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---

### Introduction
- Study context:
  - Examines monetary policy transmission mechanisms in six Pacific island countries (PICs) with their own currencies: Fiji, Papua New Guinea (PNG), Solomon Islands, Samoa, Tonga, and Vanuatu.
  - Prepared for the 25th Meeting of South Pacific Central Bank Governors, Wellington, New Zealand, 2–3 December 2010.
- Crisis context and central bank responses:
  - At crisis onset, monetary policy remained tight in several countries to protect foreign reserves and contain inflation after global food and fuel price shocks.
  - As the global financial crisis intensified, central banks loosened policy to maintain credit flow and ease pressures on borrowers, with measures including:
    - lowering policy rates (Fiji and Samoa);
    - ceasing sale of government and central bank paper into the market (Samoa and Tonga);
    - lowering reserve requirements (Fiji, Tonga, and Vanuatu);
    - exchange rate devaluation or depreciation (Fiji and Solomon Islands).
  - Despite these measures, reductions in bank lending rates were limited and private credit growth remained anemic.

### Monetary policy objectives, operations, and constraints
- Primary aims of monetary policy in most PICs:
  - preserving international reserves in the context of fixed exchange rate arrangements;
  - maintaining price stability;
  - preserving financial sector stability in some countries;
  - promotion of growth is explicitly included in most central banks’ objectives.
- Structural constraints and rationale:
  - Small open economies subject to frequent shocks; adequate foreign reserves essential.
  - Fixed exchange rates provide a nominal anchor; moving to flexible rates feared to cause volatility.
  - Narrow export bases and reliance on imports lead to frequent current account deficits.
  - World commodity price movements and domestic agricultural supply often dominate inflation outcomes, limiting monetary policy’s effect on headline inflation.
  - Credit growth often mainly raises import demand with limited domestic pass-through.
- Instruments and frameworks (summary of country targets and regimes):
  - Most central banks target broad money aggregates (M2 or M3).
  - Main instruments include OMO; discount windows; policy/discount rates; reserve requirements; repos; liquid asset requirements; foreign exchange surrender; statutory reserve deposits; rediscount rate; credit ceilings.
  - Exchange rate regimes (as presented):
    - Fiji: Pegged to a basket (USD, AUD, Euro, etc.)
    - PNG: Float
    - Samoa: Pegged to a basket within a ±2 percent band (NZL, AUS, US, Euro)
    - Solomon Islands: De facto peg to the US dollar
    - Tonga: Pegged to a basket with monthly adjustment band of up to 5 percent
    - Vanuatu: Adjustable peg, linked to an undisclosed transactions-weighted basket
- Key policy trade-offs during 2007–09 shocks:
  - Tightening to protect reserves/contain inflation reduced liquidity and raised production costs.
  - Easing was constrained by high inflation and low international reserves in some countries.
  - Exchange rate depreciation could cushion demand shocks but would increase inflation.
  - Fiscal expansion could help targeted segments but could worsen inflation and was not viable for some high-debt countries.
- Policy challenges:
  - Shift from administrative measures to market-based instruments.
  - Enhance effectiveness of market-based instruments within the broader macroeconomic context.

### Empirical evidence on interest-rate pass-through
- Measurement approach:
  - Autoregressive Distributed Lags (ADL) model using monthly data over 2001–10 to estimate long-run interest rate pass-through.
  - Long-run interest pass-through defined as the percentage point change in commercial banks’ lending rates divided by the percentage point change in central bank policy rates; measured by (α_2 + α_4)/(1- α_3) in the ADL specification.
- Cross-country findings:
  - Estimated long-run pass-through ranges across PICs; econometric analysis confirms pass-through in PICs is generally low.
  - Reported range: 0.1 in Vanuatu to 0.5 in Samoa (Figure 4).
  - PNG and Samoa exhibit much higher pass-through than Fiji, Tonga, and Vanuatu.
  - Solomon Islands: pass-through rates could not be estimated because there are no changes in the policy rate over time.
- Drivers of cross-country differences:
  - PNG and Samoa: policy rates more directly linked to money market rates and more actively used to signal policy stance.
  - Importance of a well-developed money market for policy rates to affect liquidity conditions.
  - Inactivity in policy-rate adjustments or substitution with other measures in some countries (e.g., Fiji) reduces observable pass-through.

