What limits the successful application of Monetary policy tools in
developing countries
In developing countries like Kenya, the open market operations (OMO) are not quite virtually effective in controlling money supply. The main reason for this is the less developed money and capital markets, and the limited quantity and range of financial assets (securities, etc) held in the country which the Monetary Authority can buy or sell in order to increase or decrease cash holdings with the public. Sometimes, commercial banks are less sensitive to changes in their cash base. Partly, this is because they have, since the development of independent monetary system, found themselves with excess liquidity, especially due to the scarcity of good/viable projects and credit – worthy borrowers to whom they could lend. The other reason could be that such commercial banks are branches of foreign banks to which they can turn for more funds whenever their lending capacity is considerably reduced the monetary authorities. This reduces the ability of the monetary authorities to control inflation reducing money supply.
The bank rate is less effective in most developing countries for a variety of reasons such as the limited range of liquid financial assets. Even if interest rates are successfully raised (or lowered), the effect on investment may be limited. Public sector investment is not likely to be very sensitive to changes in interest rates. For local private entrepreneurs who find it difficult to get access to capital, availability of credit may be more important than its cost/price. The greater emphasis on development is likely to reduce the role played the rate of interest, which has been kept low and stable most developing countries in order to encourage capital formation. Moreover, development objectives have generally involved making credit available on concessionary terms to sectors like manufacturing and agricultural smallholders, further reducing the scope of the impact of the interest rate policy.
In the case of variable reserve requirement, increased liquidity may still be offset in part if commercial banks have access to external lines of credit from partners or their parent companies. Its also possible that a variable reserve asset ratio is likely to be much more useful in restricting the expansion of credit and of the money supply than in expanding it; if there is a chronic shortage of credit-worthy borrowers and desirable (viable ) investment projects, reducing the required liquidity ratio of the banks may simply leave them with surplus liquidity and not cause them to expand credit. Similarly, if banks have substantial cash balances (reserves) the change in the statutory cash ratio required may have to be very large.
Funding may be effective in controlling liquidity. However, its expensive since the rate of interest on long-term debt is usually much higher than on short-term loans. Considerable funding of debts might therefore have undesirable effect of increasing long-term interest rates and inflationary tendencies. Governments should therefore try as much as possible to maintain strict budget discipline to avoid frequent debt conversions whose long-term financing militates against efficient and effective discharge of
government functions.