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CS/TCM/SEMINAR/TMMP/I/8 Page 1 Distr. LIMITED CS/TCM/SEMINAR/TMMP/I/8 October, 2006 Original: ENGLISH COMMON MARKET FOR EASTERN AND SOUTHERN AFRICA Seminar on Transmission Mechanism of Monetary Policy Lusaka, Zambia 9 – 11 October 2006 REPORT OF THE SEMINAR ON THE TRANSMISSION MECHANISM OF MONETARY POLICY 06 (cm) CS/TCM/SEMINAR/TMMP/I/8 Page 2 INTRODUCTION 1. The Ninth Meeting of the COMESA Committee of Governors of Central Banks which was held in November, 2004 in Lusaka, Zambia, decided that COMESA should organise seminars on monetary policy, in order to enable member countries to implement appropriate monetary policy mix that minimises interest rate and exchange rates volatilities and contribute to economic growth and development. 2. In compliance with this decision, the COMESA Secretariat organised a seminar on monetary policy from October 10 to 14 2005 in Swaziland, under the theme of “The Conduct of Monetary Policy for Economic Development and Integration.” 3. The 10th Meeting of the COMESA Committee of Governors of Central Banks which was held in November, 2005 in Bujumbura, Burundi, decided that a seminar on the transmission mechanism of monetary policy be held in 2006, in order to enable member countries to share experiences. Based on the decision, this Seminar was held from October 9 to 11, 2006, in Lusaka, Zambia. A. ATTENDANCE, OPENING OF THE MEETING, ADOPTION OF THE AGENDA AND ORGANISATION OF WORK 4. The meeting was attended by officials from the Central Bank of Burundi, Central Bank of Egypt, Central Bank of Kenya, Reserve Bank of Malawi, Bank of Mauritius, Central Bank of Madagascar, National Bank of Rwanda, Bank of Sudan, Bank of Uganda, Bank of Zambia and Ministry of Economic Development of Zimbabwe. (The list of participants is in annex I) Opening of the Meeting (Agenda item 1) 5. Dr. Charles L. Chanthunya, Director of Trade, Customs and Monetary Affairs made a statement on behalf of Mr. Erastus J.O. Mwencha, the Secretary General of COMESA. In his statement, he stressed the importance of creating wealth that is based on structural transformation and economic diversification, savings and investment growth, export growth and conversion of comparative advantage into knowledge based competitive advantage. He stated that one of the policy instruments needed to support structural transformation of the economies of COMESA member countries, is monetary policy. He said that, the basic goals of monetary policy in the statutes of most central banks is to promote price stability in support of sustainable economic growth and employment. 6. He pointed out that, even though monetary policy cannot affect either output or employment in the long run, it can affect them in the short run. He, therefore, underscored the fact that, it is necessary to understand the channels of the transmission mechanism of monetary policy. He said, distinguishing the relative importance of various channels of monetary transmission is useful for the following reasons: First, understanding which financial aggregates are impacted by policy would improve the understanding of the links between the financial and real sectors of the economy. Second, a better understanding of the transmission mechanism would help policy makers interpret movements in financial aggregates more CS/TCM/SEMINAR/TMMP/I/8 Page 3 precisely. Finally, more information about the transmission mechanism might lead to a better choice of targets. Adoption of the Agenda and Organisation of Work (agenda Item 2) 7. The meeting adopted the following agenda: 1. Opening of the Meeting 2. Adoption of the Agenda and Organisation of Work 3. Transmission Mechanism of Monetary Policy-Conceptual Framework 4. Experience of Transmission Mechanism of Monetary Policy in: (i) (ii) (iii) (iv) (v) (vi) Kenya Egypt Zambia Mauritius Malawi Madagascar 5. Monetary Policy Transmission Mechanism in Emerging Economies 6. Monetary Policy Transmission Mechanism: Operating and Intermediate Targets 7. Any Other Business 8. Adoption of the Report and Closure of the meeting. 8. The meeting agreed on the following hours of work: Morning Afternoon 09:00 – 13.00 hours 14.30 -17.00 hours B. ACCOUNT OF PROCEEDINGS Transmission Mechanism of Monetary Policy-Conceptual Framework (agenda item No. 3) 9. Mr. Zeidy of the COMESA Secretariat, made a presentation under this agenda item. In his presentation he highlighted the following points: In conducting monetary policy, most central banks have the goal of price stability in support of stable economic growth. In trying to reach this goal, the central bank use monetary policy instruments, among others, reserve requirements, discount rate, and open market operations. CS/TCM/SEMINAR/TMMP/I/8 Page 4 Because there are several steps between monetary policy instruments and the ultimate behavior of prices and economic activity and because these steps often can’t be predicted accurately, central banks use intermediate targets called indicators. The most frequently used intermediate targets are: money supply, and interest rates. The main channels of monetary transmission mechanism include: interest rate channel, exchange rate channel, other asset prices effect and the money and credit channel 10. He then elaborated on how monetary policy is transmitted through each channel as follows: The interest Rate Channel Tight monetary policy for example through an increase in discount rate makes borrowing through the discount window more costly. If banks reduce their borrowing in response to a higher discount rate, the monetary base falls. The decrease in monetary base leads to a reduction in money supply. This leads to a general rise in interest rates. This leads to reduction in aggregate demand, via reduced investment and consumption expenditure The Credit Channel A tightening of monetary policy reduces bank reserves. With fewer deposits on hand, banks have a smaller quantity of funds available to lend. As banks cut back their lending, borrowers who depend on bank for credit are unable to obtain credit they need to make planned purchases. The resulting decline in spending depresses aggregate demand and thus economic activity. On the demand side of the credit market, tight monetary policy has the effect of making potential borrowers less eligible for loans or less eligible for loans. E.g. a firm that has a substantial amount of floating rate debt. If tightening of monetary policy raises