Improving the Monetary Policy Frameworks in Central America

Several Central American (CADR) countries with independent monetary policies are strengthening their monetary frameworks and some have implemented or are moving towards inflation targeting (IT) regimes. Strengthening the monetary policy frameworks of CADR is key to improving the effectiveness of monetary policy. The paper reviews the literature on the reforms needed for strengthening the monetary policy frameworks, and examines the experiences of IT countries, Chile, Peru, and Uruguay to help distill lessons for CADR. It also constructs an index to measure the relative strength of the monetary policy framework of CADR countries.

Abstract

Several Central American (CADR) countries with independent monetary policies are strengthening their monetary frameworks and some have implemented or are moving towards inflation targeting (IT) regimes. Strengthening the monetary policy frameworks of CADR is key to improving the effectiveness of monetary policy. The paper reviews the literature on the reforms needed for strengthening the monetary policy frameworks, and examines the experiences of IT countries, Chile, Peru, and Uruguay to help distill lessons for CADR. It also constructs an index to measure the relative strength of the monetary policy framework of CADR countries.

I. Introduction

In the 1980s and 1990s, CADR countries (except Nicaragua), had lower inflation rates than other Latin American countries (Figure 1).2 However, despite efforts to strengthen the institutional frameworks for formulating and executing monetary policy since the mid-1990s, inflation in CADR has been above inflation in other Latin American countries since the early 2000s, and more volatile and vulnerable to external shocks. CADR central banks have tended to raise interest rates less than what was required to tame inflation pressures and some have also cared about the stability of the exchange rate, thus blurring their true policy objective vis-à-vis price stability (Jácome and Parrado, 2007a). The recent weaker inflation performance of CADR countries is a symptom of their need to strengthen their monetary policy frameworks and resolve structural problems. They have lagged behind other Latin American countries, in particular the LA6 counties, who have undertaken significant monetary reforms and adopted IT regimes along with flexible exchange rates.3

Figure 1.
Figure 1.

Inflation in Central America (CADR) and Selected Latin American Countries

Citation: IMF Working Papers 2011, 245; 10.5089/9781463923242.001.A001

Source: IMF, WEO database1/ For comparibility reasons, the median inflation was used for the period 1980-95, given the hyperinflation episodes experienced by Brazil, Nicaragua and Peru.

This paper seeks to identify key reforms needed to strengthen monetary frameworks in CADR countries to reduce inflation and achieve price stability. In order to do so, it builds upon existing studies on how monetary policy is conducted in Central America (Jácome and Parrado, 2007a, 2007b, and Medina Cas, Carrión-Menéndez, and Frantischek, 2011), reviews the literature on enhancing monetary policy frameworks, and examines the reform experiences of Chile, Peru, and Uruguay to help distil lessons for CADR. These three South American countries, which have adopted IT (or, in the case of Uruguay, transitioning towards IT), have built strong monetary policy frameworks and share some of the economic characteristics of CADR (e.g., openness, vulnerability to external shocks, some degree of financial dollarization—except Chile—and, in the case of Uruguay, similar economic size and a external current account dominated by commodity imports).

The paper also constructs an index to measure the strength of the monetary policy frameworks in each CADR country. While there are significant differences among CADR countries, all of them still lag far behind the benchmark country (Chile). In particular, the study reveals that central banks in the region would benefit from ensuring the continued absence of fiscal dominance, enhancing central bank independence, and increasing exchange rate flexibility to reinforce the primacy of price stability as the main monetary policy objective. Moreover, measures to improve the effectiveness of the policy instrument, such as enhancing liquidity management, would also be important as they aid in the development of the interest-rate transmission mechanism.

The paper has four sections. Section II examines the literature on the conditions and benefits of strengthening monetary policy frameworks, many of which are similar to those associated with IT. Section III describes the monetary reforms undertaken in Chile, Peru and Uruguay in their process towards implementing IT and characterizes the monetary frameworks in CADR. In doing so, it develops taxonomy of key elements that support a strong monetary policy framework, which is used to build an index to measure the strength of monetary policy in CADR. Section IV concludes with the main policy recommendations for CADR.

II. Key Elements of A Strong Monetary Policy Framework: Review of the Literature

A well functioning monetary framework in the context of a flexible exchange rate regime is essential to maintain macroeconomic stability and offset the effects of shocks on the real economy. However, in many economies, the channels through which monetary policy is transmitted to prices and output face several constraints, including insufficient exchange rate flexibility, financial dollarization, fiscal dominance, low financial intermediation, and fragile central bank financial positions.

