Chapter

Chapter 6. Building a Framework to Harmonize Monetary Policy

Author(s):
Paulo Drummond, S. Wajid, and Oral Williams
Published Date:
January 2015
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Author(s)
Armando Morales

This chapter discusses a strategy and a timetable for harmonizing national monetary policy frameworks across the East African Community (EAC). The priority for harmonization is to cement credibility in the introduction of a monetary union, especially by ensuring low and stable inflation. Harmonization therefore needs to be gradual, given still-significant differences across EAC partner states in the degree of exchange rate flexibility, the use monetary instruments, the weight given to monetary aggregates, and the role of policy interest rates in monetary operations.

EAC interest in monetary union has historical precedent. The East Africa shilling was adopted in 1922 by countries ruled by the British (Kenya, Uganda, Tanganyika, and, in 1936, Zanzibar). After independence, local currencies were introduced, but they continued being fully and freely convertible into sterling in Kenya, Uganda, and Tanzania to continue benefiting from explicit and implicit subsidies. Sterling depreciation in the late 1960s and early 1970s and slow progress in economic integration across EAC countries led to the disintegration of the sterling area in 1972. Following a period of divergence of inflation targets and interest rates, the East African Currency Area was formally ended in 1977 (Graboyes, 1990).

Plans to relaunch the EAC initiative in the 2000s, including the adoption of a currency union in 2012, proved ambitious. The focus has moved to develop a protocol for monetary union, with a 10-year preparation period before moving to a currency union starting on the date of approval of the protocol. Although the extent and pace of harmonization will be a joint decision by countries in the monetary union, a comprehensive effort should ensure the proper allocation of technical skills, the establishment of a track record to build credibility well ahead of union, and clear progress in integrating financial markets and infrastructure.

Differences in national monetary policy regimes present a wide selection of practices that need to be harmonized. This comprises the legal frameworks governing national central bank activities and the range of tools used for monetary policy control. In principle, the East African Monetary Union (EAMU) protocol envisions that participating national central banks would be subordinate to a new East African Central Bank and that national central banks would implement monetary operations on behalf of the regional monetary authority in support of the monetary union. In anticipation of that, the central banks would benefit from conducting monetary policy using the same set of monetary tools.

The next section looks at the role of harmonization of monetary policy frameworks in the move to a currency union in the EAC, the relevant priorities, achievable outcomes, and sequencing issues. The following sections look at experiences in other currency unions and regional blocks, discuss legal and institutional frameworks in the EAC, analyze monetary policy frameworks and compare monetary operations and instruments, and identify critical areas in the preparation of a common currency area.

Harmonizing Monetary Policy Frameworks

Harmonization Role and Priorities

What is the role of harmonization of monetary policy frameworks in the move to a currency union? In planning for this, participant countries must acknowledge the preexistence of national central banks with a given track record on monetary policy effectiveness. This is a significant difference with most existing currency unions, which are in practice a continuation of arrangements established before their member countries became independent. Therefore, a relevant question for EAC countries is whether some degree of harmonization of existing monetary policy frameworks would support the transition to a currency union. In principle, harmonizing some features of monetary policy frameworks should help the transition to a currency union for the following reasons:

  • Harmonizing the framework for monetary operations requires commitments that in turn would provide an opportunity to establish a track record of coordination and give credibility to the eventual currency union.
  • Harmonizing policy frameworks will facilitate the coordination of policies in the face of common shocks, helping to minimize the differences between individual countries’ business cycles and contributing to a smoother transition over the medium term.
  • Working together toward achieving low and sustainable inflation would provide immediate benefits to EAC countries by minimizing the risks of instability as monetary union approaches.

But harmonizing monetary policy regimes can, in itself, be a complex undertaking requiring careful planning and an assessment of the costs and benefits at every stage of the process. Its complexity depends in part on the successor exchange rate regime for the new common currency. If maintaining exchange rate flexibility under the new currency is the preferred option, a gradual, multiyear process of harmonization will be required. But if an exchange rate peg is preferred, harmonization requirements may be less pressing. Furthermore, the higher the envisioned degree of decentralization across national central banks, the more harmonization will be needed to minimize the risk of coordination failures.

The priority for harmonization should be to achieve low and stable inflation. Recent experience with rapid acceleration of inflation in several EAC countries shows that challenges remain in achieving this goal. Mechanisms to ensure strict fiscal discipline will be important to this effort, by enhancing monetary policy effectiveness and minimizing the possibility of disruptions. However, harmonizing national monetary policy frameworks at the outset does not seem advisable until significant progress is made on keeping inflation low. Differences across EAC countries in the degree of exchange rate flexibility, the way monetary instruments are used, the weight given to monetary aggregates, and the role of policy interest rates in monetary operations are still significant.

Scope for Harmonization

Current monetary policy regimes and practices differ across EAC countries. The exchange rate regime is classified as floating in only three—Kenya, Tanzania, and Uganda. Policy interest rates are binding for monetary operations Kenya, Rwanda, and Uganda. And both Kenya and Uganda are moving away from hard targets on reserve money. These differences reflect a range of underlying factors:

  • Legislative history. Legal frameworks for central bank operations reflect historical national priorities. Recent changes in national central bank laws have been driven by institutional initiatives for reform (in Rwanda) and by broader political reforms, such as Kenya’s new constitution.
  • Extent of donor funding. For Rwanda and Burundi, foreign aid inflows are a significant source of fiscal revenue and foreign exchange. Here, monetary policy is dominated by issues related to the management of the monetary and foreign exchange repercussions of these inflows into these economies.
  • Financial depth and development. In Kenya and Uganda, which are the most financially developed in the region, the behavior of economic agents appears to have become more sensitive to changes in interest rates. Therefore, these countries give more weight to interest rate changes in their policy decisions.
  • Instances of fiscal dominance. Although central bank financing of national budgets is generally subject to defined limits in EAC countries, instances of exceptional financing can arise, usually when efforts to fund budgets using market-based instruments result in excessive interest costs. Where central banks are required to provide ad hoc funding in excess of defined limits, monetary policy autonomy and effectiveness can be undermined.

Transition: Starting and End Points

The extent of the harmonization challenge depends, in part, on the effectiveness of monetary policy regimes. As discussed later, central bank approaches to monetary policy design and implementation are evolving within the EAC. Although the inflation record in member countries has improved over the last decade, inflation reached double digits again in 2012.1 Improving the internal consistency of countries’ monetary policy frameworks will require fully market-determined interest rates, clear government financing arrangements, and transparent communication of policies, even if national monetary frameworks are not fully aligned.

