Back Matter

Annex 1. Empirics of Monetary Control

1. Fitting a simple error-correction model (ECM) may help clarify the relationship between BCEAO and European Central Bank (ECB) money market rates. Based largely on Ericsson (2011), the methodology suggests that if ECB rates and Central Bank of West African States (BCEAO) rates are each I (1), that is nonstationary and individually integrated, but if a certain linear combination of them has a lower order of integration such as I(0), then ECB rates and BCEAO rates could be considered cointegrated. Therefore, changes in ECB rates would translate directly in changes in BCEAO rates. If changes in BCEAO rates depend only on the changes in ECB rates the BCEAO cannot conduct an independent monetary policy. In the opposite case, if no cointegration is found, the BCEAO may have some scope for monetary policy.

2. The estimated model is

ΔBCEAOt=αΔECBt+β(BCEAOt1γECBt1)+ɛt

where αΔECBt can be interpreted as an immediate impact of the change ECB rates on the change in BCEAO rates and, therefore, α as a short-run elasticity; β(BCEAOt-1 γECBt-1) can be viewed as a disequilibrium effect, with as BCEAOt-1 γECBt-1 an error-correction term, β as a feedback coefficient, and γ as a long-run elasticity. With short-term rates and long-term elasticities built into the model, testing for cointegration between BCEAO rates and ECB rates would reveal the time-dependent properties of the model, because the impact of ECB rates on BCEAO rates may differ, depending on the time horizon. The cointegration framework tests two hypotheses: (i) in the short run, there may be some scope for an independent monetary policy; in this case α = 0, and BCEAO rates and ECB rates are not cointegrated; (ii) in the long run, there may still be scope for an independent monetary policy; in this case, γ = 0 and BCEAO and ECB rates are not cointegrated. However, the opposite may also be true, in this case, γ ≠ 0, and BCEAO rates and ECB rates are cointegrated.

3. The test for cointegration between BCEAO rates and ECB rates is performed in four steps: (i) visual analysis of data plots in level, logs, and first differences to assess their time-varying properties and comovements; (ii) evaluation of the order of integration of each variable by an augmented Dickey-Fuller (1988) test; only non-stationary variables integrated of order 1 and above can be cointegrated; (iii) estimation of the cointegration vector by the Johansen (1991) procedure; and (iv) testing the restrictions on the long-run and short-run elasticities.

4. The data plot suggests several important statistical properties of BCEAO rates and ECB rates. Both series are trending downward and most likely are not mean stationary. It is difficult to establish whether they follow the same pattern, other than in late 2008 to mid-2009 when both decreased substantially as both central banks cut their policy rates in response to the financial crisis. The distance between two series changes insignificantly and they even switch signs in late 2008, as ECB money market rates, which exceeded BCEAO rates, suddenly become substantially lower than those of the BCEAO (Figure 6).

Figure 6.
Figure 6.

Evolution of BCEAO and ECB Money Market Rates, 2007–2013

(Level in percent)

Citation: IMF Working Papers 2015, 099; 10.5089/9781484366646.001.A999

Source: BCEAO and ECB.

5. Plotting the same data in first differences the same series may be stationary, suggesting an I (1) process. RM is more volatile than net foreign assets (NFA), in particular after 2003 (Figure 7).

Figure 7.
Figure 7.

BCEAO and ECB Money Market Rates in First Differences (logs)

Citation: IMF Working Papers 2015, 099; 10.5089/9781484366646.001.A999

Source: BCEAO and ECB.

6. A more formal test for the order of integration confirms that both series are integrated of order 1. The augmented Dickey-Fuller (1981) statistics and the tested leg length are selected by the Akaike information criterion (AIC) on a model with a maximum of six lags, with an intercept and no trend or seasonal component (Table 4). The ADR tests are presented for the levels of both variables (LBCEAO and LECB), their first differences (DLBCEAO and DLECB), and second differences (DDLBCEAO and DDLECB), all in logs. The null hypothesis presence of a unit root is not rejected at the 1 percent critical level for levels of both variables but is strongly rejected for the first differences of BCEAO rates and second differences of ECB rates. Therefore, BCEAO and ECB money market rates in levels do not seem to be stationary, and ECB rates may not be even stationary in first differences, Both series should be differenced at least once or more to achieve stationarity. Therefore, both series can be treated as at least I (1), and their cointegration analysis in levels is possible.

Table 5.

AFD Statistics for BCEAO and ECB Money Market Rates, Monthly 02/1997–09/2013 (T=80)

article image
Source: Author’s estimates.

7. Testing for cointegration using the Johansen procedure suggests no cointegration between ECB and BCEAO rates. The multivariate test for stationarity of each variable using a wider information set than the regular ADF test and taking into account the potential for cointegration, strongly suggests that both BCEAO and ECB series are not stationary and that the search for a cointegration between them is legitimate. All eigenvalues are small and statistically are not different from zero (Table 5). The eigenvalue statistic λτ accepts the null hypothesis of no cointegration and assigns it the cointegration rank r = 0. This may be interpreted as evidence of no cointegration vectors between ECB and BCEAO money market rates. The trace statistic λmaxa with a degrees of freedom adjustment is well below the 95 percent critical value. The normalized eigenvector β in a common notation presented in the table with the opposite signs can be normally written as BCEAO = 0.19ECB if the cointegration relationship is present. The estimated adjustment coefficient for the BCEAO equitation, which shows how much of its past disequilibrium affects the current disequilibrium, is -0.049 and negative. This suggests the linear combination of variables may potentially converge to the steady state. The estimated coefficient on the ECB rate is 0.01, very small and positive suggesting their possible divergence from the steady state. Moreover, both coefficients are not significant for the potential cointegration vector.