Many of the conditions to strengthen independent monetary policy frameworks and consequently the effectiveness of monetary policy are similar to those required for successful implementation of IT. These conditions encompass several elements, the most important of which is that price stability should be the main objective of monetary policy. Under an IT framework, the central bank has an explicit quantitative target or target ranges for the inflation rate, and the inflation forecast over some time horizon is the de-facto intermediate target of policy (Batini, Kuttner, and Laxton, 2005). In response to a wide-range of new information, the central bank changes monetary conditions to bring expected inflation in line over time with the inflation target. IT is accompanied by a high level of central bank transparency in its communications of the monetary policy strategy and implementation, and by a high amount of accountability on the attainment of its objective (Rogers, 2010).

In the process of strengthening the monetary frameworks, recent studies conclude that there are three basic preconditions that should be in place when adopting IT: priority of the inflation target, absence of fiscal dominance, and central bank instrument independence.4 Other conditions can be developed after the adoption of IT, including institutional changes and increasing technical capacity of the central bank (Batini et al., 2005; Freedman and Otker-Robe, 2010). Interestingly, it has also been found that highly financially dollarized economies can successfully implement IT, while giving some role to exchange rate smoothing as long as intervention does not aim at targeting a certain level or trend for the real or nominal exchange rate (Leiderman, Maino, and Parrado, 2006).

There is evidence that the introduction of IT—and the associated increase in exchange rate flexibility— in emerging markets has contributed to a reduction of the exchange-rate pass-through to inflation (Coulibaly and Kempf, 2010). This is important as a low pass-through increases the effectiveness of the exchange rate as an indirect channel of transmission to output and prices because changes in the exchange rate would have a greater impact on net exports. Some degree of exchange rate smoothing can be beneficial for financially vulnerable emerging markets, due to the perverse impact that exchange rate movements have on activity and financial variables (Rogers, Restrepo, and Garcia, 2009). However, the primary objective of monetary policy needs to be the inflation target, with exchange rate smoothing playing a clearly secondary role (Goldstein, 2002). In particular, it is key to avoid the appearance of multiple objectives as insufficient clarity on the relative importance of each of these objectives could leave the system without a clear anchor and undermine its credibility (Mishkin and Savastano, 2000)

The main benefits of IT stem from its ability to lower inflation, while reducing adverse effects on output. IT has been shown to be associated with lower inflation, lower inflation expectations, and lower inflation volatility relative to non-IT countries (Batini, et al. 2005). At the same time, there has not been adverse impact on output, or on the volatility of interest rates, exchange rates, and international reserves. IT has also helped better anchor inflation expectations, allowed exchange rates to become efficient shock absorbers, helped boost communication and transparency of the central bank, and resulted in institutional reforms, thus reinforcing further the IT framework (Freedman and Okter Robe, 2009)

The existence of supply shocks argue for implementing a flexible monetary policy framework that takes into account changes in the output gap while enhancing communication. In the short run, monetary policy should be allowed to respond to the output gap (i.e., a Taylor rule) so that part of the temporary shock can be reflected in an increase in the price level (Frankel, 2010). Placing greater importance on core CPI, which excludes volatile food and fuel components, is also useful in the case of temporary shocks. As done in many IT countries, monetary flexibility can be increased by setting a target range for inflation, rather than a point target. Clear communication by the central bank that these shocks are considered temporary is also crucial to anchoring long-term inflation expectations and maintaining credibility.

IT has shown to be an effective monetary framework, even in the face of adverse supply shocks. This can be illustrated using the experience of the major IT central banks in the Latin America (Brazil, Chile, Colombia, Mexico, and Peru—the LA5 countries) during the food and fuel price shock in 2008. During this episode, on average, these countries had significantly lower inflation volatility and better contained inflationary pressures than other Latin American countries with less flexible exchange rate regimes (Figure 2; Canales-Kriljenko, et al. 2010). Once it was clear that the supply shock was not temporary and was beginning to affect core inflation, the LA5 countries tightened monetary policy with a short lag and allowed their nominal exchange rates to appreciate. They communicated to the markets that a rise in interest rates was necessary as inflation expectations had begun to divert from the inflation band, and reiterated their commitment to price stability.

Figure 2.
Figure 2.

