II. The Monetary Transmission Mechanism in Trinidad and Tobago10
Inflation has been on the rise in Trinidad and Tobago since 2004. Monetary policy actions of the Central Bank of Trinidad and Tobago have been aimed at containing the rise of inflation and influencing inflation expectations. Understanding the monetary transmission mechanism is key to the implementation of monetary policy. This paper reviews the main aspects of the monetary transmission mechanism in Trinidad and Tobago, and offers some suggestions to improve the effectiveness of monetary policy transmission.
27. Understanding the monetary transmission mechanism is central to fighting inflation. This paper reviews the functioning of the monetary transmission mechanism in Trinidad and Tobago and offers suggestions to improve the effectiveness of monetary policy in controlling inflation. Section B describes some special characteristics of the Trinidad and Tobago economy and financial markets. Section C discusses how these affect the monetary transmission mechanism. Section D provides recommendations to strengthen the effectiveness of monetary policy, and briefly describes how the transmission mechanism would change in a more flexible exchange rate regime. The last section presents the main conclusions.
B. The Trinidad and Tobago Economy
28. Very favorable terms of trade and an expansionary fiscal policy have generated upward pressures on the real exchange rate in recent years. Trinidad and Tobago is an energy rich economy that has benefited from surging energy prices, the exploitation of new gas fields, and an expansion of industrial capacity in recent years. Economic activity has been growing rapidly, the external accounts have been strengthening, and the government’s balance sheet improved. However, the rapid increase in public spending together with tax cuts to the nonenergy sector have led to a deterioration in the underlying fiscal position. This has added to the upward pressures on the real exchange rate from the positive terms of trade shock. Given the de facto fixed exchange rate regime, these pressures have been manifested in the form of higher inflation, which has risen to nearly 9 percent from 3 percent in 2003.
29. Monetary policy independence is limited in Trinidad and Tobago due to the de facto fixed exchange rate and open capital account.11 With the liberalization of financial markets, foreign interest rates have had a greater degree of influence on domestic interest rates, and the extent to which the central bank can affect domestic interest rates is determined by the risk premium over foreign interest rates, and by the degree of substitution between domestic and foreign assets. The capacity to deviate from foreign interest rates has likely diminished in recent years. The premium on local currency-denominated assets has narrowed as the country’s balance sheet strengthened due to the energy boom. At the same time, the substitutability between domestic and foreign assets seems to be increasing as investors’ risk aversion regarding foreign investments appears to be waning—as demonstrated by the increase in investments in foreign assets with low credit ratings. Moreover, the fastest growing segment of the financial sector is the less regulated one, which is less constrained in terms of foreign investments. In the short term, the central bank can gain some degrees of freedom to influence monetary conditions through changes in reserve requirements, prudential regulations, and moral suasion. However, their scope is limited.
30. Monetary policy gained some independence from a rationing of foreign exchange leading to a less open capital account than suggested by the official classification. The excess liquidity in the system has prompted an excess demand for foreign exchange. This demand has only been partially met by central bank sales. Unsatisfied customer demand for foreign exchange led to “queues” which increased substantially in 2005, when the central bank started giving guidance to banks to prioritize the supply of foreign exchange to their clients for current account transactions. The rules governing the foreign exchange market ensure that only minor movements in the exchange rate can occur.
31. The conduct of monetary policy is Trinidad and Tobago is influenced by a number of country-specific characteristics of the economy and financial system, including: (i) the dual structure of the economy; (ii) the composition of the price index; (iii) the excess liquidity generated by the monetization of energy receipts to finance the nonenergy budget deficit; and (iv) the design of monetary instruments and operations.
- The dual structure of the economy complicates the conduct of monetary policy due to the asymmetric response of the two main segments of the economy. The energy sector accounts for over 40 percent of GDP, about 90 percent of exports, and over half of government revenues, though its contribution to employment is minor. The impact of domestic monetary policy on the energy sector is minimal, whereas its impact on the nonenergy corporate sector and household can be significant. Companies in the energy sector obtain their financing mostly from foreign sources, in part because of domestic banks’ limited lending capacity. The share of the oil and gas sector in commercial banks’ assets was below 3 percent in 2005. On the other hand, the nonenergy corporate and household sectors are impacted by monetary conditions due to their reliance on domestic financing. Lending to households is the largest component of banking sector assets at around 40 percent.
- The composition of the price index (RPI) basket in Trinidad and Tobago makes the link between monetary policy and measured inflation less straightforward. The RPI basket is dominated by items that are subject to strong supply shocks (food) or subject to administrative prices (transportation, utilities, health care, and education). As a consequence, headline inflation reacts to changes in policy rates with longer and more irregular lags than would generally be expected. From this point of view, a good measure of core inflation is needed to help guide interest rate decisions. Moreover, the central bank needs to follow closely a variety of indicators, such as excess liquidity, when judging the appropriateness of monetary conditions.