The extent of the harmonization challenge also depends on the successor exchange rate regime for the new single currency.2 Under a currency peg, the institutional challenges are greatly reduced, because of the elimination of monetary independence. Under this regime, the operating responsibilities of national central banks would be limited, and the need for harmonized or coordinated activities reduced. By contrast, if the EAC maintains exchange rate flexibility under the new currency, the East African Central Bank and national central banks will face the challenge of operating an independent monetary policy. This will require the use of a range of monetary policy instruments and operations to achieve the inflation objective—activities that would need to be harmonized across national central banks to prepare for operating in a decentralized system.

Sequencing Harmonization

The timeline for the move to a monetary union will have implications for harmonization. The timetable for strengthening the effectiveness of monetary policy, harmonizing legal frameworks, and developing common monetary policy practices and instruments will need to be consistent with the decision on the starting date for monetary union. In Europe’s Economic Monetary Union (EMU), institutions to guide monetary integration were established at an early stage, and a program of reforms was adopted on a multiyear basis. This chapter implies that sufficient time is available in advance of monetary union to allow a sequencing of the preparatory reforms to monetary frameworks, probably right after the enactment of the protocol.

The following considerations are important for the design of the timetable for harmonization, and will be the reference for the recommendations:

  • Costs and benefits of reforms. Reforms are, by their nature, costly to implement. Agreement at a national and regional level takes time, experts may need to be hired, new institutional structures will need to be launched, and new skills will need to be learned, among other things. At the same time, poorly designed reforms can be counterproductive and may lead to undesired outcomes. Given these considerations, monetary policy reforms should prioritize areas where benefits are high, risks of inaction are great, or where an early start is needed to allow for the fine-tuning of outcomes.
  • “Variable geometries” alternatives should be considered. Because of the disparity of practices across EAC countries, there may be a case for focusing on harmonization in some areas across a smaller group of countries at the outset, and bringing in remaining countries once workable practices have been developed. This two-speed convergence approach could be adopted either in the run-up to monetary union or as part of the monetary union process itself, with some countries joining ahead of others; for example, by setting a set of preconditions based on agreed convergence criteria.
  • Flexibility in the introduction of reforms should strike a balance between trying to make fast progress in harmonization and keeping commitments realistic, taking into account disparities across countries. A “do-no-harm” approach will help gain acceptance of agreements during harmonization.

Complementary efforts will support progress in the harmonization of the conduct of monetary policy:

  • Fiscal arrangements should be given priority to facilitate a steady reduction of the extent of fiscal dominance. The possible use of fiscal rules should be assessed, including enforcement mechanisms, taking into account institutional capacity constraints and individual reform plans (e.g., fiscal decentralization in Kenya).
  • Statistics should be upgraded under common definitions. This is especially important for measures of inflation, chiefly on headline and core inflation. Other important areas include the classification of monetary, financial, and fiscal accounts.
  • The regulatory framework should be gradually adapted to internationally recognized and agreed practices. This includes capital account regimes, capital market regulations, and prudential frameworks for financial activities that take into account the evolving nature of the work in this area.

Lessons from Other Currency Unions

International experience shows that harmonization should be consistent with the choice of exchange rate regime and the desired level of autonomy of the central bank under monetary union. Experience suggests that aligning the policy environment in EAC countries before the implementation of monetary union with its envisaged arrangements should minimize the probability of disruptions. Experience also shows that harmonization can be supportive of macro policies prior to adopting a common currency. Harmonization can help “discover” the parity between currencies in the absence of an external anchor and ensure consistency between centralized policies and decentralized operations. Harmonization can also facilitate capacity improvement to ensure effective coordination between national central banks.

Choice of Exchange Rate Regime

The exchange rate regimes of existing monetary unions are a variety of free floats, pegs, and anchor currencies. The euro and the South African rand both float. The franc in the CFA franc zone comprising the West African Economic and Monetary Union and the Central African Economic and Monetary Community is pegged to the euro, and the Eastern Caribbean Currency Union is pegged to the U.S. dollar. Current plans for an EAMU are consistent with exchange rate float experiences; the historical experience of the failed East Africa shilling is consistent with the exchange rate peg experiences.

In floating regimes, the currency of the largest economy has served or still serves as an anchor for a common monetary policy:

  • The South African rand remains the anchor for the Common Monetary Area formed by some members (South Africa, Lesotho, Swaziland) of the Southern Africa Customs Union. The arrangement functions as an effective currency board.
  • The deutschmark served as the effective anchor for the European Union’s exchange rate mechanism for several years in the lead up to the euro. Tensions from diverging macroeconomic developments (growth, inflation, fiscal policies) and the Bundesbank’s understandable focus on German economic developments led some countries to reconsider their commitment to the exchange rate mechanism until a common currency was adopted. The euro operates as a floating global reserve currency, with minimal intervention in support of the currency.

The period between the adoption of a common exchange rate arrangement and monetary union exceeded 10 years in both cases. The Common Monetary Area was formed in 1986, 14 years after the formation of the Rand Monetary Area. In the case of the European Union, the period between the adoption of an exchange rate mechanism and full monetary union was 20 years (1979–1999).

Centralized versus Decentralized Monetary Operations

Decentralized monetary policy operations require upfront harmonization and integration. In such an arrangement, monetary and exchange rate policies are decided centrally in existing currency unions, but they differ substantially in the degree of centralization of monetary policy and foreign exchange operations. The European System of Central Banks and European Central Bank statute explicitly stipulates that operations should be delegated to national central banks “to the extent deemed possible and appropriate.” At the other end of the spectrum is the Eastern Caribbean Currency Union, which has no national central banks but a “resident representative” in each country. It is worth noting that in currency peg regimes there were no national central banks in place at the outset.

The degree of centralization has important implications for resource requirements and prior harmonization and regional integration efforts in the lead up to a monetary union. The less centralized are monetary policy operations, the more important is the role of harmonization of monetary policy frameworks before the implementation of a common monetary policy. Progress with harmonization will help reduce the scope for inconsistency between centralized policy and decentralized operations that could undermine the efficacy of monetary policy.

Central Bank Autonomy

Effective fiscal rules for monetary financing of member governments are a critical foundation for a currency union and the credibility of a common monetary policy. The stance of fiscal policy remains a sovereign decision for member countries in a monetary union. All monetary unions have strict limits in place on the use of central bank advances and direct financing to governments. Such restrictions have been binding and in general have been observed, although the CFA franc zones found it necessary to tighten the rules and gradually phase out the use of central bank advances entirely.

