This Selected Issues paper for Botswana highlights the macroeconomic impact of an effectively implemented National Strategic Framework (NSF) program. The NSF is anchored on the goals of prevention, care, and support; management of the national response; economic impact mitigation; and provision of a strengthened legal and ethical environment. The treatment of the pandemic focuses on the administration of antiretroviral drugs to the infected, the effect of which would be to prolong their lifespan, as well as increase the average level of productivity.

Abstract

This Selected Issues paper for Botswana highlights the macroeconomic impact of an effectively implemented National Strategic Framework (NSF) program. The NSF is anchored on the goals of prevention, care, and support; management of the national response; economic impact mitigation; and provision of a strengthened legal and ethical environment. The treatment of the pandemic focuses on the administration of antiretroviral drugs to the infected, the effect of which would be to prolong their lifespan, as well as increase the average level of productivity.

IV. External Competitiveness, Exchange Rate Flexibility, and the Monetary Policy Framework in Botswana38

A. Introduction

73. Botswana has made several adjustments to its exchange rate regime over the last 20 years, mainly with the objectives of maintaining inflation at reasonable levels, restoring external competitiveness, and coping with external shocks. In particular, the exchange rate has played an important role in maintaining the flexibility in Botswana’s macroeconomic framework to deal with the changes in the country’s external terms of trade caused by the narrow export base. In February 2004, the pula was depreciated by 9.4 percent against the U.S. dollar, as the authorities became increasingly concerned about the adverse impact of the strong South African rand on external competitiveness. In light of these developments, a number of important policy questions emerge: What is the appropriate exchange rate regime for Botswana? What is the link between exchange rate developments and competitiveness? Apart from the exchange rate regime, what can Botswana do to increase competitiveness and to reduce its vulnerabilities to external shocks (for example, export diversification and financial deepening). What are the implications or options for monetary policy? This section discusses these issues, focusing in particular on the tension between the two key exchange rate policy objectives of maintaining a low inflation rate, which is helped by exchange rate stability, and promoting external competitiveness, which can sometimes require exchange rate adjustments to take account of inflation differentials with trading partners or productivity shocks.

74. The section starts with a discussion of Botswana’s exchange rate arrangement, its evolution, the factors underlying the decisions behind the adjustments to the exchange rate regime, and the impact of recent exchange rate developments on external competitiveness. The discussion emphasizes that the impact of external shocks on domestic economic activity depends in part on the nature of the exchange rate regime, and that it is all the more important in economies with a narrow export base. It then turns to the core issue of the trade-off between price stabilization and the competitiveness of exports. This discussion points to the important role of policy credibility in the choice of exchange rate regime, which leads to an analysis in the last part of the paper of the complications arising from nominal anchors that are based on the exchange rate, and the choice between monetary and inflation targeting.

B. Evolution of the Exchange Rate Regime

75. Although Botswana gained independence in 1966, it continued to use the South African rand until 1976, when its own currency, the pula, was introduced. At that time, since both the rand and the pula were pegged to the U.S. dollar, the exchange rate regime served to protect external competitiveness because it provided a stable relationship between the pula and the exchange rates of Botswana’s major trading partners. However, after the introduction of the floating exchange rate regime in South Africa in 1979, and the subsequent depreciation of the pula against the rand, the authorities decided to adopt a basket peg to control inflation, which had risen to double-digit levels by 1980.

76. Since June 1980, the exchange rate of the Botswana pula has been determined with reference to a weighted basket of currencies comprising the SDR and the South African rand, but the authorities have occasionally changed the composition of the basket and made discrete adjustments to the peg when circumstances required. While the introduction of the currency basket helped to bring down inflation, the country faced a number of external shocks linked to the South African economy and the international diamond market that adversely affected external competitiveness and prompted the authorities to devalue the pula on a few occasions. In the early 1980s, diamond prices fell sharply in the aftermath of the recession in the major industrial countries, and the authorities devalued the pula against the basket by 10 percent to check the deterioration in the external current account balance.