interest rates, the firm’s interest rate costs will rise, reducing its profitability. The firm’s reduced profitability makes lending to the firm riskier, so the firm will have problem of obtaining credit. Alternatively, a consumer who wants to use some shares of stock that he owns as collateral for bank loans. Tight monetary policy reduces the value of those shares (as financial investors, lured by higher interest rates, switch from stocks to bonds). With reduced collateral, the consumer will be able to borrow less. The reduction in credit available to the borrower is likely to lead to reduced spending and thus a weaker economy. Exchange Rate Channel Tightening of monetary policy strengthens the real exchange rate. A stronger real exchange rate, by making domestic goods more expensive for foreigners and foreign goods cheaper for domestic residents, reduces the demand for CS/TCM/SEMINAR/TMMP/I/8 Page 5 the home country’s net exports. All else being equal, this reduced demand for net exports reduces aggregate demand, depressing output and prices. 11. He also discussed how the impacts of a change in monetary policy instrument (e.g. the short term interest rate or base money) on intermediate variables (such as broad money or domestic credit) and final objectives (output and inflation) are examined by using VARs (Vector Autoregressive Model). 12. He highlighted the following challenges for Transmission Mechanism of Monetary Policy in developing economies: The effectiveness of monetary policy guided by quantitative targets depends not only on the stability of the demand for money function, but also on the closeness of the relationship between monetary aggregates and ultimate target of inflation. In a rapidly changing environment it is indeed very difficult to identify with precision the channels through which monetary policy affects the economy. The remarkable development of the financial system in recent years has provided the business community with a much wider array of financing alternatives. Business community in many countries are now able to avail themselves of a great diversity of products offered by finance companies and other non-bank financial institutions which have experienced very rapid growth in recent years. The growing trend of securitisation has also led to a greater marketability and liquidity of every type of economic activity or transaction. Country Experiences on Transmission Mechanism of Monetary Policy (Agenda item No. 4) (i) Kenya 13. Dr. Benjamin O. Maturu discussed the evidence on monetary policy transmission mechanism in Kenya. He observed that apart from identifying excess money supply as the main cause of inflation, there is need to understand the nature of the causal relationship between money and inflation. The basic question therefore is: how does money influence inflation? More specifically, one needs to answer the following questions. 1. By how much does inflation fall following a specified amount of reduction in money supply? 2. Does the influence of a change in money supply/policy rate on inflation occur immediately or gradually? 3. Is the influence of a change in money supply/policy rate on inflation temporary or permanent? 4. What is the sequence of events starting with a change in the value of the monetary policy-operating instrument to a change in inflation? 5. Alternatively, what are the channels of monetary policy transmission mechanism? CS/TCM/SEMINAR/TMMP/I/8 Page 6 14. He informed the meeting that while evidence continued to increase, the study findings on transmission mechanism are not amenable to generalized application across countries because of varied socio-economic structures among countries. With rapid socio-economic transformation, especially in the financial sector, even countryspecific evidence is quickly rendered obsolete. The best way forward, therefore, is to carry out studies on monetary policy transmission mechanism within each country for more specific and relevant results. These results should however be reviewed regularly to keep pace with socio-economic transformations. Consistently, the Central Bank of Kenya has been studying monetary policy transmission mechanism in Kenya leading to the preliminary results shared at the seminar. 15. He informed the meeting that, the conduct of monetary policy in Kenya is within the context of a monetary targeting policy operating framework. Reserve money is the operating target, money supply, the intermediate target and inflation the ultimate target. He observed that under this framework, it is expected that changes in reserve money are fully and quickly reflected in corresponding changes in money supply. Similarly, the policy-induced changes in money supply are expected to fully and quickly influence inflation. Thus, a change in reserve money causes a liquidity effect that induces the cost-of-capital effect that in turn influences demand, supply and then inflation. The effect on inflation arising from a change in money supply need not necessarily be direct. 16. He informed the seminar participants that the evidence on transmission mechanism of monetary policy in Kenya is derived using vector autoregressive analysis and simulations carried out on the Bank’s macroeconomic model. The Structural VAR model results show that the traditional money channel is not operational since the liquidity effect is insignificant, thereby, precluding the existence of the cost-of-capital effect. Besides, only 40% of the policy signal released as a shock to reserve money is delivered to broad money supply that is the intermediate target while only 43% of the policy signal released as a shock to broad money supply is directly delivered on overall inflation. 17. In contrast, the repo rate significantly influences inflation, at the very earliest, in the 5th month while the largest significant impact occurs in the 13th through the 18th month. Accordingly, the implied monetary policy transmission lag in Kenya is 13 to 18 months which compare well with the results derived from simulations using the Central Bank Macroeconomic model whereby the peak impact of monetary policy change on inflation occurs in the 19-20 months. 18. The vector auto-regressive and macroeconomic model simulation results show that the exchange rate responds to monetary policy changes in a theoretically consistent manner whereby monetary tightening leads to an appreciation of exchange rate and a reduction in inflation. 