Average Inflation in CADR and LA5

Citation: IMF Working Papers 2011, 245; 10.5089/9781463923242.001.A001

III. Monetary Frameworks in Selected South American Countries and Cadr

This section reviews the monetary reforms undertaken in Chile, Peru and Uruguay and the existing monetary frameworks of CADR. It also develops an index to measure the strength of the monetary policy frameworks in CADR. Understanding the experience of the three IT South American countries is useful for identifying key reforms to strengthen the monetary frameworks in CADR. The monetary policy frameworks of these countries provide useful benchmarks for CADR as they share key characteristics: they have become increasingly open, are subject to external shocks, and the financial systems are partially dollarized (with the exception of Chile) and generally dominated by banks. In addition, Uruguay has an economic size similar to some of the largest economies in CADR and is exposed to similar terms of trade shocks given that it is a commodity importing country.

A. Monetary Frameworks and Reforms in Chile, Peru, and Uruguay

The following review of the experience of the countries chosen is based on a taxonomy of characteristics of strong monetary policy frameworks derived from the literature, namely: price stability as the main monetary objective (and the associated exchange rate flexibility), absence of fiscal dominance, central bank instrument independence, the effectiveness of the policy instrument, and other elements (e.g., deep and sound financial markets, good technical capacity at the central bank for forecasting inflation, and accountability and transparency of the central bank). A detailed examination of the monetary frameworks in Chile, Peru and Uruguay is presented in Annex I.

Priority of the inflation target (and the associated exchange rate flexibility)

The main monetary policy objective in Chile, Peru, and Uruguay is price stability. Chile started with an informal IT framework in the early 1990s and adopted a fully-fledged IT in 1999. After a successful disinflation process, Peru adopted IT in 2002, while Uruguay has been transitioning to a fully-fledged IT since late 2007. A few years before adopting IT, in the new legislation of the Central Bank of Chile (BCC) and of the Central Reserve Bank of Peru (BCRP), monetary and currency stability became their main policy objective, which was interpreted by these central banks as preserving price stability. In the case of the Central Bank of Uruguay (BCU), the legislation was modified one year after it started transitioning to IT in 2007, and price stability became the main objective.

All countries adopted floating exchange rate regimes, which allowed central banks to focus on price stability as the dominant target. In 1999, Chile adopted a floating exchange regime, after an eight-year period under an exchange rate band regime. Foreign exchange interventions have been infrequent and, when carried out, the central bank has announced the reason, size, and time span for the intervention. In 1991, Peru unified the foreign exchange market and allowed the exchange rate to float. Foreign exchange intervention in Peru has been important and frequent, justified by the presence of high financial dollarization, which has led the BCRP to manage exchange rate volatility to avoid potential balance sheet effects. In 2002, Uruguay abandoned a crawling band, and since then has a floating exchange rate regime but with frequent foreign exchange interventions to smooth out exchange rate fluctuations.

Absence of fiscal dominance

All the central banks are forbidden to grant credit to the public sector, and fiscal positions improved considerably in Chile since the 1990s and in Peru since the 2000s, while Uruguay has significantly narrowed its overall deficit since 2003. Chile and Peru reformed central bank legislation at least ten years before adopting IT, while Uruguay modified it one year after transitioning to IT. In the new legislations, the central bank is forbidden to extend credit to the public sector. In the case of Peru and Uruguay, the central bank can purchase government securities in secondary markets but within strict and well established limits. The BCC can only lend to the government in case of a national emergency. A few years prior to the adoption of IT, the policy frameworks in the three countries, and the fiscal framework in particular, strengthened significantly. Chile and Peru were running fiscal surpluses up to the global crisis in 2008, while Uruguay was running small fiscal deficits. After implementing countercyclical fiscal policies to face the crisis, fiscal positions deteriorated in 2009, but it is expected that they will strengthen in the near future.

Central bank independence

The three countries have a high degree of central bank independence. Prior to the latest changes in central bank legislations, these countries did not have de jure instrument independence. After the changes, the BCC and the BCRP achieved greater independence and became more shielded from political interference, with board members nominated by the President of the country and ratified by Congress from a pool of qualified and independent professionals. In contrast with the BCU and BCRP, the independence of the BCC is further protected as the terms of the governor and the board members are staggered and do not coincide with electoral calendars. While the BCU does not have de jure independence, in practice it has had a high degree of autonomy comparable to the BCC and BCRP.