77. The Bank of Botswana (BoB) has accorded a high priority to achieving a low rate of inflation, but the monetary policy also aims to support the national objectives of economic diversification and export competitiveness. By attempting to keep the real effective exchange rate (REER) of the pula stable, the authorities aim to avoid an erosion in external competitiveness.39 However, developments in the external sector, such as the sharp fluctuations in the exchange rate of the rand against the currencies in the SDR basket, have impinged on the conduct of monetary policy, which has been geared toward the task of reconciling inflation control with external competitiveness.40 For example, the pula was devalued against the basket in 1984 and 1985, by 5 percent and 15 percent; the devaluations were mainly attributed to the concerns regarding external competitiveness arising from the instability of the rand against the U.S. dollar. The nominal effective exchange rate (NEER) and the REER have on occasion not moved in tandem, because the inflation rate in Botswana has differed from the rates in major trading-partner countries.

78. The Botswana pula exchange rate regime has undergone five distinct phases since the late 1980s. First, the authorities allowed a significant real appreciation of the pula during 1988–89 to reduce imported inflation and absorb some of the demand pressures through higher imports (Figure IV.1). Second, the authorities implemented a policy to maintain a broadly stable real exchange rate against the rand in the early 1990s. This policy required discrete adjustments to the rate of the pula relative to the currency basket; the pula was devalued by 5 percent against the basket in both 1990 and 1991 (Figure IV.2). Third, from 1994 to August 2000, the exchange rate rarely moved out of the range of R 1.25–1.35 per pula, which led to market speculation that the pula was effectively linked to the rand (Figure IV.3). Fourth, from the second half of 2000, the policy of de facto rand targeting was abandoned because the rand plummeted against the SDR currencies, and the basket mechanism was allowed to operate for the next two years. Fifth, as the rand reversed its downward movement against the SDR currencies and appreciated sharply, the Botswana authorities became increasingly concerned about the adverse impact of the rand’s appreciation on external competitiveness, and the pula was depreciated against the U.S. dollar by 9.4 percent (7.5 percent against the basket) in February 2004.

Figure IV.1.
Figure IV.1.

Botswana: Selected Exchange Rate Indicators January 1995 - December 2003; (1995 = 100; foreign currency per pula) 1/

Citation: IMF Staff Country Reports 2004, 212; 10.5089/9781451806380.002.A004

Source: Botswana authorities.1/ A rise in the index indicates an appreciation of the pula.
Figure IV. 2.
Figure IV. 2.

Botswana: Exchange Rate Index, January 1990-December 2003

(U.S. dollars per national currency, 1990=100)

Citation: IMF Staff Country Reports 2004, 212; 10.5089/9781451806380.002.A004

Source: International Monetary Fund, Economic Data Sharing System.
Figure IV.3.
Figure IV.3.

Botswana: Bilateral Exchange Rate, January 1990-December 2003

(South African rand per pula)

Citation: IMF Staff Country Reports 2004, 212; 10.5089/9781451806380.002.A004

Source: International Monetary Fund, Economic Data Sharing System.

79. The above discussion indicates that the various changes in exchange rate management were prompted, on the one hand, by concerns about the inflationary pressures arising from the sharp depreciation of the rand against the currencies in the SDR basket and, on the other hand, by the loss in external competitiveness due to the appreciation of the pula. From September 2000 to December 2001, the pula appreciated against the rand, which also meant an appreciation in effective terms (Figure IV.4). This concomitant appreciation in effective terms is due to the way in which the basket for the currency peg is calculated, which is based on the arithmetic average method; since this method gives decreasing weight to a depreciating currency, the weight of the rand in the basket peg fell to about one-half. However, the effective index is calculated as a geometric average of the exchange rate indices of the major trading partners, and the weight given to South Africa is three-fourths in Botswana’s effective exchange rate. Thus, the appreciation of the pula against the rand led to a significant loss of competitiveness, with the REER of the pula appreciating by 11 percent from September 2000 to October 2001. Another indication of external competitiveness is provided by the internal terms of trade, which is the ratio of the price index of tradables to the index of nontradables. The internal terms of trade index fell during the same period, indicating a weakening of external competitiveness because of the reduction in the incentive to produce tradables and the promotion of the domestic consumption of tradables relative to nontradables (Figure IV.5). Yet another indication of the loss in external competitiveness is provided by the fact that output growth in the manufacturing sector slowed; South Africa is Botswana’s major competitor in manufactures, and the pula appreciated by more than 20 percent against the rand during this period (Statistical Appendix, Table 34).

Figure IV.4.
Figure IV.4.

Botswana: Bilateral Exchange Rates, January 2000-December 2003

(Index, January 2000=100)

Citation: IMF Staff Country Reports 2004, 212; 10.5089/9781451806380.002.A004

Source: International Monetary Fund, Economic Data Sharing System.
Figure IV.5.
Figure IV.5.

