Cemac: Macrofinancial Linkages and the Effectiveness of Monetary Policy1
The oil price slump of 2014/15 has important implications for macroeconomic policy in the Monetary and Economic Community of Central Arica (CEMAC), in particular with regard to the external balances and the conduct of monetary policy. In the present conjuncture, declining external reserves and lower domestic liquidity provides an opportunity to strengthen liquidity management to enhance monetary policy transmission. Because of CEMAC’s fixed exchange rate regime, domestic liquidity management, in addition to its impact on monetary transmission, plays an important role in maintaining external reserves at levels consistent with the sustainability of the exchange rate peg. The purpose of this paper is to assess the effectiveness of monetary policy transmission in CEMAC using vector autoregression models (VARs). Results show that, in line with internal studies undertaken by the BEAC, the interest rate channel of monetary transmission is ineffective. Conversely, the expansion of the monetary base affects inflation.
A. Monetary Policy Transmission Mechanisms
1. The link between monetary policy and interest rates in the economy is complex and depends on the financial characteristics of each economy. Although long-term interest rates are generally viewed as having more of an impact on economic decision making, monetary authorities are generally more successful in influencing short-term rates than in driving long-term rates. Short-term money-market rates are mainly influenced by central banks’ monetary policy actions, notably liquidity management operations. However, the effectiveness of such policy actions can be limited when the central bank operates in a context of a structural surplus of liquidity that, for a number of reasons, it is not able or willing to sterilize. This is particularly true in CEMAC. High petroleum revenues since 2005 have led to a large accumulation of the central bank’s (BEAC) net foreign assets and to a massive injection of liquidity into the domestic financial market that the BEAC did not sterilize, leading to sizeable amounts of excess reserves in the banking sector (Figure 1).
Figure 1.CEMAC: Monetary Developments and BEAC Balance Sheet, 2000–14
2. Excess liquidity has stymied the emergence of an interbank market, hence depriving BEAC of an effective vehicle for its market-based liquidity management operations. The result is the central bank’s inability to influence short-term rates. The combination of weak liquidity management (leading to large excess reserves) and underdeveloped government securities markets has resulted in an impaired monetary transmission mechanism through the interest rate channel, and in particular the inability of monetary policy impulses to be transmitted to commercial bank rates through the yield curve. Furthermore, the persistent excess liquidity in the banking system acts as an implicit tax on financial intermediation and hinders financial deepening.
3. In fixed exchange rate regimes, central banks’ ability to conduct monetary policy is constrained. Central banks’ scope for policy action may also be constrained by capital flows responding to interest rate differentials, although in CEMAC, this has been less evident. Against this backdrop, and to support the exchange rate peg, BEAC has to take into consideration the need to maintain an adequate level of international reserves, which in turn has implications for the stance of monetary policy.
B. Foreign Reserves and Monetary Base Developments
4. CEMAC’s economy is vulnerable to exogenous shocks and its banking system to liquidity shocks. Oil proceeds represent a significant part of governments’ revenues, which in turn significantly impact systemic liquidity. In the absence of appropriate sterilization mechanisms and unwillingness of banks to participate in interbank operations because of credit risk consideration, banks end up holding large excess reserves and the allocation among banks may not be optimal. In this environment, exogenous adverse shocks may have an impact on systemic liquidity by draining liquidity out of the system, thus exposing weaker banks to possible liquidity crunches in the absence of an effective interbank market.
5. As with previous shocks, the 2014/15 oil price slump has had a significant impact on CEMAC’s external position. Before 2009, positive current account surpluses led to a significant expansion in BEAC’s balance sheet and a concomitant increase in systemic liquidity, stemming from unsterilized government expenditures in local currency, originating from natural resource revenues in foreign currency. CEMAC experienced current account reversals in 2009 and in 2012, which appear to be lasting in the context of low oil prices. In 2015, CEMAC’s current account deficit is expected to widen to 5.8 percent of GDP. The decline in external reserves is likely to lead to a contraction in the monetary base.2
6. Although BEAC’s liquidity injections remain relatively small compared to the size of its balance sheet, banks’ reserves have increased significantly since 2004. Between January 2004 and September 2014, high oil prices resulted in large government revenues, which resulted in a four-fold increase in BEAC’s balance sheet and a significant increase in liquidity. However, the recent oil slump has not had yet the opposite effect. Although adverse current account developments have led to a decline in excess reserves, the banking system remained overly liquid in September 2014, when excess reserves represented 211 percent of reserve requirements. This situation is mainly explained by autonomous factor trends, in particular government expenditures originating from revenues in foreign exchange and the modest volume of BEAC’s monetary operations.