19. Dr Maturu further, argued that while the vector auto-regressive results do not cover analysis of the operational status of the expectations channel, indications are that the expectations channel operates, too. He cited Maturu, Kethi and Maana (2006) that fits Kenyan data to the New Keynesian Phillips Curve model of the inflationary process to establish that 60% of the firms that adjust their prices exercise a forward-looking expectation scheme while only 40% are backward-looking. CS/TCM/SEMINAR/TMMP/I/8 Page 7 Moreover, preliminary work on Central Bank credibility show that the credibility parameter estimate is significant. These results imply that economic agents including consumers and investors anchor their expectations about inflation on the inflation target pursued by the Bank as a sufficiently good indicator of future inflation. Consistently, the agents are responsive to monetary policy changes and the expectations channel of monetary policy transmission is operational. 20. Dr. Maturu concluded that the interest rate and the exchange rate channels of monetary policy transmission are the most effective. These channels are re-enforced by the bank-lending channel. The traditional money channel is not operational since the liquidity effect is insignificant thereby precluding transmission to the cost-ofcapital that would have in turn induced a change in aggregate demand and inflationary pressures. There are indications also that the expectations channel is operational in Kenya. 21. The policy implication of the results is that an interest rate monetary policyoperating framework would be more effective in transmission of monetary policy. Ongoing research on monetary policy transmission mechanism and building a macroeconomic model for policy analysis and forecasting are good steps towards adoption of a policy framework based on an interest rate operating framework. (ii) Egypt 22. Mrs. Samia Torky of Central Bank of Egypt presented a paper on the experiences of the Central Bank of Egypt on implementation and transmission mechanism of monetary policy. She informed the seminar participants, the following on the experiences of the Central Bank of Egypt in implementation of monetary policy: (a) Institutional Features The Central Bank of Egypt (CBE) is no longer under the supervision of any government Ministry, but it directly reports to the President, which enabled CBE to be more independent. By the new Law issued in 2003, the CBE is responsible for design and implementation of monetary policy. The Law also states that the ultimate target for monetary policy is price stability. The government announced its intention to apply inflation targeting, when fulfilling the prerequisites. The co-coordinating Council has been established in 2005, chaired by the Prime Minister. The members include: some experts who have experience in international organizations. The Council is responsible to coordinate the fiscal and monetary policies. The Monetary Policy Committee (MPC) has been established with in the members of the Board of Directors of CBE, chaired by the Governor. The MPC meets according to a pre-announced schedule. It makes decisions on the policy rates and communicates immediately after each meeting to the market. CS/TCM/SEMINAR/TMMP/I/8 Page 8 The Monetary Policy Unit (MPU) has been separated and is under the supervision of the Deputy Governor and is supported by high officials. (b) The Operational Framework The operational framework applied by CBE since June 2005 includes the following: The operational target for CBE is the overnight inter-bank rate. The set of instruments used are the following: (1) Open Market Operations (OMO) are the main operations carried out on a weekly basis. Long term operations are carried out once a month for three months. Fine tuning operations are carried out to cover the liquidity shocks and forecasting errors. (2) Reserve requirements: This is 14% of total deposits after excluding the savings certificates, which mature in three years and more. The maintenance period is two weeks and the averaging mechanism is used.. (3) Standing facilities: These are overnight deposit facility and overnight lending facility. The instruments are used using the corridor system with two overnight facilities. The deposit rate represents the floor of the corridor rates and the lending rate is it’s upper boundary. The benefits of the new framework are steering the short term interest rates, lowers volatility in interest rates and excess liquidity, in addition to increasing the volume of interbank activities. (4) Liquidity forecasting is a very important element in conducting monetary policy. (5) Communication and transparency are also very important elements in conducting monetary policy. 23. Mrs. Torky informed the participants that the transmission of monetary policy in Egypt is affected by the level of development of the money market, the liquidity position of banks and government operations. (iii) Zambia 24. Dr. Noah Mutoti of Bank of Zambia presented a paper on the transmission of monetary policy in post-liberalized Zambia, corresponding to monetary targeting. He informed the meeting that, in developing countries, especially Sub-Saharan very little is known about issues central to underlying monetary policy. In particular, how the economy responds to shocks, the relative importance of various transmission channels, the magnitude and timing of monetary policy effects and the effectiveness of various policy instruments are less understood. Recently, however, with the deregulation of financial markets and monetary policy becoming more oriented towards market-based operations, there has been increased interest in understanding the working of such economies. Contributing to this growing literature, CS/TCM/SEMINAR/TMMP/I/8 Page 9 his article examines the transmission of monetary policy in post-liberalized Zambia, focusing on the role of money and exchange rate. 25. He informed the meeting that, facing rising inflation in early 1990s, as part of International Monetary Fund (IMF) /World Bank-supported reforms, Zambia adopted monetary targets as a guide to monetary policy. During the early years of this regime, inflation abated and declined to unprecedented levels not seen in more than two decades. Annualized consumer price (CPI) inflation, consistently in 3 digits in the last half of 1980s, broke at the end of 1994, falling sharply to about 54 % and subsequently to below 20 % at