Demand for money in laos for PRD and policy implications (tt)

This dissertation is organized into four chapters as follows: chapter 1: Overview of theoretical and empirical studies on money demand; chapter 2: Lao financial system and monetary polic

INTRODUCTION

Demand for money plays a major role in macroeconomic analysis, especially in selecting appropriate monetary policy actions Consequently, a steady stream of theoretical and empirical research has been carried out worldwide over the past several decades The relationship between monetary policy and economic growth is still debated Hossain and Chowdhury (1996) argued that there is a significant correlation between money supply growth and economic growth in the long-run Other studies in this field also point out the importance of monetary policies, especially, in managing the demand side

2010 (1993Q1-2010Q2), using available data, and to propose some policy implications

This dissertation is organized into four chapters as follows: chapter 1: Overview of theoretical and empirical studies on money demand; chapter 2: Lao financial system and monetary policy; chapter 3: Demand for money in Lao PDR; and chapter 4: Policy implications

CHAPTER 1 OVERVIEW OF THEORETICAL AND EMPIRICAL STUDIES ON MONEY DEMAND

This chapter reviews the main theories of money demand in order to find out what factors can affect demand It also presents some empirical studies on money demand The lessons learned from the literature survey will be helpful

in selecting the appropriate modeling framework and to choose suitable variables in the following chapters

There is a stream of theory about the demand for money The theoretical development of money demand begins from classical economics All theories try to explain two motives for holding onto money, which are transaction motive and the asset motive

1.1 Some empirical issues in estimating money demand functions

Money demand was first conducted in developed countries where the financial system developed and central banks realized the role of money demand in monetary policy There has been considerable interest in other industrial and developing countries over the past decades

All empirical studies are based on a conventional textbook formulation

of a simple theoretical demand for money function, rm = f(r,Y), relating demand for real money balances (rm) to a measure of transactions or scale variable (Y) and the opportunity cost of holding money (r) However, the

demand for money functions estimated for different countries are not the same, because of the differences in the definitions of the dependent variables, the available of scale variables, and financial development, etc in different countries

Choice of variables

Definition of money

Empirical studies have focused on three monetary aggregates, namely

M1, M2, and M3 The components of monetary aggregates differ from

country to country and depend on many factors, e.g., a country’s level of financial market development Economists have shown that the studies which

interchange the use of M1, M2, or M3 to estimate the demand for money will

face the problem of estimating heterogeneous assets For example, cash and demand deposits may differ significantly in terms of transaction costs, risk of loss, and the ease of which illegal or tax-evading activities can be hidden A solution is to separately estimate the demand functions for cash and demand deposits This approach yields more robust empirical results, however, it does not resolve the underlying empirical difficulties Any analysis on Lao PDR will face similar issues regarding the definitions of money and should leverage the advances made by economists to deal with these empirical difficulties

Opportunity costs of holding money

The interest rates in money demand function include two groups: the

own-rate of money and the rate of return on alternative assets Tobin (1958) and Klein (1974) argued that both rates are important and should be included

in any model for the for money demand This may include interest rates of government securities, commercial paper, or saving deposits In some countries where the financial sector is not highly developed and which suffers from hyperinflation, the expected rate of inflation is also a useful variable to calculate the opportunity cost of holding money

Empirical estimation problems

Empirical studies may face “missing money” and spurious regression The problem of spurious regression arises when a regression equation contains independent variables which are random walk or non-stationary variables To avoid the problems with spurious regression as demonstrated by Granger and Newbold (1974) and Plosser and Schwert (1978), Hafer and Hein (1980) and Gordon (1984b) showed that it is preferable to estimate a money demand function which contains differential terms In this case, the specification becomes:

lnrm t a1lnY ta2 r t a3lnrm t1

1.2 Some Asian studies on the money demand function

A lot of data is available to estimate money demand function The initial work in this area was primarily confined to industrial countries, especially the U.S and the U.K However, there have been good studies also in developing countries in Asia and South East Asia Many central bank officials realize that understanding the money demand function is the cornerstone of monetary policy The followings studies were chosen on the basis of the potential associated with the Lao PDR context

