IDA).
The Bank provides loans to build infrastructure and to aid economic development. The
Bank also raises funds to lend by selling bonds in the international capital market.
(ii) International Monetary Fund (IMF)
The IMF performs three main functions as discussed below:
Regulatory function in laying down the ground rules for its members to aide by. This is
essential in order to regulate trade and to eliminate any destructive trade practices among its
members. The IMF is also involved in the financial regulation of national economies as part
of the agreement to lend money. Borrowing members may be asked to make structural
adjustments to their economies such as fiscal conservatism and the privatisation of state-run
enterprises.
Financial assistance covers credits and loans extended by the IMF to member countries
with any balance of payments problems. In the recent financial crisis in the Asian region
the IMF had extended financial assistance to Korea, Thailand and Indonesia.
Technical assistance comprises expertise and aid provided by the IMF to its members in
several broad areas, including the design and implementation of fiscal and monetary policies,
institution-building (development of Central Banks) and the review and drafting of legislation.
(b) (i) European Monetary System (EMS)
The EMS was set up in 1979 with the objectives of overcoming international instability,
establishing monetary stability in Europe, pulling together the monetary and economic
polices of the EEC economies, promoting inter-community trade by stabilising exchange
rates and to achieve in the long-run, the Economic Monetary Union through a common
currency. Thus, the EMS has two key features:
First, an exchange rate intervention system known as the Exchange Rate Mechanism,
which attempts to preserve stability between different currencies.
Second, each member country makes available 20% of its gold and dollar reserves
to the European Monetary Cooperation Fund (ECMF) in return for European
Currency Unit (ECU). The ECMF would extend credit facilities to member countries
that have economic instability.
The EMS is not an institution in its own right. It, therefore. has no powers to force members
to pursue some prescribed monetary and fiscal policies. Indeed, for its success there must
be convergence of economic policies and performance of members. Thus, the strength of
the EMS lies in its pragmatic flexibility, which allows for differences in economic
performances, inflationary rates and balance of payments positions of members by explicitly
allowing readjustments of currencies.
(ii) Floating Exchange Rate Regime
In this regime, the Central Bank allows the exchange rate to adjust to equate the supply and
demand for foreign currencies. As an illustration, if the rate of Ringgit against the US$ falls
to RM2.5 per US$ to RM3 per US$, Malaysian exports would increase and this would
increase the demand for Ringgit. The Central Bank would simply stand aside and allow the
Question 6
The candidates who attempted this question generally had a good understanding of the concepts
relating to exchange rate regime. However, many showed a poor understanding of the offshore
currency trading, capital control measures and balance of payments.
14 Monetary Economics And The Malaysian Financial System
exchange rate to adjust itself. However, in reality, under this regime, the exchange rate is
not predetermined and also not left to fluctuate freely. As such, this regime has also been
known as dirty float to distinguish it from a clean float, in the latter case, the Central
Bank makes no attempts to influence the foreign exchanges rates. Industrial economies
operate a hybrid system of managed floating rates, whereby, the Central Bank may attempt
to moderate exchange rate movements without keeping the exchange rate rigidly fixed.
(iii) Fixed Exchange Rate System
In contrast, under this regime the exchange rates are set at levels determined and maintained
by the government. The government would attempt to maintain the exchange rate of their
country at a fixed rate, or within a narrow margin of a predetermined value, against other
currencies. Thus, the Central Bank would intervene in the foreign exchange market to buy
or sell foreign currencies in order to maintain the exchange rate at a predetermined level. A
Central Bank can maintain the exchange rate within the acceptable level as long as it is able
and willing to buy and sell the amounts of its own currency necessary for exchange rate
stabilisation. When the Central Bank buys its own currency, it sells dollars. Hence, there is
an important asymmetry in Central Bank adjustments in response to market pressures on
the exchange rate. Under this system, the Central Bank would need to have a sufficient
amount of foreign reserves. The ability to buy its own currency (to raise its value relative to
the dollar) is limited by the countrys stock of international reserves.
An example of a fixed exchange rate regime was the Bretton Woods Agreements adjustable
peg system, which was in operation between 1945-72. Another recent example is the
European Monetary Systems Currency.