### Private sector credit response to policy rate changes
- Long-run credit responses to a 1 percentage point policy rate change (econometric results):
  - Fiji: change of 4-5 percentage points
  - Papua New Guinea (PNG): change of 4-5 percentage points
  - Vanuatu: change of 4-5 percentage points
  - Tonga: change of 1½ percent
  - Samoa: change of only half a percentage point
- Interpretations of behavior:
  - Samoa: limited credit response may reflect higher interest rate pass-through — banks lower lending rates due to competition but are reluctant to increase lending because of limited low-risk lending opportunities.
  - Fiji and Vanuatu: banks respond primarily by increasing credit rather than lowering lending rates.
  - PNG: banks respond by both reducing lending rates and increasing credit.
  - Tonga: both interest rate and credit responses relatively weak.
  - Banks may extend credit to higher-risk customers rather than lower lending rates when funding costs fall.

### Monetary policy transmission during the global financial crisis (2008–10)
- Transmission weaker during the crisis than long-run estimates suggest.
- Despite policy easing, private sector credit growth slowed sharply; growth turned negative in Solomon Islands and Tonga in 2009.
- Liquidity indicators (Jan-2009 index = 100) and loan-to-deposit ratios show rising excess reserves and falling loan-to-deposit ratios in some countries — reflecting liquidity provision amid weak activity.
- Causes of weak interest and credit responses:
  - Weak regional economies and global environment reduced profitable investment opportunities.
  - Increased bank risk aversion and tighter lending standards.
  - Country-specific factors:
    - Tonga: slowdown reflected correction after a prior lending boom with high non-performing loans.
    - Fiji: exchange restrictions and intensified price controls dampened investment appetite.
    - Vanuatu: strong 2008–09 credit expansion driven by entry of BRED Bank and ensuing competition.
- Real lending rates:
  - Falling inflation after mid-2008 led to sharp increases in real lending rates, keeping real borrowing costs elevated and likely contributing to slow credit growth.
  - Fiji: sharp fall in real lending rates since Q2 2009 reflected one-off increases of domestic prices after April 2009 devaluation.
- Real exchange rates:
  - All PICs except PNG maintain pegged exchange rates.
  - Nominal effective exchange rates at end-2010 for most PICs (with Fiji and Solomon Islands exceptions) remained roughly at their 2005 levels.
  - Higher inflation than trading partners produced real exchange rate appreciation during the crisis in all six PICs except Fiji.
  - Fiji’s April 2009 devaluation led to sharp real depreciation since Q2 2009, boosting tourism amid weak overall activity.

### Fiscal policy interaction with monetary policy during the crisis
- Fiscal stance during crisis:
  - Most PICs eased fiscal policy to support activity in 2009; Vanuatu neutral; Solomon Islands tightened.
  - Tonga and Samoa continued to loosen in 2010; Samoa’s 2010 stance driven largely by post-Tsunami reconstruction needs.
- Domestic financing and crowding out:
  - At least part of fiscal expansion financed domestically; given weak private activity, little evidence of crowding out — fiscal expansion likely did not cause slow private credit growth.
- Policy coherence:
  - Crisis highlights limits of monetary policy alone for stabilization; consistency between exchange rate, monetary, and fiscal policies strengthens transmission effectiveness.
  - Inconsistency between exchange rate and monetary policies during adverse terms-of-trade shocks weakens transmission.

### Constraints on monetary policy transmission and recommended reforms
- Broad constraints:
  - Fixed exchange rate regimes subordinate monetary policy to exchange rate maintenance.
  - Limited capital flows and shallow domestic money markets reduce monetary autonomy and transmission channels.
  - Large remittance flows can materially affect domestic liquidity; remittances often driven by migrant family needs rather than returns.
- Financial market underdevelopment:
  - M2 to GDP indicates domestic money markets are shallow and compare unfavorably with Caribbean countries.
  - Lack of collateralized interbank lending and secondary markets for government/central bank paper; underdeveloped commercial paper, corporate bond, and FX product markets; nascent equity markets.
  - Underdevelopment weakens interest-rate and credit pass-through and other channels (asset prices, exchange rates).
- Banking sector structure and competition:
  - Small domestic markets imply few commercial banks per country (sample counts 2000–2009):
    - Solomon Islands: 3, 3, 3
    - Samoa: 3, 4, 4
    - Vanuatu: 4, 3, 4
    - Tonga: 3, 3, 3
    - Papua New Guinea: 6, 4, 4
    - Fiji: 5, 5, 5
  - Provident funds and a few insurance companies are key players and often hold large volumes in bank deposits and government paper.
- Recommended market infrastructure reforms:
  - Establish credit reporting bureaus.
  - Enact secured transactions laws.
  - Create collateral registries.
  - Strengthen enforcement of credit contracts for reliable and rapid resolution of defaults, bankruptcies, and disputes.
- Policy consistency and central bank credibility:
  - Central bank independence, policy consistency, and effective communications would build expectations aligned with policy intentions and strengthen transmission.
  - Restrictions and controls over interest rates inconsistent with market conditions are unlikely to help transmission in the long run.

