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November 11, 1988

Monetary Policy in the Pacific Basin
The importance ofthe Asia"Pacific Basin in the
world economy has grown enormously over the
past three decades. Over this period, average
output growth in this region has consistently sur"'
passed that of any other region in the world.
Moreover, in recent years, the rapid growth and
transformation of the financial systems of the
Asia-Pacific nations have made this region an exciting arena for observing financial reform and
deregulation. Since the mid-1970s, almost all
countries in the region have undertaken steps to
reform and liberalize their domestic financial
systems and to remove restrictions on international capital flows.

In spiteoLthisdiversity, nearly all the financial
systems in the Pacific Basin were subject to regulatory and legal restrictions on financial activity.
In most countries, these restrictions included interest rate regulations, credit allocation controls,
explicit and implicit taxes on financial institutions, and/or international capital controls. Such
measures were designed to affect private savinginvestment flows through their influence on the
flow of credit and to finance government expenditures by extracting seigniorage through money
creation and regulation of the financial sector.

Financial market development, liberalization,
and reform have posed new challenges to the
central banks of Pacific Basin nations. Policymakers have responded by changing their
conduct of monetary policy. To analyze these
developments, compare experiences, and draw
policy implications, the Federal Reserve Bank of
San Francisco sponsored a major conference last
Fall drawing together central bank officials from
the Pacific Basin region, academics, and other
scholars. The papers prepared for that conference
were recently published in a volume entitled
Monetary Policy in Pacific Basin Countries. This
Letter provides an overview of the implications of
the financial market transformations for the conduct of monetary policy in the region based on
the findings of the studies presented at the

Policymakers sought to control the flow of loanable funds from savers to investors because they
wanted to ensure the flow of funds to certain
sectors of the economy and, they felt, the normal
financial intermediation process could not guarantee the socially optimal allocation of credit.
Consequently, interest rate regulations on both
deposit and loan rates were used as instruments
of monetary policy. Likewise, credit controls
were imposed to encourage lending to priority
sectors, including the government. These controls ranged from quantitative restrictions on
lending by various types of financial institutions
to measures that encouraged lending to certain
sectors through central bank rediscounting of
credits to those sectors at subsidized rates. Finally, controls on both inflows and outflows of
international capital prevented financial institutions from evading domestic financial controls by
undertaking transactions in external markets.

Restrictive environment

Winds of change

During the 1970s, the degree of financial market
development and sophistication varied widely
among countries in the Pacific Basin. Correspondingly, the degree of financial market
restrictiveness and the conduct of monetary policy varied as well. Some nations, notably the
United States, Hong Kong, and Singapore, had
relatively free and well~developed financial markets. At the other end of the spectrum were
countries with heavily regulated financial systems, such as Indonesia, Korea, Taiwan, and

Since the mid-1970s, a variety of forces have
been at work to force changes in the financial
markets of countries in the Pacific Basin. Inflationary monetary policies in the mid-1970s,
coupled with regulated deposit rates that yielded
negative real returns, drove private savings from
regulated banks. Then, in the late 1970s and
early 1980s, monetary authorities' attempts to
bring inflation under control put further pressure
on interest rates and accelerated this process of
financial disintermediation. In time, such disintermediation led to the growth of nonbank finan-

cial institutions and markets outside the regulated sector, thereby reducing the effectiveness of
the existing apparatus of monetary control.
At the same time, policymakers in most Pacific
Basin countries came to recognize that financial
restrictions hindered economic growth. Ceilings
on interest rates ,by depressihgfealinterest
yields in high inflation environments, worked to
reduce incentives to accumulate domestic financial assets. Domestic investment was consequently dampened. Credit controls also allocated
credit inefficiently by emphasizing financing for
government deficits and capital-intensive projects of large firms to the detriment of smaller
firms, which were denied access to organized
financial markets.
External macroeconomic developments and
competitive pressures from abroad also made it
more difficult to maintain tightly regulated financial systems and created another motivation for
reform in many countries. In particular, rising foreign interest rates stimulated the demands of
domestic investors for higher returns on financial
assets and intensified pressures for reductions in
exchange and capital controls.
Given the shortcomings of the existing financial
regulatory framework in most Pacific Basin countries, policymakers sought to lessen the government's role in directing resource allocation and to
permit market forces to reduce distortions and
inefficiencies. As a result, almost all countries
have relaxed interest rate controls on bank deposits, lowered bank reserve requirements and
liquidity ratios, eliminated rules concerning the
allocation of credit, stopped providing special
credit at preferential rates, and reduced
exchange controls. In many instances the authorities have also sought to encourage the
development of new financial instruments with
open-market determined interest rates.
Monetary policy
The changes in the structure of financial markets
have changed the conduct of monetary policy in
all these countries in the last 15 years. While the
extent and specifics of these changes have varied
across countries, their direction generally has
been toward market-oriented conduct of monetary policy.

