Zambia: Selected Issues and Statistical Appendix
Author: International Monetary Fund
Publication Date:
21 Mar 2006
eISBN:
9781451841282
Language:
English
Keywords:
ISCR; CR; government; monetary policy; real GDP; bank deposit; liquidity injection; monetary policy target; GRZ Govt. securities; monetary policy environment; liquidity operation; Government securities; Commercial banks; Liquidity
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This Selected Issues paper on Zambia reports that the authorities have outlined a range of alternative policy scenarios to achieve greater pro-poor growth. The thrust of these policies is to support higher growth in rural areas, where the incidence of poverty is particularly high, by investing more in infrastructure development, while also stepping up delivery of public services, notably in health and education. Implementing these alternative policies would require significantly more financial assistance from the donor community.

Abstract

This Selected Issues paper on Zambia reports that the authorities have outlined a range of alternative policy scenarios to achieve greater pro-poor growth. The thrust of these policies is to support higher growth in rural areas, where the incidence of poverty is particularly high, by investing more in infrastructure development, while also stepping up delivery of public services, notably in health and education. Implementing these alternative policies would require significantly more financial assistance from the donor community.

III. Recent Experience in the Implementation of Monetary Policy1

A. Introduction

1. Until recently, the scope for an active monetary policy to contain inflationary pressures was severely limited by the large domestic borrowing requirement of the central government to finance its deficit. This has contributed to high inflation and domestic interest rates, and the crowding out of the private sector. Following the marked improvement in the fiscal position of the government in 2004 and 2005, the Bank of Zambia (BoZ) has been able undertake a more active policy, and this has led to a significant slowdown in the growth of monetary aggregates in the course of 2005. The conduct of policy has, however, faced challenges, owing mainly to the tensions between the stated and unstated objectives of policy. In particular, efforts by the monetary authorities to respond especially to exchange rate developments, while at the same time pursuing the explicit targets for reserve money and international reserve accumulation under the monetary program, has led to unplanned sharp fluctuations in reserve money, creating uncertainty about the policy stance.

B. Fiscal Adjustment and the Monetary Policy Environment

2. Prior to the recent improvement in the fiscal position of the government, the macroeconomic pressures from the budget rendered monetary policy largely passive. In 2000, net banking sector claims on the government were equivalent to nearly 60 percent of GDP, most of which were essentially the monetization of the fiscal deficits of the government. Following considerable but highly uneven fiscal consolidation efforts, especially in the last few years, these pressures have been gradually brought under control. At the end of 2003, net bank claims on the government had declined by about a half to 30 percent of GDP. Further fiscal adjustment undertaken in 2004 sharply reduced the BoZ’s net domestic claims on the central government by 10 percentage points to 12 percent of GDP.

Figure III.1.
Figure III.1.

Bank Claims on the Central Government

Citation: IMF Staff Country Reports 2006, 118; 10.5089/9781451841282.002.A003

3. The contraction in government borrowing from the Bank of Zambia (BoZ) has substantially eased pressure on the growth of reserve money and monetary conditions. The contribution of the BoZ’s net domestic assets to the growth in reserve money, largely reflecting the claims on government, fell from nearly 150 percent in 2001 to 26 percent in the first quarter of 2003 (Figure III.2). Over the same period, market interest rates and yields on government securities fell from a range of 35–60 percent to 21–38 percent (Figure III.3). Since 2004, reserve money growth has been driven almost entirely by the increase in foreign assets.

Figure III.2.
Figure III.2.

Contribution to the growth of Reserve Money

(In percent)

Citation: IMF Staff Country Reports 2006, 118; 10.5089/9781451841282.002.A003

Figure III.3.
Figure III.3.

Zambia: Yield on Government Securities and Commercial lending rates

(In percent)

Citation: IMF Staff Country Reports 2006, 118; 10.5089/9781451841282.002.A003

C. Conduct of Monetary Policy

4. In the conduct of policy in 2005, especially in the first half of the year, the BoZ was generally successful in coordinating its foreign exchange transactions, the main source of growth in reserve money in the period, and its interventions through its two main instruments of policy. These instruments are primary issues of government securities and open market operations (See Box 1). Reserve money was maintained on the desired path and within the indicative monthly levels most of the time. On a year-on-year basis, the growth of broad money has continued to decelerate in line with the goal of policy (Figure III.4). However, while the growth of reserve money trended downward, its movement showed rather wide fluctuations. The broad measure of reserve money, which includes currency and all commercial bank deposits at the BoZ, has on the whole been more stable than the narrow measure, which is the Bank’s operating target of policy. The narrow measure excludes commercial bank deposits held in interest-bearing term deposits at the BoZ (Figure III.6).2

Figure III.4.
Figure III.4.