### Provident funds in PICs — role, effects on transmission, and policy measures
- Role and composition:
  - Provident Funds are the largest financial sector institutions in PICs and account for the majority of private saving in many PICs.
  - Their assets average around 30 percent of total banking sector assets and reach over 60 percent in Fiji.
  - Provident fund assets are normally held in a mixture of long-term investments, government paper and bank deposits.
  - Very few funds hold assets overseas, partly due to concerns over the impact on official reserve positions.
  - Footnote on data timing: 2007 for Vanuatu and 2009 for other countries.
- Ways provident funds complicate monetary policy transmission:
  - Deposit rates:
    - Provident funds often control much of banking system liquidity and place deposits in lumpy amounts.
    - Banks compete vigorously for these deposits, which can drive up banks’ cost of funding even when ample liquidity exists, frustrating central bank attempts to ease policy.
  - Lending rates:
    - Provident funds can be significant sources of private sector credit; their credit provision can dampen the influence of monetary policy on aggregate credit and demand.
  - Dampening price signals:
    - Government-owned provident funds financing the budget deficit may be pressured to provide finance below true market rates.
    - Significant lending to quasi-government bodies and state-owned enterprises may not be fully commercial.
- Observed central bank responses:
  - Example: Vanuatu — reserve bank placed a temporary ceiling on deposit rates when provident fund offerings pushed up interest rates while RBV was trying to loosen policy.
  - Provident funds likely to remain main liquidity providers while markets remain shallow and investment opportunities limited.
- Policy measures to increase provident funds’ sensitivity to market interest rates:
  - Ensure open and transparent price auctions for deposits placed in the banking system.
  - Use market-based variable-rate auctions for government securities.
  - Increase the range of financial products available to provident funds for investments.
  - Contingent on the external position, allow greater levels of investment overseas.

### Appendix: estimating interest rate and credit pass-through (methodology)
- ADL model specification used:
  - l_t = α_0 + α_1 * m_t + α_2 * p_t + α_3 * l_{t-1} + α_4 * p_{t-1} + ε_t.
  - l_t = lending rate; m_t = time trend; p_t = policy rate; ε_t = error term.
- Long-run interest pass-through measured by (α_2 + α_4)/(1- α_3).
- Rationale for ADL choice:
  - ADL models widely used for cross-country comparisons; VAR models require much more information and long lag structures that reduce efficiency in small samples.
  - Credit pass-through estimated by replacing lending rate with credit growth in the ADL specification.
- Data sources: IMF IFS, MBTS, APDLISC, MBRF2 databases; central bank country authorities; IMF staff estimates (country-specific series listed for Fiji, PNG, Samoa, Solomon Islands, Tonga, Vanuatu).

*Source: IMF staff paper prepared for the 25th Meeting of South Pacific Central Bank Governors, Wellington, New Zealand, 2–3 December 2010.*

### Box 1. Provident Funds in PICs .........................................................................................

### Box 1. Provident Funds in PICs

### Introduction
- The recent global financial crisis tested the effectiveness of monetary policy transmission mechanisms in Pacific island countries (PICs).
- At the onset of the crisis, monetary policy remained tight in a number of countries to protect foreign reserves and keep inflation under control following global food and fuel price shocks.
- As the crisis intensified, central banks loosened policy to maintain credit flow and ease pressures on borrowers with the explicit objective to lower interest rates. Policy measures used included:
  - lowering policy rates (Fiji and Samoa),
  - ceasing sale of government and central bank paper into the market (Samoa and Tonga),
  - lowering reserve requirements (Fiji, Tonga, and Vanuatu),
  - exchange rate devaluation or depreciation (Fiji and Solomon Islands).
- Despite these efforts, reductions in bank lending rates were limited and private credit growth remained anemic, raising questions about the effectiveness of monetary policy transmission in PICs.
- The paper covers six PICs that have their own currencies: Fiji, Papua New Guinea (PNG), Solomon Islands, Samoa, Tonga, and Vanuatu.
- The paper was originally prepared for the 25th Meeting of South Pacific Central Bank Governors in Wellington, New Zealand, 2–3 December 2010.

