This Selected Issues paper examines the monetary policy framework in Sudan, and assesses the effectiveness of monetary transmission mechanism since the secession of South Sudan. The econometric analysis concludes that reserve money, the exchange rate, and private sector credit are the main determinants of inflation after the secession of South Sudan and that the transmission lags have been shortened significantly compared with previous studies. These findings reinforce the need for a comprehensive package of fiscal and monetary measures that strengthens the monetary policy framework and improves its effectiveness.

Abstract

This Selected Issues paper examines the monetary policy framework in Sudan, and assesses the effectiveness of monetary transmission mechanism since the secession of South Sudan. The econometric analysis concludes that reserve money, the exchange rate, and private sector credit are the main determinants of inflation after the secession of South Sudan and that the transmission lags have been shortened significantly compared with previous studies. These findings reinforce the need for a comprehensive package of fiscal and monetary measures that strengthens the monetary policy framework and improves its effectiveness.

Monetary Transmission Mechanism in Sudan1

This chapter examines the monetary policy framework in Sudan, and assesses the effectiveness of monetary transmission mechanism since the secession of South Sudan. The econometric analysis concludes that reserve money, the exchange rate, and private sector credit are the main determinants of inflation after the secession of South Sudan and that the transmission lags have been shortened significantly compared with previous studies. These findings reinforce the need for a comprehensive package of fiscal and monetary measures that strengthens the monetary policy framework and improves its effectiveness.

A. Introduction

1. Sudan faces difficult challenges in the conduct of its monetary policy following South Sudan’s secession in 2011. Sudan’s economic conditions deteriorated rapidly after this permanent shock. The fiscal deficit widened owing to the loss of oil revenues and delays in fiscal adjustment. Monetization of the fiscal deficit led to high inflation, which reached 47.8 percent in March 2013. An understanding of the effects of monetary policy on macroeconomic variables (such as output, employment and prices) and the channels through which these effects are transmitted is critical for effective policy formulation and timely implementation, and for ensuring macro-financial stability.

2. The aim of this chapter is to examine issues relating to the monetary policy framework and the monetary transmission mechanism in Sudan since the secession of South Sudan. As the structure of the banking system and the degree of domestic financial development have a significant bearing on the effectiveness of monetary transmission, the analysis is cast against the background of the main institutional features of Sudan’s Islamic banking system.

3. The rest of the chapter is organized as follows: Section B reviews the monetary policy framework in Sudan. Section C assesses the effectiveness of the monetary transmission mechanism and analyzes the challenges facing the monetary authorities. Section D presents the model and estimation results. Section E concludes and provides policy recommendations.

B. Monetary Policy Framework

4. In principle, a fixed exchange rate policy provides the anchor for Sudan’s monetary policy framework, but its effectiveness is weakened by the prevailing system of multiple exchange rates. Sudan’s exchange rate regime pivots around the following rates: (i) a central rate of SDG 4.42 per U.S. dollar that applies also to the importation of fuel products, the payment of government obligations, and valuation assessment at customs; (ii) a subsidized rate for wheat of SDG 2.9 per U.S. dollar; (iii) a gold exchange rate used by the central bank in its gold transactions, which is in line with the curb market rate; and (iv) a commercial bank rates that applies to all other transactions.

5. The recourse to multiple exchange rates raises the need for another anchor for monetary policy. Moreover, access to foreign exchange is hindered by some restricted administrative measures. The shortage of FX and the resulted exchange rationing have driven virtually all private sector transactions to the parallel market. The gap between the commercial banks rate and parallel market exchange rates reached a peak of almost 48.5 percent in May 2012. After the 66 percent devaluation of the central rate in June 2012, the gap declined to about 3 percent before rising again to stand about 20 percent at end-June 2013 (Figure 1).

Figure 1.
Figure 1.

