Journal Issue

Chapter 4. Monetary and Exchange Rate Policy in the CCA: Progress, Challenges, and Policies for the Next Decade

International Monetary Fund. Middle East and Central Asia Dept.
Published Date:
April 2014
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Over the past twenty years, CCA countries have made significant progress in strengthening monetary and exchange rate policy frameworks and in securing better policy outcomes—lower inflation and interest rates, and deeper financial sectors. In the future, the region’s vision should be to emulate the best practice in monetary policy frameworks of emerging market countries. Consolidating the decline in inflation and reducing its volatility, fostering an environment that promotes lower dollarization and interest rates, and dealing with “fear of floating” concerns will be important steps in attaining this vision.


Monetary and exchange rate policies in the CCA have achieved significant successes over the past twenty years. This progress is evident when judged either in terms of the operational frameworks for monetary and exchange rate policies, or in terms of the outcomes that have been achieved:

  • Operational frameworks. CCA central banks have been given greater independence to conduct monetary and exchange rate policies and, although to varying degrees, have improved their technical expertise. In addition, central banks in the region now operate with better quality national statistics, and have become much more transparent with the public about a wide range of economic developments and policies.
  • Outcomes. The improvement in outcomes has perhaps been even more significant. Inflation rates have declined from triple-digits in the mid-1990s to single-digits in most of the CCA countries. Even in those countries where inflation has reached double digits in recent years, it has typically been below 15 percent. Nominal interest rates have also declined significantly.

In this context, monetary and exchange rate policies have helped improve the functioning of financial systems and have supported growth. With lower inflation and less uncertainty regarding exchange rate developments, financial sectors in the CCA countries have been able to intermediate resources more efficiently. Over the last decade, the decline in inflation and interest rates has led to significant financial sector deepening.

Figure 4.1.CCA Monetary Policy—Successes

Sources: National Authorities, IMF WEO, IMF IFS, and IMF staff estimates.


Despite these important successes, there is still scope for further improvements in monetary and exchange rate policy:

  • Regarding operational frameworks, there is room for strengthening central bank independence, communications, and accountability in all CCA countries, although to varying degrees. Dincer and Eichengreen (2010) calculated that CCA countries lagged countries in other regions in terms of central bank transparency by a wide margin.14 Even in CCA countries that have made significant progress in developing policy frameworks and instruments, including related to inflation targeting regimes (e.g., Armenia, Georgia), there is a need to strengthen communications with the market and the public. Data quality and analytical research can also be strengthened.
  • Regarding outcomes, inflation volatility remains high, which adds uncertainty to investment and savings decisions. While this inflation volatility in part reflects volatility in commodity prices—beyond the countries’ control—domestic policies have also played a role. Real interest rates and interest rate spreads also remain high, and have increased since the beginning of the global financial crisis. Finally, but no less important, there is significant scope for reducing financial dollarization. Dollarization had declined during the last decade as economic stability improved. But this trend was reversed in the late 2000s, as the global crisis hit the CCA. Dollarization exposes countries to balance sheet losses in case of disorderly exchange rate adjustment, weakens the transmission mechanism of monetary policy, and forces central banks to accumulate substantial international reserves if they are to act as lenders of last resort.

Some countries in the region are trying to address these challenges by developing modern monetary policy frameworks. This is a promising strategy, and one which the IMF and other international organizations have supported (see for instance the 2011 CCA and CEE workshop). Yet, perhaps more important than the specific framework that CCA countries choose is the articulation of a policy vision that properly guides policy frameworks and measures and that this vision is well communicated.

Figure 4.2.CCA Monetary Policy—Challenges

Sources: National Authorities, IMF WEO, IMF IFS, and IMF staff estimates.

Transformation of Monetary Policy Frameworks

As the region embarks on its third decade of transition, it should strive for monetary and exchange rate policy frameworks in line with best practices in emerging markets. Those frameworks should help to:

  • Consolidate stability. Consolidate the gains in terms of inflation reduction, so that price stability becomes engrained in the expectations of economic agents.
  • Enhance flexibility. Help the economy respond to external shocks—such as changes in commodity prices or capital inflows—but also to domestic business cycles. For this, central banks will need to develop the capacity to run countercyclical monetary policy and to strengthen the monetary policy transmission mechanism. Also, it is important to reduce the dollarization of the financial system, so that exchange rate movements do not produce large adverse balance sheet effects in the economy.
  • Support growth. Enabling an environment that allows lower domestic interest rates, and financial systems that can produce an efficient and broader allocation of credit across the economy (including through having access to foreign financing).