### Monetary Policy Objectives and Operations
- Primary aims of monetary policy in most PICs:
  - preserving international reserves in the context of fixed exchange rate arrangements,
  - maintaining price stability,
  - preserving financial sector stability in some countries,
  - promotion of growth is explicitly included in most central banks’ objectives.
- Rationale and constraints:
  - PICs are small open economies subject to frequent internal and external shocks; maintaining an adequate level of foreign reserves is essential.
  - Fixed exchange rates provide a nominal anchor; there is concern that moving to flexible exchange rates could cause considerable volatility in currency and domestic prices given small foreign exchange markets.
  - With a narrow export base and need to import most manufactured goods, food and fuel, trade balances are generally in deficit, and current account deficits are often very high.
  - Movements in world commodity prices and domestic supply conditions (mainly agriculture) often dominate inflation outcomes, limiting the effectiveness of monetary policy on headline inflation.
  - Credit growth often translates largely into raising import demand with limited pass-through into the domestic economy.
  - Monetary policy actions intended to influence domestic demand often have limited impact on domestic supply because of limited capacity of domestic industries (tourism being a notable exception).
- Policy trade-offs highlighted by recent shocks:
  - During the 2007–08 global food and fuel crisis, tightening monetary policy to protect reserves and contain inflation would have exacerbated falling liquidity and rising production costs.
  - At the onset of the global financial crisis, some PICs were reluctant to ease monetary policy because inflation remained high and international reserves were low.
  - Exchange rate depreciation—generally not considered an option for most countries under fixed exchange rate regimes—would have helped cushion demand shock and contain import growth but would have adverse effects on inflation.
  - Fiscal expansion could be targeted to assist affected segments but could worsen inflationary pressures and was not viable for some countries with high public debt.
- Monetary policy frameworks and instruments (Table 1 summary):
  - Most central banks target broad money aggregates (M2 or M3).
  - Main instruments include OMO; discount windows; policy/discount rates; reserve requirements; repos; liquid asset requirements; foreign exchange surrender; statutory reserve deposits; rediscount rate; credit ceilings.
  - Exchange rate regimes vary:
    - Fiji: Pegged to a basket (USD, AUD, Euro, etc.)
    - PNG: Float
    - Samoa: Pegged to a basket within a ±2 percent band (NZL, AUS, US, Euro)
    - Solomon Islands: De facto peg to the US dollar
    - Tonga: Pegged to a basket with monthly adjustment band of up to 5 percent
    - Vanuatu: Adjustable peg, linked to an undisclosed transactions-weighted basket
  - Country monetary objectives and targets (as presented):
    - Fiji: Promote monetary stability and a sound financial structure; foster credit and exchange conditions conducive to orderly and balanced economic development. Target: Broad money (M2).
    - PNG: Achieve and maintain price stability and financial system stability, and promote macro-economic stability and economic growth. Target: Broad money (M3).
    - Samoa: Promote sustainable real economic growth by maintaining price stability and international reserves viability. Target: Broad money (M2).
    - Solomon Islands: Promote monetary stability and a sound financial structure; foster financial conditions conducive to orderly and balanced development. Target: Broad money (M3).
    - Tonga: Maintain internal and external monetary stability; promote a sound and efficient financial system; support macroeconomic stability and economic growth. Target: Broad money (M2).
    - Vanuatu: Maintain low and stable inflation rate and maintain a sufficient level of official foreign exchange reserves. Target: Broad money (M2).
- Policy challenges:
  - Moving away from administrative measures to market-based instruments.
  - Making market-based instruments more effective in the broader macroeconomic policy context.