Botswana: Internal Terms of Trade, 1996: Q1-2002: Q1 1/

(Index, November 1996=100)

Citation: IMF Staff Country Reports 2004, 212; 10.5089/9781451806380.002.A004

Source: International Monetary Fund, Economic Data Sharing System.1/ The ratio of the price index of tradables to the price index of nontradables.

C. Choice of the Exchange Rate Regime

80. Economists generally group the available options that a country has in determining the monetary linkage between its economy and the rest of the world around three polar regimes: (i) a flexible regime, where the country lets its currency float freely in the exchange markets against other currencies; (ii) a fixed regime, where the country fixes the price of its currency against a specific foreign currency or a basket of foreign currencies; and (iii) an intermediate regime, where the country lets its currency float to some extent but intervenes to limit those fluctuations according to some predetermined parameters, such as in the case of target zones, crawling bands, etc. Many other categories of exchange rate regimes may be derived from various combinations of these three main categories, ranging from the most flexible (a pure floating regime with no foreign exchange market intervention by the central bank) to the most fixed-rate commitment (dollarization or monetary union). As mentioned above, the Botswana authorities adopted various exchange rate options during the 1980s and 1990s, and more recently, they have been refining the monetary policy framework to focus on inflation modeling and control, which has implications for the exchange rate regime. The next few paragraphs discuss some of the exchange rate options that have been adopted by other countries, with a view to pointing out both the advantages and disadvantages that are particularly relevant in the context of the Botswana economy.

81. One of the intermediate exchange regimes is the fixed-but-adjustable exchange rate regime, which has recently been much criticized in the literature because it is particularly vulnerable to speculative attack. In the wake of the Asian financial crisis, there was a growing consensus that the intermediate exchange regimes were not sustainable because of large-scale capital flows, which thus limited the options to either free-floating or firm-fixing regimes.41 This proposition was also referred to as the “impossible trinity” in international monetary economics, which stated that an open economy could not achieve all three goals of exchange rate stability, monetary independence, and financial market integration simultaneously. It can achieve only two of the three goals at a given time: for example, the two goals of exchange rate stability and monetary independence can be attained only by giving up capital mobility. Alternatively, the two goals of exchange rate stability and capital mobility can be achieved only at the expense of giving up the autonomy of monetary policy. The third approach would be to have monetary independence and free capital mobility, but at the expense of exchange rate volatility.

82. In considering the impossible trinity proposition in an open economy, some economists would argue that the increasing globalization of financial markets—Botswana is no exception to this trend of a high degree of cross-border capital movements—has pushed countries toward the region where the choice should be narrowed to choosing either a free-floating or a firm-fixing regime. More specifically, Botswana’s external capital account is expected to register larger gross transactions, attributed both to increasing foreign direct and portfolio investment in the country—due, in turn, to the diversification and growth of the domestic market—and to increasing portfolio investment abroad, as more domestic residents seek investment opportunities abroad. With regard to domestic residents investing abroad, one recent noteworthy development has been the major international stock adjustments following the transfer of sizable pension funds from the public sector to private managers. When transferring the pension funds to the private managers, the authorities granted them permission to hold up to 70 percent of the total assets in foreign investments. Although there was an immediate sharp capital outflow, the asset managers are still holding domestic assets far above the required minimum levels because of the relatively high rates of returns on pula-denominated assets and the recent appreciation of the pula against the SDR. As market conditions change, these funds could be invested abroad for diversification purposes, and this outcome, as well as the other steps that the authorities have taken to increase the external capital account linkages, will no doubt impose constraints on the conduct of monetary policy. However, while recognizing that greater financial integration imposes constraints on monetary policy, it is still the case that even small, open economies, such as Botswana, can choose an intermediate solution between floating and fixed rates under perfect capital mobility, as long as there is a credible nominal anchor for the conduct of monetary policy.

