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Distr. LIMITED November, 2013 Original: ENGLISH COMMON MARKET FOR EASTERN AND SOUTHERN AFRICA 19th Meeting ofCOMESA Committee of Finance and Monetary Affairs 24 – 26 November, 2013 Lilongwe, Malawi PROPOSAL FOR APPROPRIATE MONETARY POLICY REGIMES FOR COMESA REGION By: Ibrahim A. Zeidy, Nicholas Korir, Zorodzo Chuma 2013 (IZ-mkc) 1 Table of Contents Background…………………………………………………………………………………………..……4 Objectives of Appropriate Monetary Policy Framework……………..…………………………...…..5 Review of alternative Monetary Policy Frameworks……………..………………….………………..5 Exchange Rate Targetting……………..………………………………………………………………..6 Monetary Targeting…………………………...…..…………………………...…..…………………….7 Inflation Targeting…………………………...…..…………………………...…..………………………8 Table 1…………………………...…..…………………………...…..…………………………...………8 The Pros and Cons of Alternative Monetary Policy Regimes…………………………...…………..8 Table 2……………………………………………………………………………………………………9 Advantages of Indirect Monetary Poliy Instruments…………………………...…..………………..12 Criteria for Determining the Instrument Mix…………………………………………………………..13 Table 3……………………………………………………………………………………………………14 Insulate Monetary Policy From Deficit Financing…………………………...…..…………………...15 Strengthen and Integrate Money Markets…………………………...…..…………………………...16 Foster Competition in the Banking Sector and Restrusutre the Banking Sytem…………………16 Adapt Supervisory and Regulatory Framework to Market Conditions……….……………………16 Bolster the Technical Capacity of the Central Bank…………………………………………………16 Key Global Challenges in the design and Implmentation of Monetary Policy…………………….17 Analysis of Monetary Policy Frameworks in Seleteced African Countries………………………..19 Table 4……………………………………………………………………………………………………19 Performances of the Existing Monetary Policy Regimes in Select COMESA Countries………..20 Table 5……………………………………………………………………………………………………22 Proposal for Approrpaioate Monetary Policy Regime for COMESA Countries…………………..33 Implementing Indirect Instruments of Monetary Policy……………………………………………...33 2 Undertake Key Concomitant Refoms to Minimize Difficulties of Implmenenting Indirect Policy Instrusments…………………………...…..…………………………...…..…………………………...34 Careful Sequencing Based on Country Specific Circumstances of the Path for Introduction of Indirect Monetary Policy Instruments…………………………………………………………………35 Develop a Communication Strategy that Enhances Transparency of Monetary Policy…………35 Bibiliography……………………………………………………………………………………………..36 Annex 1…………………………………………………………………………………………………..38 3 Back ground 1. COMESA has a programme of monetary cooperation, which will culminate in Monetary Union. The mandate to set up a Monetary Union in COMESA is derived from Article 4 (4) of the COMESA Treaty signed in Kampala, Uganda on 5th November, 1993, which states that the COMESA Member States shall “in the field of monetary affairs and finance, co-operate in monetary and financial matters and gradually establish convertibility of their currencies and a payments union as a basis for the eventual establishment of a monetary union”. This mandate is further reinforced in Articles 76-78 which respectively deal with the COMESA Monetary and Fiscal Policy Harmonization (MFHP), establishment of currency convertibility and formation of an exchange rate union. 2. COMESA has agreed on a specific time lines for the establishment of the monetary union among its member countries. To that objective, it has instituted monetary convergence programme and prescribed convergence criteria to be observed by member countries during various stages on the road towards monetary union. One of the prerequisites to achieve faster convergence is the designing of an appropriate monetary and exchange rate policies framework for the region. 3. In order to enhance the COMESA monetary integration agenda, the COMESA Committee of Governors of Central Banks set up a COMESA Monetary Institute (CMI), in order to undertake all activities related with making the region zone of macroeconomic and financial stability and to ultimately achieve monetary union. The Institute became operational in March 2011. One of the key functions of CMI is the design of an appropriate monetary and exchange rate policies framework for the region. 4. This paper is prepared based on the decision of the COMESA Committee of Governors of Central Banks in their 18th Meeting which was held in December 2012, in Kigali, Rwanda in which they instructed COMESA Monetary Institute to undertake a study on Appropriate Monetary Policy Regimes Targeting Single Digit Inflation for the COMESA region. 5. The key objective of the paper is, therefore, to contribute for enhancing monetary integration in the COMESA region by making recommendations, which will lead to the design of the appropriate monetary policy regime in member countries of the region. 6. In what follows, section one presents objectives of appropriate monetary policy frameworks. Section two reviews monetary policy frameworks. Section three elaborates on the pros and cons of alternative monetary policy regimes. Section four discusses issues related with introducing indirect monetary policy instruments. Section five highlights pros and cons of different indirect monetary policy instruments. Section 6 presents supporting actions to facilitate effective use of indirect monetary policy instruments. Section seven highlights the challenges of monetary policy regime in a period of uncertainty. Section eight analyses monetary policy frameworks in selected African countries. Section nine presents performance of existing monetary policy regimes in selected COMESA member countries. Finally, proposal for appropriate monetary policy regimes for COMESA member countries will be made. 4 Objectives of Appropriate Monetary Policy Framework 7. Monetary policy is the major component of economic policy in market economies. The central bank is assigned the primary responsibility for conducting monetary policy and often for formulating it. In addition, some auxiliary functions of central banks-notably, promoting the development of the money market, safeguarding the payments and clearing system, and performing bank regulation and supervision-support the main function. 8. The basic policy objectives of a central bank operating in a market economy with its own currency is generally considered to be the stability of the nation’s currency. This represents an evolution from past practices, which gave more prominence to other objectives of monetary policy –including rapid economic growth and a low unemployment rate. In practice, attempts to use monetary stimuli to promote economic growth directly frequently ran into problems. Typically, the stimuli increased the rate of growth in the short run at the cost of an undesirable rise in inflation, balance of payments difficulties, and a lower rate of growth in the longer term. Hence, during the last decade, there has been increasing agreement that monetary policy can best promote medium and longer-term growth by maintaining overall price stability. 9. However, the central bank is also concerned with the stability and efficiency of the financial sector. As the leading financial institution, it is concerned with the efficiency of intermediation between savers and investor, which takes place via the financial system and contributes to economic growth. Moreover, the structure and development of financial markets affect the transmission and impact of central bank policies, which are implemented through those markets. Indeed, in view of these operational linkages, significant changes to the monetary policy framework require parallel measures aimed at the structure and development of financial markets. Full open market operations do not work well, for example, unless the money and interbank markets function effectively. 10. In the case of Regional monetary integration, the objective of appropriate monetary policy framework in member countries is to achieve enhanced macroeconomic convergence. These policies ensure the viability and sustainability of the monetary integration agenda by making the region zone of macroeconomic stability. This in turn will enable member countries to maintain their relative competitiveness. Review of Alternative Monetary Policy Frameworks 11. A monetary policy framework is an institutional arrangement under which monetary policy is formulated and implemented. All contemporary monetary policy frameworks establish a credible nominal anchor for domestic prices. They differ in terms of the choice of anchor and, as a consequence, choice of instruments, mode of operation (for example, rules versus discretion) and communication and engagement. They also differ in terms of how and how far concerns about other objectives are reconciled with inflation objectives. 12. A nominal anchor is a variable the central bank uses to discipline its policy decisions and convince agents in the economy that it is committed to and can deliver price stability. It not only helps tie down inflation expectations directly through its constraint on the value of domestic money but more importantly provides a discipline on policy making that avoids the timeinconsistency problem1 of monetary policy. “The time-inconsistency problem arises because there are incentives for a policymaker to pursue short-run objectives even though the result is poor long-run outcomes which result from forward-looking behavior on the part of economic agents. Expansionary monetary policy will produce higher growth and employment in the short-run, and so policymakers will be tempted to pursue this 1 5 13. While the choice of monetary policy framework by a country depends on economic, financial, and institutional environment within which policy operates apart from other constraints in policy formulation, the choice of exchange rate arrangement by a country determines the degree of independence of its monetary policy. There are at least three alternative monetary policy frameworks that countries have adopted. These are: Exchange Rate Targeting 14. This entails fixing the price of the domestic currency in terms of another country’s currency (or a basket of other countries’ currencies) to inherit the properties of the underlying nominal anchor of the anchor country. This means that monetary and fiscal policies are conducted to sustain that fixed exchange rate. The monetary authority therefore stands ready to buy or sell foreign exchange at given quoted rates to maintain the exchange rate at its predetermined level or within a range (the exchange rate serves as the nominal anchor or intermediate target of monetary policy). This monetary policy framework is employed by countries with the following exchange rate regimes: No separate legal tender (i.e. official dollarization); Currency Board Arrangements; Fixed pegs with or without bands; Crawling pegs with or without bands. 