end1997. With CPI inflation stuck within the 17–30% range between 1998 and 2005, the disinflation process seemed to have stalled. Recently, CPI inflation has assumed a remarkable downward trend, declining to single digit, 9.4%, in April 2006 for the first time in 30 years. At the end of the first half of 2006, it declined further to 8.5% and three months later to 8.2%. He stated, therefore, that the question of the effects of money-supply and money-demand shocks in consumer price formation is highly relevant. With the advent of flexible exchange rates, the role of exchange rate shocks in output and inflation dynamics is also of great empirical interest, especially that the exchange rate has been quite volatile. As effective monetary policy implementation requires, inter alia, the monetary authority developing a reasonably clear view of the major shocks that influence the economy, an investigation of how the domestic economy responds to aggregate supply, IS and foreign shocks is also deemed vital. He explained that these questions were addressed by means of a structural vector error correction model (SVECM). 26. In his study, he concluded that the impact of money supply shocks on Zambia’s output is little and temporary. Output volatility is mainly associated with aggregate supply and IS shocks, the latter more pronounced in the short run. Money supply shocks also hardly explain Zambia’s consumer price inflation. Further, though the money demand is relatively stable, the role of money-demand shocks in consumer price developments is only pronounced in the short run. What underlay most consumer price movements are aggregate supply and exchange rate shocks. With monetary policy found to have generally served to dampen inflationary pressures induced by exchange rate shocks, support is given to exchange rate as a plausible channel of transmission. 27. He drew policy implications from two key observations. First, though a positive monetary policy shock leads to a sharp and persistent rise in money supply, a strong consumer price response is only recorded in the initial period. Second, money demand is stable and yet the role of money demand shocks in consumer price is only pronounced in the short run. These suggest a weakened link between money and inflation, giving rise to situations where getting the monetary target does not produce the desired inflation outcome and where money fails to produce reliable signals of the stance of monetary policy. Since food price has the largest share in CPI and the dominant role of exchange rate in inflation dynamics established, sustaining lower inflation in Zambia requires policies meant at boosting domestic food supply and stabilizing exchange rate. CS/TCM/SEMINAR/TMMP/I/8 Page 10 (iv) Mauritius 28. Mr. Bissessur of Bank of Mauritius highlighted the transmission mechanism of monetary policy in Mauritius. He elaborated on the monetary policy implementation that was pursued by Bank of Mauritius in the last two decades. He added that according to the Bank of Mauritius Act 2004, the primary objectives of the Bank of Mauritius are to maintain price stability and to promote orderly and balanced economic growth. The Bank is also required to regulate credit and currency in the best interests of the economic development of Mauritius and to ensure the stability and soundness of the financial system of Mauritius. 29. Regarding the transmission channels of monetary policy, he noted the following : (a) Exchange Rate Channel (b) Inflation in Mauritius is determined by both domestic and external factors. When the Bank of Mauritius changes the Lombard Rate, exchange rates are also affected. However, the impact of monetary policy on exchange rate did not provide conclusive results. Nonetheless, the exchange rate channel must operate in Mauritius, especially as Mauritius is a small open economy. The pass-through from exchange rate changes to consumer prices is estimated at around 0.4. That is, a one per cent change in the exchange rate brings about a 0.4 per cent change in the rate of inflation. Interest rate channel .When the Bank changes the Lombard Rate, which is the rate that is used to signal the monetary policy stance, banks’ lending and deposit rates are affected, with banks adjusting their prime lending rate and savings deposit rate accordingly. Since lending rates and term deposit rates are linked to the prime lending rate and savings deposit rate, they are also affected accordingly. Then, short-term interest rates and other interest rates in the economy are affected. The exchange rate of the rupee is also influenced following the change in the Lombard Rate. Interest rates and exchange rates affect aggregate economic activities (aggregate demand and supply), and finally, the changes in aggregate demand and supply affect inflation. The efficacy of the mechanism depends largely on the Bank’s ability to control the liquidity position of the banking sector. The liquidity forecasting exercise involves estimating the next day’s liquidity position of the banking sector and also, the weekly average level of liquidity in the banking system based on the maintenance week for the cash reserve ratio. Based on this information, the Bank decides on the level of intervention that is needed to inject more liquidity or remove liquidity from the market. The intervention is conducted through open market operations. Changes in lending rates affect the cost of capital in the economy and have an impact on cash flow, thereby affecting the propensity to save. A welldeveloped financial market is essential to ensure the transmission of policy at this stage. Interest rates and exchange rate are also affected by factors other than the very short-term interest rates. In particular, government budgetary CS/TCM/SEMINAR/TMMP/I/8 Page 11 considerations and the underdevelopment of financial markets have a significant influence on other interest rates, while the international economic environment affects the exchange rate. He stated that the transmission of changes in interest rates and the exchange rate to aggregate demand and supply takes place through changes in the cost of capital, changes in inter-temporal substitution, and wealth effects. The cost of capital affects the purchases of durable goods, investment in housing, business investment in plant and equipment, and inventory holdings. A rise in interest rates reduces the present value of any expected income stream and tends to lower