Table 6.

Cointegration Analysis of BCEAO and ECB Money Market Rates

(Logs, with 12 lags and unrestricted intercept, 2008[2] - 2013[9)])

article image
Source: Author’s estimates.

8. The ECM model may still contain useful information about the long- and short-run elasticities of responses to changes in ECB on BCEAO rates. The restrictions on parameters α = 0 and γ ≠0 can be tested in their autoregressive distributed lag (ADL) presentation of the ECM. From ΔBCEAOt = αΔECBt + β(BCEAOt-1γECBt-1) + εt it follows that. BCEAOtBCEAOt-1 = α(ECBt - ECBt-1) + β(BCEAOt-1γECBt-1) + εt. Removing the lagged term, BCEAOt = α0ECBtα1ECBt-1 + α1BCEAOt-1 + εt, where α = α0; β = α2-1 and γ=α0+α1α21..

9. Testing amounts to exclusion restrictions on parameters in the ADL equation. The estimated ADL equation is BCEAOt0.0572(0.691)ECBt0.0582(0.066)ECBt1+0.6592(7.571)BCEAOt1. The restriction α0=0 has test statistics X 1 = 0.47748 [0.4896] and the null hypothesis that α = 0 in the ECM equation is not rejected. From γ=α0+α1α21=0.05720.5820.65921=0.029, which is clearly very close to zero. Therefore, it seems that the fact that in the ECM equation α = 0 supports the hypothesis that in the short run there may be some scope for an independent monetary policy because changes in the ECB money market rates do not affect BCEAO rates contemporaneously. Because γ=0, there may be some scope for an independent monetary policy even in the long run, because changes in the ECB money market rates still do not affect the BCEAO rates even after a lag.

Annex 2. BCEAO’s Monetary Policy Instruments: a Stylized Presentation

1. For the Central Bank of West African States (BCEAO), the concept of liquidity refers to the monetary base. Demand for liquidity means the public’s demand for currency as determined by the degree of monetization of the economy, the opportunity cost of holding money, and the banking system’s demand for reserves. To meet this demand, the BCEAO supplies liquidity in currency and bank reserves and, by doing so, attempts to influence liquidity conditions, the level of the interbank rate, and to ensure the overall stability of the financial system.

2. Setting interest rates and reserves requirements are the two main tools at BCEAO’s disposal. To achieve the desired level of the interbank rate, the BCEAO uses liquidity injections, which increase the supply of banks’ reserves. Shifts in the supply curve to the right against an unchanged demand curve, reduces the interbank rate to the targeted level (Figure 8a). The same effect can be achieved by reducing the reserve requirement ratio, which would reduce banks’ demand for reserves and would shift the demand curve to the left against a stable reserve supply curve (Figure 8b).

Figure 8.
Figure 8.

BCEAO’s Monetary Policy Instruments

Citation: IMF Working Papers 2015, 099; 10.5089/9781484366646.001.A999

3. Monetary transmission may be both weak and unreliable in most low-income countries (LICs). In an extensive study, Mishra, Montiel, and pilimbergo (2012) show that for the monetary policy transmission to function properly, countries should have a strong institutional setup: an independent central bank; well-functioning interbank, government securities, equities, and real estate markets; a high degree of capital mobility; and a floating exchange rate. In LICs the interbank market is the only financial market, which usually exists but is very weakly developed. This may suggest that the bank credit channel should be marginally effective for the transmission of monetary policy signals. At the same time, in most cases, there is no secondary market for government securities; or this market is very limited and shallow, not allowing the interest rate channel to perform its transmission function. Many LICs either maintain a fixed exchange rate arrangement or target a certain level of a floating exchange rate, which makes the exchange rate channel obsolete. Finally, while stock exchanges exist in many LICs, their market capitalization is very small and listing is limited, which impedes the functioning of the assets channel.

4. A fixed exchange rate provides a long-term anchor for prices. In this framework, the central bank should only be concerned about stabilizing short-term deviations of prices and output from their long-term trend. However, downward rigidities in prices can result in an unsustainable deviation of the real effective exchange rate from its equilibrium level through a cumulative price differential; conversely, an appreciation of the equilibrium real exchange rate (manifested in a long-term appreciation of the prices of nontradable items vis-à-vis those of tradables) can result in persistent—but sustainable—inflationary pressures. In a currency union, these issues are usually further complicated by cross-country differences in cycle and economic structure.

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1

The author is grateful to D. Fanizza, H. Joly, P. Imam, C. Kolerus, E. Hitaj, A. Mansoor, R. Morales, M. Pani, M. Saxegaard, A. Zdzienicka, K. Wiseman, BCEAO, and AFR colleagues for useful comments, data, and discussion. Any remaining errors are the author’s.

2

Banque Centrale des Etats de l’Afrique de l’Ouest.

3

Although convertibility is guaranteed by the French Treasury, it does not mean that this guarantee is without any limits. For instance, large imbalances in the region ultimately led to a devaluation of the CFA franc in 1994.

4

Bank reserves=Bank own reserves + BCEAO injections.

How to Improve the Effectiveness of Monetary Policy in the West African Economic and Monetary Union
Author: Mr. Alexei P Kireyev