15. Annex I shows that at least 115 countries use the exchange rate as a nominal anchor as indicated below: a) Exchange arrangements with no separate legal tender – At least 10 countries have either the US currency or the euro circulating as their sole legal tender. Those with the US dollar circulating as the sole legal tender are Ecuador, El Salvador, Marshall Islands, and Federal States of Micronesia, Palau, Panama, and Timor-Leste. Those with the Euro circulating as the sole legal tender are Montenegro, San Marino and Kiribati. b) Currency Board Arrangement – At least 13 countries have adopted a Currency Board Arrangements. Of these 13 countries, 8 including one from COMESA have a monetary regime that is based on an explicit legislative commitment2 to exchange their domestic currency for the US dollar at a fixed exchange rate. The eight countries are: Antigua and Barbados, Djibouti, Dominica, Grenada, Hong Kong SAR, St. Kitts and Nevis, St. Lucia, and St. Vincent and the Grenadines. The remaining five countries, namely Bosnia and Herzegovina, Bulgaria, Estonia, Lithuania, and Brunei Darussalam have a monetary regime that is based on an explicit legislative commitment to exchange their domestic currency for the Euro at a fixed exchange rate. policy even though it will not produce higher growth and employment in the long-run because economic agents adjust their wage and price expectations upward to reflect the expansionary policy. Unfortunately, however, the expansionary monetary policy will lead to higher inflation in the long-run, with its negative consequences for the economy”. Mishkin, 1998:1 2 This implies that domestic currency will be issued only against foreign exchange and that it remains fully backed by foreign assets, eliminating traditional central bank functions, such as monetary control and lender-of-last-resort, and leaving little scope for discretionary monetary policy. 6 c) Other Conventional Fixed Peg Arrangement – At least 68 countries have pegged their currencies at fixed rates to either the US dollar or the Euro or a basket of currencies, where the basket is formed from the currencies of major trading or financial partners and weights reflect the geographical distribution of trade, services, or capital flows. Of the 68 countries, 36 and 16 have respectively pegged their currencies at a fixed rate to the US dollar and the Euro. Those that have pegged their currency to a basket of currencies are seven as shown in the annex. d) Pegged Exchange Rate Within Horizontal Bands – Few countries are implementing pegged exchange rates within horizontal bands where the value of the currency is maintained within certain margins of fluctuation. It also includes arrangements of countries in the exchange rate mechanism (ERM) of the European Monetary System (EMS) that was replaced with the ERM II on January 1, 1999. There is a limited degree of monetary policy discretion, depending on the bandwidth. The three countries are: Slovak Republic, Syria, and Tonga. e) Crawling Peg – At least 8 countries have adopted crawling pegs where the currency is adjusted periodically in small amounts at a fixed rate or in response to changes in selective quantitative indicators, such as past inflation differentials vis-à-vis major trading partners, differentials between the inflation target and expected inflation in major trading partners. The eight countries that include one in COMESA are: Bolivia, China, Ethiopia, Iraq, Nicaragua, Uzbekistan, Botswana, and Iran. f) Crawling Band – Costa Rica and Azerbaijan are the only two countries that have crawling bands, implying each currency is maintained within certain fluctuation margins. The degree of exchange rate flexibility is a function of the bandwidth. The commitment to maintain the exchange rate within the band imposes constraints on monetary policy, with the degree of policy independence being a function of the bandwidth. Monetary Targeting 16. This entails dealing with a domestic monetary anchor i.e. targeting the growth of a nominal aggregate such as money supply (for example, reserve money and broad money) or nominal incomes. To attain the intermediate target and ultimate objectives of monetary policy, an operational framework is adopted that specifies operational variables of the monetary policy. 17. Under monetary targeting framework, a stable relationship is assumed between inflation and a chosen monetary aggregate. Under this framework, monetary policy may aim at controlling the interest rates or monetary base of the banking system. In the case of the former, interest rates are used as a policy variable and control of inflation is the ultimate objective while broad measure of money or exchange rate is the intermediate target. The central bank affects the level of short-term interest rates by its discount policy, supplemented by open market operations to influence money supply. In the case of the latter, the monetary aggregates are controlled through making changes to monetary base of the banks. In this case, the interest rates are not used as policy instruments and are instead allowed to fluctuate according to market forces. The policy instrument under these conditions is then primarily bank reserves requirement. The monetary authority uses its instruments to achieve a target growth rate for a monetary aggregate, such as reserve money, M1, or M2, and the targeted aggregate becomes the nominal anchor or intermediate target of monetary policy. 18. Most of the COMESA member countries fall under this framework. Most of these countries have managed floating exchange rate regimes with no predetermined path for the exchange rate. This means that the monetary authority attempts to influence the exchange rate without having a specific exchange rate path or target. 7 Inflation Targeting 19. Inflation targeting involves a public announcement of medium-term numerical targets for inflation, with a commitment by the monetary authority to achieve these targets. It also includes an active and effective communication with the public and the financial markets about the plans and objectives of monetary policy makers and increased accountability of the central bank for its inflation objectives. Monetary policy decisions are guided by the deviation of forecasts of future inflation from the announced inflation target, with the inflation forecast acting (implicitly or explicitly) as the intermediate target of monetary policy. 20. Annex I shows that at least 45 countries in the world use inflation targeting as a framework for monetary policy. None of these countries are in COMESA. Majority of them are either developed or emerging economies. Most of them have adopted independently floating exchange rate regimes. The rest have managed floating exchange rate regimes. South Africa, Ghana, is among the few countries in Africa that have adopted inflation targeting monetary policy framework. 21. Table 1 below summarizes the main objective, intermediate target, operating target and main instruments of the alternative monetary policy regimes. Main objective Intermediate Target Inflation forecast Inflation Price stability Targeting Exchange Rate Exchange Rate Targeting Stability Monetary Price Stability Monetary Targeting aggregates Operating Target Short term rate Exchange Rate Reserve Money Main Instrument OMO; FX Operations OMO; FX Operations OMO, FX Operations The pros and cons of Alternative Monetary Policy Regimes. 22. The pros and cons of the various monetary policy regimes are summarized in tables below: 8 Table 2: Pros and Cons of Different Monetary Policy Regimes Regime Exchangerate pegging Pros Cons (i) Easily understood by the public. (ii) Given full support by monetary policy, an unchanged peg will over the long run produce the same rate of inflation as in the country of the currency peg (iii) Simple and transparent (i) Loss of monetary policy autonomy leaves the policy maker unable to respond to developments in the domestic economy that are not present in the country to which the currency is pegged (iv) A visible and easily monitored anchor for (ii) With open capital markets, price expectations. causes domestic interest rates to be closely linked to (v) Fixes the inflation rate for internationally those of the anchor country. traded goods, and thus directly The targeting country contributes to keeping inflation under therefore loses the ability to control use monetary policy to respond to domestic shocks (vi) Anchors inflation expectations to the that are independent of inflation rate in the anchor country. those hitting the anchor (vii) Provides an automatic rule for the country conduct of monetary policy that avoids the (iii) Shocks to the anchor time-inconsistency problem. country are directly o It forces a tightening of monetary transmitted to the targeting policy when the domestic currency country because changes in tends to depreciate or a loosening of interest rates in the anchor policy when the domestic currency country lead to a tends to appreciate. corresponding change in interest rates in the o Monetary authorities no longer have targeting country the discretion that can result in the pursuit of expansionary policy to (iv) Leaves the country prone to obtain