Limited financing options may also help enforce fiscal discipline. The smaller Common Monetary Area countries do not have access to financing from the South African Reserve Board and are not able to issue rand-denominated debt. Also, bilateral agreements with the South African Reserve Bank require 100 percent foreign exchange coverage for their domestic currency base. Spending has therefore been limited to domestic revenue and proceeds from the revenue-sharing arrangement of the South African Customs Union.

Harmonization Experience

Harmonization requirements are more relevant for floating union-wide currencies. The EMU experience shows that harmonization in a floating currency regime is more demanding because, without an external anchor, macroeconomic stability relies on the effectiveness of instruments and operations. An established track record in the use of common instruments and operations would help minimize uncertainty and reinforce credibility ahead of the adoption of a common currency.

EMU harmonization involved intensive multiyear coordination. As noted, 20 years elapsed between the adoption of an exchange rate mechanism and full monetary union, with a strong regional institution to lead integration launched 5 years ahead of monetary union. The European Monetary System, with its exchange rate mechanism (a system of intervention corridors around bilateral exchange rates) was in place until 1979. In 1989, the broad design of monetary union was approved by the European Council, and the European Monetary Institute was created in 1994, with the convergence criteria agreed upon three years later and the common currency born in 1999.

Monetary policy effectiveness was important to the EMU transition. Reflecting the strong anti-inflation discipline of the Bundesbank, the deutschmark quickly became a de facto anchor of the exchange rate system, even though the nominal anchor was the European Currency Unit, a weighted basket of the participating currencies. In fact, to stay in the exchange rate mechanism “snake,” participating central banks ceded a good deal of monetary policy sovereignty to the Bundesbank.

The creation of the European Monetary Institute played a key role in facilitating the harmonization efforts for EMU. The institute led the bulk of the detailed, technical preparatory work between 1995 and 1997.3 Technical staff provided reports on strategic and implementation issues to be approved by policymakers. Work on a policy framework and the convergence criteria took place separately from monetary policy operational issues, with the latter broken into five substantive themes: monetary policy instruments and their preunion harmonization, decentralized execution of liquidity management, integration of money markets, structural demand for money and central bank balance sheets, and integration of interbank markets and payment systems.

Legal and Institutional Frameworks Governing the Conduct of Monetary Policy

Decentralized versus Centralized Arrangements

A decentralized model for EAC member states has a number of advantages (European Central Bank, 2010). National expertise located in national central banks will continue to be available both to the governors, as participants in the governing council, and to the working of the system of central banks as a whole. At an early stage, a decentralized model helps minimize disruption in the transition. To function properly, national central banks will have to be legally subordinate to the East African Central Bank in areas where the monetary authority has competence. Specific advantages of this model are:

  • National central banks would contribute to the preparation of briefing material reflecting a national perspective, and comments from that perspective on material prepared in the East African Central Bank.
  • The governors, directors, and senior officials of national central banks would represent the EAMU to a domestic audience, and they would need support from staff in their national central bank to carry out this role.
  • National central bank researchers would contribute analysis and statistics in close contact with reporting institutions, including ensuring compliance with requirements, timely delivery, and data quality control.
  • Monetary and foreign exchange market operations also require close contact with national financial institutions, and knowledge of national financial markets and instruments (including acceptable collateral).
  • In case of dispersion of country risk premiums across EAC countries once monetary union is in place, it would help to keep open market operations conducted by national central banks, at least until macroeconomic convergence progresses significantly.

Key Differences in National Legal Frameworks

Harmonization of institutional arrangements across EAC partner states would benefit from a common understanding on legal mandates and central bank autonomy. Ultimately, the design of legal and institutional frameworks depends on the desired relationship between the East African Central Bank and treasuries. Two important elements of central bank autonomy concern policy coordination with treasuries and central bank lending to the government. The draft EAMU Protocol in principle aims at regulating coordination between monetary and fiscal policies and envisages the gradual phasing out of national central bank lending to governments.

Central Bank–Treasury Relations

The legal frameworks of central banks in the EAC show certain distinctive features regarding central bank autonomy relative to the treasury. While some jurisdictions have strong legal safeguards in place to protect their national central bank against political influence while facilitating policy coordination with the treasury, other jurisdictions explicitly authorize the treasury to give central banks binding policy instructions. Although in the area of monetary financing the legal frameworks of central banks are less divergent, terms of temporary financing including the maximum amount to be lent to the government and the repayment modalities differ. Moreover, in practice, central bank financing to the government has at times been accommodated by resorting to a flexible application of legal restrictions (Annex Table A6.1).

Legal Mandates

EAC central banks mandates diverge mainly in their legal powers, in particular for monetary policy instruments. In the EAC, legal frameworks differ in the way they govern the use of indirect monetary policy instruments (i.e., open market operations, credit operations, and minimum reserve requirements):

  • For open market operations, the differences relate to the type of instruments (government versus corporate securities) and type of legal operations (buying and selling versus repurchase agreements).
  • Although all EAC central banks may enter into credit operations, the legal framework diverges for counterparties, maturity, collateral requirements, and their creditor positions.
  • The legal framework for minimum reserve requirements needs further harmonization for the group of financial institutions subject to such requirements, discretion regarding certain types of institutions or liabilities, remuneration of minimum reserves, and whether the law sets a maximum reserve ratio.

The statutory objectives of EAC central banks are similar but not synchronized. All EAC jurisdictions expect their central banks to ensure price stability and all have financial stability responsibilities and promote government economic policies. However, central bank acts have different objectives and/or priorities, such as for financial supervision.

The institutional allocation of powers over foreign exchange is different in EAC jurisdictions. Not all the legal frameworks specify who is responsible for determining the foreign exchange regime. Legal frameworks assign different roles for treasuries in policy formulation. And in most jurisdictions the law does not ensure that the foreign exchange regime and policy should be consistent with the objective of price stability.

Legal Safeguards

Legal safeguards for central bank autonomy should be strengthened in all the central bank acts of EAC member states. With a view to establishing a strong autonomy framework in the East African Central Bank, the legal frameworks of national central banks should explicitly confirm their autonomy and include safeguards to protect their operational and financial autonomy and the autonomy of their decision makers. A number of key areas that need to be addressed are as follows:

  • Statutory autonomy is not always ensured in EAC jurisdictions. In most countries, there is no explicit prohibition on instructions, and in only three is there an explicit statement that the central bank has operational and financial autonomy.
  • Financial autonomy should be strengthened. Although all EAC central banks appear to have budgetary autonomy, rules on profit determination and the treatment of unrealized revaluation gains, profit distribution gains, and recapitalization requirements and modalities lack clarity, compromising the financial autonomy of EAC central banks.
  • The personal autonomy of EAC central bank officials should be improved. Legal frameworks in EAC jurisdictions diverge on qualification requirements, grounds for dismissal, appointment and dismissal procedures, due process requirements, and length of mandates.