D. Nominal Anchors, Exchange Rate Rules, and External Competitiveness

83. The importance of a nominal anchor is brought out most clearly in those situations where exchange rate policy is designed to maintain external competitiveness at a level consistent with a sustainable balance of payments position. Like the BoB, central banks in many emerging market countries have focused on the critical role of the real exchange rate in maintaining external competitiveness, and various approaches have been followed to ensure that the exchange rate does not deviate very far from its equilibrium level. Some central banks have even gone to the extent of adopting a real exchange rate rule, under which the nominal exchange rate is automatically adjusted in response to a differential between domestic and foreign price levels; such a rule seemingly provides a monetary framework that can prevent the emergence of large and sustained misalignments of relative prices and thereby avoid an external imbalance. By allowing the nominal exchange rate to adjust frequently and by relatively small amounts, the real exchange rate can be kept at an appropriate level without imposing undue adjustment costs on the economy, thus removing the issue of devaluation from the political arena. Furthermore, a real exchange rate rule will provide market participants with useful information on the likely evolution of relative prices, and thus prevent production decisions from being made based on incorrect expectations. However, real exchange rate rules may bring with them major disquieting implications for macroeconomic stability, even if they help to address the issue of external competitiveness. In particular, the adoption of a real exchange rate target, which means pursuing a real target with a nominal instrument, might leave a small open economy without a nominal anchor for the domestic price level, and shocks to domestic inflation might acquire a permanent character in some circumstances. This is particularly the case if the target real exchange rate is set at an overly depreciated level—and, needless to say, there is often a lot of uncertainty as to what is the equilibrium exchange rate, as evidenced by the prediction of different rates under different models. It would be desirable, nonetheless, to preserve some of the advantages of real exchange rate rules—specifically, the assurance provided by such rules to potential investors in the traded goods sector that the real exchange rate will not be allowed to get too far out of line—without sacrificing domestic price stability.

84. The issue of a competitive exchange rate versus domestic price stability bears particular emphasis in Botswana because, notwithstanding the significant progress that has been made in a number of areas, sizable risks to the economic outlook remain, not least of which is the lack of export diversification. Reflecting Botswana’s heavy reliance on diamond exports, the external terms of trade have shown significant fluctuations. Furthermore, the trade balance has exhibited considerable variations not only because of the significant movements in diamond prices in major industrial country markets, but also because of the changes in the prices of key imported goods. Many risks are beyond Botswana’s control—for example, diamond prices might decline, the South African rand could appreciate more against the major currencies, as it has done in the past, and there is the problem of weather-related production shocks. In such circumstances, external competitiveness and the need for export diversification continue to be the major challenges to which the Botswana authorities have indeed given a great deal of attention.

85. Since the economy is highly vulnerable to shocks, the authorities have taken steps to improve the diversification of the economy by strengthening infrastructure, increasing labor skills and productivity, and reducing public utility and transportation costs. The authorities have worked on codes for foreign direct investment and companies. The Industrial Development Act will soon be sent to the cabinet for discussion, and the bill for the Companies Act will be going to the parliament for a second reading shortly. The quality of the communications infrastructure, which has been cited as a constraint by private investors, is being upgraded, including the plans to invest P 300 million to improve the telecommunications sector.42

86. The Botswana authorities recognize that they face many challenges in attracting private investment, including the sparsely populated country, small markets, limited financial development, and high costs of communication and transportation. The authorities’ diversification strategy focuses on developing infrastructure, adding value to exports of raw materials, and promoting the textile, leather, jewelry, and other industries in which Botswana has a comparative advantage. The authorities are taking steps to overcome the shortcomings in the business environment to attain the level of investment needed to maintain growth at a high and sustainable level. With regard to the exchange rate regime and export diversification, there are some key linkages among monetary policy, labor productivity, and external competitiveness that have become increasingly important in the formulation of macroeconomic policy. One of these is the impact of the HIV/AIDS pandemic on the government budget, and the various direct and indirect ways in which HIV/AIDS has affected the country’s unit labor costs.43 In this regard, as the authorities contemplate the transition to alternative monetary frameworks (e.g., the strict or full-fledged inflation-targeting regime), such a transition would entail the confining of foreign exchange market interventions to smoothing the effects of temporary shocks, and the exchange rate objectives would be subordinated to the inflation target. This approach could lead to large swings in the real exchange rate for the pula, thereby highlighting the point that the ongoing structural reform efforts should ensure sufficient flexibility in the labor and product markets to dampen any adverse effects on external competitiveness.