employment gains which lead speculative attacks on the to time-inconsistency currency. (v) An exchange rate peg that is not fully supported by monetary policy and by fiscal discipline may presents a number of drawbacks: o 9 Excessive monetary expansion or fiscal laxity will increase inflation pressures. Non-tradable prices will rise relative to tradable prices, held down Table 2: Pros and Cons of Different Monetary Policy Regimes Regime Pros Cons by foreign competition. Eventually, the deterioration in international competitiveness leads to external current account imbalances. Monetary targeting (i) (ii) (iii) (iv) (v) (vi) o Individuals and firms will try to shift out of the domestic currency into foreign currencies, leading to capital outflows and/or a parallel exchange rate that is more depreciated than the official rate. o Given limited official foreign exchange reserves, the authorities may resort to rationing of foreign exchange, opening the door to favoritism in its allocation and corruption, and inefficiencies as imports of necessary intermediate inputs are curtailed Monetary targets are simple and (i) Depends on the relationship transparent i.e. easy to follow, and require between the targeted no sophisticated models or techniques aggregate and the goal of monetary policy remaining Enables a policy-maker to take account of stable, and the aggregate domestic developments when setting being controllable by the policy central bank. The failure of these conditions in a large Easy to assess performance. number of countries has led to the widespread Published monetary aggregate vis-à-vis abandoning of monetary the target gives public signal on the targeting stance of monetary policy. Signals help fix inflationary expectations (ii) Money demand has proved unstable in many countries, that help produce lower inflation. limiting its usefulness as an indicator of the appropriate Allows for accountability in case of 10 Table 2: Pros and Cons of Different Monetary Policy Regimes Regime Pros Cons monetary policy mistakes. stance of monetary policy (vii) A target for monetary aggregate growth (iii) Requires strong and reliable provides a nominal anchor that is easy to relationship between the be communicated to and understood by goal variable and the target the public. variable (viii) Enables the monetary authorities to (iv) Other related challenges choose goals for inflation that may differ include: from those of other countries and allows o Instabilities in the money some response to output fluctuations. multiplier; (ix) Like an exchange-rate target, information o Interest rate volatility; on whether the central bank is achieving its target is known almost immediately o Problems in forecasting Announced figures for monetary liquidity; aggregates are typically reported periodically with very short time-lags. o Choice of reserve Thus, monetary targets can send almost aggregates for targeting; immediate signals to both the public and markets about the stance of monetary o Limited and inflexible policy and the intentions of the monetary policy policymakers to keep inflation in check. instruments. Inflation targeting (x) Monetary targets promote almost immediate accountability for monetary policy to keep inflation low and so constrain the monetary authorities from the time-inconsistency trap (i) Enables monetary policy to focus on (i) domestic considerations and to respond to shocks to the domestic economy. (ii) Velocity shocks are largely irrelevant as the monetary policy strategy no longer relies on a stable money-income relationship. Thus, unlike monetary targeting, stability of the relationship between the monetary aggregates and income is not essential as it focuses directly on the final goal – inflation. (ii) (iii) By allowing policy to respond to all available information – and not just to the monetary aggregates – an inflation target allows discretion at the level of interpreting information. i.e. allows the monetary authorities to use all available 11 Difficulty of directly controlling inflation. The long and variable lags in monetary policy and the absence of a simple rule may make it difficult for the public to monitor the performance of the central bank in a timely manner. IT is especially difficult in emerging market economies because inflation is hard to control and there exist long lags between the adoption of monetary policy instruments and the inflation outcome Table 2: Pros and Cons of Different Monetary Policy Regimes Regime Pros Cons information on various variables rather (iii) Is too rigid and it allows for than one to determine the best settings too much discretion. for monetary policy. (iv) Has the potential to (iv) Easily understood by the public and thus, increase output instability transparent. IT has been associated with along with lowering of increased transparency and accountability output growth of monetary policy. (v) The exchange rate flexibility (v) Reduces the likelihood of the central bank required for success in of falling into time inconsistency trap since inflation targeting might it raises accountability and transparency cause financial instability, especially in the context of (vi) Sustained success in the conduct of the emerging market monetary policy as measured against a economies pre-announced and well-defined inflation target can be instrumental in building public support for creating an independent central bank Issues Related with Introducing Indirect Monetary Policy Instruments Advantages of Indirect Monetary Policy Instruments 23. The following are the main benefits of indirect monetary policy instruments: a) Unlike direct controls, they do not encourage disintermediation and the growth of an informal financial sector, which lowers the share of financial assets that the monetary authorities control; b) Indirect instruments permit much greater flexibility in policy implementation. Small, frequent changes in instrument settings are feasible, enabling the authorities to respond rapidly to shocks and to correct policy errors quickly, prompting the need for major shifts in policy. Such timely responses are difficult with direct instruments, particularly credit ceilings, since they are often set on an annual or quarterly basis. Frequent changes in credit limits would also place an undue burden on banks, since banks typically lack the administrative means to adjust their credit portfolios abruptly. c) Indirect instruments’ reliance on market forces helps to “depoliticise” the formulation of monetary policy and the allocation of credit. d) They can help to deepen financial market. Unconstrained, competitive, deep financial markets tend to price capital according to its scarcity, in a transparent and efficient way. Credit tends to flow to those able to pay the highest rates (adjusted for risk), hence those able to use resources most productively. It therefore, improves the efficiency of investment, as well as in increase in savings. 12 24. Inherent Complexities in the Use of Indirect Monetary Policy Instruments a) Much of the appeal of direct methods lies in the close and apparently forthright link they seem to have with policy objectives. Such a simple correspondence does not hold in the case of indirect instruments, and policy may be more difficult to implement by indirect methods. Only bank reserves (the monetary base) or, at most, one short-term interest rate (the overnight rate or money market rate, such as the three month bill rate) may be controlled in the short run. Therefore, the central bank needs to define its objectives clearly and know how to set its instruments to achieve them. Because of lags in the transmission process, the effects of particular setting cannot be observed immediately. b) Some aspects of financial liberalisation that accompany the introduction of indirect instruments may complicate the conduct of monetary policy. In many cases for example, interest rate liberalisation, or the ending of credit controls, destabilises money or credit aggregates for a time, making their control virtually impossible. In addition, interest rates and exchange rates may become more interdependent. Finally, the opening of the capital account, drastically curtails the authorities influence over the real rate of interest, even in the short run. Criteria for Determining the Instrument mix 25. As regards the indirect monetary policy instruments, the most important matter is the criteria for determining the instrument mix. The following are the general criteria to be used: I. The extent to which the instrument can control the variable that the monetary authority wishes to influence, such as the levels of money, credit, and interest rates. To exercise control, the effects of using the instruments must be predictable. The ability to control is also enhanced if the instrument is flexible, that is, if it’s monetary effects can be changed or reversed relatively quickly. II. Side effects on resource allocation. Would the use of the instrument interfere with financial markets and distort the allocation of real resources? For example, credit controls on each bank may be highly effective in controlling the aggregate amount of credit, but they can lead to financial disintermediation, slow down market development, and distort the allocation of resources. III. The extent to which the instrument contributes to the overall financial development of the country and the stability of its financial system. For instance, central bank operations with securities are not only a means of controlling the amount of liquidity but can also encourage the development of financial markets, particularly those for short term government debt instruments. IV. Whether the central bank can use the instrument to deal with financial shocks and stresses on a bank specific basis, for instance by assisting individual banks to adjust to a temporary outflow of deposits. A discount window can be used to address individual problems of this type. 26. In general, central banks make use of several instruments of monetary policy, in