Monetary Policy Frameworks and Their Effectiveness

Key Differences in National Monetary Policy Frameworks

The path toward monetary union must take into account differences in existing national monetary policy frameworks and their effectiveness. As discussed in the following, EAC countries currently give different emphasis to the monetary aggregates, exchange rates, and interest rates at the heart of their monetary policy frameworks, and these approaches need to be harmonized under a single currency. The success of this regime change will, in turn, likely reflect the effectiveness of the preexisting monetary frameworks in delivering low and stable inflation.

The evolution of inflation and monetary aggregates show some commonalities across EAC countries. In particular, inflation has remained below 10 percent for all countries except during external shocks. By the same token, inflation across the EAC has accelerated faster than other regions hit by shocks, including sub-Saharan Africa, suggesting delays in the appropriate monetary policy response. Broad money growth also shows some correlation explained by an increase in financial intermediation in the region that is somehow reversed when inflation shocks hit their economies (Figure 6.1).

Figure 6.1Inflation and Broad Money Growth in East African Community Countries

Source: National central banks.

By contrast, policies across EAC countries have only shown some degree of convergence in recent years. The lack of correlation among policy rates also reflects differences in design and implementation. Changes in base money appear volatile and heterogeneous across countries, to a large extent explained by differences in their de facto exchange rate regimes. In turn, these explain different trends in the evolution of international reserves, despite a joined commitment to increase their level. In short, despite progress in recent years, some differences across the monetary policy frameworks of EAC countries are significant (Figure 6.2).

Figure 6.2Policy Rates, Base Money, and Exchange Rates in East African Community Countries

More progress is needed in all monetary frameworks in EAC countries to achieve low and stable inflation. Before the 2010–11 episode of food price inflation, all countries showed average inflation of around 10 percent, higher than their country targets. Differences in policy frameworks do not seem to affect the level of inflation, although higher inflation volatility in Burundi and Rwanda may be associated with their larger exposure to external price shocks. Assessing the implementation of policy frameworks and the transmission of policy decisions across EAC countries will help understand the challenges to improve monetary policy effectiveness (Figure 6.3).

Figure 6.3Inflation and Inflation Volatility in South Africa and the East African Community

Source: National central banks.

Note: CPI = consumer price index.

Differences in Exchange Rate and Interest Rate Policies

No country in the region uses exchange rates as a de jure nominal anchor; however, the degree of exchange rate flexibility is different across countries. Exchange rate regimes in Kenya, Tanzania, and Uganda have been classified as floating for the last four years in the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions. Burundi and Rwanda are currently classified as managed floating and stabilized, respectively. Kenya allows its exchange rate to respond to market pressures to a much larger extent than other EAC countries, about 25 percent compared to 10 percent of Uganda in recent times, and 8 percent in Tanzania (Figure 6.4) (Slavov, 2011).

Figure 6.4Measuring Exchange Rate Flexibility in East African Community Countries

Source: Slavov (2011).

Note: EMP = exchange market pressures.

1 EMP coefficient between zero and 1.

Use of monetary aggregates and policy interest rates is evolving. The Central Bank of Kenya adopted in 2011 a new monetary policy framework that gives more prominence to the policy interest rate. Under the new monetary policy framework, the Central Bank of Kenya uses the policy interest rate to guide interbank rates to achieve its net domestic assets operational target. The Bank of Uganda is moving to a form of inflation targeting “lite.” Under this framework, the operating target will be a publicly announced central bank interest rate centered on the seven-day interbank rate. The central bank will refrain from direct central bank financing of the deficit. The Banque de la République du Burundi, the National Bank of Rwanda, and the Bank of Tanzania operate under a money targeting framework (Figure 6.5).4

Figure 6.5Features of Monetary Policy Frameworks in East African Community Countries

Source: Author.

Note: Dark gray denotes full flexibility.

Generally, EAC countries are increasingly relying on interest rates as financial markets develop and dependence on foreign exchange inflows decline. In 2012, Rwanda and Burundi committed to allowing greater exchange rate flexibility and promoting the development of their foreign exchange markets. And Kenya and Uganda are moving toward a greater role for the policy interest rate, initially introduced as a signaling device.

Differences in Monetary Policy Transmission and the Macroeconomic Environment

A two-way interaction between increasing financial intermediation and monetary policy transmission can be seen across EAC countries. Money multipliers and velocity become unstable with financial development and less relevant for transmission, which is generally confirmed by studies conducted by EAC central banks and the International Growth Center.5 In Kenya and Uganda, increasing focus on interest rates in policy decisions has resulted in lower interest rate volatility (before, that is, the recent surge in inflation), which in turn favors financial intermediation.

The choice of monetary policy frameworks in EAC countries is conditioned by the nature of central bank–treasury relations, the financial environment, and the structure of the balance of payments (Figure 6.6). The higher the government’s use of monetary financing, the lower its reliance on market securities for monetary operations. Also, the higher the excess reserves, the lower the elasticity of market interest rates to changes in money market rates. And the higher the share of foreign exchange flows channeled out of interbank markets, the lower exchange rate flexibility. A number of challenges in the coordination between monetary and fiscal policy remain. Government monetary financing is a concern. It appears much larger in Burundi than in the other EAC countries. Significant central bank financing for the government limits the scope for relying on market instruments to conduct monetary policy. At times, EAC governments are reluctant to borrow on market terms due to concerns over collusion, preferring instead to use central bank financing, sometimes under ad hoc arrangements that undermine central bank room to maneuver in conducting monetary policy.

Figure 6.6Macroeconomic Factors Conditioning the Choice of Monetary Policy Frameworks in East African Community Countries

Source: Author.

  • Burundi and Rwanda absorb large foreign inflows relative to foreign exchange receipts and fiscal revenue. The size of these inflows relative to the size of the economy explains some reluctance to allow for exchange rate flexibility. Not surprisingly, Kenya shows higher exchange rate flexibility, consistent with the insignificant share of foreign aid inflows in total foreign exchange receipts.
  • Kenya also shows the highest degree of financial deepening, coupled with the lowest structural liquidity surplus across EAC countries. Liquidity injection operations through foreign exchange purchases, open market operations, and/or the overnight lending facility are more relevant in Kenya relative to countries with low financial deepening and high structural liquidity surpluses. Here, the challenges are more related to mopping up liquidity effectively to minimize commercial banks’ excess reserves.