Twelve-month Growth of Money

(In percent)

Citation: IMF Staff Country Reports 2006, 118; 10.5089/9781451841282.002.A003

Figure III.5.
Figure III.5.

Actual and Program Levels of Reserve Money

(In millions of Kwacha)

Citation: IMF Staff Country Reports 2006, 118; 10.5089/9781451841282.002.A003

Figure III.6.
Figure III.6.

Discount Rate and Yield on Government Securities

(In percent)

Citation: IMF Staff Country Reports 2006, 118; 10.5089/9781451841282.002.A003

Institutional Framework of Monetary Policy

The institutional arrangements for the conduct of monetary policy in Zambia have a number of important structural features that are conducive to the effective conduct of policy. A policy coordinating committee chaired by the Governor meets monthly to review economic and policy developments and decide on future policy. The bank’s policy, including underlying assumptions, are communicated formally in monetary policy statements issued twice each year.1/ To enhance liquidity forecasting, a formal structure is in place for coordination between the central bank and the ministry of Finance and Development Planning (MoFNP). The bank also maintains regular and timely communication with participants in the money market regarding issues of government securities and open market operations.

The conduct of policy is handicapped, however, by limitations associated with the under-development of the financial markets. These include a small, mainly overnight interbank market where transactions are largely all collateralized, absence of secondary market activity, and a highly limited range of market instruments. Although under active consideration in the context of the ongoing constitutional reform, the independence of the BoZ remains an issue. There are, in addition, technical limitations associated with data deficiencies. To address these weaknesses, the authorities plan to implement a range of reforms set out in the Financial Sector Development Plan, which is being phased into the National Development Plan, 2006–2011.

The Bank of Zambia relies on indirect instruments of monetary policy, which comprise primary issues of government securities, Treasury Bills and bonds, and open market operations involving repos and placements of tenure deposits by commercial banks at the BoZ at commercial interest rates. The other instruments of policy are the discount rate, cash reserve requirements and liquidity ratio.2/ The intermediate target of policy is broad money (M3) while reserve money serves as the operating target. Monetary policy is conducted within the framework of floating exchange rate regime, with no preannounced target.

1/

The BoZ Act requires the Bank to submit these statements to the minister of finance who in turn presents them to Parliament. They are also required to be published in the Government’s Gazette.

2/

In practice, the BoZ has relied mainly on the first two, primary issues of securities and OMO.

5. At the beginning of 2005, the BoZ took firm action to address an overhang of liquidity associated with the bunching of donor assistance toward the end of the previous year. Over the next three months, these interventions would have been sufficient to keep reserve money on the targeted path with little or no recourse to open market operations. The authorities, nevertheless undertook substantial open market operations that had the effect of maintaining reserve money well below the indicative target (Figure III.6). Domestic interest rates fell in this period, reflecting confidence in the monetary authorities’ commitment to prudent monetary and fiscal policies. Toward the end of the second quarter, however, the broader measure of reserve money, which had so far been kept in line with policy, began to rise significantly above the target path and, in July, reserve money considerably exceeded the indicative level. Furthermore, against the backdrop of a continuing rise in the inflation rate outside the target, interest rates, which had been on a downward trend from the beginning of the year, edged steadily upward.3

6. The setback to policy implementation stemmed partly from the difficulty in finding an appropriate balance between various objectives. In addition to the explicit targets for reserve money and the accumulation of international reserve, the authorities were paying close attention to exchange rate developments. As the kwacha continued to strengthen in the foreign exchange market, commercial banks reduced their foreign exchange positions in an effort to rebalance their portfolios and this provided an opportunity for the BoZ to accumulate international reserves. In July, purchases of foreign exchange by the bank, however, proved difficult to sterilize fully and led to a spike in reserve money to well above the program. Significant foreign exchange sales in the following month became necessary to bring reserve money back to the target level.

7. The coordination of open market operations and issues of government securities also pointed to continuing inadequacies. In September, for example, relatively large open market operations became necessary largely to offset the liquidity injection from the bank’s transactions in government securities (See Table 1). While this lack of alignment in the bank’s interventions reflects existing shortcomings in forecasting the financing needs of the government, on this occasion the problem appears to have been amplified by the emergence of the structural increase in liquidity, as indicated by the widening gap between the broad and narrow measures of reserve money.4

Table III.1.