In the countries with already highly developed financial markets, the conduct of monetary policy
has changed relatively little. For example, in the
United States, the Federal Reserve has continued
to rely on the market mechanism in conducting
monetary policy, using open-market operations
to affect the level of bank reserves. The deregulationotcleposit rates since the late 1970s has
induced only modest changes in the way policy
is conducted. Likewise, the only significant policy shift in Hong Kong occurred in 1983, when it
changed from floating to fixed exchange rates. In
Singapore, the shift from direct controls to a
market-oriented monetary policy occurred early,
and was largely accomplished by 1975.
The greatest shifts in monetary policy regimes
have occurred among the countries in the Pacific
Basin where financial systems have undergone
relatively greater transformation. For example, in
the early 1980s Australia and New Zealand abolished interest rate controls, floated their
exchange rates, and completely discarded the
use of administrative directives for the conduct of
monetary policy. Both central banks shifted to
extensive use of open-market operations for
adjusting the level of bank reserves. The development of monetary markets operating outside the
regulated banking sector has facilitated the central banks' open-market operations.
Indonesia, in a dramatic leap, cast off all its
direct controls in both the domestic financial
markets and the foreign exchange market and
floated its exchange rate. In addition, it has assiduously nurtured the growth of domestic money
markets by issuing large volumes of central bank
certificates and establishing institutions to ensure
the liquidity of the new instruments in secondary
markets. As a result, domestic money markets
have developed sufficiently for the central bank
to engage in open-market operations in domestic
securities in order to supplement operations in
the foreign exchange market.
The changes in Japan's monetary policy regime
have been more modest. The pressing need to
finance large government deficits, which grew
fivefold in the late 1970s, forced Japan to dismantle interest rate controls and to permit new
financial instruments and markets to arise,
although the pace has been gradual. It has also

gradually removed capital controls. Floating exchange rates have enabled the Bank of Japan to
retain some indirect control of domestic interest
Korea and Taiwan have tried to develop their
financial systems by creating money markets outside the banking sector, and in the process have
also partially liberalized their exchange controls
while simultaneously attempting to peg their exchange rates. Monetary policy in both countries
is still conducted primarily through direct
controls on state-owned banks,ยท althoughinterest
rates are now adjusted more frequently in response to changes in market conditions.
Thailand also has not changed its way of
conducting monetary policy very much. The
central bank's attempt to stabilize both the exchange rate and domestic interest rates in the
face of widely fluctuating world interest rates has
exacerbated money instability, however. More
recent policy changes suggest a move toward
greater exchange rate stability and more domestic interest rate flexibility.
Finally, monetary policy in China is changing
dramatically, as the nation moves away from a
rigid, planned economy to one that is more market oriented. In the process of reforming the
economy, a central bank has emerged, and stateowned banks have been allowed to engage in
deposit taking and business financing under the
central bank's close administrative controls. A
rudimentary interbank money market has
emerged, but there is no significant open money
market yet. Although the country is still in an
early stage of developing a market-oriented
banking system, monetary policy in China is assuming an important role in macroeconomic
stabilization for the first time.

The changes in the conduct of monetary policy

in Asia-Pacific nations over the last 15 years have
been both a response to the rapidly changing
economic and market environment of the 1970s
and 1980s and a reflection of fundamental revisions in the regulatory thinking of national
authorities. While the extent of change has varied
from country to country, the way monetary policy
is conducted in the region now is fundamentally
different from the way it was conducted in the
Monetary authorities now have greater independencefromfiscal authorities because financial
liberalization has spurred the development of
money and capital markets, thereby enabling
central banks to pursue open market operations
more actively. As a result, central banks are relying less on discount policy, reserve requirements,
and direct control of credit.
Moreover, the development and deepening of domestic financial markets, together with the
growth of international financial markets have increased the mobility of international capital, and
as a consequence, have tied domestic interest
rates more closely to world interest rates. In this
new environment, individual countries have had
to revise exchange rate regimes and policies that
rely on insulation from world interest rate fluctuations.
The new financial environment has posed challenges to central bankers, and they have responded with major changes in the way they
conduct monetary policy. It is too early to evaluate the relative success of each nation's particular
policies, but it is clear that the departure from
the past has led to greater economic efficiency in
these nations.

Reuven Glick
Senior Economist

Michael Hutchison
Assistant Professor
University of California,
Santa Cruz

Interested readers may obtain copies of the book, Monetary Policy in Pacific Basin Countries,
edited by Hang-Sheng Cheng, by ordering directly from the publisher:
Kluwer Academic Publishers
P.O. Box 358, Accord Station
Hingham, MA 02018-9990

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Barbara Bennett) or to the author.... Free copies of Federal Reserve
publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702,
San Francisco 94120. Phone (415) 974-2246.


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