### Empirical Evidence on Monetary Pass-Through
- Interest rate movements are used to gauge monetary policy transmission in PICs; lack of response of market interest rates to central bank policy changes during the crisis has been a major concern.
- Observed patterns:
  - Pass-through of policy rates to commercial bank interest rates appears low and varies across PICs.
  - In PNG and Vanuatu, commercial banks’ deposit and lending rates seem to respond to changes in policy rates.
  - In Fiji, Solomon Islands, and Tonga, such a response is hardly discernable. Possible reasons:
    - Policy rates do not change very often (inactive interest rate policy), or
    - Other policy measures were used as substitutes for interest rate policies.
  - Example: In Fiji, the Reserve Bank of Fiji introduced administrative measures in 2009 to push down lending rates by:
    - setting an interest rate ceiling at the end-2008 level, and
    - imposing an allowable interest rate spread of 4 percent.
  - Interest rate spreads have fallen somewhat in Fiji and Vanuatu, but have not changed much or have increased in other PICs.
  - Interest rate spreads in PICs are broadly comparable to those observed in Caribbean countries, with similar recent developments (PFTAC, 2010).
- Econometric evidence:
  - An Autoregressive Distributed Lags model using monthly data over the period 2001-10 was used to estimate long-run interest rate pass-through.
  - Long-run interest rate pass-through is defined as the percentage point change in commercial banks’ lending rates divided by the percentage point change in central bank policy rates.
  - The estimated long-run pass-through ranges across PICs (figure referenced); overall, econometric analysis confirms that interest rate pass-through in PICs is generally low.

*Source: IMF staff paper prepared for the 25th Meeting of South Pacific Central Bank Governors, Wellington, New Zealand, 2–3 December 2010.*

### 0.1 in Vanuatu to 0.5 in Samoa (Figure 4).

### 0.1 in Vanuatu to 0.5 in Samoa (Figure 4).

### Interest-rate pass-through: cross-country findings
- Pass-through in PICs is lower than in larger Asia-Pacific countries; absolute levels indicate limited influence of central bank policy rates over commercial bank lending rates in some countries.
- PNG and Samoa have much higher pass-through than Fiji, Tonga, and Vanuatu.
- Primary reason: PNG and Samoa’s policy rates are more directly linked to money market rates (rates on central bank securities and government paper) and are more actively used to signal the policy stance, as measured by the frequency of change in policy rates.
- Importance highlighted: a well developed money market through which policy rates can directly affect liquidity conditions.
- For Tonga, the repo rate was used as a proxy for the policy rate.
- Pass-through rates could not be estimated for Solomon Islands because there are no changes in the policy rate over time.

### Private sector credit response to policy rate changes
- The response of private sector credit to policy rate changes is generally more significant than interest-rate pass-through.
- Econometric results (long-run pass-through of private credit to a 1 percentage point policy rate change):
  - Fiji: change of 4-5 percentage points
  - Papua New Guinea (PNG): change of 4-5 percentage points
  - Vanuatu: change of 4-5 percentage points
  - Tonga: change of 1½ percent
  - Samoa: change of only half a percentage point
- Interpretations and country-specific behavior:
  - Samoa: limited response of credit growth could result from higher interest rate pass-through — competition forces commercial banks to lower lending rates but they are reluctant to increase lending when responding to lower policy rates, perhaps due to limited low-risk lending opportunities.
  - Fiji and Vanuatu: commercial banks respond primarily by increasing credit rather than lowering lending rates.
  - PNG: banks seem to respond by both reducing lending rates and increasing credit.
  - Tonga: both interest rate and credit responses are relatively weak.
- Possible bank behavior: when funding costs are reduced as a result of policy easing, banks may extend credit to customers with higher credit risk without lowering interest rates.

### Monetary policy transmission during the global financial crisis
- Monetary policy transmission appears weaker during the global crisis than long-term responses suggest.
- Despite easing of the policy stance, growth of private sector credit slowed sharply in the wake of the global financial crisis; in Solomon Islands and Tonga, growth turned negative in 2009.
- Indicators during Jan-2009 to Jul-2010 period:
  - Excess reserves indexed to Jan 2009 = 100 (series shown for Fiji, PNG, Samoa, Solomon Islands, Tonga, Vanuatu).
  - Loan-to-deposit ratios presented (In percent) for Samoa, Solomon Islands, Tonga, Vanuatu, Fiji over Jan-09 to Aug-10.
- Rising levels of excess reserves and falling loan-to-deposit ratios in some countries reflect sufficient liquidity provision during weak economic activity.
- Causes of weak interest and credit responses during the crisis:
  - Weak state of regional economies and broader international environment reduced profitable investment opportunities.
  - Commercial banks reluctant to lower lending rates or increase lending despite signals of easing.
  - Global financial crisis made banks more risk-averse, tightening lending standards.
  - Tonga: slowdown in credit expansion was reaction to high non-performing loans from a previous lending boom.
  - Fiji: exchange restrictions and intensified price controls in the wake of the crisis may have dampened appetite for new investment and demand for credit.
  - Vanuatu: strong credit expansion in 2008 and 2009 resulted from opening of a branch by BRED Bank and ensuing competition.
- Developments in real lending rates:
  - As world food and fuel prices began to retreat in the second half of 2008, inflation fell quickly in most PICs, leading to sharp increases in real lending rates and keeping them at elevated levels in most countries (Figure 7).
  - Fiji: sharp fall in real lending rates since Q2 2009 reflected one-off increases of domestic prices after April 2009 devaluation.
  - Overall, real borrowing costs for business increased considerably during the crisis, likely contributing to slow credit growth.
- Real exchange rate movements:
  - All PICs except PNG maintain a pegged exchange rate.
  - Nominal effective exchange rates (NEER) at end-2010 for most PICs (with Fiji and Solomon Islands exceptions) remained roughly at their 2005 levels.
  - Higher inflation than trading partners led to real exchange rate appreciation during the crisis in all six PICs except Fiji.
  - Solomon Islands: real exchange rate appreciating trend preceded world price rises.
  - Decline in world prices since mid-2008 has not returned real exchange rates to pre-crisis levels.
  - Fiji’s April 2009 devaluation led to sharp real depreciation since Q2 2009, boosting tourism amid weak overall economic activity.