- Energy receipts and the monetization of the nonenergy deficit has led to a situation of structural excess liquidity.12 The nonenergy deficit, which has risen rapidly in recent years and reached 10 percent of GDP in fiscal year 2004/2005, has been financed by the monetization of energy receipts in foreign currency. The ensuing liquidity injections have only been partially sterilized by foreign exchange sales and open market operations in excess of scheduled treasury securities sales by the central bank.
- Monetary operations have had difficulties coping with the structural excess liquidity. The central bank signals the stance of monetary policy through the repo rate. However, the repo rate has not been binding in the current structural excess liquidity environment, and treasury bill rates and effective commercial bank rates have diverged persistently from the interest rate path signaled by the central bank’s policy rate. Between mid-2005 and mid-2006, the gap between the repo rate and treasury bill rates widened markedly and the average effective commercial bank lending did not tend to follow repo rate increases. Commercial banks’ prime lending rate increased with the repo rate, but the link between the prime and average effective lending rate became weaker. Average deposit rates also stayed flat, contributing to increased financial disintermediation. However, more recently, the central bank has allowed treasury bill rates to rise, thus facilitating the tightening of monetary conditions.
C. The Monetary Transmission Mechanism in Trinidad and Tobago
Interest rate channel
32. Trinidad and Tobago’s relatively large financial sector creates the conditions for effective monetary policy transmission. The relatively high level of domestic credit to the private sector (around 40 percent of GDP or 65 percent of nonenergy GDP) makes the interest rate channel a potentially important channel of monetary transmission.13 However, as discussed above, the effect of changes in the central bank’s policy rate (repo rate) on commercial banks’ lending and deposit rates has been muted in the current excess liquidity environment.
33. The dual structure of the economy, however, limits the effectiveness of the interest rate channel. Access to foreign financing by the energy sector and some related industries (accounting for over 40 percent of GDP) renders the interest rate channel very weak for that segment of the economy. At the same time, low access to domestic finance by domestic small and medium-size companies limits the importance of interest rate changes for this segment of the nonenergy sector. On the other hand, the high and increasing indebtedness of households is strengthening the interest rate channel for this sector (Table 1). Government plans to increase the domestic content of energy sector investments are likely to make the monetary transmission mechanism even more complex by increasing the share of domestic resources the use of which is decided independently of domestic monetary conditions.
|Sectoral distribution of loans-to-total loans|
|Proportion secured as mortgage loans||9.8||10.2||11.4||11.3||18.3||27.2|
|Oil and gas sector||2.9||5.5||4.2||4.6||2.9||2.8|
|Transport and communication||6.8||4.9||3.7||3.7||3.6||2.7|
|Geographic distribution of loans-to-total loans|
34. The degree of competition in the financial sector also affects the interest rate channel. In a competitive financial sector, changes in monetary policy rates are more rapidly transmitted to loan and deposit rates than in a highly concentrated one. In this regard, the concentration in the Trinidad and Tobago banking sector reduces the speed of transmission for lending rates. For deposit rates, the transmission appears faster in the financial sector as a whole than just in the banking system, as other segments such as the mutual fund industry seem more competitive than the banking sector. However, within the banking sector the transmission mechanism for deposit rates has been slow due to limited competition among banks for funds resulting from excess liquidity conditions. Regarding securities market development, deep and liquid securities markets usually respond faster to monetary policy changes than bank loan and deposit rates. Inactive secondary markets for government and private securities in Trinidad and Tobago hamper the functioning of the monetary transmission mechanism. In this connection, developing a benchmark yield curve would aid monetary policy.
35. The terms of financial contracts and extent of dollarization also play an important role in determining the effectiveness of monetary policy. The larger the share of short-term loans and deposits and/or the share of variable rate instruments compared to fixed rate ones, the faster the interest rate transmission. On the other hand, dollarization hampers the transmission of domestic interest rates. The significant share of foreign currency loans, representing approximately one quarter of total loans, and of foreign currency deposits, amounting to over 30 percent of total deposits, in Trinidad and Tobago reduces the effectiveness of monetary policy.
Other transmission channels
36. The importance of the asset price channel remains limited, but it is growing, especially in the case of real estate. This channel operates through wealth effects generated by variations in asset prices—mainly bonds, equities and real estate—resulting from changes in interest rates. In Trinidad and Tobago, this channel is unlikely to be strong for bonds given the lack of a deep secondary market. However, the excess liquidity in recent years seems to have contributed to a real estate price boom and rapid rise in stock prices.14 The effect on aggregate demand seems limited thus far, but rapidly growing mortgage lending indicates that the asset price channel is likely to strengthen.