Analytical Accounts of the Bank of Zambia, December 2004–September 2005

(In billions of Kwacha)

article image
Source: Bank of Zambia; and staff estimates.

The broad measure of reserve money.

The narrow measure of reserve money.

Banks’ free reserves (excess, precautionary)

These arise from open market operations.

The indicative program under the PRGF arrangement for 2005.

A withdrawal of liquidity occurs when primary issues in the period exceed the amount utilized to finance the government in the month.

8. Hence, while the broad goal of slowing down the growth of monetary aggregates is being achieved, experience in the conduct of policy suggest areas of improvement to avoid the unintended swings in reserve money growth that could work to the detriment of the objective of lowering inflationary expectations and the development of a clearly understood policy transmission mechanism. With government borrowing from the BoZ ceasing to be a source of liquidity expansion, the task of the BoZ in controlling overall liquidity has largely become that of managing its response to the net inflows from the external sector. An important aspect of this role relates to interventions by the BoZ to smooth fluctuations in the interbank foreign exchange market, which would not normally present major liquidity problems. However, to the extent that exchange market developments create an opportunity for the BoZ to step up its reserve accumulation beyond the target level for the year, the change in objective would need to be accompanied by an adjustment in the program of primary issues of government securities and/or open market operations to address the structural liquidity increase that results. The point is not to suggest the need to always sterilize, but simply to say that, for a given monetary program scenario, inadequate coordination of foreign exchange and liquidity operations can undermine the objective of policy.

9. The sharp swings in reserve money have to a significant extent been more the result of inadequate coordination in the use of policy instruments than of exogenous liquidity developments elsewhere in the financial system. The widening divergence between the broad and narrow measures of reserve money, which reflects the increasing recourse to open market operations, has been necessary partly because of the liquidity injections from the operations in government securities. The intention of the authorities to keep reserve money growing at a steady pace and below the program level is evident in the first quarter and to a lesser extent in the second. From the beginning of the third quarter, however, adjusting to the increase in structural liquidity associated with the Bank’s foreign exchange interventions and injections of liquidity from operations in government securities operations, contributed to swings in reserve money.

D. Conclusion

10. The fiscal adjustment undertaken by the government over the last few years and especially since mid-2004 has allowed the Bank of Zambia to undertake an active monetary policy in 2005 that has helped to control excess liquidity in the system and achieve a marked slowdown in the growth of broad money. At the same time, the conduct of policy contributed to unintended swings in reserve money capable of creating uncertainty about the stance of policy. Going forward, the appropriate setting of policy instruments, especially between foreign exchange transactions and primary issues of government securities needs to be consistent with the monetary policy targets, to avoid the build up of liquidity pressures that could work against the objective of maintaining a stable policy stance.

1

Prepared by Patrick Akatu.

2

The maturities of these deposits are mainly 90 days and longer, and they do not qualify for satisfying reserve requirements. They would not therefore, not fit into the category of liabilities that support the expansion of broad money and credit.

3

Following a broad review of developments in the first half of the year and a reassessment of the inflation outlook, in light of rising oil prices and increases in food and electricity prices, the authorities moved to tighten policy in the second half of the year. In its Monetary Policy Statement for July-December 2005, the BoZ lowered the target for reserve and broad money growth to 9.8 percent and 9.9 percent, respectively, from 10.8 percent and 14.8 percent, respectively, with a view to ensuring that the inflation target of 15 percent for the year is achieved.

4

The volume of Treasury bill issues is decided on a quarterly basis by the monetary policy committee taking into account the financing needs of government, maturing securities, and other influences on liquidity including expected inflows of foreign assistance. Forecasts of the latter are explicitly incorporated into the monthly monetary program.

Same Series

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Cover IMF Staff Country Reports
Zambia: Selected Issues and Statistical Appendix
Author: International Monetary Fund
Volume/Issue:
Volume 2006: Issue 118
Publisher:
International Monetary Fund
ISBN:
9781451841282
ISSN:
1934-7685
Pages:
75
DOI:
https://doi.org/10.5089/9781451841282.002

Bank Claims on the Central Government

Contribution to the growth of Reserve Money

(In percent)

Zambia: Yield on Government Securities and Commercial lending rates

(In percent)

Twelve-month Growth of Money

(In percent)

Actual and Program Levels of Reserve Money

(In millions of Kwacha)

Discount Rate and Yield on Government Securities

(In percent)