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)

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

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

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.
  1. 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.
  1. 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 ratepolicies framework for the region.
  1. 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.
  1. 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.
  1. 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.

Objectives of Appropriate Monetary Policy Framework

  1. 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.
  1. 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.
  1. 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.
  1. 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 ofAlternative Monetary Policy Frameworks

  1. 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.
  1. 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 policymaking that avoids the time-inconsistency problem[1]of monetary policy.
  1. 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

  1. 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.
  1. Annex I shows that at least 115 countriesuse the exchange rate as a nominal anchor as indicated below:

a)Exchange arrangements with no separate legal tender – At least 10 countrieshaveeither the US currency or the euro circulating as their sole legal tender. Those with the US dollar circulating as the sole legal tender areEcuador, 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 commitment[2] 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, namelyBosnia 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.

c)Other Conventional FixedPeg 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 theannex.

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

  1. 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.
  1. 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.
  1. 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.

Inflation Targeting

  1. 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 includesan active and effective communication with the public and the financial markets about the plans and objectives of monetary policymakers 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.
  1. 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.
  1. Table 1below summarizes the main objective, intermediate target, operating target and main instruments of the alternative monetary policy regimes.

Main objective / Intermediate Target / Operating Target / Main Instrument
Inflation Targeting / Price stability / Inflation forecast / Short term rate / OMO; FX Operations
Exchange Rate Targeting / Exchange Rate Stability / Exchange Rate / OMO; FX Operations
Monetary Targeting / Price Stability / Monetary aggregates / Reserve Money / OMO, FX Operations

The pros and cons of AlternativeMonetary Policy Regimes.

  1. The pros and cons of the various monetary policy regimes are summarized in tables below:

Table 2: Pros and Cons of Different Monetary Policy Regimes
Regime / Pros / Cons
Exchange-rate pegging / (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
(iv)A visible and easily monitored anchor for price expectations.
(v)Fixes the inflation rate for internationally traded goods, and thus directly contributes to keeping inflation under control
(vi)Anchors inflation expectations to the inflation rate in the anchor country.
(vii)Provides an automatic rule for the conduct of monetary policy that avoids the time-inconsistency problem.
  • It forces a tightening of monetary policy when the domestic currency tends to depreciate or a loosening of policy when the domestic currency tends to appreciate.
  • Monetary authorities no longer have the discretion that can result in the pursuit of expansionary policy to obtain employment gains which lead to time-inconsistency
/ (i)Loss of monetary policy autonomy leaves the policymaker unable to respond to developments in the domestic economy that are not present in the country to which the currency is pegged
(ii)With open capital markets, causes domestic interest rates to be closely linked to those of the anchor country. The targeting country therefore loses the ability to use monetary policy to respond to domestic shocks that are independent of those hitting the anchor country
(iii)Shocks to the anchor country are directly transmitted to the targeting country because changes in interest rates in the anchor country lead to a corresponding change in interest rates in the targeting country
(iv)Leaves the country prone to speculative attacks on the currency.
(v)An exchange rate peg that is not fully supported by monetary policy and by fiscal discipline may presents a number of drawbacks:
  • Excessive monetary expansion or fiscal laxity will increase inflation pressures. Non-tradable prices will rise relative to tradable prices, held down by foreign competition. Eventually, the deterioration in international competitiveness leads to external current account imbalances.
  • 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.
  • 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 targeting / (i)Monetary targets are simple and transparent i.e. easy to follow, and require no sophisticated models or techniques
(ii)Enables a policy-maker to take account of domestic developments when setting policy
(iii)Easy to assess performance.
(iv)Published monetary aggregate vis-à-vis the target gives public signal on the stance of monetary policy.
(v)Signals help fix inflationary expectations that help produce lower inflation.
(vi)Allows for accountability in case of monetary policy mistakes.
(vii)A target for monetary aggregate growth provides a nominal anchor that is easy to be communicated to and understood by the public.
(viii)Enables the monetary authorities to choose goals for inflation that may differ from those of other countries and allows some response to output fluctuations.
(ix)Like an exchange-rate target, information on whether the central bank is achieving its target is known almost immediately Announced figures for monetary aggregates are typically reported periodically with very short time-lags. Thus, monetary targets can send almost immediate signals to both the public and markets about the stance of monetary policy and the intentions of the policymakers to keep inflation in check.
(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)Depends on the relationship between the targeted aggregate and the goal of monetary policy remaining stable, and the aggregate being controllable by the central bank. The failure of these conditions in a large number of countries has led to the widespread abandoning of monetary targeting
(ii)Money demand has proved unstable in many countries, limiting its usefulness as an indicator of the appropriate stance of monetary policy
(iii)Requires strong and reliable relationship between the goal variable and the target variable
(iv)Other related challenges include:
  • Instabilities in the money multiplier;
  • Interest rate volatility;
  • Problems in forecasting liquidity;
  • Choice of reserve aggregates for targeting;
  • Limited and inflexible monetary policy instruments.

Inflation targeting / (i)Enables monetary policy to focus on 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.
(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 information on various variables rather than one to determine the best settings for monetary policy.
(iv)Easily understood by the public and thus, transparent. IT has been associated with increased transparency and accountability of monetary policy.
(v)Reduces the likelihood of the central bank of falling into time inconsistency trap since it raises accountability and transparency
(vi)Sustained success in the conduct of monetary policy as measured against a pre-announced and well-defined inflation target can be instrumental in building public support for creating an independent central bank / (i)Difficulty of directly controlling inflation.
(ii)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
(iii)Is too rigid and it allows for too much discretion.
(iv)Has the potential to increase output instability along with lowering of output growth
(v)The exchange rate flexibility required for success in inflation targeting might cause financial instability, especially in the context of the emerging market economies

Issues Related with Introducing Indirect Monetary Policy Instruments