7. Although excess liquidity has not affected price stability, it constrains financial market development and the effectiveness of market-based monetary policy instruments. In the recent period, inflation has hovered around the 3 percent regional convergence criterion, despite a significant monetary expansion (close to 15 percent a year on average in 2004–13) and unsterilized excess liquidity. This is attributable to the exchange rate peg to a low-inflation zone, combined with administered prices for social goods and energy products.
C. Monetary Base and Transmission
8. We assess the effect of a monetary base expansion on prices by estimating two VAR models. The first model assesses the effect of a change in BEAC’s main policy rate on inflation, and the second, the impact of a quantitative monetary policy shock on inflation. Because of the unavailability of quarterly GDP data, credit is used as an indicator of economic activity, even if it is more volatile than GDP and is not stationary. To address the non-stationarity issue, a Hodrick-Prescott filter is used.
The first VAR model’s results show no statistically significant impact of BEAC’s main policy rate on inflation. The variables considered in the first model are the “TIAO;”3 the cyclical component of the year-on-year change in credit to the economy (HPCYCLECREDITPC); and year-on-year inflation (INFLATION). The main variable to shock is the TIAO. The model is estimated for the period 2001Q2–2014Q3. It is identified according to the following order of variables: TIAO, HPCYCLECREDITPC, and INFLATION. The impulse response functions show that the impact of the TIAO is only significant at a 10 percent confidence level. When adding oil prices4 and the dollar/euro exchange rate5 as independent variables to the model to control for their effects, the TIAO’s impact on inflation remains statistically insignificant (Figure 2).
The second VAR model’s results show that a monetary base expansion impacts inflation. The variables considered in the model are the year-on-year change in the monetary base (M0PC); the cyclical component of the year-on-year change in credit to the economy (HPCYCLECREDITPC); and year-on-year inflation (INFLATION). The main variable to shock is M0PC. The model is estimated for the period 2001Q2–2014Q3. It is identified according to the following variables order: M0PC, HPCYCLECREDITPC, and INFLATION. The impulse response functions show that inflation increases by about 1 percent after four quarters following an 8 percent shock on the monetary base. The effect of the monetary base shock is persistent and statistically significant at the 5 percent confidence level (Figure 3).
Figure 2.CEMAC: Inflation Reaction to a Policy Rate Shock
Sources: EAC data; and author’s estimates.
Figure 3.CEMAC: Inflation Reaction to a Monetary Base Shock
Sources: BEAC data; and author’s estimates.
9. Recent research undertaken by BEAC confirms weak monetary policy transmission through the interest rate channel.6 In a forthcoming working paper analyzing the effects of monetary policy on economic activity and inflation, BEAC authors estimate three structural VAR models for each CEMAC country. With the first model, they find that the interest rate transmission is weak. The transmission mechanism is barely existent in the Central African Republic, Chad, Gabon, and Equatorial Guinea. In Cameroon, a shock to the TIAO has a statistically significant, but an overall weak effect on economic activity that lasts for four quarters; however, the shock has no effect on prices. With the second model, the authors find that a positive shock to the monetary base has a positive effect on growth that lasts for five quarters. Using a panel VAR model, the authors further confirm the weakness of the transmission mechanisms in CEMAC—shocks to the TIAO and to money supply have no significant effect on activity and prices.
10. This paper finds that changes in the BEAC’s policy rate have no impact on prices but changes in the monetary base do affect inflation. Therefore, with falling oil prices, a policy-induced expansion in the monetary base would lead to higher inflation and a real exchange appreciation. Since the exchange rate cannot adjust, it could also lead to higher import volumes, a worsening of the current account balance, and falling reserves, which over time could reduce excess liquidity. This new policy context provides an opportunity for the BEAC to undertake a monetary framework reform to boost the effectiveness of its monetary policy instruments.
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Prepared by Mariam El Hamiani Khatat. The author would like to thank BEAC’s staff for the quality of the discussions on monetary transmission in CEMAC and for sharing related forthcoming working papers.
The monetary base is defined as currency in circulation and financial institutions’ deposits at the BEAC.
TIAO: « Taux d’intérêt des appels d’offres à 7 jours » is the BEAC’s main policy rate, that is the rate of its seven-day auctions offered to banks.
For oil prices, we use the percentage change of the simple average of three crude oil spot prices (Dated Brent, West Texas Intermediate, Dubai Fateh) computed in U.S. dollars per barrel, taken from the IMF’s World Economic Outlook (WEO) database.
U.S. dollars per euro, period average, WEO database.