A number of Asian studies, e.g Fan and Liu (1970); Aghevli et.al

(1979); Khan (1980); Tseng and Corker (1991); Watanabe S and Pham T B

(2005); Nguyen, D H., and W D Pfau (2010) showed that demand for money is a proportion of income level and constrained by a measure of wealth which can be represented by income or permanent income The demand for money fluctuates with changes in the opportunity cost of holding money This opportunity cost depends on the relative return on non-money assets, such as other financial investments Expectations are also important The demand for money depends not only on the prevailing level of factors, such as the interest rate and inflation, but also on the future expected values of each of these factors In case of dollarization, the interest rate of dollar and the exchange rate are also interesting explanations for money balance demand

In developed countries, the nominal interest rate is considered as an appropriate proxy for the opportunity cost of holding money, whereas the weak financial markets and the administrative interest rates are the overriding feature in most of the developing countries In these countries, the nominal interest rate is institutionally determined and does not fully capture the opportunity cost of holding money Furthermore, the administrative nominal interest rates are not often adjusted to change in inflation and consequently the real interest rate in many periods becomes negative Therefore, to overcome on this problem, researchers often use the consumer price index as the representation for the interest rate In fact, asset substitution in developing countries usually occurs between money and real assets as inflation hedges and not between money and other financial assets Thus, the expected rate of inflation rather than the nominal interest rate can be regarded as a better proxy for opportunity costs of holding money in developing countries

CHAPTER 2 LAO FINANCIAL SYSTEM AND MONETARY POLICY

Lao PDR is a small and land-locked country in Southeast Asia, bordering China, Vietnam, Cambodia, Thailand and Myanmar The total area covers 236,800 square kilometers with a total population of 6.2 million 80 percent of the population engages in subsistence agriculture, utilizing traditional tools to plow and cultivate rice production for economic survival The industrial sector is restricted to hydropower, and mining The social indicators reflect a low level of socio-economic development as demonstrated

by high degree of poverty, high illiteracy rate, low life expectancy and high risk for the public health sector

2.1 Overview monetary development in the Lao PDR

In the Lao PDR, the overriding objective of monetary policy is to stabilize price and sustaining economic growth The monetary authority’s strategy for inflation management is based on the view that inflation is essentially a currency stability and monetary phenomenon Because targeting the exchange rate level and money supply growth are considered as appropriate methods of targeting inflation in Lao economy, the central bank

of Lao PDR (BOL) chose an exchange rate anchor and monetary targeting policy framework to achieve its objective of price stability and economic growth With the exchange rate and broad measure of money (M2) as the intermediate target, and the exchange rate and monetary base as the operating target, the BOL utilized a mix of indirect (market-determined) instruments to achieve monetary objectives These instruments include reference exchange rates, reserve requirements, open market operations on Treasury bill, liquid asset ratios and the discount window

The banking system before 1988 had some weaknesses: the main sources for providing credit came from banknote printing; high level of non-performing loans; the interest rate did not reflect the variation of the market-oriented conditions; restrictions of the bank capacity in mobilizing deposits for financial resources; payment and settlement systems had problems of liquidity and the banking system itself did not clearly define its roles between the central bank and commercial bank

Banking system reform

The Council of Ministers approved the resolution No 11/PM, dated 11thMarch 1988 on the transformation of the banking sector into a commercially-oriented system which was aimed at restructuring the State Bank from a mono-bank system and it replaced by a two-tier banking system, consisting of Bank of the Lao PDR, and commercial banks

This law gave the Bank of the Lao PDR power and obligations similar to the central bank of developed countries The Bank of the Lao PDR became a Central Bank of the Lao PDR, and one organization of the Council of Ministers, with the main function of maintaining the stability of the value of

domestic currency associated with price management and foreign currency management to ensure the flexibility and efficiency of the performance of the banking system The function of the Bank of the Lao PDR (BOL) is to serve

as lender of last resort to commercial banks, responsible for issuing or revoking the banking license to commercial banks, and the BOL also has the degree of autonomy in macroeconomic management relating to monetary management

In 1992, the government issued the decree No.3 to commercial banks which has become the legal document or basis to transform the branches of the State Bank into commercial banks, performing its operations with autonomy and opening up the banking industry to several types of banking by having other economic sectors invest in the banking sector

2.3 Monetary Policy

Monetary instruments

To implement monetary policy consistent with market forces, the BOL began to develop monetary instruments, starting from October 1990 by introducing the reserve requirement ratio of commercial banks, providing a short-term loan to cope with liquidity problems of banks, the government or BOL began to issue bills and the BOL began to introduce the interest rate policy Nowadays, monetary tools of the BOL include reserve requirement (RR), interest rate policies, discount window lending, open market operation, and exchange rate