Sudan: Central Rate, Commercial Banks Rate, and Parallel Rate, 2009–13

Citation: IMF Staff Country Reports 2013, 320; 10.5089/9781484305430.002.A001

6. With a full-fledged Islamic banking system, the monetary policy framework lacks adequate instruments for monetary operations, liquidity management, and non-inflationary financing of government deficits.2 Under an effective monetary policy framework, the central bank would use debt-based instruments in the interbank money market and government security market to inject or mop up the flow of liquidities from the banks and transmit its policy intentions. Under the Islamic mode of finance, debt-based instruments cannot earn a positive rate of return through interest and cannot be discounted in a secondary market. However, equity-based securities can be traded in the open market, with trading values reflecting market expectations of economic performance, and rates of return. Designing equity-based instruments linked to government or central banking operations can pose significant difficulties because of complexities in computing appropriate profits and rates of returns.3 These constraints have limited the development of efficient instruments for interbank market and central bank credit facilities.

7. As a result, the monetary policy framework of Sudan has to rely on the conventional instruments for regulating money supply, using quantitative control by fixing ad hoc credit ceilings and imposing high unremunerated reserve requirements. In 2012, Central Bank of Sudan (CBOS) raised the required reserve ratio three times from 11 percent to 18 percent. This has not proven to be an effective way of controlling money supply nor is it conducive for economic development. The absence of an active interbank money markets has led to large excess reserves and a loss of monetary control when CBOS continues to provide credit to individual banks while lacking flexible means to mop up excess liquidity (Figure 2). As in other Islamic banking systems, the lack of adequate monetary instruments has led to high intermediation cost and persistent inflationary pressures.

Figure 2.
Figure 2.

Sudan: Required and Excess Reserves and Inflation, 2011–13

Citation: IMF Staff Country Reports 2013, 320; 10.5089/9781484305430.002.A001

Sources: Sudanese authorities and Fund staff calculations.

8. Monetization of the rising fiscal deficits has further undermined the effectiveness of monetary policy in achieving any nominal target and has forced the CBOS to follow an accommodative monetary policy stance, particularly after the secession of South Sudan. The rising fiscal deficit after the session has been mostly financed by the CBOS, resulting in rapid monetary expansion that reached 40 percent at end of 2012 (Figure 3). Inflation reached a peak of 47.8 percent in March 2013, nearing hyperinflation. At this high inflation rate, fiscal policy and monetary policy tend to become virtually inseparable4 and central bank independence is significantly weakened, thus undermining its ability to ensure price stability. A comparison with some other MENA oil importer countries show that Sudan’s heavy reliance on seigniorage to finance its fiscal deficits led to the highest inflation among the oil importers in the region by end of 2012 (Figure 4).

Figure 3.
Figure 3.

Sudan: Net Credit to Central Government, 2011–13 1/

(In billions of SDG)

Citation: IMF Staff Country Reports 2013, 320; 10.5089/9781484305430.002.A001

1/ Excluding IMF.Sources: Sudanese authorities.
Figure 4.
Figure 4.

Selected MENA Importers: Seigniorage and Inflation, 2012

Citation: IMF Staff Country Reports 2013, 320; 10.5089/9781484305430.002.A001

Sources: Country authorities and Fund staff calculations.1/ Defined as the annual change in the monetary base divided by nominal GDP.

C. Channels of Monetary Transmission

9. According to Mishra, Montiel, and Spilimbergo (2012), there are four main channels of monetary transmission:

  • Interest rate channel. An increase in real interest rates raises the cost of capital, leading to a decline in investment spending and decrease in aggregate demand and output.

  • Asset price channel. There are two basic channels involving asset prices that are important to the monetary transmission mechanism: Tobin’s q theory of investment and wealth effects on consumption. Monetary policy affects the economy through its effects on the valuation of assets. q is defined as the market value of firms divided by the replacement cost of capital. If q is high, the market price of firms is high relative to the replacement of capital and new plant and equipment capital is cheap relative to the market value. Hence, investment spending will rise. In addition, if asset prices rise, the value of financial wealth increases which will lead to higher lifetime resources of consumers and consumption will rise.