### Fiscal policy and interaction with monetary policy during the crisis
- Fiscal policy was eased in most PICs during the crisis to support activity.
- Exceptions:
  - Vanuatu: policy stance neutral.
  - Solomon Islands: policy stance tightened.
- All other PICs covered loosened fiscal policy in 2009; Tonga and Samoa continued to loosen in 2010.
  - Samoa’s policy stance in 2010 largely driven by need for post-Tsunami reconstruction.
- At least part of fiscal expansion financed domestically; given weak private activity there was little risk of crowding out, so fiscal expansion likely did not contribute to slow private sector credit growth.
- Crisis experience highlights limitations of monetary policy in stabilization without support from other macro policies:
  - Monetary easing may have prevented worse credit outcomes, but inconsistency between exchange rate and monetary policies during adverse terms of trade shocks weakens transmission effectiveness.

### Constraints on monetary policy transmission
- Broad constraint: macroeconomic policy framework — most PICs have fixed exchange rate regimes making monetary policy subordinate to exchange rate maintenance.
- Limited capital flows give some monetary autonomy; higher domestic interest rates may not attract rapid capital inflows.
- Large remittance volumes in some PICs could materially affect domestic liquidity and monetary policy effectiveness; remittances typically respond to migrant family needs rather than returns, but their response could matter.
- Main constraint: underdeveloped domestic financial markets.
  - Measured by M2 to GDP, domestic money markets are quite shallow and on average compare unfavorably with Caribbean countries.
  - Collateralized interbank lending not widely available; secondary markets for government and central bank paper virtually non-existent.
  - Markets for commercial paper, corporate bonds, foreign exchange products underdeveloped; equity markets in infancy.
  - Underdevelopment affects interest rate and credit pass-through and channels through asset prices and exchange rates.
- Lack of vigorous competition in domestic banking sector:
  - Small domestic markets imply few commercial banks in each PIC.
  - Provident funds and a few insurance companies are key players in domestic money and credit markets; provident funds often hold large volumes in bank deposits and government paper due to limited long-term investment opportunities and restrictions on overseas investment.
  - Actions by provident funds have large influence on domestic liquidity and effectiveness of monetary policy transmission.
- Perceived elevated country and economic risk in PICs impedes financial market deepening; investors require higher returns, deterring expansion.
- Recommended market infrastructure reforms to support development:
  - Establish credit reporting bureaus.
  - Enact secured transactions laws.
  - Create collateral registries.
  - Strengthen enforcement of credit contracts to ensure reliable and rapid resolution of defaults, bankruptcies, and disputes.
- Policy consistency and market expectations:
  - Central bank independence, policy consistency and effective communications would build expectations in line with policy intentions and strengthen transmission.
  - When fiscal and monetary policies move together, credibility of monetary policy and its transmission increase.
  - Restrictions and controls over interest rates inconsistent with market conditions are unlikely to help transmission in the long run.

