A. Introduction

1. Strengthening the monetary framework has been an important element of macroeconomic policy in Nicaragua since the 1990s. Broadly appropriate economic policies prior to the 1980s resulted in a stable macroeconomic environment with gains in real income per capita, low inflation, and exchange rate stability. By contrast, the civil strife together with loose monetary policies adopted during the 1980s resulted in massive devaluations, hyperinflation, debt overhang, and financial repression. Beginning in the 1990s the authorities have been gradually implementing stabilization policies including using the exchange rate as an anchor for inflation. The adopted crawling peg regime has facilitated a substantial fall in inflation but risks are posed by the highly dollarized financial system and potential political instability, highlighting the need to further strengthen policy credibility.

2. Sustained implementation of sound macro-policies and further financial sector reforms will be important prerequisites for moving to a more flexible exchange rate regime. It will be important to maintain a medium term track record of sound policies to strengthen credibility while pushing ahead with the structural reform agenda to bolster the financial sector and further strengthen the central bank.

3. This chapter reviews the historical context and current operation of monetary policy with a view to discussing prospects for medium term reforms. Section B provides a historical context by describing the decline in macroeconomic performance and confidence observed during 1978-93 and the turn around since then. Section C contains a brief analysis of the design of the monetary framework in recent years. Section D looks forward to some medium term policy challenges.

B. Historical Context

4. Nicaragua implemented a fixed exchange rate regime until the early 1980’s. This regime, combined with a supportive fiscal policy stance, helped to maintain a relatively stable macroeconomic framework. Inflation remained low, averaging 5.3 percent during 1961-77, while economic growth was high, averaging 6.7 percent per annum during this period (Figure 1). The new government that assumed office in 1979, after a step exchange rate adjustment of 40 percent, fixed the exchange rate until 1985. However, the civil war and interventionist economic policies in this period disrupted economic activity, and price and currency stability.

Nicaragua: Historical Perspective, 1960-04

Citation: IMF Staff Country Reports 2006, 173; 10.5089/9781451829273.002.A003

Source: Minister of Finance, BCN and Fund staff transformations

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Nicaragua: Historical Perspective, 1960-04

Citation: IMF Staff Country Reports 2006, 173; 10.5089/9781451829273.002.A003

Source: Minister of Finance, BCN and Fund staff transformations

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Nicaragua: Historical Perspective, 1960-04

Citation: IMF Staff Country Reports 2006, 173; 10.5089/9781451829273.002.A003

Source: Minister of Finance, BCN and Fund staff transformations

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5. Pressures mounted during 1980-85 and finally the exchange rate collapsed, triggering hyperinflation.² During 1980-85, a progressive deterioration of political and economic conditions set the stage for a series of massive devaluations setting off a hyperinflation (Figure 1). As an illustration, in 1988 alone, the inflation rate surpassed 10,000 percent. As economic conditions worsened, growth slumped, averaging -2.6 percent during 1978-93.³ Net international reserves also declined markedly in this period. After averaging 2.3 months of imports during 1960–77, NIR turned negative, declining to an average of -4.5 months of imports in 1978–93. It was not surprising that in these circumstances the only possible price of reference was with respect to foreign currencies, which played the store-of-value role that the domestic currency could not fulfill.

6. Beginning in the 1990s, a gradual process of economic stabilization ensued in the context of a strengthening of macroeconomic policies. Eventually, a crawling peg regime was put in place in 1993 to help rebuild the credibility of monetary policy as well to preserve some room to absorb shocks as the economy gradually stabilized. This effort was supported by a fiscal consolidation program and substantial financial support from the international community. During 1994–2004, as the improvement in macroeconomic management took hold, economic activity recovered, with annual real GDP growth averaging 4.7 percent. Inflation moderated and international reserves were gradually rebuilt.

7. The crawling peg exchange regime has served well to stabilize inflation expectations. The central bank law explicitly establishes price stability as the primary objective of monetary policy and the pegged regime has contributed to achieving this goal in the last decade. In recent years, a key policy objective has been to gradually slow the rate of crawl to reduce inflation, given the high pass through (Figure 2).

Nicaragua: Monetary Framework, 2003-05

Citation: IMF Staff Country Reports 2006, 173; 10.5089/9781451829273.002.A003

Source: Central bank

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Nicaragua: Monetary Framework, 2003-05

Citation: IMF Staff Country Reports 2006, 173; 10.5089/9781451829273.002.A003

Source: Central bank

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Nicaragua: Monetary Framework, 2003-05

Citation: IMF Staff Country Reports 2006, 173; 10.5089/9781451829273.002.A003

Source: Central bank

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8. However, the economy remains highly dollarized.⁴ The ratio of dollar to total deposits in the financial system increased from 28 percent in 1990 to about 70 percent in 2005. Moreover, most loans, government bond issuances, real estate valuations, and other major transactional operations are fully indexed to the U.S. dollar. This high level of dollarization reflects a lack of investor confidence resulting from the history of high inflation and currency instability.

C. Recent Design and Conduct of Monetary Policy

9. The history of macroeconomic instability during the 1980s has constrained the current design and conduct of monetary policy in Nicaragua. Nicaragua, like most other Central American economies, maintains an exchange rate system linked to the dollar.⁵ Nicaragua’s choice of the crawling peg regime⁶ reflects its position as a small open economy, susceptible to confidence and other shocks. Moreover, monetary policy has been conducted in the context of large fiscal imbalances, low international reserves, and under the burden of heavy external and domestic debt. Further, the efficiency of monetary instruments is hampered by the relatively small size of the financial sector, resulting shallow markets, and dollarized financial system.

