Building Integrated Economies in West Africa

Part IV: Regional Monetary Policy

Alexei Kireyev
Published Date:
April 2016
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The West African Economic and Monetary Union (WAEMU) is a currency union with a fixed exchange rate and limited capital mobility and, therefore, an independent monetary policy in the short term. The Central Bank of West African States (BCEAO) conducts the single monetary policy with the main goal of preserving price stability and supporting economic growth. However, the effectiveness of the WAEMU’s monetary policy remains low, with a weak reaction of market interest rates and inflation to BCEAO’s policy actions.

The institutional framework for monetary policy has been recently revamped. The new framework includes changes to the BCEAO’s decision-making bodies, revisions to the objectives of monetary policy, and a larger set of operational tools. The main decision makers now include the governor; the Monetary Policy Committee (MPC); the board of directors; the audit committee; and the national credit councils, with one council in each member state of the WAEMU. The MPC is responsible for setting monetary policy in the WAEMU. It is headed by the governor and meets four times a year for ordinary sessions. In addition, ad hoc sessions may be called. The MPC is also responsible for defining the instruments used to achieve the policy objectives. The BCEAO regularly publishes communiqués on the meetings of the MPC and quarterly a detailed report on monetary policy. To strengthen financial supervision, a Financial Stability Committee, headed by the governor and comprising mainly regulators (banking commission, social security regulator, insurance regulator, and the regional council for savings and financial markets) has also been put in place.

Price stability is the main objective of monetary policy. Price stability is defined as an annual average inflation rate of 2 percent plus or minus 1 percentage point and set over a 24-month horizon. This rate is set as the operational indicator. A number of secondary objectives of monetary policy are mentioned in the WAEMU documents. The BCEAO Statute (Article 8) also mentions support of sound and sustainable growth as a secondary objective of its monetary policy. Under the WAEMU Treaty (Article 62), monetary policy should also support integration in the economic union, “without prejudice to objectives assigned to it.” In addition, the Statute of the BCEAO specifies an intermediate target of monetary policy (Article 76). For three consecutive months, the ratio of the average foreign assets of the BCEAO to its sight liabilities (banknotes in circulation and deposits of banks, governments, and other organizations) should exceed 20 percent. In the opposite case, the MPC must take an appropriate action to restore the ratio.

In the institutional setup with a fixed exchange rate, is there scope and need for monetary policy in the WAEMU? Chapter 15, Monetary Policy in a Currency Union, seeks to answer this question. Although at first glance, the answer would appear to be “no,” as the WAEMU is a currency union with a fixed peg to the euro. However, the limited de facto capital mobility provides some scope for monetary policy. Institutional and other characteristics jointly needed for an independent monetary policy under a fixed exchange rate regime are present. The BCEAO can control regional interest rates, which diverge substantially from the euro area rates, as capital mobility is limited. Moreover, the BCEAO has substantial weight in the banking system and therefore can exercise sufficient influence on monetary conditions in the area. The BCEAO has the needed instruments (interest rates and reserve requirements) for achieving the goals of its monetary policy. In the absence of the exchange rate channel, all other channels of monetary policy transmission (through the volume of credit, interest rates, asset prices, and expectations) can, in principle, be more active. However, shallow financial markets and interest rate rigidities impede the transmission of monetary policy signals and the link from the BCEAO’s policy actions to market interest rates and inflation remains extremely weak, and can affect both only marginally. To improve monetary policy implementation, the BCEAO should also continue developing deep and functioning interbank, secondary debt, stock, and other financial markets. Improving the transmission of BCEAO policy actions to inflation by reducing price and interest rate rigidities, in particular by introducing more flexibility of deposit rates, is also important.

The transmission of the BCEAO’s single monetary policy to individual WAEMU countries has remained limited, despite some recent progress in regional financial development. Chapter 16, Country Effects of a Single Monetary Policy, assesses the effectiveness of the transmission mechanism of the BCEAO’s monetary policy for individual members of the WAEMU. The impact of a single monetary policy, although limited for the region as a whole, may be significant for individual countries with more developed financial markets and/or different product market structures and institutions. The hypothesis of an asymmetric transmission of the single monetary policy actions to individual countries can be tested empirically. In particular, the impact of the policy interest rate changes on each WAEMU country’s deposit and lending rates and inflation can be tested. BCEAO policy rate changes have no impact on deposit rates. The main channel of transmission of the single monetary policy to individual countries is through the link between the BCEAO’s single policy rate and the lending rates in individual countries; this link is relatively strong in Benin, Burkina Faso, Guinea-Bissau, Mali Senegal, and Togo and very weak in Côte d’Ivoire and Niger. The link to core inflation is observed only in some countries. However, the link to overall inflation, which is the ultimate goal of monetary policy, can be reliably traced only in Benin, Senegal, and Togo. In this context, further developing financial markets, increasing financial intermediation, and fostering competition in the banking sector are crucial to improving the effectiveness of the single monetary policy for individual WAEMU countries.

Liquidity injections by the BCEAO to commercial banks have increased recently and a substantial part has been used to fund purchases of government securities. Chapter 17, Liquidity Injections and Risks, documents that the liquidity position of the commercial banking system vis-à-vis the BCEAO has recently swung from a structural liquidity surplus to a deficit. The underlying causes are likely to include a combination of widening fiscal and external imbalance, and carry-trade activity by some banks. These developments, in turn, pose risks to fiscal and financial stability, financial development, and monetary policy effectiveness. WAEMU authorities should nevertheless monitor closely these trends in liquidity and consider whether any preemptive policy action might be appropriate, in order to prevent such risks from crystallizing. Possible measures include reducing fiscal deficits of individual WAEMU countries, which would reduce commercial banks’ demands for funding from the central bank to finance them; discouraging carry-trade activity by commercial banks; mitigating market distortions through changes in prudential regulation; relaxing regulatory barriers to entry for financial institutions other than domestic banks; and issuing a greater share of public debt externally.

The implementation of the BCEAO’s monetary policy with a view to achieving the objective of price stability requires a better understanding of the degree of sensitivity of the inflation rate to changes in the economic and financial environment. Chapter 18, Monetary Policy and Inflation, explored the impact of a change in the key interest rates of the BCEAO, as well as other economic, monetary, and financial aggregates, on inflation in the WAEMU. Specifically, the effects of interest rates, the money supply, imported inflation from the euro area, domestic credit, the fiscal deficit, and the output gap on inflation are evaluated. Econometric models suggest that most monetary and financial variables have an impact on the inflation rate. Monetary and financial variables have an influence on inflation. Their impact on the evolution of prices is evident over the short and long term. In particular, the impact of the BCEAO marginal lending rate and money market rate on inflation is significant, irrespective of the time horizon. As for the impact of domestic credit, it is just as significant as that of the BCEAO’s key rates and the money supply. The impact of domestic credit on inflation appears to be stronger than that of interest rates. Furthermore, the output gap, which has been negative, has had an overall moderating effect on inflation over the recent period. The impact observed over the long term is related to the fact that the transmission of interest rate fluctuations to inflation depends to a large extent on how they are reflected in borrowing rates and in demand among economic agents. Finally, the fiscal deficit (or public spending), as well as imported inflation, have considerable effects on the dynamics of inflation in the WAEMU. The impact of imported inflation has been generally stronger than that of the marginal lending rate.

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