Apparent weakness in monetary transmission channels in EAC countries is partly explained by an accommodating policy bias that is inconsistent at times with the inflation objective. An accommodating policy bias may have hampered the impact of policies on market behavior. For example, Davoodi, Dixit, and Pinter (2013) find that reserve money and the policy rate often move in conflicting directions. In the presence of shocks, countries tend to maintain an accommodating bias long after evidence of demand pressures emerges. Andrle and others (2013) find that monetary policy in Kenya during the 2011 food inflation episode remained accommodating despite significantly low interest rates and diminishing global demand weakness.6Stepanyan (2012) finds a similar pattern in EAC countries as a whole, relative to other sub-Saharan African countries.7

Anecdotal evidence points to the pursuit of multiple objectives as a factor explaining lack of consistency of monetary policy in EAC countries at times. In particular, central banks often use policy rates to try to persuade commercial banks to keep lending interest rates low to help accelerate credit growth. Also, the impact of high credit growth on inflation is often understated on the grounds that fast credit growth is required to enhance financial deepening and, as such, should not threaten stability.8 Furthermore, government financing needs occasionally lead central banks to make decisions not always consistent with stabilization targets.

Preliminary evidence suggests that, despite overall weak transmission, interest rates, credit, and the exchange rate are effective channels from policy decisions to prices and economic activity. By adapting methodologies to low-income countries, the evidence suggest that the specific features of EAC economies enable monetary transmission in a manner that is different from the standard literature.9 Incorporating high volatility of output, flexible wages, and an accommodating bias to a monetary policy model for Kenya still leads to features of monetary policy transmission common to emerging markets (Andrle and others, 2012). Combining different specifications of vector autoregression models, Davoodi, Dixit, and Pinter (2013) find that the exchange rate and the credit channels from policies to inflation are active for Kenya.

Monetary Policy Instruments and Practices

Key Differences in the Use of Monetary Instruments

Major differences exist among EAC countries in the role of the policy rate, the design of liquidity absorption tools, and reserve requirement systems (Figure 6.7). EAC countries have similar arrangements for injecting liquidity, but no standing deposit facilities are in place in any EAC country. This is partly explained by chronic large excess reserves held by commercial banks. Policy decisions are generally made by a monetary policy committee.

Figure 6.7Features of Monetary Instruments and Operations in East African Community Countries

Source: Author.

Note: Dark grey = yes.

Liquidity Forecasting

Liquidity forecasting capabilities need to be strengthened in all EAC countries. High-frequency information on government transactions remains deficient and complicated by the absence of a single treasury account (except in Rwanda and Burundi). The use of market indicators is still evolving. However, in Kenya and Uganda, selective market information is incorporated into their short-term projections.

Policy Decision Making

All EAC central banks have a monetary policy committee responsible for formulating and implementing monetary policy, but their composition and mandates differ. Monetary policy committee provisions are established in legislation in Kenya and Tanzania, with the ministry of finance having a larger role in Kenya, where it appoints four external members (two external members are appointed in Tanzania). In Uganda, all members come from the central bank (in Tanzania, they all have voting power), and in Rwanda, the monetary policy committee is composed of members from the central bank except for one representative from the university. However, in Tanzania the permanent secretaries from the ministries of finance of Tanzania Mainland and Zanzibar and the accountant general attend as invitees. Frequency of meetings ranges from weekly (Uganda) to bimonthly (Kenya, Tanzania). All EAC central banks would benefit from improved analytical support, communication mechanisms, and, in some cases, information flows to facilitate a more informed decision making.

Central Bank Credit to the Government

Central banks in the region provide direct advances to governments, in most cases with a ceiling set as a percent of government revenues. Interest is charged on credits except in the case of the Bank of Uganda. Governments use this facility intensively, exceeding legal ceilings occasionally.

Policy Interest Rates

The role of the policy rate differs across countries reflecting differences in their monetary policy frameworks. The Central Bank of Kenya, National Bank of Rwanda, and Bank of Uganda set their policy rates independent of market rates. The Bank of Uganda defines the policy rate as the target around which the bank guides interbank rates. The Central Bank of Kenya is moving in the same direction, but still emphasizes the policy rate’s role as a signaling device. All EAC central banks link their policy rate to their corresponding standing lending facility rates. Under the Central Bank of Kenya’s monetary policy framework, interest rates on repo/reverse repo operations use the policy rate as a ceiling/floor. In Rwanda, an interbank interest rate corridor guides interest rate developments, with the National Bank of Rwanda policy rate playing a signaling role.

Reserve Requirements

Key features of reserve requirements differ significantly across EAC countries. Differences include the following (Figure 6.8):

  • Required reserve ratios range from 3 percent in Burundi to 10 percent in Tanzania, applied uniformly to their deposit base (except in Tanzania where the reserve ratio for government deposits is 30 percent).
  • The reserve base includes domestic and foreign currency deposits in all countries, including government deposits. But in Rwanda, the base also includes payable accounts.
  • Eligible reserve assets consist of deposits at the central bank in all five EAC countries, plus 10 percent of vault cash in Uganda for banks with more than 10 branches (5 percent for the rest). In Tanzania, required reserves are deposited in a designated account.
  • Reserves on foreign currency deposits are denominated in the domestic currency in Kenya, Tanzania, and Uganda, and in foreign currency in Rwanda. In Burundi, both domestic and foreign currency can be used.
  • Average deposits are used for the computation of requirements in all countries except Tanzania. The maintenance period ranges from 7 days in Rwanda to 30 days in Burundi and Kenya. In Burundi and Tanzania, the reserve base are not lagged, which complicates the liquidity management of banks.
  • Required reserves are not remunerated in any EAC country. Penalties on reserve deficiencies vary across EAC central banks.

Figure 6.8Reserve Requirements in East African Community Countries

Source: Author.

Note: Dark grey = yes.

Banks in all five EAC countries maintain considerable excess reserves; indeed, more than required. However, differences in design and the lack of development of interbank markets explain differences in precautionary reserves and, therefore, the magnitude of “free” reserves other than for precautionary motives is difficult to gauge. Moreover, the distribution of excess reserves is uneven, with a few small banks often tapping central bank resources.