	Full dollarization	Crawling peg	Float
Costa Rica		X
El Salvador	X
Guatemala			X
Honduras		X
Nicaragua		X
Panama	X

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	Full dollarization	Crawling peg	Float
Costa Rica		X
El Salvador	X
Guatemala			X
Honduras		X
Nicaragua		X
Panama	X

10. A key policy objective has been to strengthen net international reserves and the central bank financial position. A supportive fiscal policy stance has been key to reducing any tension between these two objectives. Towards this goal, the authorities’ monetary program has targeted building international reserves while reducing high levels of expensive central bank debt, a large part of which was issued to recapitalize banks following the financial crisis of 2000-01 (Figure 2). Adjusted NIR levels have been built up from US$16 million in 2001 to US$200 million in 2005, but key coverage ratios remains relatively low highlighting the need for a continued focus on further reserve accumulation. Meanwhile the central bank has reduced its outstanding debt by over US$300 million in the last three years.

Nicaragua: Gross International Reserves Adequacy, 2000-2005

Source: Central Bank of Nicaragua and Fund staff estimates/projections.

Nicaragua: Gross International Reserves Adequacy, 2000-2005

	2000	2001	2002	2003	2004	2005
Foreign currency deposits/GIR	38.0	42.8	41.6	42.5	37.2	45.0
GIR/GDP	12.6	9.3	11.3	12.2	14.7	12.9
GIR/M3	25.9	25.9	28.6	29.3	35.0	30.3
GIR in months of imports of G&S	2.1	2.1	2.8	2.1	2.8	2.3

Source: Central Bank of Nicaragua and Fund staff estimates/projections.

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Nicaragua: Gross International Reserves Adequacy, 2000-2005

	2000	2001	2002	2003	2004	2005
Foreign currency deposits/GIR	38.0	42.8	41.6	42.5	37.2	45.0
GIR/GDP	12.6	9.3	11.3	12.2	14.7	12.9
GIR/M3	25.9	25.9	28.6	29.3	35.0	30.3
GIR in months of imports of G&S	2.1	2.1	2.8	2.1	2.8	2.3

Source: Central Bank of Nicaragua and Fund staff estimates/projections.

11. Fiscal policy has played a key role in supporting reserve accumulation given the central bank’s domestic debt reduction target. In this context, tightening the stance of fiscal policy by increasing government deposits at the central bank has been a key driver of reserve accumulation. A large part of international reserves accumulation reflects increases in government deposits at the central bank in turn funded by foreign grants and loans, as opposed to market purchases. Net foreign currency market operations at the central bank have generally involved sales of foreign exchange to the public (Figure 2).

12. The central bank’s debt reduction goal has in practice meant that net open market operations have been expansionary in recent years. The net change in the central banks’ bond operations has mostly implied liquidity injections reflecting the repayment of bank recapitalization bonds and other central bank debt (Figure 2). In the absence of offsetting fiscal policy support, achieving reserve accumulation goals would have required net contractionary open market operations or further increases in already high levels of reserve requirements.⁷ Increasing public sector deposits and/or shifting public sector deposits from commercial banks to the central bank has been an option for liquidity management, though this requires very close coordination between the central bank and the central government.

13. Shallow financial markets hamper the conduct of open market operations. This reflects in part a perception of high costs arising from the lack of competition in the financial system.⁸ The use of short-term interest rates, as an intermediate operating target, is severely hampered by the lack of depth of the primary debt market and the technical problems to measure daily liquidity. The bond market is underdeveloped, with low volumes of operations in the secondary market and low usage of repo operations. Government bond auctions are irregular and market bids are frequently not accepted.

14. Moreover, the financial position of the central bank needs to be strengthened. The central bank has a high external and domestic debt burden, reflecting past quasi-fiscal operations, that constrains its ability to implement monetary policy. At end-2004, central bank external debt stood at 42.3 percent of GDP, and domestic debt at 8.8 percent of GDP. The service of this debt explains in part the central banks significant quasi-fiscal losses that have averaged about 1½ percent of GDP in recent years. The government is mandated to absorb the central bank’s losses but this has been in the form of very long-term, relatively low-yielding government bonds.

D. Medium-term Policy Challenges

15. The crawling peg regime limits the flexibility of the economy to respond to shocks and dollarization poses a key additional risk. While participation in CAFTA-DR should help reduce macroeconomic volatility, developing a more independent monetary policy regime would provide important additional insurance to help smooth shocks. Moreover, high dollarization increases the vulnerability of the economy to shocks. In a mixed-currency economy, the rationale for flight out of domestic currency is more compelling given the possibility of conversion into dollars.⁹ Moreover, any shock leading to sudden pressure on the exchange rate could adversely affect the balance sheets of the banking system to the extent that resulting credit risks are transformed into significant currency mismatches.

16. However, medium term reforms will be required for moving to a more flexible regime and reducing dollarization. It will be crucial to continue to strengthen the fiscal position, lower debt levels, buttress the cushion of international reserves and consistently achieve low levels of inflation to further strengthen the credibility of the policy framework. This is key for reversing the dollarization hysteresis currently observed.

17. Further strengthening the financial sector and developing the domestic capital markets are also crucial components of this strategy. Stronger banks will go hand in hand with deeper capital markets in creating a more resilient economy. Key requirements for the former will be effective implementation of the recently strengthened legislative framework for the financial sector including by continuing to strengthen bank supervision. This would need to be supported by judicial reforms. Capital market development could receive a boost from a market-based solution to the problems of the pension system. Combined, these will also provide the central bank the opportunity to develop a wider range of instruments to conduct market-based monetary operations. Further strengthening the financial position of the central bank will be another important part of this policy agenda.