The BCRP’s balance sheet has strengthened, though weaknesses still remain in those of the BCU and BCC. All three central banks experienced high operational deficits in the 1980’s (Table 1). In the case of the BCU, the government recapitalized the central bank in October 2010, with the issuance of US$2.4 billion worth of government inflation-indexed bonds. In the case of the BCC, under the Fiscal Responsibility Law (2006) annual government transfers were made in 2006-2008 equivalent to 0.5 percent of GDP every year, but its net worth continues to be negative.5 However, this has not been an impediment to the conduct monetary policy, as the BCC has been able to issue debt instruments due to strong market demand supported by the strength of fiscal policy and the growing pool of institutional investors, particularly private pension funds. The BCRP balance sheet position strengthened in 1994 after the redefinition of its role, with increased autonomy provided in its new charter, and the recapitalization from the central government.

Table 1.

Central Bank Profits and Losses in Chile, Peru, and Uruguay

(In percent of GDP)

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Source: IMF Staff Reports.

The effectiveness of the policy instrument

The three countries have developed over time market-supportive monetary operational frameworks and have gradually gained more control over their policy instrument, which is a short-term interest rate. Following a transition period, they have adopted a daily interbank rate as an operational target, relying primarily on market-based monetary instruments to manage liquidity. During the transition, they fostered interbank and money market operations and refined the scope of monetary instruments, including by improving auctions, extending maturities of central bank securities, creating credit and deposits standing facilities, and introducing repos and reverse repos operations. Regarding the operational target, the BCC moved from a real to a nominal interbank rate, while the BCRP moved from a quantitative target (banks’ reserves at the central bank) to a daily interbank rate. The BCU moved from the monetary base toward a market interbank rate as its operational target. The BCRP and BCU still rely on reserve requirements to help managing liquidity conditions.

The three central banks have developed a good understanding of the transmission mechanism of monetary policy. In the case of the BCC, monetary policy is well anchored on a free floating exchange rate regime with financial dollarization posing no constraints to policy decisions. In the cases of Peru and Uruguay, the interest-rate transmission mechanism is hindered to a certain extent by low exchange rate flexibility and financial dollarization. However, the BCRP and BCU have implemented measures to discourage dollarization, such as imposing limits on net open foreign-currency positions of banks, higher capital requirements for foreign-currency loans, higher reserve and liquidity requirements on foreign-currency deposits, and tighter loan classification for foreign-currency loans.

Other elements for strengthening the monetary policy framework

All three countries have strengthened their financial systems and are promoting the development of domestic financial markets. While bank concentration may still weaken interest-rate transmission in Peru and Uruguay, the regulatory and prudential frameworks have been upgraded in all three countries and financial sector indicators have improved significantly.6 Regarding the development of their financial systems, the Chilean pension reform of the early 1980s contributed to the development of the financial system by allowing a stable accumulation of large funds to be invested in private sector assets. In addition, the Chilean financial system is characterized by relatively long bond maturities, and an equity market that is large by Emerging Market standards. Peru’s financial market has grown rapidly in recent years, facilitated by increasingly capitalized pension and mutual funds, sound public finances, and higher demand for Peruvian assets by foreign investors. Moreover, the Peruvian authorities have been establishing a yield curve in local currency as a reference point for the corporate sector. The Uruguayan financial system is dominated by banks, while the equity market and the domestic corporate bond market are small and relatively illiquid. The BCU has focused on the development of the fixed-rate local currency securities markets by lengthening the maturity structure of central bank securities.

The BCC and the BCRP have good technical capacity for inflation forecasting. They have developed models for inflation and macroeconomic forecasting and policy analysis, including time series models for short-term forecasts, structural macroeconomic models for quarterly forecasting, and dynamic stochastic general equilibrium (DSGE) models. The BCU is advancing in model forecasting but needs to develop further technical capacity in this area.

The accountability and transparency of the central bank is high in all three countries. All publish quarterly monetary or inflation reports, financial stability reports, annual audited financial statements, and detailed monetary policy decisions. The governor of the BBC reports to Congress four times a year, once to full Congress and three times to the Finance Committee; the governor of the BCRP report to Congress once a year. The BCC is particularly transparent regarding board policy decisions, as it publishes monetary decisions, the minutes of the policy meetings, and voting patterns shortly after the meetings. All the central banks publish comprehensive economic analyses and extensive monetary and economic data on their websites.

B. The Monetary Policy Frameworks in CADR

The channels through which monetary policy is transmitted to prices and output face several constraints in CADR. The interest-rate transmission mechanism, for example, is weakened by factors such as limited exchange rate flexibility, the level of dollarization, and the development of the financial sector (Medina Cas, Carrión-Menéndez, and Frantischek, 2011). In addition, the reputation and credibility of central banks needs to be further strengthened to achieve better inflation results (Jácome and Parrado, 2007a, 2007b). Reducing these constraints should enhance the effectiveness of their monetary policy frameworks. The status and progress achieved by CADR in these areas is described below following the taxonomy used in the previous subsection. A detailed examination of the monetary frameworks for the individual CADR countries is presented in Annex II.