present consumption. Changes in the exchange rate affect the price of goods, thus affecting the supply and demand. A rise in the real exchange rate shifts demand from local goods to imports thus affecting the aggregate demand. Following a change in interest rates, the wealth effect and substitution effect change current expenditure on consumption. For instance, for a lender, the fall in interest rate will lower his interest income, thereby adding an income effect on current consumption. On the supply side, since firms usually finance most of their working capital through loans, higher interest rates will affect their activities through the cost of funds. Changes in the exchange rate affect aggregate supply through changes in competitiveness. In the final stage of the mechanism, changes in aggregate demand affect inflation and expected inflation, through increasing or decreasing the slack in demand in relation to long run output level. c) Bank Portfolio Channel H Hee iinnffoorrm meedd tthhee sseem miinnaarr tthhaatt aannootthheerr ppiieeccee ooff eevviiddeennccee rreeggaarrddiinngg tthhee m moonneettaarryy ttrraannssm miissssiioonn m meecchhaanniissm m iinn M Maauurriittiiuuss iiss pprroovviiddeedd tthhrroouugghh tthhee bbaannkk ppoorrttffoolliioo aapppprrooaacchh.. H Heerree,, bbaannkkss’’ rroollee iinn tthhee m moonneettaarryy ttrraannssm miissssiioonn pprroocceessss tthhrroouugghh iinntteerrm e d i a t i o n a n d f a c i l i t a t i n g m o n e t a r y l e n d i n g a n mediation and facilitating monetary lending andd bboorrrroow wiinngg iiss hhiigghhlliigghhtteedd.. TThhee ttrraannssm miissssiioonn ooff m moonneettaarryy ppoolliiccyy tthhrroouugghh bbaannkk aasssseettss,, tthhee ccrreeddiitt cchhaannnneell,, oorr tthhrroouugghh tthheeiirr lliiaabbiilliittiieess,, tthhee m moonneeyy cchhaannnneell,, aarree uussuuaalllyy iinntteerrttw wiinneedd,, aass iinnccrreeaasseess iinn bbaannkk rreesseerrvveess ffoollloow wiinngg aann eexxppaannssiioonnaarryy m o n e t a r y p o l i c y t y p i c a l l y l e a d s t o i n c r e a s e s i n b o monetary policy typica ly leads to increases in botthh m moonneeyy aanndd ccrreeddiitt.. Q Quuaarrtteerrllyy ddaattaa hhaavvee bbeeeenn uuttiilliisseedd ttoo eexxaam miinnee tthhee ttrreenndd bbeettw weeeenn m moonneeyy ssuuppppllyy ((M 2 ) , w h i c h r e p r e s e n t s m o n e t a r y p o l i c y , a n d m a c r o e c o n o m i c M2), which represents monetary policy, and macroeconomic vvaarriiaabblleess lliikkee tthhee nnoom miinnaall eexxcchhaannggee rraattee aanndd G GD DP P ggrroow wtthh rraattee.. W Whhiillee aa ppoossiittiivvee ccoorrrreellaattiioonn bbeettw e e n m o n e y s u p p l y g r o w t h a n d p r i v a t e s e c t o r g ween money supply growth and private sector grroow wtthh eexxiissttss,, nnoott m muucchh ccaann bbee ddeedduucceedd ffrroom m tthhee ccoorrrreellaattiioonn bbeettw weeeenn m moonneeyy ssuuppppllyy ggrroow wtthh aanndd cchhaannggeess iinn tthhee nnoom miinnaall eexxcchhaannggee rraattee aanndd oorr tthhaatt bbeettw weeeenn m moonneeyy ssuuppppllyy ggrroow wtthh aanndd ggrroow t h i n n e t c r e d i t t o g o v e r n m e n t . wth in net credit to government. H Hee ssaaiidd,, tthhiiss cchhaannnneell hhaass aallssoo bbeenneeffiitteedd ffrroom m tthhee iinntteennssiiffiieedd rreegguullaattoorryy aanndd ssuuppeerrvviissoorryy aaccttiivviittiieess ooff tthhee B Baannkk rreecceennttllyy.. TThhee B Baannkk hhaass ffooccuusseedd eexxtteennssiivveellyy oonn iim p r o v i n g t h e b a l a n c e s h e e t p o s i t i o n s o f b a n mproving the balance sheet positions of bankkss aanndd iinn tthhiiss pprroocceessss,, nnoonn-ppeerrffoorrm miinngg llooaannss hhaavvee ccoom mee ddoow wnn.. CS/TCM/SEMINAR/TMMP/I/8 Page 12 30. (v) Mr. Bissessur made the following conclusions (i) To successfully conduct monetary policy, the central bank needs to have a good assessment of the timing and magnitude of the impact of the policies on the economy. Consequently, an understanding of the channels of transmission mechanism is vital. (ii) A good payment system as well as sound banking sector are essential for the transmission mechanism to work. (iii) The monetary transmission mechanism in Mauritius is about to undergo some significant changes as the Bank is moving away from targeting reserve money towards targeting the overnight interbank interest rate. A new monetary policy framework is in process. A key Repo rate will be used to signal the monetary policy stance of the Bank, instead of the Lombard Rate, as has been the case hitherto. With banks used to moving interest rates in accordance with changes in the Lombard Rate, the monetary transmission mechanism is expected to operate through the interest rate channel. This is because the key Repo rate, as the price of a significant source of funds to banks than was the Lombard Rate, will be much more closely connected to other short-term market interest rates. (iv) Nonetheless, because the supply of reserve money will be varied as required to keep the overnight interbank rate near the key Repo rate, the money channel should continue to be important. Moreover, Mauritius being a small open economy, the exchange rate channel is also expected to prevail. Malawi 31. Mr Milner of the Reserve Bank of Malawi presented a paper on Monetary Policy and Transmission Mechanism in Malawi. He highlighted the following: (a) Monetary Policy in Malawi Until the late 1980s, Malawi’s monetary policy regime was characterized by extensive controls, ranging from direct credit and interest rate ceilings to controls on foreign exchange allocation From 1987 into the 1990s, Malawi embarked on policy reforms that led to the replacement of most of the controls with indirect, marketoriented instruments The reforms eased entry of banks into the market and, therefore, ushered in new financial institutions The banking supervision function was moved to the central bank and was enhanced to include prudential issues Malawi started practicing a more active monetary policy in pursuit of the price stability objective Currently Malawi is pursuing a monetary targeting regime, under which the broad money stock (M2) is the nominal anchor while net domestic assets (NDA) of the monetary authorities is the operating target CS/TCM/SEMINAR/TMMP/I/8 Page 13 (b) A Monetary Policy Committee was instituted in February 2000 in order to enhance efficiency and transparency in the formulation and conduct of monetary policy Monetary Policy