87. In terms of external competitiveness, the HIV/AIDS pandemic has increased the labor costs of companies because of sick leave and disability pensions, medical care, pensions to surviving dependents, and, more generally, the loss of productivity.44 These costs and the loss in labor productivity have resulted in higher unit labor costs, which measure labor compensation relative to labor productivity.45 Unit labor costs in Botswana are expected to rise further in the medium term: a study by the Botswana task force on AIDS has estimated that the HIV/AIDS-related cost would increase from about 5 percent of the wage bill in 2004 to 7–8 percent in the medium term.46

88. In addition to the issue of external competitiveness, the exchange rate also has a role to play in satisfying the need for flexibility in Botswana’s macroeconomic policy framework to cope with changes in the country’s external terms of trade. Under a fixed exchange rate system, the value of the pula is pegged to the value of another currency or basket of currencies, while, under a flexible exchange rate regime, the value of the pula is allowed to adjust in response to supply-and-demand conditions in the foreign exchange market. When the exchange rate is flexible and Botswana’s export prices decline, the pula will depreciate in the foreign exchange market, thereby helping to increase exports and economic activity, and partly offsetting the initial impact on output of the negative terms of trade shock. In contrast, the fixed exchange rate regime will require intervention in the foreign exchange market to keep the value of the pula from declining; however, when the BoB purchases foreign exchange to support the exchange rate peg, this reduces the amount of domestic credit available for businesses and consumers, which is equivalent in terms of its effects on output to a tightening of monetary policy. In this regard, the policy response under the fixed exchange rate adds to the negative terms of trade shock that caused the initial contraction in output. Since exchange rate flexibility allows the economy to adjust to exogenous terms of trade shocks with lower costs in terms of output fluctuations, this would appear to be an important consideration in the case of Botswana.

89. However, the fact that a country with a fixed exchange rate regime will adjust to a negative terms of trade shock through a contraction in output, while a country with a flexible exchange rate will adjust through a currency depreciation that significantly offsets the shock’s negative effects on output, does not necessarily mean that a flexible exchange rate is unambiguously the best choice. As mentioned above, the effectiveness of the flexible exchange rate in responding to terms of trade shocks is only one of several considerations that need to be weighed in choosing an exchange rate regime. The optimum currency area (OCA) literature has shown that the case for flexible exchange rates depends, among other things, on the evaluation of the microeconomic benefits to be gained from a fixed exchange rate in comparison to the costs of losing monetary policy as a tool for economic stabilization.47 The OCA identifies a number of key factors that influence the choice of the exchange rate regime: the degree of labor mobility between countries; openness, or the degree of trade integration; the degree of wage and price flexibility; and the degree to which the two countries have similar economic structures and experience shocks. According to these criteria, Botswana is a highly open economy, with wage and price flexibility, and South Africa has a very large share of the imports into Botswana; however, the economic structures of the two countries are not similar, and, in particular, Botswana’s export base is very different from that of South Africa, which means the countries are subjected to asymmetric external shocks. Because of the asymmetric shocks, Botswana will have to bear significant costs from the loss of monetary independence if it were to maintain a relatively fixed rate for the pula against the rand.

90. In addition to the considerations raised in the OCA literature, the financial crises that hit Mexico, Russia, and several Asian developing countries in the 1990s have reinforced what already appeared to be a growing consensus against fixed exchange rates. The experiences of these countries showed that fixed exchange rates not only limited the ability of real exchange rates to adjust to external shocks but also restricted the monetary authorities’ ability to correct excessive growth of credit or to act as a lender of last resort. Fixed rates also tended to encourage excessive borrowing of foreign currency by reducing concerns about exchange rate risk and made worse the abrupt and disruptive reversals of investor confidence once exchange rate pegs were broken. Some countries, particularly those in which monetary policy has had low credibility, have felt it necessary to adopt fixed exchange rates to reduce inflationary expectations. However, Botswana’s record of good macroeconomic management suggests that this argument for fixed exchange rates is not applicable in the present context.

E. Alternative Monetary Policy Frameworks

91. The previous discussion has emphasized that, when there are large-scale capital flows or significant terms of trade shocks, a conflict can arise between the objectives of maintaining a stable nominal exchange rate and promoting domestic economic stability. In this connection, since a more flexible exchange rate regime in Botswana can facilitate simultaneously the pursuit of domestic stabilization objectives and open capital market objectives, the remainder of this subsection discusses several types of monetary policy frameworks that are consistent with the central objective of maintaining low inflation under a flexible exchange rate regime. Each of these options focuses on a different long-term nominal anchor, which is implied in the names attached to these frameworks: monetary targeting, nominal income targeting, and inflation targeting.