Priority of the inflation target (and the associated move towards exchange rate flexibility)

All the central banks in CADR have price stability as an objective, but it is not the only objective of monetary policy. The Dominican Republic is the only country that has price stability as the fundamental objective of monetary policy in its central bank legislation; Guatemala has it as a secondary objective (the main objective is creating conditions for the orderly development of the economy). In the legislation of Costa Rica, Honduras, and Nicaragua, the objective of monetary policy is to preserve the stability of the currency. In practice, Guatemala, Costa Rica, and the Dominican Republic have inflation target ranges, but the two latter countries give high importance to the exchange rate as a nominal anchor and the Central Bank of Guatemala (Banguat) has an intervention rule to limit exchange rate volatility.

In fact, all CADR countries place importance on exchange rate stability, thus blurring to different extents the priority attached to the inflation target or price stability. Only Guatemala has adopted a floating exchange rate regime, but exchange rate flexibility has generally been low, partly due to the intervention rule. Costa Rica has a crawling band regime, while the Dominican Republic has a de jure managed float, but de facto the exchange rate continues to be a key anchor as is tightly managed with discretionary intervention. Honduras has recently re-introduced a crawling band regime and Nicaragua has a crawling peg.

Absence of fiscal dominance

The conditions in CADR in this area are generally positive. All central banks by law are not allowed to provide credit to the government, though Costa Rica, Honduras, and Nicaragua permit some short-term lending. In particular, the Central Bank of Costa Rica (BCCR) is allowed to buy treasury bills, the Central Bank of Nicaragua (BCN) can provide short-term advances by discounting treasury bills, and the Central Bank of Honduras (BCH) can only provide short-term credit to the government. However, in two recent occasions the BCH short-term credit to the government was converted into long-term credit. In the cases of the Banguat and the Central Bank of the Dominican Republic (BCRD), they can only lend to the government under emergency circumstances.

As a result of the global economic crisis, the fiscal positions deteriorated in all CADR countries since 2008. In particular, fiscal deficit have worsened, often as a result of increases in permanent spending. Thus, while nonfinancial public sector debt remains relatively low in the Dominican Republic, Guatemala, and Honduras (at around 25–30 percent of GDP), and is relatively higher in Costa Rica and Nicaragua (at about 35 and 80 percent of GDP respectively), strict adherence to fiscal consolidation targets is essential to reduce deficits and debt-to GDP ratios to regain fiscal space used during the crisis.

Central bank independence

Following changes in legislations in the 1990’s and in the first-half of the 2000’s, the central banks of CADR were empowered with de jure instrument independence. However, political autonomy needs to be strengthened further to enhance institutional independence in the following aspects: the process to appoint/dismiss central bank governors, the terms of the board linked to political cycles, and the composition of the board.7 For example, in the Dominican Republic, Guatemala, Honduras, and Nicaragua, the President of the country appoints the governors of the central bank; and in Costa Rica, the governing council chaired by the President does. Furthermore, in Costa Rica and Nicaragua, the President has considerable influence when it comes to firing the governor or board members. Except in Honduras, all the central bank board include the minister of finance, and, in the case of the Banguat, board members also include members of Congress, the banking association, and non-bank private representatives. In Costa Rica and the Dominican Republic, the mandate of the governor or board members overlaps with that of the President of the country (though in the Dominican Republic a new draft law is expected to be passed in 2011 that would lengthen the mandates of board members and will not overlap with the presidential period). In Honduras, the mandate of the governor and one board member overlaps with the presidential mandate, while in Nicaragua the term of only one board member overlaps with the presidential mandate.

Operational autonomy is undermined in all countries by weaknesses in central banks’ balance sheets. The CADR central banks have been running operational deficits and have negative or insufficient capital under accounting frameworks that comply with International Financial Reporting Standards (IFRS). In some cases, the losses have been the result of recent quasi-fiscal activities (Nicaragua), of quasi-fiscal activities in the 1980s and 1990s (Costa Rica and Honduras), or a legacy of a banking sector crisis (the Dominican Republic in 2003–05).8 Since 2003, Guatemala has a mechanism to absorb central bank losses, but losses prior to that year have not been recognized. In Nicaragua and Honduras, the government is mandated to absorb losses but this has not been very effective in strengthening the capital position of the central banks.9 For example, in Honduras the government has provided nonmarketable securities with long-term maturities at very low yields. In the Dominican Republic, a recapitalization plan is being implemented, but in Costa Rica a central bank recapitalization plan has been in Congress since 2007 without being approved.