Transmission in Malawi Little analytical work has been done on monetary transmission mechanism in Malawi. However, results from a VAR-based analysis that was presented indicated that: - the exchange rate is the most important channel of transmission - the interest rate channel is not that important - results for the money and credit channel are inconclusive 32. He therefore outlined the following major challenges for the study of the monetary transmission mechanism in Malawi: (a) A low level of monetization of the economy, which is associated with the existence of parallel credit and foreign exchange markets. Thus, modeling the transmission mechanism in the traditional way would only produce spurious results. It is therefore necessary to incorporate these parallel structures in the transmission mechanism model; (b) Domestic demand is insensitive to interest rate changes. While it is important to model this, disaggregated data to enable analysis of various demand components does not exist; (c) Future work on the monetary mechanism in Malawi should take into account the fact that the exchange rate has become a major influence on economic activity and inflation in recent times; (d) The low level of competition in the banking industry is a constraint on the effectiveness of the credit channel; and (e) The envisaged monetary union will, among other things, entail loss of independent monetary policy for member countries and the resultant reduction/amelioration in importance of some transmission channels. In that regard, the following issues have to be considered: the likely impact of such dynamics on the effective operation of monetary policy; implication of differences in transmission mechanisms among member countries; and appropriateness of monetary policy against a background of differences in the speed of adjustments owing to diverse conditions in different countries. 33. He concluded by stating that a lot of work needs to be done to unravel the monetary transmission mechanism in Malawi to better inform policy makers on the timing and effects of monetary policy. The econometric study that was undertaken points to a weak transmission mechanism. In order to come up with better coefficients, the above-mentioned challenges have to be addressed. Studying the monetary transmission is a data intensive exercise and calls for concerted efforts to gather that information. CS/TCM/SEMINAR/TMMP/I/8 Page 14 (vi) Madagascar 34. Mr. RAZAKAMANANTSOA of Central Bank of Madagascar presented the operation and transmission of monetary policy in Madagascar. He highlighted the following to the seminar participants: Interest rate channel is inefficient. Deposits rate are very low even though central bank rate significantly increases Lending rate automatically adjusts when Central Bank raises its rate. Most loans are however, concluded with a fixed interest rate. The amount of the credit (in real terms) did not decrease significantly after the Central Bank discount rate had risen. The Treasury bill rate seems to be used as a reference rate instead of the central bank discount rate. The interest rate channel is inefficient because of the importance of the fixed rate on loans and lack of competitiveness of the banking system, The high level of Treasury bill rate weakens liquidity operations which are made to avoid sudden devaluation of local currency. In order to improve the transmission mechanism of monetary policy the following policies were recommended: - Improve competitiveness of the banking ; - Decrease short term Treasury bill rates step by step. - The Central Bank should not only pay attention to inflation and devaluation but also to production. Transmission of Monetary Policy in Emerging Economies (agenda item 5) 35. Dr. Noah Mutoti of Bank of Zambia presented a paper on the Transmission Mechanism of Monetary Policies in Emerging economies, written by Steven Kamin, Philip Turner, and Jozef Van’t dack . 36. He informed the meeting that there are two important aspects that have to be considered in evaluating how fast monetary policy affects the real economy. The first is the transmission from instruments directly under the central bank’s control, e.g. short-term interest rates or reserve requirements to those variables that most directly affect conditions in the non-financial sector- loan rates, deposit rates, asset prices and the exchange rates. This linkage is determined primarily by the structure of the financial system. The second aspect is the link between financial conditions and the spending decisions of households and firms. In this regard, the initial financial position of households, firms and banks is likely to play a key role, including the extent of leveraging, the composition and currency denomination of assets and liabilities, and the degree of dependence upon external financial resources, in particular bank financing. 37. He stated that both aspects of the monetary transmission channel are likely to have been affected by the process of financial liberalization in many countries in the past decade. The reduced role of the government in the financial system has lessened the importance of the credit availability channel compared with the interest CS/TCM/SEMINAR/TMMP/I/8 Page 15 rate channel. The increased fragility of the financial sector in the wake of financial liberalization may have accentuated other aspects of the credit channel. At the same time, the opening and deepening of financial systems in emerging market countries has caused both the assets and the liabilities side of the private non-financial sector’s balance sheet to become more diversified, there by enhancing the role of asset prices, in particular the exchange rate, in the monetary transmission process. 38. He then outlined the four important aspects of the monetary transmission process where uncertainties and/or disagreement are especially deep, namely: (i) the transmission of monetary policy actions to long term interest rates and asset prices; (ii) gauging the tightness of monetary conditions, (iii) The scope for monetary policy under fixed exchange rates and financial fragility, and (iv) the effects of monetary policy in high inflation economies. In all cases, the state of expectations very largely conditions the impact of monetary policy, and it is this which gives rise to the uncertainties. 39. He proposed that there is need to undertake research on the following unexplored topics. 