37. The credit availability channel is important in emerging market economies like Trinidad and Tobago. Monetary policy works through credit rationing when there is imperfect information or contract enforcement problems. Since collecting information about small borrowers is costly, the implicit cost of borrowing and the volume of credit vary substantially more for them than for large firms during the monetary policy cycle.15 This way credit rationing amplifies the direct interest rate effects. In Trinidad and Tobago microeconomic data makes it difficult to reach a definitive conclusion on the strength of the credit availability channel. However, the small and medium-size borrowers’ apparent lack of access to alternative financing sources and evidence from other similar emerging markets indicate that the credit channel is likely to be important.16
38. The expectations channel is crucial for monetary policy effectiveness. All variables that have intertemporal implications, and are therefore determined in a forward looking way, are affected by agents’ beliefs about future shocks to the economy and how the central bank will react to them. The expectations channel operates through the economic agents’ expectations about the real rate of return on financial assets (ex-ante) and investment decisions. Moreover, inflation expectations play a role in wage negotiations. Strong central bank autonomy and credibility strengthen the speed and effectiveness of the transmission of monetary policy signals. CBTT autonomy in monetary policy decisions is key to its credibility and thus to the strength of the expectations channel. The cost of fighting inflation is significantly reduced as the expectations channel is strengthened.
D. Strengthening the Effectiveness of Monetary Policy in Trinidad and Tobago
39. Regaining control over the liquidity in the system should be the main focus of monetary policy in the near term. In the current excess liquidity environment, the interest cost of open market operations can be quite high. Sterilization through open market operations involves visible costs: the interest rate paid on the instruments placed to mop up the liquidity. On the other hand, foreign exchange sales incur the opportunity cost of the interest that could be earned on international reserves. Moreover, foreign exchange sales may also increase in the country’s perceived financial vulnerability. Therefore, a proper mix of foreign exchange sales and open market operations needs to be found.
40. Several measures could improve the effectiveness of Trinidad and Tobago’s monetary transmission mechanism. The main areas for improvement are the following: (i) increasing the effectiveness of the central bank’s interest rate policy; and (ii) debt financing of the nonenergy deficit.
41. The active use of a reverse repurchase facility could improve the signaling of the central bank’s policy intentions and increase the effectiveness of the monetary transmission mechanism.17 A liquidity absorbing facility, such as a reverse repo or deposit facility, would provide a better policy signal as it would be binding in the current structural excess liquidity environment.18 It would not allow persistent significant divergence of treasury and commercial bank rates from the path signaled by the central bank. Such facilities are usually between one and four weeks in maturity as opposed to the standard overnight standing deposit facilities.19 The maturity should be coordinated with the characteristics of the reserve requirement framework. The instrument can be devised as tender-based or unlimited access depending on the design of the other sterilization instruments, the magnitude of sterilization needs, and the structure and concentration of the banking sector.
42. A properly designed liquidity-absorbing instrument would not hamper the development of the interbank market. The interbank money market serves the very short-term liquidity management needs of the banking sector and a sufficiently long (at least seven days) reverse repo facility would not eliminate banks’ need to manage their day-to-day liquidity through the interbank market. In case of a reverse repo or deposit facility, the central bank would directly bear part of the sterilization costs as opposed to the current situation when all sterilization costs are directly financed by the budget. This is similar to the costs which the central bank would incur if it were to issue its own paper to mop up liquidity. More importantly, such costs should not be a problem if there is a well-functioning profit transfer and recapitalization arrangement between the central bank and the budget. The bulk of sterilization should continue to be carried out by longer-term open market operations.
43. Debt financing of the nonenergy budget deficit would eliminate the need for the central bank to sterilize the government’s liquidity injections, and would contribute to financial market development. Instead of financing the nonenergy deficit by monetizing the foreign currency energy receipts, the government could consider issuing domestic debt to finance the deficit while keeping the energy receipts deposited in the central bank as part of the international reserves. Straightforward debt financing would make monetary policy more transparent and eliminate the problem of partial sterilization. In addition, it would make debt management and planning more predictable, thereby aiding the development of the primary market and eventually the secondary market. More efficient primary and secondary markets would reduce the costs of government debt in the long run.