The effectiveness of the policy instrument

All central banks in CADR rely on rules-based instruments and open market-type operations, with only partial reliance on money market operations.10 This reflects the relatively undeveloped situation of the money market. All central banks in the region use reserve requirements, standing facilities, and auctions of central bank securities to regulate liquidity. With the exception of Nicaragua, all central banks have an explicit policy rate, but the signaling of the policy stance is hindered by a structural liquidity surplus and shallow interbank markets. The Banguat has strengthened the monetary operation framework in recent years and introduced an overnight rate with a one-day instrument as its operational target in June 2011. The BCRD and BCCR use lending and deposit facilities at the central bank to establish a corridor for short-term interest rates. The BCRD is gradually narrowing the interest-rate corridor, and the BCCR also plans to do so.

The transmission mechanism from the policy rate to lending rates in CADR is weakened by low exchange rate flexibility and financial dollarization (Medina Cas, et al., 2011). In Costa Rica, the Dominican Republic, and Guatemala there is an understanding of how the transmission mechanism works, but limited exchange rate flexibility hinders the interest-rate transmission mechanism. CADR countries have not seen a substantial decline in deposit dollarization ratios since 2008, though their levels are below those in countries with stronger monetary policy frameworks such as Peru and Uruguay. In addition, most of the central banks need to improve liquidity forecasting to more effectively tackle the excess liquidity held by banks, which is another factor hindering the transmission mechanism.

Other elements for strengthening the monetary policy framework

Looking ahead, it will be important to continue strengthening and developing further the financial systems in CAPDR. While banks play a dominant role in the financial markets of the region and concentration remains high (particularly in Nicaragua and the Dominican Republic), the banking sector is adequately capitalized and liquid, and non-performing loans are low (2–4 percent range). Costa Rica and Guatemala tend to have the most advanced supervisory practices, though the region still lags with respect to best international practices in some areas.11 Regarding the development of financial systems, capital markets are dominated by government bonds or central bank paper, and given that secondary markets are limited or non-existent, countries do not have benchmark yield curves for government bonds, or other curves that reflect market conditions. Interbank markets are also shallow and the foreign exchange market is often dominated by the central bank. Costa Rica is the only country with a significant private securities market, though it still remains small.

Central banks in the region need to develop methodologies for inflation forecasting. Within the region, the BCCR, the BCRD, and the Banguat have stronger technical capacity to model inflation (including a portfolio of inflation forecasting models and macroeconomic forecasting models) but further technical improvements are still needed. The BCN and BCH have only basic models for inflation forecasting. Since they are more advanced towards IT, the central banks for the Dominican Republic, Costa Rica, and Guatemala conduct monthly surveys of inflation expectations. The Banguat and BCCR publish the surveys on their website, while the BCRD shares it with the survey participants.

The central banks in CADR generally have appropriate accountability and transparency frameworks. They report annually to their respective Congresses and publish annual audited financial statements and decisions regarding monetary policy actions. The Banguat is one of the most transparent central banks in the region as it publishes the minutes of its monetary policy decisions and its governor appears twice a year before Congress. The CADR central banks publish several monetary policy reports during the year, except for Honduras which only publishes one, and they publish extensive monetary and economic data on their websites.

C. Index to Measure the Strength of Monetary Policy Frameworks in CADR

In order to map concisely the relative strengths of the monetary frameworks of each CADR country, it is possible to build an index that captures the key elements of a strong monetary policy framework. Following the taxonomy used in the previous subsections, the index is constructed based on five main criteria: (i) the central bank’s main policy objective; (ii) absence of fiscal dominance; (iii) central bank independence; 12 (iv) a considerable control over policy instrument; and (v) transparency and accountability. Within the five main criteria we distinguish 12 sub-criteria, which are given a scale ranging from zero to one (with higher values indicating a better performance) and assessed using legal and de facto indicators.13 The overall index is a weighted average of the individual criteria; the structure and specific scores of the index are spelled out in greater detail in Appendix III. The results from the index indicate that the strength of the monetary policy framework varies significantly within the region (Figure 3). According to the index, Guatemala has the strongest monetary policy framework in the region, with those of Costa Rica and Dominican Republic being above the regional average. However, the monetary frameworks in all CADR countries still lag far behind Chile, which was selected as benchmark given that it has one of the strongest monetary frameworks in Latin America.