1. The conduct and transmission of monetary policy in a partially dollarised financial system; 2. Sectoral response of demand to monetary policy shocks in developing countries. Monetary Policy Transmission Mechanism: Operating and Intermediate Targets (agenda item No. 6) 40. Dr. Michael Antigi-Ego of Bank of Uganda made a presentation under this agenda item. He highlighted the following to the seminar participants: In the long run, monetary policy has no effect on output. In the short run monetary policy has real effects on output and employment The pursuit of final goals of monetary policy rests on a series of choices or strategy, which in turn depends on: The structure of the economy and financial markets Information set used as a basis for short term and long term policy adjustments; and Weights and specific roles attached to various economic variables. World over, price stability is a core objective in most central banks. Deep and well functioning financial markets affect the speed and impact of monetary policy on aggregate demand, output and eventually inflation in the economy. Well functioning financial system, therefore, are important CS/TCM/SEMINAR/TMMP/I/8 Page 16 for implementation of monetary policy, thus, financial sector stability as well concerns central banks . But implementation of monetary policy would also influence financial markets in other ways – the reason why central banks have remained major stakeholders in ensuring financial stability. 41. He explained that an increase in Policy/official interest rates is more effective in reducing inflation where: The broader interest rate spectrum and exchange rate is sensitive to the changes in policy/official rates Residents’ demand for domestic net liabilities and foreign demand for domestic assets are sensitive to changes in interest rates; Financial liabilities are large relative to GDP; and The country’s net financial liabilities increase 42. He underscored that the effects of monetary policy will be much greater in an economy where there is macroeconomic stability, and credibility and consistency in monetary policy. Monetary policy commitment to macroeconomic stability is key in influencing expectations of economic agents, hence their savings and investment decisions, thus AD and inflationary expectations. 43. He pointed out that the exogenous shocks namely, fiscal shocks, developments in global economy, commodity prices, and weather complicate the transmission mechanism of monetary policy: Changes in an economy, say through economic liberalization, financial sector reforms; have had implications for the transmission of monetary policy. This calls for continuous study of how monetary shocks are transmitted into prices. However, precise impact of monetary policy on expectations is difficult to ascertain and probably varies from time to time. 44. Dr. Antigi-Ego also explained that transmission of monetary policy in developing countries like COMESA region would be characterized with lags and uncertainties as to which avenue has been utilized. Hence, strategic issues for monetary authorities to facilitate implementation of monetary policy include: choice of operational target, intermediate targets and indicators. He stated that operational target should share a close and predicable relationship with the intermediate target. Common examples are: base money, reserves and short term interest rates. In the COMESA region, base money is most commonly used as operating target. He emphasized that the intermediate variable should have a close and predictable underlying relationship with inflation, the final goal. Where monetary aggregates are used as an intermediate targets there should be a stable money demand function. At best, monetary policy must be able to guide the intermediate variable towards its target 45. He further explained that the choice of intermediate target is the determinant of the monetary policy regime or framework for implementation of monetary policy. He stated that, historically monetary frameworks have been identified along the lines of: Monetary, Exchange rate, Interest rate, and Inflation targeting regimes. The most common framework of monetary policy is the monetary targeting framework in the COMESA region. CS/TCM/SEMINAR/TMMP/I/8 Page 17 46. He recommended the following policy actions to improve the conduct of monetary policy in the region: i. ii. iii. iv. v. vi. vii. viii. ix. x. xi. xii. Institutional and Structural Reforms in the Financial Sector; Examination of Money Multipliers and Income Velocity of Money in the COMESA member countries; commitment to avoiding excessive money creation, including for the financing of fiscal deficits; a high degree of political and instrument independence of central banks during the move toward monetary union, and for the common central bank thereafter. an improvement in financial sector soundness by strengthening and harmonising prudential regulation and supervision, reduce nonperforming loans, improve and harmonize the legal and judicial environment, allow cross-border flows of funds within the region, Put in place the necessary indirect instruments of monetary policy for effectively influencing market-determined interest rates in the region. Harmonize exchange arrangements vis third countries, including the existing regimes of regulatory controls for external capital transactions with countries outside the region. Increased capital account convertibility should be preceded by adequate progress in strengthening and harmonizing prudential regulations and supervision practices in the financial sectors. Prevent costly government bailouts of banks, reduce the high interest rates and spreads between the lending and deposit rates of banks, enhance the transmission of monetary policy effects, improve the prospects for regional capital mobility and intermediation, narrow the cross-country differentials in interest rates within the region. 