light of the multiplicity of criteria outlined above. This requires them to coordinate how much each 13 instrument will be used and how its use will affect the overall level of liquidity. Reserve money programming is an indispensable tool in achieving this coordination, since it can be used to analyze systematically the sources and uses of liquidity. Pros and Cons of Different Indirect Monetary policy Instruments Table 3: Pros and Cons of Different Monetary Policy Instruments Instruments Advantages Disadvantages Reserve requirements An increase in reserve requirements can be useful in one-off sterilization of excess liquidity Rediscount window Develops demand for rediscountable papers. May also be used in circumstances where open market operations are limited due to lack of papers. Primary market sales of central bank papers (Open market type operations) Flexible instrument for short-term liquidity management because issuance is at the discretion of central bank, and various auction/tender formats can be used to steer interest rates. If treasury is not willing to accept sufficient interest rate flexibility, central bank papers preserve operational autonomy of central bank. A high requirement imposes tax on bank intermediation. This can be neutralized through reserve remuneration at market rates. The tax may result in a widening of the spread between lending and deposit rates, which can lead to disintermediation. Not convenient for shortterm liquidity management, as frequent changes disrupt bank portfolio management. Not very convenient for precise base money targeting, since access to window is usually at initiative of banks. Criteria for rediscountable paper and for access to window have often utilized to implement selective credit policy If central bank bills are used in parallel with treasury bills, problem may occur in the absence of strong coordination between the issuing agents. 14 Experience and assessment Used extremely in many developing countries. Active variation for policy purposes has dropped significantly in industrial countries Used in many countries as a standard instrument for monetary control, although access at initiative of banks can complicate its usefulness. Used by many countries, particularly when there is a need to separate monetary policy objectives from public debt management objectives. Also used when secondary markets are insufficiently developed to permit open market operations in the secondary market. Primary- market sales of government securities (Open market type operations) Foreign Exchange (FX) swaps and outright sales and purchases Secondarymarket operations (outright purchases and sales or repo operations) -It will be an important instrument, if appropriate coordination between treasury and central bank is achieved. . -Encourage fiscal discipline on the part of the government if direct central bank financing is discontinued In case of deep foreign exchange market but inactive government securities market, swaps can substitute for repo operations in government papers. FX outright sales and purchases may be useful when FX market is more developed than money market Can be undertaken on continuous basis: hence provide flexibility. Transparent. Enhance market development. Immediacy of response in money market. Debt management objective can conflict with monetary management, if treasury manipulates auction to keep funding costs below market. When monetary management relies on primary issuance, high frequency of auctions may hamper secondary market developments Used in many countries when secondary markets are insufficiently developed to conduct open market operations Central bank can suffer losses if foreign exchange operations are used in attempts to preserve an unsustainable exchange rate. Swaps used on a regular basis by few countries (e.g. Switzerland) Require liquid and deep secondary market, and central bank must have an adequate stock of marketable assets. Used by most countries with liquid and deep secondary markets. Supporting Actions to Facilitate Effective Use of Indirect Monetary Policy Instruments Insulate Monetary Policy From deficit Financing 27. The following are required in order to insulate monetary policy from deficit financing: I. Setting strict limits on monetary financing of the government’s fiscal deficit by a central bank; II. A comprehensive programme for public debt management- This programme involve widening the range of debt instruments and holders; adopting market based selling techniques; and strengthening secondary market arrangements and coordination with monetary management. 15 Strengthen and Integrate Money Markets 28. Because control by the Central bank over the supply of reserve money is the fulcrum of indirect monetary control, such methods will not be fully effective unless the “market” for shortterm bank liquidity (either an interbank or a money market) can signal and transmit the central bank’s actions rapidly and transparently to all market participants. Thus, seamless money and interbank markets are essential to the full use of indirect instruments. There are two aspects to market development. First measures to improve market infrastructure such as modernizing the payment and clearing system; , an appropriate legal framework to permit securities trading ( covering such issues as settlement procedures, collateral arrangements, trading rule, and the regulatory framework for securities markets ) and suitable market instruments and techniques (such as commercial papers and repos etc). These conditions facilitate interbank transaction and active liquidity management. Foster Competition in the banking sector and restructure the banking system 29. A healthy and competitive banking and financial system is a key element in ensuring that central bank actions to control the supply of liquidity are fully and rapidly transmitted. If the commercial banks do not respond to the signals given by the central bank by altering interest rates or liquidity conditions, indirect instruments will not have the desired effect on monetary and credit conditions and hence on the economic objectives. 30. The experience of money countries also indicate that, without appropriate restructuring to deal with problem loans and problem banks, weaker segments of the banking sector may not be able to adapt to the newly competitive environment raising the risk of a financial crisis. Existing weaknesses in bank’s asset positions become increasingly difficult to manage as the economy becomes liberalized and debtors can no longer accumulate arrears. For example, banks holding old government paper issued at low rates may face capital losses when interest rates increases. The imposition of hard budget constraints and the ending of interest rate subsidies, which frequently accompany financial liberalization and the introduction of indirect monetary instruments, put pressure on bank’s financial positions. Adapt supervisory and Regulatory Framework to Market Conditions 31. In an environment of liberalized interest rates and unrestricted credit allocation, the ongoing solvency of particular financial institutions hinges on the ability of those institutions to manage new credit and market risks. Safeguards- in the form of minimum capital standards, provisioning for doubtful loans, limits on loan concentration, collateral requirements, collateral valuation standards, and adequate enforcement mechanisms- are needed to foster prudent behavior by financial institutions. Financial reporting and disclosure standards are needed to guarantee transparency in the operations of financial institutions and provide a basis for the public to assess the creditworthiness of particular financial institutions. The too frequent experience has been that financial liberalization in the absence of such measures –lead to financial crisis and subsequent reversion to direct methods of monetary control. Bolster the Technical Capacity of the Central Bank 32. Regardless of the instruments they use, central banks need to build up their technical capacity to maintain monetary control in an increasingly sophisticated financial world. Reliance on indirect instruments requires that the central bank have the capacity to project the demand and supply of reserves and their effect on broader credit and money aggregates; it also 16 assumes that the central bank has the legal capacity to utilize indirect instruments, which may require changes in central bank legislation. Thus, the central bank will need a programming framework and some ideas of the money multiplier relationship to estimate how much reserve money to add or withdraw to achieve the required effect on broader money and credit aggregates. This can be particularly difficult during the transition period when several of the key behavioral relationships tend to become unstable, at least temporarily, thereby, greatly diminishing the information content of past observations. In those circumstances, central banks have to adjust their implementation strategies and tactics accordingly. 33. As part of their programming framework, central banks need to develop a framework for managing liquidity they provide to the market in order to ensure that the short-run instrument setting is consistent with the policy objectives. Specifically, such a programme provides the central bank with indications about the timing and the size of its interventions, which helps in making indirect instruments of monetary policy most effective. 