Target of monetary policy

Since 1988, the BOL implemented the monetary policy with the objective to maintain price stability by setting the monetary aggregates to maintain the value of currency using direct instruments Since 1995, the BOL used indirect instruments to control money supply following the BOL set reserve requirement ratio to provide a short-term loan and serve as a lender of

last resort, and the government also issued T-bills to finance fiscal deficits During the global financial crisis in 2007-2008, the BOL pursued monetary policy and exchange rate policy to maintain monetary stability In particular, the BOL used exchange rate policy as a main instrument or nominal anchor to maintain price stability and to control the fluctuation of exchange rates, along with the foreign currency management policy by sufficiently supplying foreign exchanges to the public

2.4 Dollarization

The Lao economy is partially dollarized Foreign currency deposits to total deposits remains high, accounting for 53.7 percent and the degree of dollarization is becoming a chronic problem in Lao PDR In Lao PDR, the broad money to GDP ratio is relatively low, approximately 39.3 percent in

2010 The high level of dollarization causes the real demand for domestic currency to decline

2.5 Bond market

The government began to issue securities in June 1990 amounting to 2 billion Kip, with 3 months maturity, priced at 4% per month for the subscription by the non-bank public to control the rising inflation and to absorb excess liquidity in the economy The first auction for Treasury Bills occurred in March 10th, 1994 Since then biweekly auctions were held between state owned and private banks In January 9th, 1995 the T-bill auction was amended, particularly taking into account the inclusion or participation of the non-banking sector in the bidding

2011, overall trading stocks on the Lao securities exchange amounted to 301.49 billion Kip and total trading stock amounted to 40.01 million On 27thDecember, 2011 the securities exchange index closed at 899.46 points, a drop

of 10.05 percent compared to the base index and the total value of market capitalization equivalent to 0.1% of GDP

2.7 Interbank market

An inter-bank market has played an important role recently in the development of the financial market, compared to the previous 10 years when trading was only between commercial banks and the BOL The BOL occasionally provides liquidity for commercial banks that hold T-bills through: repurchase agreements (repo), discount, and collateralised lending

2.8 Exchange rate policy

After the declaration of full independence in 1975, economic development in Lao PDR followed in the footsteps of the Soviet style centrally planned economy During this period, the government implemented

a fixed exchange rate policy and had multiple exchange rates for different purposes

In September 1995, the fixed exchange rate was abolished and the government adopted a floating exchange In 2006, the BOL set exchange rates by determining the range between selling and buying rates within +/- 0.25 percent Since then, the implementation of this policy exchange rate has been relatively stable for some time

CHAPTER 3 DEMAND FOR MONEY IN LAO PDR

3.1 The theory-based money demand function for Lao PDR

The theory money demand function for Lao PDR is assumed to take the following practical form:

the scale variable, and r is the interest rate on the alternative assets which

represent the opportunity cost variable

3.2 Data description and issues

The data used in this study is taken from the Bank of Lao PDR The estimated sample uses quarterly data in the period from Q1/1993 to Q2/2010

Definition of money

The study applies both narrow money M1 and broad money M2 as the

dependent variables In addition, given the fact that there are multi-currencies used in the Lao PDR, the monetary aggregate will be classified by currency as

local currency (Kip) and foreign currencies M1 is narrow money including cash in circulation and current account, while M2 is broad money consisting

of M1, saving and time deposits

Scale variable

According to data availability, the scale variable used in this study is the gross domestic product (GDP) as an income measurement

3.3 Unit root and co-integrated test

Unit root test

The prerequisite for a co-integration test is to examine the properties of the time series variables, in order to have a reliable regression test, the dissertation first needs to make sure that the model could not be subjected to

“spurious regression”

Johansen co-integration test

Since the variables are considered to be I(1), the co-integration method is appropriate to estimate the long-run demand for money If the unit roots test suggests that there are non-stationary series with indifferences in integrating orders, the Johansen test approach is conducted to identify the long-run

equilibrium of the variables in the structural forms

3.4 Estimating money demand function for Lao PDR by using ECM

Error Correction Models

Error correction model (ECM) is used in order to determine money demand and explain their dynamics of the economic model equation (3.8) if observed variables are non-stationary and they are co-integrated (Engle and Granger, 1987) If the results obtained from unit root tests and the co-