47. He also recommended that the following policy measures should be in place during the transition period to monetary union in COMESA: need to maintain interest rate flexibility; promote greater stability in bilateral exchange rates, credibility and confidence in the process leading to the eventual fixity of these exchange rates. The decline in inflation supported by substantial reductions in the rates of growth of both reserve and broad money. Future policies seeking to control inflation need to be coordinated based on an understanding of its key determinants in each country, including differences in money demand that affect the velocity of money, and in the reserve money multiplier that affect supply The design of policies in support of monetary stability, should closely follow developments in the degree of monetization, a variable in which vary considerably in the COMESA region. public expenditure programs should aim at achieving the MDGs. CS/TCM/SEMINAR/TMMP/I/8 Page 18 When the stage of Exchange rate union is reached the (supra)/central bank needs to make various strategic decisions on how it is to proceed. Key among these are: the instruments and operating target the intermediate target variable and hence monetary policy regime. Undertake studies to understand the transmission mechanism of monetary policy. In the region. Recommendations of the Seminar 48. After an extensive discussions, the seminar agreed on the recommendations which are in paragraphs 46 and 47. 49. The seminar recommended that a comparative study on transmission mechanism of monetary policy in member States should be undertaken by the COMESA Secretariat. The study should identify weaknesses, differences and commonalities on the transmission process and make recommendations on how to achieve efficient transmission of monetary policiy given the target of price stability in each member country. Any Other Business (Agenda item No. vii) 50. No issues where raised under this agenda item. Adoption of the Report and Closure of the Seminar (Agenda item No. viii) 51. The seminar adopted the report with amendments.. 52. In closing the seminar, the Chairman thanked all delegates for their contributions. He emphasized the importance of networking in order to learn lessons from each other. He thanked COMESA Secretariat for organizing the seminar. 53. Dr. Charles L. Chanthunya, the Director of Trade, Customs and Monetary Affairs in COMESA also thanked the delegates for having come to the seminar and for their useful contribution. This he said, enabled participants to learn a lot of lessons from each other. He also thanked the interpreters and the Mulungushi Conference Centre. He wished all the delegates safe journey back home. CS/TCM/SEMINAR/TMMP/I/8 Page 19 LIST OF PARTICIPANTS/LISTE DES PARTICIPANTS BURUNDI Nkusi Rose Kamariza, Board Advisor, Banque de la Republique du Burundi, P O Box 705, Bujumbura; Tel: (257) 218244, Fax: (257) 223128; E-mail: [email protected] M. Augustin Riragendanwa, Responsable du services Caissier de l’Etat, Banque de la République du Burundi, B. P. 705, Bunjumbura, Tel: (257) 225811/225142, Fax: (257) 223128; E-mail: [email protected] KENYA Dr. Benjamini Ongwae Maturu, Assistant Director, Central Bank of Kenya (CBK), P.O. Box 60000, Nairobi; Tel: (254-20) 251710/2863204, Fax: (254-20) 214982; Email: [email protected] EGYPT Mrs. Samia Abd El-Wahab Ali Torky, Assistant Sub-Governor, Central Bank of Egypt, 31. Kasr El-Nil Street, Downtown, Cairo, Tel: (202) 3911051/2012, 2675083, Fax: (202) 3922875; E-mail: [email protected] or [email protected] MADAGASCAR Ms. Razakamanantsoa Lalaniaina Mamisoa Christian, Attaché de Direction, Banqué Centrale De Madagascar, B.P. 550, Antananarivo, Tel: (261) 202221751, Fax: (261) 202234532; E-mail: [email protected] or [email protected] Noromahefa Lala Harifetra, attaché De Direction, Banqué Centrale De Madagascar, B.P. 550, Antananarivo, Tel (261) 202221751, Tax: (261) 202234522; E-mail: [email protected] or [email protected] MALAWI Mr. Joseph L. G. Milner, Manager, Middle Office, Treasury Dept, Reserve Bank of Malawi, P.O. Box 30063, Lilongwe 3, Tel: (265-1) 770600, Fax: (265-1) 772752; Email: [email protected] MAURITIU/SMAURICE Mr. Jitendra Nathsingh Bissessur, Assistant Director, Research (Statistics), Bank of Mauritius, 29 Sir William Newton Street, Port Louise, Tel: (230) 2023987, Fax: (230) 2084638; E-mail: [email protected] CS/TCM/SEMINAR/TMMP/I/8 Page 20 Yandraduth Googoolye, First Deputy Governor, Bank of Mauritius, Sir William Newton Street, Port Louis, Tel: (230) 2023962, Fax: (230) 2120313; E-mail: [email protected] RWANDA Mr. Munyankindi Pascal, Head of Monetary Research, National Bank of Rwanda (Central Bank), P.O. Box 531, Kigali, Tel: (250) 574282, Fax: (250) 572551; E-mail: [email protected] Kasangwa Chantal, chef de section “Interventions sur le Marche Monetaire”, Avenue Paul VI, B.P. 531, Kigali, Tel: (250) 59142272/08504063, Fax: (250) 576197; E-mail: [email protected]; [email protected] SUNDAN/SOUDAN Ms. Salaheldin Sheikh Khidir, Director, Central Bank of Sudan, P.O. Box 313, Khartoum, Tel: (249) 183 781341/912985481, Fax: (249) 183 781341; E-mail: [email protected] Mr. Rehab El Sharief El Khatim Mohamed, Official Economist, Central Bank of Sudan, P.O. Box 313, Khartoum, Tel: (249) 0912247037, Fax: (249) 183 781341; Email: [email protected]/ [email protected] UGANDA/OUGANDA Dr. Michael Atingi-Ego, Research Director, Bank of Uganda, 37/43 Kampala Road, P O Box 7120, Kampala, Tel: 256 41 259866, Fax: 256 41 254760, E-mail: [email protected] ZAMBIA/ZAMBIE Dr. Noah Mutoti, Acting Assistant Director, Macroeconomic Analysis Division, Economics Department, Bank of Zambia, P O Box 30080, Lusaka, Tel: 260-1-228888, Fax: 260 -1221722, E-mail: [email protected] Mr. Mulenga Musepa, Senior Economist, Bank of Zambia, P.O. Box 30080, Lusaka, Tel: 228888, Fax: 221721; E-mail: [email protected] Mr. Jacob Lungu, Economist, Bank of Zambia, P.O. Box 30080, Tel: 228888, Fax: 221722; E-mail: [email protected] ZIMBABWE Ms. Melania Mujutywa, Economist, Ministry of Economic Development, P/B 7772, Causeway, Harare, Tel: 263 794571, E-mail: [email protected] CS/TCM/SEMINAR/TMMP/I/8 Page 21 COMESA SECRETARIAT Dr. Charles L. Chanthunya, Director, Trade, Customs and Monetary Affairs, E-mail: [email protected] Mr. Ibrahim Zeidy, Senior Monetary Economist, E-mail: [email protected] Mrs. Rosemary P. Manuwele, Secretary, E-mail: [email protected] Ms Loliwe Jere, Secretary, E-mail: [email protected] INTERPRETERS/INTERPRÈTES Mr. Paul Kaunda, Consultant, P.O. Box 320288, Woodlands, Lusaka, Tel: 097154715, Fax: 265831; E-mail: [email protected] Mr. John Licati Kabala, Manager, International Relations, ZAMPOST, P.O. Box 71845, Ndola, Tel: 095 717898, Fax: 02-614831; E-mail: [email protected] Mr. Douglas-Paul Kapenda, Zambia Alliance Française Director-Ndola, P.O. Box 73001, Ndola, Tel: 095 434791; E-mail: [email protected] Mr. Jonathan Kabaso Kazembe, Interpreter, Lusaka, Tel: 097-504881; E-mail: [email protected]