Monetary targeting

92. Many central banks, including the BoB, have used monetary aggregates as indicators in their policy frameworks; however, some central banks although their numbers have declined—have used monetary aggregates as intermediate targets. To serve the role of an intermediate target variable, a monetary aggregate should meet a number of conditions, including three major ones. First, there should be a predictable relationship between money and nominal income growth because otherwise, even if the central bank hits the monetary target, there is no assurance that the ultimate target will be observed. Second, the relationship between adjustments in the monetary policy instruments—say, a short-term interest rate and the money supply—should be stable because otherwise it would be difficult to hit the intermediate target. Third, monetary growth should lead nominal income growth because, if the reverse were the case, other intermediate targets besides money would give a lower variability of nominal income. The experience from a number of countries has been that, while some monetary aggregates such as the monetary base or narrow money—might be sufficiently stable to use as an indicator variable for monetary policy, these aggregates are frequently not suitable for the more demanding role of an intermediate target variable, and this appears to be the case in Botswana. In particular, the relationship between money and nominal income might not be easy to predict on account of the recent and prospective changes in the financial sector. Also, the links from monetary policy instruments to inflation are not always easy to capture in the monetary-targeting framework, not least because of instability in the demand for money.

Nominal income targeting

93. Before turning to inflation targeting and the conditions that would need to be addressed in a successful transition to that regime in Botswana, a few words about nominal income targeting as a projector of potential output might be appropriate. The main point to stress in this context is that the Botswana authorities are trying hard to diversify the economy so as to reduce the heavy reliance on diamond exports, which, together with the ongoing structural reforms in the financial and other sectors, might make it difficult to make the projection of potential output that is needed for inflation forecast targeting. In inflation targeting, monetary policy is adjusted in response to deviations of the forecast of inflation from the target, but the inflation forecast, in turn, requires an estimate of the level of potential output in order to measure excess demand pressures. However, when there is considerable uncertainty regarding the level of potential output, nominal income targeting has an advantage over inflation targeting in that it is more robust, that is, serious estimation errors are less likely. This is because nominal income targeting requires only an estimate of the trend growth rate of potential output. If experience were to indicate that estimates of potential output are very uncertain, therefore, it might be better to adopt nominal income targeting as an interim monetary policy framework, until such time as potential output can be estimated with greater confidence.48

Inflation targeting

94. Instead of using an intermediate target variable, the BoB could move toward direct inflation targeting, a framework that has been adopted in many emerging-market countries, including South Africa.49 As with any other monetary framework, however, there are a number of issues that would need to be addressed, including meeting certain preconditions to effect a successful transition to inflation targeting. Masson and others (1997) identify several potential obstacles in the transition to inflation targeting, and at least three of these should be noted here. First, “fiscal dominance” should not prevent the monetary authorities from pursuing the objective of achieving a low inflation rate, because the fiscal authorities interfere in terms of their reliance on seigniorage revenues. Second, the banking system should be strong enough to enable the monetary authorities to pursue their inflation objectives without having to worry about the balance sheets or solvency of the commercial banks. Third, capital markets should not be so shallow that they constrain the implementation of monetary policy.

95. A first glance would indicate that Botswana appears to meet the first two of these preconditions. The fiscal authorities have not relied on seigniorage revenues because the inflation rate has been low, and, until recently, the country has been running substantial budget surpluses. With regard to the strength of the banking system—the second precondition—the banks have registered strong profits and do not have large nonperforming assets; in general, the banks measure up well in terms of various indicators of performance.50 With regard to the depth of capital markets—the third precondition—Botswana’s markets may not be as large as those in many other countries, but they are growing rapidly, and the recent changes are going to give an added boost to their development. Notable among these changes are the sizable transfers of pension funds from the government to private managers, which are discussed in Section III of this paper. Furthermore, shallow capital markets would be a problem in the implementation of other monetary frameworks as well; as concern is thus not confined to inflation targeting per se, it needs to be addressed more generally in terms of financial development and the diversification of the economy.