34. To be useful, a reserve money programming requires timely and accurate data on the central bank balance sheet and financial sector development. Key Global Challenges in the design and Implementation of Monetary Policy 35. Monetary authorities still face multiple challenges in the design and implementation of monetary policy. These challenges may be institutional or technical and could emanate from external developments and/or macroeconomic shocks. The following are the key challenges: a) Lack of independence by Central Banks. In some countries, it is a statutory requirement for the central bank to be under the scope of the Ministry of Finance. In other countries, political forces determine the actions of the central bank, thus affecting the central bank’s ability to maintain legitimacy and objectivity. b) Central banks may be constrained by conflicting monetary policy objectives. Policy makers are often faced with multiple objectives that are equally desirable. This creates challenges in assigning a single policy instrument to an objective. Furthermore, while some objectives are consistent with each other, others are not, for example maintaining the exchange rate at a particular level can often limit a central bank in using policy instruments such as interest rates. c) The lack of fiscal discipline. This is often characterized by high levels of government budget deficits and public debts. The central bank has to, therefore, focus its monetary policy towards meeting government spending objectives rather than price stability. d) Weak transmission mechanisms mainly caused by under developed financial markets often obstruct monetary policy effectiveness. This may be due to a shaky banking system that may discourage policy makers from the use of aggressive policy rates for the fear of the effects of these changes to balance sheets of already fragile banks. e) Lack of market integration within developing countries often results into asymmetrical response to monetary policy. Consequently, the delays in the effects of monetary policy on economic activity are relatively longer and more variable. The absence of deep and 17 liquid markets also means that there is inadequate feedback about the effect of the policy actions on the market. f) Heavily aid dependent countries also suffer from distortions caused by aid flows. These flows are often volatile and can greatly disorganize policy makers in their efforts to implement monetary policy. Moreover, external shocks like the worldwide food and energy prices experienced in 2007 and 2008 may distort inflationary expectations and therefore make it hard for policy makers to formulate pertinent strategies to respond to these shocks. g) Central banks also face technical challenges in implementing monetary policy especially inflation targeting. The central bank needs the technical capacity to model the economy, understand the transmission mechanism and forecast inflation and output. h) Central bankers have to make decisions in a world of pervasive uncertainty. The uncertainties are related to the state of the economy, the structure of the economy, and the interaction between private sector and the policy makers. The following are the nature of the uncertainties: i) The uncertainty related with the state of the economy arises from the imperfectness of information used for analysis; and difficulty in identifying the nature of the shocks that are driving observed economic developments. That is whether shocks, originate from domestic or foreign sources, and are transitory or long lasting. ii) The uncertainties related with the structure of the economy result from imperfect knowledge by central banks on suitable descriptions of the structural relationships in the economy. They are not sure which models provide suitable descriptions of the structural relationships in the economy. As a result, central banks cannot afford to rely on one single model of the economy, but need to have a number of alternative modeling tools available. For example, there is a widespread consensus that inflation is, as indicated by the quantitative theory of money, a monetary phenomenon in the long run. At the same time, there is a multiplicity of different approaches, of modeling the inflation process at short and medium-term horizons. Even if there were a consensus on a suitable model of the economy, considerable uncertainty would remain regarding the strength of the structural relationships, i.e. the value of parameters, within that particular model. Inevitably, available parameter estimates are affected by data imperfections and by the particular econometric techniques that are employed for estimation. An even more fundamental problem is that parameters may vary over time as a result of structural change in the economy. Uncertainty about parameters confronts all central banks. iii) The uncertainty related with the interaction of the private sector and policy is related to the role of expectations. The central bank often wonders about the reaction of economic agents and financial markets to its own policy decisions and announcements. Conversely, economic agents may be unsure about the precise motivations and actions of central banks and other economic agents. This is always the case, even if market developments are fairly close to what would be expected based on fundamentals. However, the degree of this kind of uncertainty may in some cases become especially pervasive. This appears when some of the uncertainties mentioned above are amplified by deeper or more widely spread doubts on the side 18 of market participants about the stability of economic relationships, thus leading to what some call "fundamental uncertainty". Such developments are relatively limited in developed countries as their central banks usually prevent their appearance through the very success of their policies. However, their potential occurrence needs to be taken into account by central banks in order to avoid them. 36. The following are key strategies many countries used to address the above challenges: a) Fiscal and monetary policies should be complementary and should ensure consistency with the overall goal for an economy. b) Getting rid of everything used to undermine the effectiveness of monetary policy, which include political interference, fiscal dominance, and poor legal environments. This can be achieved by giving independence to a Central Bank and giving the Central Bank a clear mandate and appropriate instruments for achieving a sustainable reduction of inflation. c) When setting monetary policy and in order to ensure consistency with the overall goal for an economy; central banks should look beyond just inflation by taking into account other variables that many times are spelled out in their charter. These include stability of financial markets and institutions, balance of payments equilibrium, the level and quality of information data and the communication facilities in place should ensure consistency with the overall goal for an economy. d) Monetary policy can effectively maintain price stability but it must be accompanied by structural reforms that will create the enabling environment for accelerated growth in the long run. Therefore, notwithstanding the central bank’s monetary policy stance to preserve price stability and create enabling environment to foster growth, structure reform to ease binding constraints in the economy must be implemented to make the economy competitive. e) Take appropriate measures to reduce uncertainties of Central Banks as related to the state of the economy, the structure of the economy, and the interaction between private sector and the policy makers Analysis of Monetary Policy Frameworks in Selected African Countries 37. There have been several significant changes since the 1990s in the design and conduct of monetary policy around the world, including in African countries. Two main examples of these changes are: first, the movement by a number of countries, many in Africa, from fixed exchange rate regimes to more flexibility, which has allowed for greater monetary independence. Second, the adoption of inflation targeting regimes as a framework for conducting monetary policy in several industrial countries, as well as in about 19 emerging economies and developing countries to date (including three African countries). Table 4 below shows monetary policy frameworks in Sub-Saharan African Countries (SSA). Table 4: Monetary Policy Frameworks in SSA Countries Type of Framework Exchange Number of Countries Rate 23 19 Pegs Inflation Targeting RSA, Mauritius, Ghana, Uganda (IT light), Kenya (hybrid), Rwanda (soon) Monetary targeting 18 Source: Kasekende et al. (2010) 38. Many African countries have been using money supply as a nominal anchor under the monetary policy framework but a breakdown in the relationship between money and inflation, which lead to challenges in the ability to forecast reserve money, has led some countries to abandon the framework. 39. Exchange rate targeting uses the exchange rate as a nominal anchor and comes in two forms: soft and hard pegs. More than half of the countries in SSA anchor their monetary policy on an exchange rate peg. 14 of these countries are members of the West African and Central African CFA Zone Monetary Union. Botswana is pursuing a crawling peg where the Botswana Pula is pegged to a basket of currencies (Rand, Euro, and USD), while Lesotho, Namibia and Swaziland are using hard pegs to the South African Rand under the Common Monetary area (CMA). These countries have registered single digit inflation rates with the exception of the global financial crisis era. Furthermore, inflation has been less volatile in these countries. The limitation of exchange rate targeting is the loss of independent monetary policy and thus the inability to protect the target countries from shocks transmitted from the anchor country. 