Figure 3.
Figure 3.

Index of Strength of Monetary Policy Framework

Citation: IMF Working Papers 2011, 245; 10.5089/9781463923242.001.A001

The areas of the monetary framework that need to be strengthened the most are those related to establishing a clear mandate for the central bank and enhancing the effectiveness of the policy instrument (Table 2). In particular, the mandate of the central banks could be enhanced by placing greater emphasis on price stability and increasing exchange rate flexibility (Appendix III). Regarding the effectiveness of the policy instrument, all countries need to increase the signaling effect of the monetary policy rate and reduce the reliance on rules-based instruments and improve liquidity forecasting (particularly Costa Rica, Honduras and Nicaragua). In addition, all CADR countries need to strengthen central bank independence, but the polices to achieve it vary by country; for example, it is particularly important to strengthen the balance sheets of the central banks of Costa Rica, Honduras and Nicaragua, address the weaknesses in the composition of the monetary board in Guatemala and Nicaragua, and delink the terms in office of the governor from the political cycle in Dominican Republic. Moreover, it is important to reduce the degree of fiscal dominance by trimming down public debt ratios (Costa Rica and Nicaragua) and by prohibiting central bank lending or advances to the government (particularly Honduras and Nicaragua). Most countries in the CADR region, fare relatively well regarding transparency and accountability of its central banks, though improvements could still be achieved in this area by ensuring the publication of detailed financial statements following International Financial Reporting Standards and enhancing the reporting of the central bank governor to Congress.

Table 2.

Index: Strength of Monetary Policy Framework

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Source: Appendix III.

Total index = 0.30*(1)+0.25*(2)+0.20*(3)+0.20*(4)+0.05*(5)

IV. Conclusions and Policy Recommendations

Further strengthening the monetary policy frameworks of CADR countries would help reducing existing constraints to an effective monetary policy and achieve lower and more stable inflation rates. While the central banks in the non-dollarized economies of the region have continued to modernize their monetary frameworks and operations, there are important areas where efforts would bring them closer to international best practices. In particular, the index to measure the strength of the monetary policy frameworks for CADR countries, especially when compared to Chile, suggests that there is considerable room for improvement by establishing a clearer mandate for central banks and enhancing the effectiveness of the policy instrument.

Arguably, a key step that could be taken by central banks is to increase exchange rate flexibility. This would help reinforce price stability as the primary objective of monetary policy and avoid the appearance of multiple objectives, which could leave the system without a clear anchor and undermine its credibility. A higher degree of exchange rate flexibility is possible in economies that have some degree of financial dollarization, as shown by the experience of Peru and Uruguay (which also indicates that there is a role for foreign exchange intervention to dampen volatility, particularly in times of stress).

To increase the effectiveness of the policy instrument, the signaling function of the monetary policy rate has to be enhanced by removing structural excess liquidity in the banking system through more reliance on market-based monetary operations. To this end, central banks need to improve liquidity management by establishing cash flow programs and fine-tuning through the introduction of repos and reverse repos and promote further development of interbank markets. At the same time, there should still be a role for rules-based instruments, such as reserve requirements. In particular, the experience of Peru and Uruguay indicate that using higher reserve requirements on dollar deposits could be useful to reduce dollarization, thus helping increase the transmission mechanism of monetary policy. This policy could be considered in Costa Rica, Guatemala, and Nicaragua.

Two other important steps to strengthen monetary policy frameworks are to preserve the absence of fiscal dominance and enhance central bank independence, particularly as some CADR countries aim at enhancing or moving towards IT regimes. Most countries need to implement reforms aimed at stabilizing (or even reducing) public debt-to-GDP ratios and in some others (particularly Honduras and Nicaragua) it is also key to strengthen legislation to shield the central bank from financing the government. On central bank independence, it is key to tackle weaknesses related of the process of appointment/dismissal of the central bank governors, terms of the board linked to political cycles and the composition of the board, as well as strengthening the balance sheets of the central bank (particularly in the case of Costa Rica, Honduras, and Nicaragua).

Other conditions to enhance the monetary policy frameworks can be developed, and in some instances their fulfillment can be accelerated, once the above steps are taken. These conditions include developing further the capacity of central banks for inflation forecasting (where further technical assistance will be required), and continuing to improve the transparency and accountability of central banks (including by publishing monetary or inflation reports on a quarterly basis, and disclosing the minutes of their monetary policy decisions; Costa Rica could also continue publishing regularly an annual financial statement, audited externally).