Liquidity Injection and Mop-up Tools

Liquidity injections are conducted mainly through reverse repos of government securities and foreign exchange purchases across EAC countries.10 Foreign exchange purchases are used for the provision of liquidity by all countries. Burundi uses collateralized seven-day loans instead of reverse repos. For other countries, the tenor of reverse repo operations ranges from 7 days in Kenya and Rwanda, to overnight to 62 days in Uganda.

Mop-up instruments show more differences across countries than instruments for liquidity injection. All central banks use foreign exchange sales explicitly or implicitly to mop up liquidity, extensively in Burundi and Rwanda, less frequently in Kenya. The Central Bank of Kenya, Bank of Uganda, and National Bank of Rwanda are also equipped with repo operations, and the Bank of Uganda also uses term auction deposits. No government securities are issued for liquidity management purposes. The Bank of Tanzania uses government securities, Treasury bills for debt and liquidity management, and Treasury bonds for debt management. The government bears the sterilization costs in Rwanda and Uganda, unlike the Banque de la République du Burundi, and the Central Bank of Kenya. In Tanzania, the central bank and treasury share sterilization costs based on a memorandum of understanding.

Standing Facilities

All EAC central banks have lending standing facilities in place, but no deposit facilities. Maturities range from overnight in Kenya to up to three months in Uganda. Access to overnight lending is unlimited in principle, but subject to collateral. Most central banks require government securities as eligible collateral, but the National Bank of Rwanda and Banque de la République du Burundi also accept promissory notes and commercial paper. In Kenya, Rwanda, and Uganda, interest rates charged for use of these facilities are set relative to the policy rate (policy rate plus 6 percent in Kenya and plus 4 percent in Rwanda and Uganda). Typically, the interest rate charged on these facilities constitutes a ceiling for interbank interest rates. In Burundi and Tanzania, standing facility interest rates are linked to market rates.

Recently, access to lending facilities has been limited in some cases out of concerns over significant demand for liquidity in times of high inflation. In Uganda, the central bank exercises discretion in the provision of liquidity through its standing facility beyond the equivalent of 25 percent of the borrower bank’s reserve requirement. In Kenya, the use of this facility more than twice in a week is subject to further scrutiny by the central bank. In Rwanda, access to this facility is entirely subject to the central bank’s discretion.

Looking Ahead

Harmonizing Monetary Policy Frameworks

Harmonizing monetary policy frameworks before the adoption of the common currency would enhance credibility in the process. Achieving and maintaining low inflation before a monetary union is established would increase the credibility of the new central bank and thus reduce the cost of moving to a new framework. In turn, a successful transition will provide an effective anchor to consolidate gains in achieving price stability. The move to a common policy framework will benefit from clear progress in aligning financial development across EAC countries. Thus, complementary measures to remove obstacles for financial development and integration across EAC countries should be a key component of the strategy to harmonize monetary policy frameworks.

Significant progress in other elements of the convergence strategy needs to be reached to support the move to a common monetary policy framework. In particular, government monetary financing should decline significantly to buttress the effectiveness of existing monetary policy frameworks. Likewise, the external position should be strengthened to help contain excessive exchange rate volatility. Moving to a common monetary policy framework will require low and stable inflation to be achieved for a sufficiently long period to make it credible.

A hybrid arrangement with increasing reliance on policy interest rates and flexible exchange rates may be more appropriate. A hybrid framework should ensure that all countries will be in a position to accumulate international reserves in line with regional commitments. Common full-fledged inflation targeting does not appear feasible in the immediate term, as this would require some track record of using interest rates to guide monetary policy. And this is still a work in progress in Kenya and Uganda,

Any arrangement should give priority to the accumulation of foreign exchange by EAC central banks as an important source of permanent liquidity. The operations framework and the exchange regime should be consistent with the planned accumulation of international reserves by the central banks. These alternative arrangements could use monetary aggregates as an intermediate step while international reserves increase to a sufficiently high level. In Kenya, a ceiling on net domestic assets and a floor on net international reserves have proved useful to guide monetary policy decisions.

A two-speed approach to convergence of monetary policy frameworks would facilitate moving ahead with harmonization plans. Countries where economic agents have revealed sensitivity to central bank interest rate decisions—Kenya, Uganda, and perhaps Tanzania—may coordinate the adaptation of their frameworks to the new realities of the market, while countries in transition to a more flexible exchange rate (Burundi, Rwanda) may not need to change their operational targets until progress with harmonization in other areas is well advanced.

Harmonizing the Conduct of Monetary Policy

Several steps can be taken while improvements in macroeconomic convergence take hold (Figure 6.9). Although further progress in macroeconomic convergence will help consolidate stability, especially by reducing government monetary financing, some critical steps could be taken at the outset, namely the implementation of the East African Monetary Institute, the harmonization of features of some existing instruments, and the harmonization of rules for central bank financing of the government. This should be accompanied by decisive action to reduce inflation.

Figure 6.9Strategy to Implement a Framework for Harmonizing the Conduct of Monetary Policy in the East African Community

A concerted effort to pay increasing attention to market signals as markets develop is advisable. A strategy to harmonize monetary policy frameworks in the long term focusing on achieving low and stable inflation with available tools would be of benefit, as would assessing the evolving role of interest rates with the view of gradually allowing for more exchange rate flexibility.

The strategy to harmonize the conduct of monetary policy will be influenced by the choice of the transitional exchange rate arrangement in the path to monetary union. If the two-speed approach option is agreed upon, implementation of a transitional exchange rate arrangement would need to be delayed until the countries using a de facto exchange rate anchor felt comfortable in allowing the exchange rate to float.

Harmonizing practices for temporary central bank financing of government operations should be adopted at an early stage, and followed by a more comprehensive agreement on limiting central bank financing to EAC governments that may or may not be validated by changes in national legislation. However, following agreement among EAC members, the EAMU protocol should be explicit in limiting financing to the government under all possible modalities and clear in the definitions to be used (national governments, public entities, and so on) to avoid loopholes that may weaken the perception of the degree of commitment to minimize fiscal dominance under a currency union. Eventually, an agreement on a schedule to set binding limits to central bank financing to the government, restricted to the provision of overdraft facilities based on uniform criteria, would help to introduce discipline in the implementation of monetary policy.

Harmonizing Central Bank Instruments and Operations

As a general approach, the harmonization of existing instruments should be undertaken, and this should start in areas that facilitate a smooth transition, ensuring that harmonization does not interfere with the current national monetary policy frameworks in place. A plan to gradually harmonize the main features of reserve requirements should be introduced at this stage. Harmonizing key features of standing lending facilities would also be feasible and desirable. Harmonizing these features is not incompatible with differences in financial development. EAC central banks should conduct an assessment of pros and cons of the choice of liquidity absorption tools.