96. Explicit inflation targeting has been adopted by a number of central banks in both industrial and emerging-market countries. The inflation target for the central bank helps to provide an anchor for inflation expectations in the economy, and the announcement of a clear path for the medium-term inflation outlook reduces the size of inflation “surprises” and their associated costs in terms of terms of output fluctuations. An inflation-targeting regime can accommodate a goal of output stabilization by having wide inflation target bands, long inflation target horizons, and explicit exemptions for supply shocks. By focusing attention on an explicit goal, inflation targeting can help to make monetary policy more transparent and increase the public understanding of the central bank’s strategy of setting and meeting the inflation target. Inflation-targeting regimes have emphasized the creation of institutions that foster good policy and the improvement of accountability, which is good in its own right and would be appropriate for any monetary framework. Although inflation targeting is a relatively new framework and the time series for evaluating its performance are not very long, the available evidence does suggest that inflation targeting performs well in achieving a balance between output variability and inflation variability.

97. That said, a look beneath the surface reveals some questions that will need to be addressed in choosing an inflation-targeting regime. In particular, in a full-fledged inflation-targeting (FFIT) framework, the inflation target prevails over any other monetary policy objective, which makes the criteria for the preconditions for a successful FFIT more stringent.51 In this connection, it is not clear that monetary policy can control inflation perfectly, and whether it is feasible to say that inflation rates outside a specified tolerance interval will be ruled out, even in the event of unforeseen exogenous shocks, such as terms of trade and weather-related shocks, which can be quite important in the case of Botswana. A closer look at the requirements of the FFIT regime and the specific characteristics of the Botswana economy seems to indicate that, whereas Botswana meets some of these preconditions, it does not meet all of them; moreover, even those that it does meet should not be taken for granted.

98. Inflation targeting requires a good understanding of the monetary transmission mechanism, which is the connection between changes in the monetary stance and their effect on the operating target and, ultimately, inflation. The stronger the transmission links, and the better they are understood, the more effective will be the changes in monetary instruments in attaining the inflation target. However, inflation forecasting will be challenging for Botswana because the country has a high degree of vulnerability to exogenous shocks: there are ongoing structural changes in the economy, not least in financial innovations and the increased integration with international financial markets; the links from monetary policy instruments to inflation are not always stable; and there are data issues, insofar as some requisite data are not available or there are questions with regards coverage and timeliness. Furthermore, a relatively well-developed financial system is necessary for the effective transmission of monetary policy in a FFIT framework. In this connection, it should be noted that interest rates in Botswana do not reflect appropriately the market liquidity conditions, in part because of the small low volume of transactions in the interbank market, as banks prefer to transact in repurchase agreements or reverse repurchase agreements with the central bank to meet their daily liquidity requirements. There is no price incentive for banks to look first to the interbank market to place or borrow funds overnight because central bank credit is offered at the same rate as the interbank rate.52

99. As was mentioned above, a strong fiscal position is needed to support the credibility of the FFIT framework. In this regard, it should be stressed that, although Botswana had been running budget surpluses for a prolonged period, deficits have emerged in the last three years, mainly on account of temporary factors, but increasingly because of developments in both revenue and expenditure, which are more structural in nature. On the expenditure side, HIV/AIDS-related expenditures have risen sharply since 2001/02 (April–March) and are expected to be a growing source of pressure on the budget over the medium term and beyond. On the revenue side, projections for Southern African Customs Union (SACU) receipts have a wider margin for error than before because of the tariff reductions expected from the recent or forthcoming trade agreements between SACU and other countries or regions, and also because of the new revenue-sharing formula for SACU receipts, which is due to go into effect in 2006. In addition, there are questions about other sources of government revenue, such as the income from the BoB, which has declined in recent years because of the drawing down of the central bank’s reserves and is not expected to rise in relation to GDP in the medium term.53 These developments suggest that, looking forward, the Botswana authorities would need to ensure that monetary policy is not dominated by fiscal concerns. The government should be able to meet the bulk of its financing requirements from financial markets, and government recourse to central bank credit should be limited to occasional and temporary financing of liquidity shortfalls.