Although not an immediate priority in the process of strengthening the monetary policy framework, it will be important to continue enhancing financial regulation and supervision in CADR to bring it to the standards of LA5 economies. In addition, various reforms could be implemented to help develop and promote diversification of financial markets. In particular, public debt issuance needs to be further standardized and government benchmark yield curves need to be established to help develop corporate debt markets. Also, the interbank markets should be further developed to help strengthen the interest-rate transmission of monetary policy (including by setting up an electronic book-entry system and central securities depository to facilitate the transfer of securities’ ownership). The development of domestic financial markets could also be fostered by establishing a yield curve in domestic currency as a reference point to the corporate sector and by moving towards a defined benefits pension system.

Appendix I

Key Elements of a Strong Monetary Policy Framework: The Case of Chile, Peru and Uruguay

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Sources: Websites of the Central banks of Chile, Peru and Uruguay; publications of central banks of Chile, Peru and Uruguay; and IMF country reports.* A survey of the studies of the adoption of IT frameworks reveals the first three conditions (in bold) should be met prior to the adoption of IT in emerging markets (see Freedman and Otker-Robe, 2010). Some degree of exchange rate flexibility is also needed at the outset of IT; most other conditions can be developed afterwards.

Appendix II

The Monetary Policy Framework in CADR Countries

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* A survey of the studies of the adoption of IT frameworks reveals the first three conditions (in bold) should be met prior to the adoption of IT in emerging markets (see Freedman and Otker-Robe, 2010). Some degree of exchange rate flexibility is also needed at the outset of IT; most other conditions can be developed afterwards.Sources: IMF desk economists, central bank websites, and Jácome and Parrado (2007).

Appendix III

Strength of Monetary Policy Index

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Source: Information to assess the main criteria in Appendix II, The Monetary Policy Framework in CADR Countries.

Average inflation during 2005-10.

IMF de facto classification of exchange rate arrangements, 2010.

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1

The authors would like to thank Alejandro López-Mejía, Marco Piñón, and Miguel Savastano for helpful comments and suggestions. They would also like to thank Geoffrey Bannister, Issouf Samake, and Yulia Ustyugova for their inputs on the monetary frameworks in CADR.

2

The discussion excludes Panama and El Salvador, both of which officially use the U.S. dollar as their legal tender. The CADR countries with some degree of monetary policy independence are Costa Rica, the Dominican Republic, Guatemala, Honduras (which, recently re-established a crawling band), and Nicaragua (that has a crawling peg regime).

3

The LA6 countries are Brazil, Chile, Colombia, Mexico, Peru, and Uruguay.

4

Instrument independence gives the central bank the authority to utilize or set its monetary policy instruments to achieve its inflation target.

5

This was the result of the large costs of the banking crisis of the 1982 borne by the central bank and a large accumulation of international reserves during the nineties under the exchange rate band regime, prior to floating.

6

In Chile and Uruguay, reforms were implemented drawing lessons from the costly banking crises experienced in the early 1980s and early 2000s, respectively.

7

Jácome and Parrado (2007a) also describe in detail the central bank reforms undertaken in CADR since the 1990s and measure central bank independence in the region.

8

In Costa Rica, losses arose from commercial bank rescue operations, and in Honduras, losses were a result of credit and rescue operations of the financial and non financial public sector.

9

A recently approved law for the BCN (2010) mandates a government recapitalization of the BCN during 2011.

10

Rules-based instruments are based on the regulatory power of the central bank and include reserve requirements and standing facilities. Money market operations include: Open market-type operations, which are market-based monetary operations thorough auction techniques regulated by the central bank. They involve (i) lending/borrowing with underlying assets as collateral, (ii) primary market issuance of central bank or government securities for monetary policy purposes, and (iii) acceptance of fixed-term deposits. Open market operations (OMOs) are market-based monetary operations and conducted by the central bank as one of the participants in the money market. OMOs involve (i) buying/selling assets outright in the secondary market, and (ii) buying/selling assets under a repurchase agreement in the repo market or through foreign exchange swaps. See Laurens (2005).

11

For more information on developments in financial supervision in the region, see Delgado and Meza (2011).

12

This section of the index is closely based on Cukierman and others (1992).

13

Information to classify each country according to the specified criteria is presented in Appendices I and II.

Improving the Monetary Policy Frameworks in Central America
Author: Mr. Alejandro Carrion-Menendez and Ms. Florencia Frantischek