Initiatives to harmonize and integrate market infrastructures should start early; specifically:

  • Goals on upgrading and harmonizing money market infrastructures and practices will be needed. Improving money market infrastructures (payment and settlement systems, frameworks for repurchase agreements, and so on) will ensure that the capacity to inject/absorb liquidity is comparable across countries before taking more significant steps toward a currency union.
  • Decisive steps toward integrating regional money markets would be supportive of harmonization efforts. This would require the harmonization of capital account regimes, market infrastructures and practices, capital markets, and financial prudential frameworks. Structural and regulatory impediments to interbank and money market integration could usefully be eliminated in a gradual manner to allow intraregional financial flows without causing disruption in local markets.

EAC countries should exchange views regularly on their experiences with liquidity forecasting and on the preparations for monetary policy committee meetings. In particular, a common approach to improve analytical support of the monetary policy committee should help countries to acquire a better understanding of market reaction to policy decisions and will also be valuable in informing harmonization plans. The analytical support should include full use of market indicators and a continuous effort to upgrade communication mechanisms and information flows based on the regional experience.

In the medium term, harmonization efforts should build up from plans initiated at the early stage:

  • Levels of reserve requirements can be harmonized after a period accumulating experience under harmonized regimes.
  • A unique set of liquidity absorption tools can be identified (e.g., repo operations), keeping in mind the impact on central banks’ balance sheets for each EAC member.
  • Interest rates of standing facilities should ideally be aligned with policy rates and harmonize tenors, amount, and room for discretion for central banks. The feasibility of using standing deposit facilities with the same features across the EAC should be assessed once harmonization is well under way.
  • Ideally, too, central bank financing of the government needs to be eliminated in a regional arrangement, with some transitional provisions that allow the regional central bank some prorated allocation until market-based mechanisms for government financing are fully developed in each country.

Harmonizing Legal Frameworks

Harmonization of legal frameworks could be lengthy, involving political commitments. As it requires careful consideration and prior agreements involving legislative bodies in individual countries, it does not seem advisable to initiate this process at an early stage. Even so, this does not preclude the introduction of an institutional framework that could help enforce agreements across EAC countries in the process of harmonization.

The EAC is considering establishing an East Africa Monetary Institute, inspired by the European Monetary Institute, which was set up in the euro area four years before monetary union. The introduction of an East Africa Monetary Institute would help the move from intercountry coordination to the discussion of supranational considerations. The dedication of full-time staff to prepare the relevant analytical and technical work to support informed decisions by designated authorities would be a major step to raise awareness in public and private sector economic agents in the region of the implications of moving toward a monetary union.

A strong track record of implementing binding decisions through the East African Monetary Institute will enhance the credibility of the eventual East African Central Bank when monetary union is in place. Visible progress in preunion harmonization will highlight the efficacy of the eventual decentralized execution of monetary policy and liquidity management. While a harmonized legal framework is designed, EAC central banks could operate under the principles of autonomy and establishing clear common objectives, which in itself would contribute to institutional strengthening as agreements are enforced.11 This will reinforce credibility in monetary policy across the region and contribute to positive expectations about the eventual move to a monetary union.

Harmonization of the legal frameworks should take place only at a later stage in line with prior agreements within EAC member countries. The new legal frameworks should prioritize objectives in such a fashion that both the East African Central Bank and national central banks are able to use their legal powers for monetary policy and other policy areas to pursue distinct primary policy objectives. Also, legal powers and policy instruments should be aligned with one or more functions, which in turn support one or more objectives, to help manage expectations of economic agents and to strengthen central bank accountability.

Annex 6.1
Table A6.1Main Features of Legal Frameworks Affecting the Conduct of Monetary Policy Across East African Community Countries
BurundiKenyaRwandaTanzaniaUganda
Legal Status
1. StatuteCharter of the Bank of the Republic of Burundi (Law 1/34 of 2008)The Central Bank of Kenya Act (Chapter 491)Law 55/2007 on governing the National Bank of RwandaThe Bank of Tanzania Act, 2006The Bank of Uganda Act (Chapter 51)
2. Legal personalityYesYesYesYesYes
3. Public/private entityPublic entityPublic entityPublic entityNot specifiedNot specified
4. ShareholdersFully owned by governmentFully owned by governmentFully owned by governmentFully owned by governmentFully owned by government
5. Application of companies actNo provisionNoNo provisionNo provisionNo provision
Statutory Autonomy
1. Explicit statementYesNoYesYesNo
2. Governmental interference
Giving instructionsNoYesNoNoYes
Deferring/suspending decisionsNoNoNoNoNo
Censoring decisionsNoNoNoNoNo
Mandatory consultation regarding central bank decisionsNoYesNoNoNo
3. Financial autonomy
Governmental interference in budgetNoNoNoNoNo
Governmental interference in disposition of profit/lossNoConsultation with ministerNoNoNo
Distribution of unrealized profitsProhibitedUnclearProhibitedProhibitedUnclear
Recapitalization by governmentYesNo provisionYesYesYes
Threshold of recapitalization10% of total assets-General reserves become negativeHolding negative net assetsNo specification
4. Lending to governmentYesYesYesYesYes
Maturity- Intraday credit

- Purchasing treasury bills of less than 13 weeks
No limitationNo limitation- 180-day advances