### Banking sector structure (2000–2009)
- Number of commercial banks by country (Table 2, 2000–2009 sample entries in source):
  - Solomon Islands: 3 (in 2000), 3 (2005), 3 (2009)
  - Samoa: 3 (2000), 4 (2005), 4 (2009)
  - Vanuatu: 4 (2000), 3 (2005), 4 (2009)
  - Tonga: 3 (2000), 3 (2005), 3 (2009)
  - Papua New Guinea: 6 (2000), 4 (2005), 4 (2009)
  - Fiji: 5 (2000), 5 (2005), 5 (2009)

*Source: IMF staff report content provided in the supplied PDF excerpt.*

### Box 1. Provident Funds in PICs

### Box 1. Provident Funds in PICs

### Role and composition of provident funds
- Provident Funds are the largest financial sector institutions in PICs and account for the majority of private saving in many PICs.
- Their assets average around 30 percent of total banking sector assets and reach over 60 percent in Fiji.
- Provident fund assets are normally held in a mixture of long-term investments, government paper and bank deposits.
- Very few funds hold assets overseas, in part due to concerns over the impact that such investment may have on official reserve positions.
- Footnote on data timing: 2007 for Vanuatu and 2009 for other countries.

### Ways provident funds complicate monetary policy transmission
- Deposit rates
  - Provident funds often control much of the liquidity in the banking system and place deposits in lumpy amounts.
  - Banks compete vigorously for these deposits, which can drive up banks’ cost of funding even when there is ample liquidity, frustrating central bank attempts to ease monetary policy.
- Lending rates
  - Provident funds are in some countries significant sources of private sector credit.
  - Credit provided by provident funds can diminish the influence of monetary policy actions on credit growth and aggregate demand, because monetary tightening may have limited impact on credit availability from provident funds.
- Dampening price signals
  - Where provident funds are government owned and represent a key source of domestic finance for the budget deficit they can come under pressure to provide finance at lower than true market rates.
  - Some funds also have considerable lending to quasi-government bodies and state-owned enterprises, and such lending is not always on a fully commercial basis.

### Observed central bank responses and country experience
- Example: In Vanuatu the reserve bank placed a temporary ceiling on deposit rates when provident fund offerings began pushing up interest rates as the RBV was trying to loosen policies.
- Provident funds are likely to remain one of the main providers of liquidity to the banking system while markets are still relatively shallow and investment opportunities limited.

### Policy measures to increase provident funds’ sensitivity to market interest rates
- Ensure open and transparent price auctions for the deposits they place in the banking system.
- Use market-based variable-rate auctions for government securities.
- Increase the range of financial products available to provident funds for investments.
- Contingent on the external position, allow greater levels of investment overseas.

*Source: Authors’ compilation.*

### References

### _wp1196 - References

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- Jayaraman, T.K. and Chee-Keong Choong, 2009. “How Does Monetary Policy Transmission Work in Fiji?,” International Review of Economics, 56:145-61.
- Kumar, Saten and Rup Singh, 2009. “Some Empirical Evidence on the Demand for Money in the Pacific Island Countries,” Auckland University of Technology, July.
- Loayza, Norman and Klaus Schmidt-Hebbel, 2002. “Monetary Policy Functions and Transmission Mechanisms: An Overview,” in Norman Loayza and Klaus Schmidt Hebbel (eds.), Monetary Policy: Rules and Transmission Mechanisms (Santiago: Central Bank of Chile).
- Moazzami, B., 1999. “Lending Rate Stickiness and Monetary Transmission Mechanism: The Case of Canada and the United States”, Applied Financial Economics, 9:533-38.
- PFTAC, 2010. “Interest Rates and Bank Profitability in the South Pacific,” paper prepared for the Pacific Forum Economic Ministers’ Meeting, Niue, 26-29 October.
- Pongsaparn, Runchana, 2010. “Samoa: Impediments to Bank Intermediation and Monetary Transmission,” Selected Issues Papers (Washington: International Monetary Fund).
- Viñals, Jose and Jonathan Fletcher, 2010. ‘The Making of Good Supervision: Learning to Say “No”,’ IMF Staff Position Note, SPN 10/08, May 18 (Washington: International Monetary Fund).
- Wood, Richard, 2010. “Monetary and Exchange Rate Policy Issues in Pacific Island Countries,” Treasury Working Paper, No. 2010-05, September. Canberra.