The monetary transmission mechanism in a more flexible exchange rate regime
44. In a more flexible exchange rate regime, the exchange rate channel would be operational and the independence of monetary policy would increase.20 Changes in the nominal exchange rate influence aggregate demand in two different ways: the relative price effect through which the demand for domestic goods relative to foreign goods changes; and the balance sheet effect through changes in the relative position of foreign exchange assets and liabilities in economic agents’ balance sheets.21 Changes in the exchange rate may affect net worth and debt-to-asset ratios thus triggering responses to spending and borrowing. The exchange rate channel can be especially strong in small open economies, as it can have a substantial effect on aggregate supply as well as on aggregate demand.
45. The successful management of a flexible exchange rate regime has some important requirements in order to deliver low and stable inflation and work as an efficient shock absorber. These main conditions are (i) a sufficiently deep and liquid foreign exchange market; (ii) a credible domestic nominal anchor for monetary policy; and (iii) sufficient central bank independence to conduct effective monetary policy.22 Progress has been made in all three areas in Trinidad and Tobago.
46. The large positive terms of trade shock from high energy prices and the expansionary fiscal policy will continue to put upward pressure on the real exchange rate. In the context of a fixed exchange rate and an open capital account, the central bank has few degrees of freedom to affect monetary conditions in the economy. The central bank of Trinidad and Tobago has gained some room for domestic interest rates to diverge from international rates by limiting the availability of foreign exchange, allowing lower domestic interest rates than otherwise. The liquidity injections from the monetization of the nonenergy budget deficit have only been partly sterilized, adding to inflationary pressures.
47. The central bank is moving to regain control over liquidity by increased sterilization through open market operations and an increase in foreign exchange sales. The accumulation of large excess liquidity has been the main contributor to rising inflation and credit growth. It will be important for excess liquidity gradually to be drained and future liquidity injections to be effectively sterilized. The effectiveness of the interest rate transmission is limited in Trinidad and Tobago despite the relatively large size of the financial sector due to excess liquidity and certain structural characteristics of the economy and the financial sector.
48. The paper provided recommendations to improve the conduct of monetary policy and strengthen the monetary transmission mechanism. These recommendations are focused on increasing the effectiveness of the central bank’s interest rate policy, strengthening monetary operations, and debt financing of the nonenergy deficit. The active use of a reverse repurchase (or deposit) facility would be one way to improve the effectiveness of monetary transmission. Debt financing of the nonenergy fiscal deficit would maintain the “sterilization” costs in the non-financial public sector and would contribute to financial market development.
Arvai, Zs., and Heenan, G.,2005, “A Framework for Developing Secondary Markets for Government Securities,” IMF MFD Operational Paper 05/05 (Washington: International Monetary Fund)
Bank for International Settlements, 1998, “The Transmission of Monetary Policy in Emerging Economies,” BIS Policy Papers No.3 (Basel, Switzerland)
Bank for International Settlements, 2006, “Central Banks and the Challenge of Development” Meeting Proceedings (Basel, Switzerland)
International Monetary Fund, 2006, Trinidad and Tobago: Financial System Stability Assessment, (Washington: International Monetary Fund)
Schaechter, A.,2001, “Implementation of Monetary Policy and the Central Bank’s Balance Sheet,”IMF Working Paper 01/149 (Washington: International Monetary Fund)
Prepared by Zsofia Arvai (MFD).
Although the exchange rate regime is officially classified as floating, in practice, the rate is pegged to the U.S. dollar. Exchange controls on current and capital transactions were abolished in 1993.
Structural excess liquidity occurs when the central bank almost always needs to absorb liquidity from the banking system. A common feature in many developing and emerging countries, structural excess liquidity is usually the result of the monetization of budget deficits or foreign exchange inflows.
The average ratio of commercial bank loans to GDP in Latin America was 30 percent for 1999–2002.
Local financial markets have gone through an orderly correction since mid-2005 following a stricter enforcement of limits on institutional investors’ equity investments. The local stock market index has fallen by over 20 percent from its peak in May 2005.
For these segments of the economy changes in interest rates prompt changes in the supply of credit (credit availability channel) as well as in the quantity of credit demanded (interest rate channel). See e.g. the Colombian experience in BIS (1998).
Ideally the reverse repo rate would become the policy rate. However, if there is a fixed relation between the repo and the reverse repo rate, setting either one is equivalent.
The CBTT has an overnight reverse repurchase facility, but the interest rate on it was reduced to zero with the objective promoting the development of the interbank market, therefore the facility is not operational anymore.
Most Central and Eastern European countries have such liquidity absorbing facilities as one of their instruments to sterilize the large capital inflows they have received in recent years, and to credibly signal their policy stance.
A discussion on the appropriate exchange rate regime for Trinidad and Tobago is beyond the scope of this paper.