- 12-month government bonds
No limitation
Ceiling of total lendingNo limitation5% of government recurrent revenue11% of current state revenue12.5% of government revenue18% of government recurrent revenue
Requirement of clearing outstanding at the end of yearNoNoNoNoNo
Legal Mandate
1. Objectives
PrimaryDomestic price stabilityStability in general level of pricesPrice stability. Stable and competitive financial systemDomestic price stabilityEconomic stability
OthersStability of the financial system. Contribution to implementation of economic policiesStable market-based financial system. Support the economic policySupport general economic policiesIntegrity of the financial system. Sound monetary, credit, and banking conditions. Support general economic policy
2. Statutory responsibilities
Formulating monetary policiesYesNo (minister of finance)YesYesYes
Implementing monetary policyYesYesYesYesYes
Determining exchange rate regimeNo provisionNo provisionNo (president on a request of the central bank)No provisionNo provision
Determining exchange rate policyYesYesYesYes, under consultation with minister of financeYes, under consultation with minister of finance
Implementing exchange rate policyYesYesYesYesYes
Managing reservesYesYesYesYesYes
Issuing banknotesYesYesYesYesYes
Fiscal agentYesYesYesYesYes
Payment system servicesYesYesYesYesYes
Supervising financial institutionsYesYesYesYesYes
Emergency liquidity assistanceYesNo provisionNo provisionYesNo provision
3. Monetary policy instruments
Open market operationsYesYesYesYesYes
Credit operations with banksYesYesYesYesYes
Minimum reserve requirementYesYesYesYesYes
Instruments for direct controlNoNoNoNoYes, amount and period of investments and loans. Interest rate on deposits
Governance Structure
1. One-/two-tier governance structureTwo-tierTwo-tierOne-tierOne-tierOne-tier
2. Governing bodies for policy settingGeneral councilMonetary policy committee, only for monetary policyBoard of directorsBoard of directorsBoard of directors
Executive membersGovernor, two deputy governorsGovernor, deputy governor, two executivesGovernor, deputy governorGovernor, three deputy governorsGovernor, deputy governor
Nonexecutive membersFive membersFour membersFour administratorsFour membersFour to six members
Ex officio membersNoSecretary to the treasuryNoTwo secretaries to the treasurySecretary to the treasury
Voting rights-No-YesYes
Policy implementationManagement committeeBoard of directorsSame as a policy-setting bodySame as a policy-setting bodySame as a policy-setting body
MembersGovernor, two deputy governorsGovernor, deputy governor, secretary of treasury, five nonexecutive members
3. Appointment Governor: ByPresident on the proposal of minister for financePresidentPresidentPresidentPresident on the advice of the cabinet
Term RenewalFive years RenewableFour years RenewableSix years RenewableFive years RenewableFour years Renewable
Deputy governor: BySame as governorSame as governorPrime ministerSame as governorPresident on the advice of the cabinet
TermSame as governorSame as governorSame as governorSame as governorSame as governor
RenewalSame as governorSame as governorSame as governorSame as governorSame as governor
Nonexecutives: BySame as governorMinister (monetary policy committee). Same as governor (board)Prime ministerMinister of financeMinister of finance
TermSame as governorThree years (monetary policy committee). Same as governor (board)Four yearsThree yearsSame as governor
RenewalSame as governorSame as governor (monetary policy committee, board)Same as governorSame as governorSame as governor
4. Dismissal
Governor: ByPresident on the proposal of minister for financePresident on the consultation with a special tribunalPresidentNo specificationPresident1
GroundsBankruptcy, breach of law, unjustified absences, serious misconductBankruptcy, conviction of felony, unsound mind, unjustified absences, incompetentNo provisionBankruptcy, conviction of felony, unsound mind, unjustified absencesInability to perform the functions of his or her office arising from infirmity of body or mind; misbehavior or misconduct; or incompetence
Deputy governor: bySame as governorPresidentPrime ministerNo specificationPresident
GroundsSame as governorSame as governorNo provisionSame as governorSame as governor
Nonexecutives: bySame as governorPresidentNo provisionNo specificationPresident
GroundsSame as governorSame as governorNo provisionSame as governorSame as governor
Appeal procedures for dismissalNo provisionA tribunal may be appointed by the presidentNo provisionNo provisionNo provision
5. Internal oversight
Audit committeeYesNo provisionNo provisionYesNo provision
MembersThree nonexecutive members of general council--Not specified-
Appointed byGeneral council--Not specified-
Internal audit functionYes, chief internal auditorNo provisionNo provisionYes (head of internal audit)No provision
Appointment of chief internal auditor/members of auditors’ boardGeneral council on the proposal of management committeeBoard of directors
TermThree years--Three years-
Reporting toGeneral council--Governor, audit committee-
Policy-setting body powers
Oversight of managementNoYesNoNoNo
Establishing/monitoring risk management proceduresNoNoNoNoNo
Establishing/monitoring financial reporting proceduresYesUnclear (oversight for financial management)YesUnclear (approval of budget)No
6. External accountability
Independent external auditYesYesYesYesNo
Accounting standardsInternational Financial Reporting StandardsNo provision“Commercial”“International”No provision
Reporting to governmentYesYesYesYesYes
Reporting to parliamentYesYesNoYesYes
Financial statements publishedYesYesYesYesNo provision
Deadline for publicationThree months after the end of yearNo provisionSix months after the end of yearThree months after the end of year-
Source: Author.Note: - = not applicable.

Based on the 1995 constitution.

Source: Author.Note: - = not applicable.

Based on the 1995 constitution.

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1The EAC 2012 average inflation was 15 percent against a median of 6.5 percent for sub-Saharan Africa.
2Options for the new currency regime are considered in Chapter 8 by C. Adam and others.
3Before the European Monetary Institute, a committee of central bank governors met at the Bank for International Settlements in Basel, supported by a small group of economic analysts.
4Central banks operating under a reserve money program use M3 as a nominal anchor or intermediate target (except Burundi, which uses M2).
5Velocity and multiplier are unstable in Kenya (Sichei and Kamau, 2010), and the money multiplier is unstable in Rwanda and Uganda in the short term. For Tanzania, the multiplier is stable in the long term, but not in the short term (Adam and Kessy, 2010), while velocity is generally stable (Adam and others, 2010).
6Andrle and others (2013) model transmission of monetary policy in Kenya using a small dynamic-linear monetary model with calibrated parameters adapted to the specific features of Kenya, incorporating food and nonfood price dynamics via two separate Phillips Curves and a Taylor-type monetary policy rule.
7Using a panel structural vector autoregression model that allows for dynamic heterogeneity among countries, Stepanyan (2012) finds that EAC countries (as well as Ethiopia) show food inflation shocks have a more lingering impact on consumer prices, with more prolonged second round effects and higher inflation inertia.
8Actually low financial intermediation was found irrelevant for monetary policy transmission for a sample of emerging market countries. The willingness to allow exchange rate flexibility was found to be a more important determining factor (Saizar and Chalk, 2008).
9As in other low-income countries, the way monetary policy transmission channels in EAC countries function is likely different from that in the standard literature. In particular, the interest rate channel may drive credit and consumption decisions rather than investment, and the exchange rate channel transmission may take place through inflation pressures expectations and portfolio decisions rather than through exports, given the low export base of low-income countries and their low sensitivity to exchange rate changes.
10Regardless of the terminology used by each central bank in the region, in this report “repos” are transactions to absorb liquidity and “reverse repos” are transactions to inject liquidity. For example, Tanzania denominates repo to transactions where exchange of government securities actually does not take place.
11In fact, EAC central banks in many cases already operate with more autonomy than granted in the law.

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