Monetary policy is the process by which the Central Bank of Solomon Islands controls the supply of money, the availability of money, and the cost of money (or interest rate), in order to attain a set of objectives oriented towards the growth and stability of the economy.
There are a number of guiding principles behind the design of monetary policies. Policy-makers take into account the need for sustained and stable economic growth and a high level of employment; stability in the currency’s purchasing power; and the attainment of a viable balance of payments. In small, open, developing countries, these objectives can sometimes conflict and therefore involve some trade-offs.
Objectives of Monetary Policy in Solomon Islands
Monetary policy is implemented by the Central Bank, in line with functions outlined in Section 9 of the CBSI Act 2012. These are critical policy objectives – but they can work against each other, and may therefore prove difficult to achieve or implement. Instruments – or legal mechanisms –used, and methods applied, when conducting monetary policy depend on the level of development and sophistication of the financial system. Where the financial system is unsophisticated by international standards, the monetary authorities depend more on direct mechanisms than indirect ones.
The focus of monetary policy in Solomon Islands is:
- To achieve and maintain price stability; and
- To ensure Solomon Islands has adequate external reserves to meet its trade and payments needs.
Price changes have a direct impact on the economy. High inflation impedes economic growth, reduces living standards and erodes profitability, wealth and income. Central banks therefore give the lowering of inflation a high priority when designing monetary policy. Some central banks – especially those in developed economies – have the reduction of inflation as the only focus for conducting monetary policy.
Several criteria affect prices in the marketplace. They fall broadly within two bands. The first includes factors generated outside the economy, and therefore outside the authorities’ control. The second includes factors that arise from local conditions, domestic policy and the behavior of producers, consumers and businesses. As an example of the first condition, the inflation rate in the country that supplies a product to the Solomon Islands will affect its price when it is sold here. The second condition will include our own taxes imposed on imported goods, the level of money in our own financial system, any shortage of supply of the product, and the local seller’s pricing policy.
Monetary policy can influence only factors such as money growth and the cost of credit. Other factors – such as taxation, supply constraints and the pricing behavior of businesses – are outside the scope of monetary policy and need to be addressed by the government and its other policy arms and agencies.
Adequate Level of External Reserves
The availability of external reserves is critical to a small economy. External reserves facilitate trade and other payments and instill investor confidence. Where an economy is highly vulnerable to domestic or external shocks, the external reserves can provide a safety net. It is therefore vital that there are adequate levels of external reserves in place to absorb any shock to the economy without exerting undue pressure on the exchange rate.
If there is not enough external reserves to pay for imported goods and services, the Central Bank is forced to adjust the value of the Solomon Islands dollar against other major currencies. One immediate effect of this is a rise in the price of those imported products and services. This in turn undermines price stability – in direct conflict with one of the policy-makers’ objectives.
Monetary Policy Instruments used in Solomon Islands
The Central Bank develops monetary policy in consultation with government. It uses its instruments to influence variables in the economy in line with its objectives. The absence of a secondary market in Solomon Islands limits the use of indirect policy instruments.
Monetary instruments are tools used by the authorities to achieve a specific or more general monetary policy objective. For example, direct or indirect instruments may be used to influence commercial bank reserves and liquidity, or to control and influence bank lending and interest rates on deposit accounts.
During its early years the Central Bank made greater use of direct controls. In more recent times – especially since 1999 – the Bank has focused more on indirect mechanisms.
The main instruments used in Solomon Islands over 1990-2001 were:
Government securities, such as Treasury bills and Development Bonds;
Treasury Bills are short-term government papers used mainly to finance shortfalls in the government budget. They can be used as a tool to influence liquidity in the financial system – the number of Treasury bills sold affects the commercial banks’ free liquidity and reserve money. Treasury bills have been one of the main instruments of monetary policy used in Solomon Islands in recent years. Development Bonds are long-term government securities used mainly to raise funds for government development projects. Development bonds have maturity periods of 3-6 years. Treasury bonds can also be issued by the government, and act in a similar way to development bonds.
Central Bank securities (Bokolo bills)
Bokolo Bills are similar to Treasury bills, but are issued by the Central Bank. Bokolo bills have been issued mainly to mop up excess liquidity in the financial system. As the cost of issuing them falls directly on the Central Bank, they have been used sparingly over the years – mostly during periods when it was not possible to issue government securities.
Liquid Assets Ratio (LAR)
The liquid asset ratio (LAR) was the main tool used by the Central Bank. It requires commercial banks to hold a certain percentage of their total deposit in the form of liquid assets. Eligible liquid assets include till cash, deposits with the Central Bank and Treasury bills. Over 1990-2001, the LAR was used as a reactive measure against expansionary fiscal policy rather than as an active instrument of monetary policy. Over those years, the level of the ratio and definition changed in line with prevailing monetary and fiscal policy – especially in line with the financing needs of the government. The most recent change was in 1999, when the ratio was reduced and Treasury bills excluded from the definition of the ratio: the current liquid assets ratio is 7.5% of total deposit liabilities, and includes till cash and commercial bank deposits with the CBSI.
Statutory Reserve Deposits (SRD)
The Statutory Reserve Deposit (SRD) was a direct tool used by the Central Bank to freeze a proportion of commercial banks’ deposit liabilities in special deposit accounts with the Central Bank. No interest was paid. The SRD has been discontinued.
Back-to-Back facility, General Liquidity Support Scheme (GLSS) and Standby Financing Facility (SFF);
There are various other facilities enabling the Central Bank to deal with specific conditions in the financial system, or to address weaknesses in the economy. Nearly all of these have, or resemble, elements of the Bank’s lender of last resort function, and give commercial banks access to CBSI resources when they need to. For example, a back-to-back facility provides bridging finance to banks, enabling them to lend to large and long-term projects at a margin below commercial lending rate. This is to ensure that funding of important economic projects can go ahead, even if the bank financing the project lacks funds. The General Liquidity-Supporting Scheme (GLSS) enables banks to borrow from the Central Bank to comply with the prescribed LAR. The Standby Financing Facility (SFF) is similar to GLSS and allows the banks to borrow from the Central Bank using their Treasury bills and development bonds as security.
These schemes have largely fallen into disuse through lack of demand, but they can easily be reactivated.
Re-discount rates and penalty rates
The rediscount rate is a penalty applied to holders of government or Central Bank securities who decide to redeem them before maturity. The level of penalty varies according to the policy stance at the time. For example, when monetary policy is tight, the penalty is set high to discourage holders from redeeming bills prematurely.
Moral Persuasion ('Suasion')
There may also be situations where the Bank will want to influence commercial bank behavior and practice without taking tangible action. This is known as moral suasion and is usually carried out through personal contact between senior Central Bank and commercial bank officials during formal or informal meetings, either collectively or individually. Moral suasion is perhaps the most popular means of credit control in small economies where central banks are in close and personal contact with commercial bank managers and other key players. For example, if the Central Bank needed commercial banks to modify credit expansion, or wished to see more credit directed to priority sectors such as agriculture or small-scale industries, its officials might put the case informally during an established social meeting. The regular Bankers’ Meeting is one forum where moral suasion might be applied.