40. Under inflation, targeting (IT) the anchor is the expected rate of price increase and not the price level by committing to a given level of inflation. As of now, only three African countries have successfully adopted this regime: South Africa, Ghana, and Mauritius. Some review studies made on their performance indicate that they are making good progress. The transition process to IT is also underway or exsits in a number of other African countries (Uganda, Botswana, and Namibia). Kenya is currently employing a hybrid monetary policy framework of both IT and monetary target. Performances of the Existing Monetary Policy Regimes in Selected COMESA Member Countries 41. The anecdotal evidence of monetary policy regimes in some selected COMESA countries are summarized in Table 5 in the next page. The table shows that most of the COMESA member countries shifted from direct to indirect monetary policy control as part of financial sector liberalization process undertaken under the structural adjustment programmes. It indicates that there is consensus that direct controls on interest rates and credit led to the misallocation of resources and inefficiency in financial intermediation with adverse effects of savings mobilization, investment and economic growth. It also indicates that most COMESA central banks currently use the quantity theory of money framework in projecting money demand. This approach is based on studies that support existence of stable money demand functions for these countries. Most central banks have similar monetary policy instruments, namely, open market operations, reserve requirement and standing facilities. In terms of monetary policy signaling, Treasury bill rates have signaling effects on the monetary policy stance but this has been compromised by the fact that it is highly influenced by fiscal policy. Table 5 below also describes the characteristics of various indirect instruments of monetary policy and summarizes their advantages and disadvantages. 20 42. The main achievements under the current monetary targeting framework are, among others, that most central banks have harmonized their monetary aggregates data. They have also achieved relatively lower inflation rates than in earlier periods. In addition, a number of COMESA central banks have developed monetary policy rates with signaling effects on the monetary policy stance and shares information relevant to the transition to inflation targeting framework. 43. The table indicates that most COMESA countries have faced challenges that have raised concerns about the appropriateness of the current monetary targeting framework. These concerns arise from instabilities in the money multiplier; interest rate volatility; problems in forecasting liquidity; choice of reserve aggregates for targeting as well as limited and inflexible monetary policy instruments. Efforts are ongoing in most central banks to carry out studies on monetary policy transmission mechanism, strengthening real sector databases, capacity building in formulating simple macroeconomic, forecasting and simulation models as a basis for improving the current framework and for moving to inflation targeting. 21 Table 5: Performance and challenges of the existing monetary policy regimes in selected COMESA countries Country Uganda Monetary Policy Framework Has transitioned to an inflation targeting lite monetary policy framework since July 2011 The primary policy objective of monetary policy remains unchanged: the control of core inflation over a medium term horizon. Monetary policy management is hinged on using the set interest rate as the operating target of monetary policy. Monetary Performance Challenges Policy Instruments Prior to Since the While inflation expectations markets adoption of have been anchored liberalization the inflation through the reserve money s, direct targeting lite programme, instability of the monetary program, money multiplier and to policy inflation has some extent velocity has control was been raised concerns over the applied. This brought appropriateness of the involves under current approach to interest rate control. monetary policy. and credit Inflation Problems in forecasting controls declined autonomous factors A shift to from doubleaffecting base money and indirect digit levels the instability of money monetary of 66% in multiplier have undermined policy June 1992 effectiveness of the reserve control was to singlemonetary program part of digit levels Underdeveloped financial financial for most of sector, characterized by low sector the 1990s to degree of monetization of liberalization June 2008. the economy process. It has since Management of donor aid risen to 10% Open flows and implications for - 15% range market conduct of monetary policy but is Interest rate volatility operations forcasted to Weak through interest rate return to treasury bills sensitivity. single digets and in 2013 repurchase agreements The are the impressive principle inflation instrument outturn is for largely a managing result of the day-to-day continued liquidity. pursuance of prudent Other monetary instruments and fiscal include: policies. Bank rate, cash Fiscal reserve restraint, in requirement conjunction 22 Table 5: Performance and challenges of the existing monetary policy regimes in selected COMESA countries Country Monetary Policy Framework Zambia IMF’s financial programmi ng form the core of the monetary targeting framework Broad money supply and reserve money consistent with inflation target and economic growth objective. Monetary Performance Challenges Policy Instruments s and with close rediscount corate. ordination between the monetary and fiscal authorities contributed significantly to bringing down inflationary expectations . Prior to Since Weak and underdeveloped 1992, implementati financial system that Zambia on of curtailed the effectiveness of relied on monetary the monetary policy. direct targeting Money market instruments framework imperfections evidenced of monetary and use of through interest rate volatility policy such indirect and the weakness in the as fixed monetary fiscal policy. interest policy Impact of external shocks rates and instruments, such as international credit inflation has fluctuation of commodity and allocations, fallen oil prices. core liquid remarkably assets, from 3 digits statutory in early reserve 1990s to requirement double and fixed digets in the exchange from 2004rate regime. 2009 and single since Indirect 2010. monetary policy Exchange instruments rate has employed been currently are relatively the open stable market operations 23 Table 5: Performance and challenges of the existing monetary policy regimes in selected COMESA countries Country Monetary Policy Framework Kenya Employs a hybrid monetary policy framework of both inflation targetting and monetary targetsto achieve inflation objective. The framework has remained fairly the same with the bank continuously refined monetary policy operations and procedures to enhance efficiency and effectiveness Monetary Performance Challenges Policy Instruments (Secured Loans, Term Deposits & Treasury bill auctions), Bank Rate, Rediscount facility, and Core Liquid Asset Ratio. Prior to Monetary An unstable relationship financial targeting between money and inflation market framework due to financial deregulation, liberalization has served and an increasingly unstable , direct the country money multiplier and to monetary well with some extent velocity are policy refinement of making it difficult to derive a instruments operations credible path for money were used. and supply. These were procedures Challenges of forecasting in form of to enhance liquidity within a short-time interest and effectiveness period constrained effective credit . The surge implementation of Open controls. in inflation in Market Operations. This early 1990s Indirect mostly manifested in to about monetary excessive fluctuation of 70% (the policy short-term interest rates. time of first instruments Challenges due to multiparty currently increasingly globalized elections in employed World. 1992) led to include open amendment market of the CBK operations, Act in 1996 bank rate, to give CBK cash ratio more requirement autonomy to s and manage rediscount monetary facility. policy. The inflation has been maintained at 24 Table 5: Performance and challenges of the existing monetary policy regimes in selected COMESA countries Country Monetary Monetary Policy Policy Framework Instruments its objectives in a changing financial and economic environment In formulation monetary program for a specific period, the bank start with estimating the money demand consistent with the target rate of inflation and GDP growth. This form the basis for setting desired path for monetary growth to which actual money supply had to conform during policy implementati on stage. However, with the time lag in obtaining information needed for effective control of broad monetary aggregates, Performance satisfactory level supported by fiscal policy. The inflation rate recorded single digit in most cases since 1995 and it averaged 9.4% from 2004-2008. It however surge to 15.1% in 2008 owing to rise in food prices and international oil prices. Inflation rate for 2013 is estimated to be 5.2%. . 25 Challenges Table 5: Performance and challenges of the existing monetary policy regimes in selected COMESA countries Country Malawi Monetary Monetary Performance Challenges Policy Policy Framework Instruments the CBK formulates its monetary policy implementati on strategy on the basis of reserve money-more readily available as liability of the central bank. The reserve money program design is consistent with desired money supply expansion. Monetary Initially used Since Weak and underdeveloped targeting direct adoption of financial system that framework. In monetary the monetary curtailed the effectiveness of the pursuit of policy targeting the monetary policy. price stability, instruments framework Interest rate volatility the bank such as the pace of Thin and shallow markets monitoring interest inflation Limited number of growth in rates and decelerated participants reserve credit from a range o Only banks are the major monetary controls, of 29.6participants – this lowers aggregate. strict 83.3% the competitiveness of To influence controls on between price setting growth in foreign 1994 and o Policy actions lead to monetary exchange 2000) to an disproportionate price stock the and capital average of movements Central Bank flows. 