Naturally, each country needs to tailor its monetary policy framework to its own economic characteristics, but there are important common areas where CCA countries should make further progress:

Strengthen the transmission mechanism of monetary policy

Central banks need to act in a variety of circumstances, such as responding to business cycle fluctuations related to domestic or external shocks, or reacting to economic crises. No matter what the situation is, the central bank’s job will be easier if its monetary policy transmission mechanism is stronger. But a strong transmission mechanism cannot be achieved overnight and, as a result, central banks need to invest significant time and resources into building it—ideally during good times.

  • One key element of a strong transmission mechanism is the capacity of the central bank to communicate with the public and with markets, particularly regarding forward-looking guidance and policy intentions. The central bank can also communicate worthy goals, such as de-dollarization or the need to strengthen the financial system. Central banks’ communication infrastructure should, at a minimum, include periodic reports on inflation and monetary policy. Ideally, central banks should also be communicating with market participants, and the public in general, via periodic press releases and press conferences (e.g., after meetings of the central bank’s monetary policy committee and after publication of key reports). A number of CCA countries’ central banks—for example in Armenia, Georgia, Kazakhstan, and Tajikistan—follow these practices. Further transparency and guidance could be achieved through publication of the minutes of central bank meetings where monetary policy decisions are made, and regular testimony in national assemblies. The style of communication, not just the amount, is important for any good communications strategy. Central banks should be prepared to convey their messages in a way that is clear to people without any training in economics. And the discipline of having to communicate and explain may itself improve the quality of monetary policy. Limiting communications may be desirable in some circumstances, but to lack the capacity to communicate effectively and therefore not do so is not sustainable. CCA central banks should develop a communications strategy and specific capabilities.
  • Another key element of a strong transmission mechanism is a robust and deep financial sector. In particular, as argued by Fischer (2011), “If the financial system is intact, the standard anti-cyclical monetary policy response of cutting interest rates produces its response in the encouragement of purchases of durables, ranging from investment goods and housing to consumer durables.”15 But this standard monetary policy response will not work if banks are unable to expand credit due to weak balance sheets. For instance, Saborowski and Weber (2013) find that higher NPLs hinder the transmission from policy rates to market rates while Hoshi and Kashyap (2013) argue that failure to recapitalize banks’ balance sheets was one of the factors that contributed to Japan’s stagnation after its banking crisis in the 1990s.16, 17

Weak bank balance sheets can disrupt the monetary policy transmission mechanism and reduce credit growth, slowing the economy. A main cause can be high NPLs: banks may be unwilling to lend to firms, even if they have profitable investments, if they have a debt overhang problem. Monitoring and dealing with NPLs can also take away bank management time and resources, which reduces the bank’s capacity to extend new credit. Sitting on NPLs indefinitely may lead recovery values to fall and prevent new money and new players from entering. In the worst case, high NPLs may also lead banks to take new risks, in particular if they have incentives to “gamble for resurrection” by taking on riskier and higher return projects.

  • A third key element of a strong transmission mechanism is a financial sector with low levels of dollarization. In a dollarized economy it is harder for central banks to target the relevant monetary aggregates or interest rates, as a significant share of economic and financial transactions are denominated in foreign currency. Central banks also have to accumulate higher international reserves, if they are to be able to fulfill their lender of last resort function. De-dollarization in the CCA, especially in countries with more flexible exchange rates, can be further encouraged, though this is a gradual process in any country. In particular, there is scope to improve the fundamentals of the local currency by implementing sound monetary policies (delivering low and stable inflation), and sound fiscal policies (including fiscal sustainability). The central bank can facilitate access to local currency funding for banks (for example, by relaxing collateral standards on central bank lending), while encouraging banks to issue long term certificates of deposit (in local currency), to increase the stability of local currency funding. Additional measures to encourage de-dollarization include raising reserve requirements on foreign exchange funding (e.g., Kazakhstan in 2012), increasing the risk weighting of foreign exchange loans (for calculating bank capital requirements), and boosting the foreign exchange liquidity ratio. In Armenia, Azerbaijan, and Georgia, exchange rate appreciation helped drive de-dollarization as households and firms saw the purchasing power of their dollar balances declining, though this factor is unlikely to be a major one going forward.

