The effective monetary management in competitive economies, market-oriented central banking

relies on financial markets rather than discretionary in adjusting overall liquidity to stabilize
prices. Behind this reliance on money markets, however, is s stable long-run relationship
between money and output as well as the interest rate. In an illustrative estimation of the demand
for money in the Philippines covering the period 1950-1991, using the framework of an error-
correction models, such a stable relationship is found after the testing the relevant time series for
trend and mean stationarity. It is inferred from this that monetary programming on the basis of
open market operations becomes a meaningful endeavor.
There are clearly some more mundane, more concrete reasons why
nations want a central bank. These emerging market economies are
going to want competitive financial systems, effective financial
systems-that certainly go hand-in-hand with a market economy.
They need some kind of a banking system. They had a banking
6 Paul A. Volcker
system, but it was not suitable for a market economy. But rather than
starting from scratch, they took the big banks they had, broke them
up, and created some commercial banks. And it is quite natural then
to say that somebody has to supervise those commercial banks. We
will take part of that old machinery and make a central bank out of
it, and it has clearly got a role as a supervisor, a regulator, a lender
of last resort. And I think starting from scratch in that particular case,
the central bank may also have a self-interest in promoting and
facilitating a market system in the financial world so that it itself can
operate.

Well, none of that tells us precisely what a central bank ought to

do about its primary job in an emerging market economy, which is
something about economic policy. I am not going to get very
complicated about that because I do not think it is really a very
complicated question. I do not think there is any cookbook that
supplies the answers to all of these countries across the board. I think
judgments necessarily have to take account of political as well as
economic factors. These factors have to be judged by the people there
on the scene, people who are part of that political process, part of
that economy.
But I think what can be said with some certainty is that given the
kind of inflationary pressures inherent in the transition, if these
central banks are going to be successful and if their countries are
going to be successful in the transition, they are going to be tough.
They are going to have to be tough-tough in the sense of keeping
some kind of limits on the growth of money and credit sufficient to
keep inflation under control. It seems to me that if price stability is
not attained rather early in this process, establishing credibility and
stability later on will become progressively more difficult, which
could jeopardize the successful transition to a market system. There
8 Paul A. Volcker
are a lot of horror stories, particularly in Latin America, that I could
cite to reinforce that point.

These are all considerations that point toward what may be thought
of as fairly crude tools like convertibility and a par value system so
it can act as an anchor to expectations. This kind of anchor would
be a great help in making the point that stability is going to be
maintained even if those particular techniques seem to diminish the
discretion and policy role of the central bank. In fact they may
provide the most practical guide to policies in the short run.
In conclusion, I think what all this talk about central banks ought
to boil down to is this: It is crucially important to get the message
through to the public and,the political leaders that restoration of a
sense of price stability is indeed vital to the success of this great
experiment in moving toward a market economy. As a practical
matter, it is true that building the independence and the stature of the
central bank may be the best way to make that very simple point.
That is the fundamental issue in talking about the role of central
banking in these emerging market economies.

Exploring the viewpoint of emerging economies, virtually no important aspect of central banking
is left out of this complete reference. The guide examines the management of exchange rates and
foreign reserves in volatile foreign-currency regimes and the handling of external and internal
financial crises. Other issues detailed in the volume include adopting more transparent
accountancy and reporting standards for governments and financial entities, assessing the
soundness of the financial sector--as a whole and as individual institutions--and analyzing the
enormous responsibilities involved in adopting real-time payment and settlement systems.

This work provides an overview of monetary policy operating procedures in emerging market
economies. Most of the discussion reflects the situation in mid-1998. The emphasis is on general
principles although in practice country-specific factors condition actual procedures. Yet there has
been a certain convergence in monetary policy instruments and procedures in recent years, not
only in industrial countries but also in most emerging market economies. Major forces for
change have been the rapid development and deepening of a variety of financial markets and
instruments, the diversification of financial institutions and the globalisation of intermediation.

As long as the financial sector was relatively closed and dominated by commercial banks,
monetary control was exercised by the setting of only two parameters: reserve requirements
against demand deposits at commercial banks and the discount rate on bank borrowing from the
central bank. This is what is defined in the South African paper as the classical cash reserve
system. Adjustments in either parameter would induce banks to change the terms of their loans
and deposits, leading to changes in the economy-wide stock of money and in turn aggregate
spending. Even more rudimentary techniques based on quantity controls rather than on price
signals proved effective as long as financial markets remained underdeveloped and insulated
from foreign influences.

Once new financial markets developed and market integration progressed, bank intermediation
became less dominant. Households placed part of their savings outside the banking sector,
enterprises started tapping non-bank sources of funding and banks, too, had to gain a foothold in
the new markets, on both the supply and the demand side. In this new environment, the setting of
bank interest rates came to depend on conditions in financial markets. Moreover, aggregate
spending became sensitive to more than just bank-determined interest rates. In order to control
the new channels of financial transmission new procedures had to be developed, focused on
influencing the behaviour of all market participants and price formation in a variety of short-term
money and interbank markets. As paraphrased in the Bank of Israel's paper, "It is not enough to
clear the landscape, one also has to construct new modes of travelling through it".

Although the experiences and the choices made in individual countries vary widely, a number of
common trends in the modernisation of operating procedures can be detected. First, the
deepening of financial markets and the growth of non-bank intermediation have induced, if not
forced, central banks to increase the market orientation of their instruments. In most cases (but
with a few notable exceptions identified below), a higher proportion of reserves is now supplied
through operations in open markets, with the use of standing facilities limited to providing
marginal accommodation or serving as emergency finance. This, however, does not imply an
erosion of the power of standing facilities in affecting liquidity conditions; indeed, it is often the
marginal changes in bank liquidity which have the greatest impact on interest rates. Secondly,
the increased importance and flexibility of the price mechanism in the new market environment
have induced many central banks to focus more on interest rates rather than bank reserves in
trying to influence liquidity. A third trend is that, reduced market segmentation, and thus the
greater ease and speed with which interest rate changes are transmitted across the entire spectrum
of yields, has enabled central banks to concentrate on the very short end of the yield curve
where, given payment and settlement arrangements, their actions tend to have the greatest
impact. The move to real time gross settlement systems in several countries may increase the
short-term focus of policy implementation even further. Fourthly, the greater market orientation
of the central banks' instruments has been associated with a preference for flexible instruments.
In the highly volatile financial environment marking several of the emerging market economies,
flexibility in the design of the policy instruments may be particularly important. Much of this
greater flexibility has come from the growing use of repurchase operations. Finally, awareness of
the important role of market psychology and expectations has increased markedly. This has
implications for the degree of transparency which central banks need to influence interest rates,
their reliance on market information in formulating policies and their own tactics in signalling
policy changes to the market.