12.5% Limited instruments- Only Tincreases or After between bills, Tbonds, Forex and decreases 2004- 2008. liberalization Repos the amount shifted to No secondary markets for of reserve indirect securities-Once acquired, money by monetary agents tend to hold financial managing policy assets to maturity. This 26 Table 5: Performance and challenges of the existing monetary policy regimes in selected COMESA countries Country Swaziland Monetary Monetary Performance Challenges Policy Policy Framework Instruments both instruments causes makes the market domestic and that include insensitive to interest rate foreign open market movements sources of operations, reserve liquidity money. reserve requirement The bank s, daily repurchase management and discount of monetary window movements facility. involves estimates of banking system liquidity situations. No The tools at Single digit The CMA limits the country’s independent the disposal annual to formulate and implement monetary for the bank inflation rate monetary policy or respond policy include the recorded to external shocks discount since 1996 Rand circulations in the Currency is interest rate, averaging pegged to economy render the reserve 6.46% from the South measurement of money requirement 2004-2012. African Rand supply to be understated. s, and open Just like This is compounded by Monetary market most pegging rand to the local policy operations. countries, currency. formulation The Bank the inflation Free access to South Africa influenced however rate surge in largely by money and capital markets utilizes 2008 to membership limits the CBS from interest double digit to Common controlling money supply. rates that due to rise in Small and shallow financial Monetary has proved food and oil Area (CMA). market effective to prices. The countries curtail facilitate inflation smooth arising from implementati the demand on of CMA side. agreements free through CMA With flow of Governors capital meeting under the 27 Table 5: Performance and challenges of the existing monetary policy regimes in selected COMESA countries Country Monetary Policy Framework Seychelle s Prior to enactment of the Central Bank of Seychelles Act of 2004 economic management relied heavily on fiscal policy with monetary policy relegated to accommodati ng role. Since November 2008, the Monetary Policy Framework is based on monetary targeting rather than the traditional Monetary Performance Challenges Policy Instruments CMA and unitary fixed exchange rate to rand (no exchange rate risk) implies limited scope for the Swaziland interest rate to deviate substantially from South Africa’s. Open Prudent and Monetary policy market wellimplementations need to operations balanced strengthen the influence of Treasury bill monetary interest rates on economic auction, and fiscal developments. deposit stances The Bank will place more auction have emphasis on steering shortarrangement reduced term interest rates with the s and inflation to development of the foreign low single interbank and money exchange digit since markets. auction 1999. Minimum Weak coordination Reserve between Fiscal and Requiremen Monetary t (MRR) Unpredictability of Local asset government Ratio- This budgetary flows tool requires Large and commercial Unpredictable banks to expenditure floats. invest a This makes it difficult specific to match monetary percentage policy actions with of their local actual flows, and currency hence reduces deposit effectiveness of the 28 Table 5: Performance and challenges of the existing monetary policy regimes in selected COMESA countries Country Monetary Monetary Performance Policy Policy Framework Instruments exchange liabilities in rate government targeting. securities and other This claims on transition government was to and has support a been an liberalized important foreign vehicle for exchange funding market and government floating deficits exchange since its rate regime inception in as part of 1986. IMF Lending supported economic facility: The reform Standing program Credit adopted by Facility the (SCF) is an authorities in overnight November collateralize 2008. d loan facility that In monetary provides targeting funds to the framework, commercial the final banks, to target - price cover stability - is to temporary be achieved end-of-day by shortfalls influencing that can changes in arise in the the total daily amount of settlement liquidity in the of economy, payments. T with reserve he money being Emergency the Lending intermediate facility (ELF) operating 29 Challenges actions. Weak monetary policy transmission Banks are insensitive to interest rate movements in the primary market due to: Structural impediments impair monetary policy transmission Inherent risk in the economy, Weaknesses in the legal framework, Low market competition Table 5: Performance and challenges of the existing monetary policy regimes in selected COMESA countries Country Egypt Monetary Monetary Performance Policy Policy Framework Instruments target of is an monetary emergency policy liquidity support Quarterly facility monetary primarily to targets are prevent set. severe and Interventions persistent for managing short-term bank's liquidity liquidity are problems to guided by lead to liquidity insolvency monitoring and to avoid framework bank runs. maintained by the Bank. This framework identifies the factors that influence bank liquidity and is used to make forecasts on future liquidity flows. Monetary Direct Timely targetinginstruments monetary intermediate such as policy target quantitative responses involved and by the control of administrativ Central Bank annual e manage to growth rate in determinatio contain domestic n of interest inflation liquidity rates using expectation measured in interest rate particularly terms of and credit emanating broad money ceiling were from supply. abolished demand from 1992. pressures. The changes 30 Challenges Weak monetary policy transmission Banks are insensitive to interest rate movements in the primary market due to: o Structural impediments impair monetary policy transmission o Inherent risk in the economy, and o Weaknesses in the legal framework Low market competition Table 5: Performance and challenges of the existing monetary policy regimes in selected COMESA countries Country Burundi Monetary Monetary Performance Challenges Policy Policy Framework Instruments involved However, Mostly relied modification heightened on indirect of operational inflation market and expectation based intermediate mainly in instruments targets as 2008 was such as well as driven by required choice of the supply reserve monetary shocks such ratio, policy as reserve instruments. international money and fuel price Principal open market hike. monetary operationspolicy discount remained rate and focused on interest rate price stability and stabilization of exchange rate. The operational target initially involved nominal interest rate management and controlling excess bank reserves but in 2005 was replaced by overnight interest rate on interbank transactions. Monetary Prior to Remarkable Small and shallow financial aggregate 1986, direct success market targets. The monetary recorded to country policy return of implementing instruments inflation to IMF’s used such average of 31 Table 5: Performance and challenges of the existing monetary policy regimes in selected COMESA countries Country Monetary Policy Framework Poverty Reduction Growth Facility Program. Zimbabwe Official dollarization Monetary Performance Challenges Policy Instruments as credit 10.9% from ceiling and 2004-2012. interest It rose to rates 26% in 2008 control. due mainly to surge in Indirect food and oil instruments prices. adopted after 1986 through the structural adjustment programs. The instruments at the disposal of the central bank include; refinance policy, auction of treasury certificates and reserve requirement s. In the Good High fiscal deficits absorbed 1980s, the progress large portion of domestic instruments initially made savings were direct before Undeveloped financial control of political system with lack of interest rate, instability set competition in the banking credit in and which system ceilings, use greatly of reserve negatively bank bills affected the and independenc prescribed e of liquid assets monetary ratio policy The instruments 32 Table 5: Performance and challenges of the existing monetary policy regimes in selected COMESA countries Country Monetary Policy Framework Monetary Performance Policy Instruments at the Bank disposal were Bank rate, open market operations and reserve requirement s Challenges Proposal for Appropriate Monetary Policy Regime for COMESA Member countries 44. As the shortcomings of monetary targeting framework have become more apparent, many of the COMESA central banks have to start the journey towards formal inflation targeting frameworks. A successful implementation of inflation targeting, as an alternative to monetary policy framework, would require the following conditions to be in place: a strong fiscal position and entrenched macroeconomic stability; a well-developed financial system; Central bank policy and instruments independence and a mandate to achieve price stability; reasonably well understood channels between policy instruments and inflation; a sound methodology for inflation forecasting; and transparent policies to build accountability and credibility. 45. Given the above factors, the COMESA region requires more time to switch to a regime of inflation targeting. Therefore, monetary targeting seems to provide a more realistic and pragmatic monetary policy framework in COMESA countries as the preconditions for implementation of the inflation targeting framework are put in place within each country in COMESA. The following recommendations are, therefore, made to simultaneous keep refining the current monetary targeting framework in addition to putting in place the preconditions for inflation targeting in the future: Implementing indirect instruments of monetary 46. The benefits of introducing indirect monetary policy instruments are the following: a) Leads to efficient financial intermediation; b) Provide effective monetary control, especially in circumstances where direct instruments have been largely circumvented. This is particularly likely as new financial instruments develop and the opening of the capital account provides a wider range of financial alternatives. In such a setting, the shift to indirect instruments become a matter of necessity; 33 c) Permit the authorities to choose from a larger set of target than is possible with direct instruments. This is especially important when the relationship between particular aggregates such as credit variable, and the final objectives of the authorities, such as price stability, has been weakened or has become hard to establish. Often this is brought about by economic reform or financial innovation. Undertake key concomitant reforms to minimize difficulties of implementing monetary policy instruments. 