Tackle challenges associated with the choice of the exchange rate regime

To support a more robust monetary policy framework, central banks need to clarify their objectives, and may need to be more open in coming to terms with their “fear of floating”. If choosing to adopt “pure” inflation targeting regimes is a priority, then countries ought to strengthen their commitment to exchange rate flexibility, which is needed for price stability. If instead choosing “flexible” inflation targeting, i.e., when central banks also pursue an exchange rate objective (which is possible when capital market integration is incomplete), then there are advantages from being transparent about this. Acting with dual objectives, without being clear about this, can cause confusion and undermine the credibility of the central bank.

Energy exporters also face some unique challenges arising from their managed exchange rate regimes. Resource exporters with managed exchange rates are prone to circumstances that can make it difficult to manage liquidity. For example, balance of payments surpluses and the transfer of oil export receipts to the budget may result in large excess liquidity in the financial system, which can be difficult to sterilize. Moreover, in these energy exporting countries, central banks should clarify the trade-offs between the conflicting goals that their monetary policy regime faces; in particular, ensuring price stability, while supporting the nominal exchange rate and promoting economic diversification. Central banks should be clear on how these objectives are traded off if they come into conflict.

Looking ahead, central banks in energy-exporting CCA countries that are considering allowing greater exchange rate flexibility in the future should prepare for this now. In particular, building capacity (e.g., further enhancing the communication strategy, deepening the financial sector) now will allow central banks to improve the effectiveness of monetary policy under a new, more flexible exchange rate regime in the future.

Table 4.1.IMF De Facto Classification of Exchange Rate Arrangements
AzerbaijanStabilized arrangement
Kyrgyz RepublicOther managed arrangement
KazakhstanCrawl-like arrangement
TajikistanStabilized arrangement
TurkmenistanConventional peg
UzbekistanCrawl-like arrangement
Source: 2012 IMF Annual Report on Exchange Arrangements and Exchange Restrictions.
Source: 2012 IMF Annual Report on Exchange Arrangements and Exchange Restrictions.

Strengthen central bank independence and focus on their core mandate

Central banks in the CCA region generally have strong legal provisions that aim to safeguard their independence. They typically also have strong technical expertise and financial resources, particularly in the local context. This is certainly advantageous, but in some CCA countries this has also made central banks the recipient of requests to take on a number of noncore tasks or quasi-fiscal activities, which vary in terms of scope and complexity. For instance, one central bank in the region has been engaged in large-scale education reforms, while another has run a rating system for private sector companies and became involved in civil aviation polices, when a large local carrier encountered financial difficulties. Another has been involved in financing construction of government residences, recreational facilities, and housing, while yet another has been tasked with managing a new unified national pension fund system.

While it may be tempting to hand these important tasks to central banks for them to solve, this approach may prove counterproductive and risky and undermine central bank independence. It confuses the central bank’s mandate, forcing the central bank to devote staff and managerial time to solve noncore tasks. In addition, as these activities are outside the core of central bank operations and taken on at the behest of policymakers, they are likely to be less transparent than direct government action, impeding governance and accountability and making it much harder to assess central bank performance. In addition, the approach may have unintended consequences, such as creating the perception that the central bank may step in to provide a bailout if problems were to emerge (for example, if pension returns were to fall short, or if high-rated companies were to face financial difficulties and lenders demand compensation). This may also create conflicts of interest when setting the monetary policy stance. Finally, the extension of operations of the central bank may impede the development of government or private sector expertise in the area taken over by the central bank. As such, the central bank may remain “on the hook” for future noncore or quasi-fiscal requests.

But more important, by giving inherently political decisions to the central bank, ultimately the central bank’s independence will be undermined—for if it steps in on non-core questions, it moves closer to the political arena and further away from the technical design and implementation of monetary policy—the very means by which the central bank acquired its reputation for competence and technical expertise. Central banks need, therefore, to have the independence to be able to keep away from noncore goals and objectives, however worthy they may be.

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