The classical gold standard is an excellent example illustrating the successes and failures of
a fixed exchange rate regime. Under the gold standard, currencies of participating countries
are convertible into an agreed-upon amount of gold, exchange rate adjustment therefore, is
ruled out. Thus, based on this promise the exchange rates between two countries are fixed
by their relative gold weights.
(c) (i) Capital controls have been implemented based on these arguments:
To redress market failures given the macroeconomic and financial risks arising
from the free markets and flow of capital. Economies are not spared from pressures
on their currencies and stock markets. It has been argued that while strong
macroeconomic fundamentals are necessary, they are not sufficient for financial
stability, the latter also needs sound financial sector policies. In times of crisis, it
has been observed that markets do not behave rationally, resulting in overreactions
to any market developments.
To provide some breathing space for the economy and not substituting exchange
control measures for appropriate macroeconomic policies. This would ensure that
the on-going macroeconomic policies and structural adjustment measures could
continue uninhibited by external developments. The capital control measures would
preserve the gains that have been made such as the improvement of the balance of
payments position and in terms of containing inflation. This would create a positive
environment to support economic recovery. The capital control measures would
also allow the economy to pursue more aggressive policies such as lowering interest
rates, injecting greater liquidity into the banking system and enhancing the
intermediation process to assist economic recovery.
(ii) Current Account
The balance of payments is the record of the transactions of residents of a country with the
rest of the world. It is also a reflection of the health of the economy. The two key accounts
in the balance of payments are the current account and the capital account. Closely related
to the current account are the merchandise account and the services account.
Thus, the current account is expressed as:
Current account balance = Merchandise account + Services Account + Net transfers.
15 Monetary Economics And The Malaysian Financial System
Thus, by adding the merchandise balance and trade-in services and net transfers, we can
derive the current account balance. We say that the current account is in surplus when the
exports of goods and services plus transfers exceed imports of goods and services plus
transfers. The merchandise account simply records trade-in goods (exports and imports).
The services account records trade-in freight and insurance, profit, investment income and
interest payment, travel and education payment, rent, royalty and consultancy and other
transport charges. Transfers cover remittances, gifts and grants. In the Malaysian experience,
the merchandise balance is usually in surplus while the service balance is persistently in
deficit so that the overall current account balance is in deficit.
Capital Account
The capital account records purchases and sales of assets such as shares, bonds and land.
Thus, the capital account refers to the net international indebtedness of the private and
public sectors in an economy.
The capital account is expressed as follows:
Capital account = Official long-term capital flows ( borrowings of the public sector)
+ Private long-term (mainly foreign direct investment and borrowings) + short-term
capital.
There is a capital account surplus or a net capital inflow when our receipts from the sale of
shares, bonds, land, bank deposits and other assets exceed our payments for our own purchases
of foreign assets. Likewise, there is a capital account deficit if those in the country buy
more assets from foreigners than they sell to foreigners. The capital account distinguishes
between short and long-term capital flows and is indicated on a net basis. The long-term
capital component basically records net borrowing from project and market loans,
commercial and suppliers credits, subscriptions to international and regional institutions
and corporate investments. This entails an increase in future external debt servicing
obligations. On the other hand, the private capital flows which appear in the long-term
capital account essentially are equity-related flows such as corporate investment (FDI) or as
loan capital which likewise would result in higher debt servicing obligations. In the short-
term capital account, short-term capital flows are mainly from private short-term flows.
The key component comprises net external assets and liabilities of the banking system,
reflecting changes in the international indebtedness of domestic banking institutions.
(iii) Offshore Currency Trading
One of the most pervasive features of the commercial banking system in the 1980s is that
the banking system has become globalised as banks have branched out from their home
countries into foreign financial centers. Offshore banking describes the business that banks
foreign offices conduct outside their home countries. This could be done through an agency
office located abroad, a subsidiary or a foreign branch. The growth of offshore currency
trading has gone hand-in-hand with that of offshore banking. An offshore deposit is simply
a bank deposit nominated in a currency other than that of the country in which the bank
resides, example yen deposits in a London bank. Offshore currency deposits are usually
referred to as Euro Currencies. One motivation for the rapid growth of offshore currency
trading has been the growth of international trade and increasing multinational nature of
corporate activity.