47. indirect These include the following: a) Monetary Policy needs to be insulated from the pressure of financing the government’s fiscal deficit. The authorities must curtail monetary financing of the fiscal deficit, ensure that the government accepts market rates of interest on its debt, and refrain from pressuring the central bank to keep market interest rates low. Enhancing Central Bank Independence can help to achieve these goals. Limits on Central bank credit to the government must be supported by a comprehensive programme to develop public debt management and government securities market. b) Weak and segmented money and interbank markets need to be strengthened. As liquidity management by the central bank provides the fulcrum of indirect methods of monetary control, indirect instruments cannot work well unless the interbank and short-term money markets can transmit the central bank’s actions rapidly and transparently. The Central Bank must play an active role in the development of the market infrastructure, including the payments and settlement system, the legal and regulatory framework of the markets, and the introduction of suitable market instruments and techniques. At the same time, the central bank needs to stimulate trading in these markets. Introducing at an early stage some market-based indirect instruments that can be transacted at market interest rates can be the catalyst in developing the money and financial markets needed before full reliance on indirect instruments is possible. c) The banking system often needs to be restructured to create healthy banks and foster competition. Generally, financial restructuring needs to deal with nonperforming loans and problem banks and with strengthening the managerial capacity of weaker banks, which may be poorly equipped to adapt to the newly competitive environment. d) The supervisory and regulatory framework needs to be reinforced. All too often, experience has been that, in the absence of such measures, financial liberalization leads to financial crisis. Thus, safeguards- in the form of minimum capital standards, standards for provisioning for doubtful loans, limits on loan concentration, collateral requirements and collateral valuation standards, and adequate enforcement mechanisms are needed to encourage prudent behavior. Financial reporting and disclosure standards are also needed to improve transparency, so that the market can play its role in ensuring financial discipline. 34 e) The technical capacity of the central bank needs to be strengthened. Reliance on indirect instruments requires that the central bank develop a forecasting framework for short-term reserve money in order to project the demand and supply of currency and bank reserves and their effect on broader credit and monetary aggregates. That framework requires timely and accurate data-including warning indicators –on financial sector development as well as on the central bank’s balance sheet and must be based on a quantification of key monetary relationships. There must also be a clear understanding of the monetary policy transmission mechanism. The Banks should therefore be fully engaged in building capacity through the training of staff particularly in macroeconomic modelling and forecasting. These can be achieved through technical assistance from the International Monetary Fund (IMF) and other Central Banks such as the Bank of England. A comprehensive research programme in central banks is also required. Careful sequencing based on country specific circumstances of the path for introduction of indirect monetary policy instruments. 48. This should follow the following stages: a) The first stage normally requires the use of both reserve requirements to absorb liquidity and a credit facility- such as a credit auction - to provide for the growth of domestic credit. An overdraft or Lombard facility as a penal interest rate is also needed. Liberalization of interest rate must begin at this stage. b) In the second stage, the authorities should introduce auctions of short-term government or central bank securities. This not only assist the development of financial markets but also gives the authorities more flexibility in managing monetary operations and allows for a reduction in reserve requirements. At this stage, the authorities operate a mix of market-based instruments to foster both monetary control and market developments. c) In the third stage, the central bank should accelerate the development of institutions and financial market infrastructure and begin to rely on full-fledged open market operations. Total reliance on such operations is not possible until the secondary market is working well. Develop a communication strategy that enhances transparency of monetary policy. 49. The central banks through their respective Monetary Policy Committees should develop effective communication strategies to ensure that the public understands what they do. Transparency of monetary policy can be enhanced through frequent dissemination of information to the public. In addition to the press conference given by the Governor after every meeting of the Monetary Policy Committee and the release of the Monetary Policy Statement a week after each meeting, each central bank should have a publication of bi-annual inflation reports that provides an analysis of inflation developments as well as the assessment underpinning monetary policy and outlook for inflation. This will enhance the public’s understanding of the policies being applied to achieve the Bank’s primary objective of monetary policy. 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(2001). “Monetary Policy Implementation by Central Bank of Burundi” ”, Paper Presented at the South African Reserve Bank Conference on Monetary Policy Frameworks in Africa, September 17-19, 2001, Pretoria, South Africa. 37 Annex I: Monetary Policy Framework Exchan Monetary Policy Framework ge rate Exchange rate anchor arrange ment (Numbe r of countrie U.S. dollar Euro Comp s) osite (66 Countries) Exchan ge arrange ment with no separat e legal tender (10) Ecuad or, El Salvad or, Marsh all Islands , Fed. States of Micron esia, Currenc Antigu y board a and arrange Barbud ment a2 (13) Djibout i Other convent Domini ca2 Grena da2 Hong Kong SAR St. Kitts and Nevis2 Angola Palau Panam a (27 Countri es) Monten egro San Marino (15 Count ries) Other (7 Countri es) Kiribati Monet ary aggreg ate target (22 Countri es) TimorLeste St. Lucia2 St. Vincent and the Grenadi nes2 Bosnia and Herzeg ovina Bulgari a Brunei Daruss alam Estonia 3 Lithuan ia3 Seychel les Benin4 Fiji Bhutan 38 Argenti na Inflation targeting framework Other 1 (44 Countries) (11 Countr ies) ional fixed pe g arrange ment (68) Argenti na Aruba Baham as, The Bahrai n Bangla desh Barbad os Belaru s Belize Eritrea Guyan a Hondu ras Sierra Leone Solomo n Islands Sri Lanka Burkina Kuwai Faso4 t Camer Libya oon5 Lesoth o Namibi a Malawi Cape Verde Moroc co Nepal Sierra Leone Surina me Central African Rep. 5 Swazil and Tajikista n Trinidad and Tobago Turkme nistan Chad5 Russi an Feder ation Samo a Tunisi a United Arab Emirate s Venezu ela, Rep. Bolivari ana de Vietna m Yemen, Rep. of Comor os Congo, Rep. of5 Côte d'Ivoire 4 Croatia Denma rk3 Equato rial Guinea 5 Jordan Kazak hstan Leban on Malawi Maldiv es Mongo lia Zimbab we Gabon 5 Guinea Bissau4 Latvia3 Maced onia, FYR Mali4 Niger4 39 Rwand a Netherl ands Antilles Oman Seneg al4 Togo4 Qatar Rwand a Saudi Arabia Pegged exchang e rate within horizont al bands (3) Crawlin Bolivia g peg (8) China Ethiopi a Iraq Nicara gua Uzbeki stan Crawlin Costa g band Rica (2) Manage Cambo d dia floating with no Kyrgyz preRep. determi Lao ned P.D.R. path for Liberia the exchang Maurit e ania rate (44) Mauriti us Myan mar Ukrain e Slovak Rep.3 Syria. Tonga Botsw ana Iran, I.R. of. Azerb aijan Algeri a Singa pore Vanua tu Afghani Armen stan, ia6 I.R. of Burundi Colom bia Gambi Ghan a, The a Georgi Guate a mala Guinea Indon esia Haiti Peru Jamaic a Kenya Roma nia Serbia 6 40 Domini can Rep. Egypt India Malay sia Pakist an Parag uay Madag ascar Thaila nd Moldov a Mozam bique Urugu ay Nigeria Papua New Guinea São Tomé and Príncip e Sudan Tanzan ia Ugand a Zambia Indepen dently floating (40) Albani a Luxemb ourg7 Austra lia Austri a7 Belgiu m7 Malta7 Mexico Netherl ands7 Brazil New Zealan d Canad Norway a Chile Philippi nes 41 Cypru s7 Czech Rep. Poland Finlan d7 Franc e7 Sloveni a7 South Africa Portuga l7 Congo , Dem. Rep. of Japan Somali a8 Switze rland United States Germ any7 Spain7 Greec e7 Hunga ry Icelan d Swede n Turkey United Kingdo m Irelan d7 Israel Italy7 Korea, Rep. of Source: IMF (2009) 1/ Includes countries that have no explicitly stated nominal anchor, but rather monitor various indicators in conducting monetary policy 2/ The member participates in the Eastern Caribbean Currency Union 3/ The member participates in the ERM II 4/ The member participates in the West African Economic and Monetary Union 5/ The member participates in the Central African Economic and Monetary Community 6/ The central bank has taken preliminary step toward inflation targeting and is preparing for the transition to full-fledged inflation targeting 7/ The member participates in the European Economic and Monetary Union 8/ As of end-December 1989 42