### Appendix. Estimating Interest Rate and Credit Pass-Through
- Model specification (ADL model):
  - l_t = α_0 + α_1 * m_t + α_2 * p_t + α_3 * l_{t-1} + α_4 * p_{t-1} + ε_t.      (1)
  - Where l_t = lending rate; m_t = time trend; p_t = policy rate; ε_t = error term; α = parameters to be estimated.
- Long-run interest pass-through:
  - Measured by (α_2 + α_4)/(1- α_3).
- Methodology notes:
  - This type of Autoregressive Distributed Lags (ADL) models has been widely used in empirical studies to compare the interest rate pass-through across countries (Cottarelli and Kourelis, 1994; Moazzami, 1999; Espinosa-Vega and Rebucci, 2003; Guimarães and Ruiz-Arranz, 2009; and Pongsaparn, 2010).
  - Another type of popular models for the analysis of monetary policy transmission is the Vector Autoregression (VAR) model.
  - The multivariable-VAR approach requires much more information and determination of the optimal lag length for each variable.
  - A VAR model with long lag structures would reduce estimation efficiency in small samples.
  - The two-variable ADL model used here can be re-parameterized as a VAR-type error-correction model (ECM) without altering the estimated residuals.
  - The ADL model for estimating credit pass-through follows a similar structure by essentially replacing the lending rate with credit growth in equation (1).
- Data sources and country-specific series used for estimation:
  - Fiji:
    - Deposit rate (savings deposit rate): IMF, International Financial Statistics (IFS) database.
    - Lending rate (maximum commercial bank lending rate): IMF, IFS database.
    - Policy rate (bank rate, end of period): IMF, IFS database.
    - Private sector credit (monthly): IMF, MBTS database.
    - Private sector credit (annual): IMF, APDLISC database.
    - Excess reserves: IMF staff estimates.
    - Loan to deposit ratio: IMF, MBTS database.
    - Overall fiscal balance: IMF, APDLISC database.
    - Total government debt: IMF, APDLISC database.
  - PNG:
    - Deposit rate: weighted average.  Source: Country Authority.
    - Lending rate: weighted average.  Source: Country Authority.
    - Policy rate: bank rate (end of period). Source: Country Authority.
    - Private sector credit (monthly): Source: Country Authority.
    - Private sector credit (annual): Source: IMF, APDLISC database.
    - Excess reserves: Source: Country Authority and IMF staff estimates.
    - Loan to deposit ratio: Source: Country Authority and IMF staff estimates.
    - Overall fiscal balance: Source: IMF, APDLISC database.
    - Total government debt:  Source: IMF, APDLISC database.
  - Samoa:
    - Deposit rate (weighted average): Central Bank of Samoa.
    - Lending rate (weighted average): Central Bank of Samoa.
    - Policy rate (bank rate, end of period): Central Bank of Samoa.
    - Private sector credit (monthly): Central Bank of Samoa.
    - Private sector credit (annual): IMF, APDLISC database.
    - Excess reserves: Central Bank of Samoa.
    - Loan to deposit ratio: Central Bank of Samoa.
    - Overall fiscal balance: IMF, APDLISC database.
    - Total government debt:  IMF, APDLISC database.
  - Solomon Islands:
    - Deposit rate: Central Bank of Solomon Islands (CBSI).
    - Lending rate: Central Bank of Solomon Islands (CBSI).
    - Private sector credit (monthly): Central Bank of Solomon Islands (CBSI).
    - Private sector credit (annual): IMF, APDLISC database.
    - Excess reserves: Central Bank of Solomon Islands (CBSI) and IMF staff estimates.
    - Loan to deposit ratio: Central Bank of Solomon Islands (CBSI) and IMF staff estimates.
    - Overall fiscal balance: IMF, APDLISC database.
    - Total government debt: IMF, APDLISC database.
  - Tonga:
    - Deposit rate (6 months): National Reserve Bank of Tonga.
    - Lending rate (weighted average): National Reserve Bank of Tonga.
    - Private sector credit (monthly): National Reserve Bank of Tonga.
    - Private sector credit (annual): IMF, APDLISC database.
    - Excess reserves: National Reserve Bank of Tonga and IMF staff estimates.
    - Loan to deposit ratio: National Reserve Bank of Tonga and IMF staff estimates.
    - Overall fiscal balance: IMF, APDLISC database.
    - Total government debt: IMF, APDLISC database.
  - Vanuatu:
    - Deposit rate: three months (representative): IMF, IFS database.
    - Lending rate: commercial advances (representative): IMF, IFS database.
    - Policy rate: discount rate (end of period): IMF, IFS database.
    - Private sector credit (monthly): IMF, MBRF2 database.
    - Private sector credit (annual): IMF, APDLISC database.
    - Excess reserves: IMF, MBRF2 database.
    - Loan to deposit ratio: IMF, MBRF2 database.
    - Overall fiscal balance: IMF, APDLISC database.
    - Total government debt: IMF, APDLISC database.

*Content derived from _wp1196 - References*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2011/_wp1196.pdf_