100. In what has been called inflation targeting lite (ITL), a country announces an inflation objective, but it does not fully subordinate all other objectives of monetary policy to inflation. These countries do not adopt a FFIT because they do not meet all of the preconditions, particularly as regards a conflict between inflation and other objectives, a weak relationship between monetary instruments and inflation, and an institutional framework that might not be strong enough for a credible full commitment to an inflation target. In ITL, the BoB would aim for an inflation target, broadly defined, it would also give weight to other objectives in the loss function. In other words, although there would be an inflation target, but it would still be appropriate in the context of an open economy to specify other objectives, including the exchange rate or international reserve holdings. The exchange rate would be taken into account in the inflation-targeting framework not only to the extent that the inflation forecast, which is the intermediate target of monetary policy in this regime, is affected by the exchange rate, but also in that the BoB may need to adjust the monetary policy instruments to limit the impact of exchange rate changes on other objectives—say, for example, external competitiveness. This is not to say that, in ITL, the BoB should aim for an inflation target and at times switch to other objectives, but rather that the target range specified for the inflation target should be wide enough to leave some room for maneuver, or equivalently, the authorities’ loss function would give weight to other objectives. Nonetheless, ITL could help the Botswana authorities to package many features of an eclectic approach to monetary management into a more formalized, disciplined, and transparent structure that bolsters accountability. In particular, it is important that the information be conveyed in a consistent manner and presented in a way that makes it readily understood by the public; this could entail, inter alia, regular media releases, press conferences, and publications of research by the staff and of speeches by the central bank management.

F. Conclusions

101. This section focused on the choice of exchange rate regime and the implications of alternative monetary policy frameworks for Botswana. To this end, a number of considerations that have a bearing on the exchange rate regime and the monetary policy framework were examined, which showed the close links among international competitiveness, the appropriate exchange rate regime, and the choice of a monetary policy anchor. Most of the recent research in emerging-market economies, and especially that based on the experience of the 1990s, has suggested that, in the context of rapid international capital mobility, sustaining a fixed exchange rate in the face of terms of trade or international financial market shocks is very difficult. Furthermore, a forced abandonment of a fixed exchange rate under pressure has proved to be quite disruptive for some countries. Since Botswana has a narrow export base and relies heavily on just one commodity, the analysis provided some support for a flexible exchange rate regime, because it can function as a kind of automatic stabilizer, absorbing by means of its own movements the fluctuations in the terms of trade. However, commitment to nominal exchange rate stability can constrain monetary policy and even induce procyclical monetary policy responses to exogenous shocks. In addition to discussing the suitability of a flexible exchange rate regime for Botswana, this section discussed in some detail the issue of a nominal anchor in an open economy and, in particular, the question of monetary targeting versus inflation targeting.

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Table 1.

Botswana: GDP by Type of Expenditure at Current Prices, 1996/97-2003/04 1/ A45

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Sources: Central Statistics Office; and Fund staff estimates.

National accounts year beginning July 1.

GDP minus consumption.

Table 2.

Botswana: GDP by Type of Expenditure at Constant 1993/94 Prices, 1996/97–2003/04 1/

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Sources: Central Statistics Office; and Fund staff estimates.

National accounts year beginning July 1.

Table 3.

Botswana: GDP by Type of Economic Activity at Current Prices, 1996/97–2003/04 1/

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Sources: Central Statistics Office; and Fund staff estimates.

National accounts year beginning July 1.

Table 4.

Botswana: GDP by Type of Economic Activity at Constant 1993/94 Prices, 1996/97-2003/04 1/

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Sources: Central Statistics Office; and Fund staff estimates.

National accounts year beginning July 1.

Table 5.

Botswana: Beef Sales, 1996/97-2003/04 1/

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Source: Botswana Meat Commission.

Year beginning October 1.

Table 6.

Botswana: Mineral Production and Value, 1996-2003

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Source: Central Statistics Office.

Estimated value of production.

First 2 Quarters only

Table 7.

Botswana: Agricultural Producer Prices, 1996/97-2003/2004 1/

(Pula per tonne)

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Source: Botswana Agricultural Marketing Board.

Crop year beginning April 1.

Table 8.

Botswana: Formal Sector Employment, 1996-2003 1/

(Number of employees, unless otherwise indicated)

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Sources: Central Statistics Office.

Data for September of each year.

Table 9.

Botswana: Statutory Minimum Hourly Wage Rates, 1996-2003 1/

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Source: Central Statistics Office.

Data for May.

100 thebe = 1 pula.

Table 10.

Botswana: Average Monthly Cash Earnings by Sector, 1996-2001 1/

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Source: Central Statistics Office.

Data are for March, except 1999, which are for September. Figures for 2001 are preliminary.

Table 11.

Botswana: Consumer Price Index of Tradables and Nontradables, January 1999-October 2003

(November 1996 = 100, unless otherwise indicated)

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Source: Central Statistics Office.