  • Exchange Rate Channel. The exchange rate channel works through the impact of monetary developments on exchange rates and aggregate demand and supply. For example, an increase in interest rates would normally lead to an appreciation of the exchange rate, which lowers the price of imported goods and services and thereby pushes down domestic inflation. The effectiveness of the exchange rate channel depends on the exchange rate regime, the extent of exchange rate pass-through and the degree of openness to capital flows.

  • Bank Lending Channel. The bank lending (or credit) channel works through the response of credit aggregates to changes in interest rates and other policy instruments. Therefore, the credit channel is an extension—an enhancement mechanism—to the interest rate channel and amplifies the real effects of monetary policy through changes in the supply of bank credit. The necessary condition for the credit channel to operate is the significant role of banks as a source of capital for the private sector.

10. In Sudan, the first two channels are not likely to be strongly developed because the necessary institutional prerequisites are absent. The interest rate channel is not effective in Sudan as the Islamic banking system prohibits interest rate and existing interbank market does not carry any interest rate and is not well developed. As the interbank money market is very shallow, monetary policy implementation is constrained by the shortage of marketable policy instruments. The equity and bond markets are not developed as well. Based on data from the Khartoum Stock Exchange, the total market capitalization is less than 4 percent of GDP in 2012. This leaves only the exchange rate and bank lending channel.

11. There are several empirical studies focusing on the monetary transmission mechanism in Sudan. Moriyama (2008) investigated inflation dynamics in Sudan using three different approaches: the single equation model, the structural vector-auto regression model and a vector error correction model with data spanning 1995Q1 to 2007Q2. The estimated results concluded that money supply and nominal exchange rate changes affect inflation with 18-24 month time lag. Jabrallah and Hasan Mohamed (2008) used impulse response analysis and the GARCH model with monthly data from July 1995 to December 2007. Their study suggested that the change in money supply will be reflected in the inflation after about 7 to 10 months. Abdoun (2012) used a model consisting of three equations: (i) an equation explaining price developments for tradable; (ii) an equation explaining price developments for non-tradable; and (iii) an equation deriving inflation as a function of both tradable and non-tradable inflation. The main model was estimated over period 1998Q1-2011Q4, and two sub-models were estimated relative to the high and low inflation periods, respectively. The estimation results found that the exchange rate, reserve money, fiscal monetization and wages are key determinants of inflation.

D. The Model

12. This chapter will focus on the monetary transmission mechanism in Sudan after the secession of South Sudan. As the secession of South Sudan is a major structural change in the economy, it is appropriate to study the monetary transmission against this background. Because the sample period after the session is very short and Sudan does not compile quarterly GDP data, it is not feasible to include output in this analysis. Instead the study would focus on how the accommodative monetary policy transits into near hyperinflation in a short period which would certainly hurt future growth.5 The model regress the inflation rate (y-o-y percentage change) on the three independent variables: reserve money, nominal effective exchange rate based on the parallel exchange rate6 and credit to the private sector (all monthly data and y-o-y percentage changes from July 2011 to June 2013). All the regressions have been done using the OLS methodology. The following model is used:

Y= constant + a*RM + b* NEER + c*PrivateCredit

where Y is inflation rate, RM is reserve money, NEER is nominal exchange rate based on the parallel rate and PrivateCredit is credit to the private sector. The estimation uses lagged values of the three explanatory variables.

13. The estimation results suggest that expansionary monetary policy led to high inflation in Sudan through the exchange rate channel and bank lending channel. The results are presented in the Table 1:

  • As expected, reserve money has a positive and significant effect on inflation rate and there is a lag of between 4 to 5 months. This suggests that the monetization of the deficits does lead to high inflation but with a lag of 4 or 5 months.

  • Credit to the private sector also has a positive and significant effect on the inflation rate with no lags.

  • The effect of the NEER is significant with a lag of 3 and has the correct sign, i.e., a devaluation of the exchange rate will fuel inflation.

Table 1.

Sudan: Effectiveness of Monetary Transmission

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Note: * denotes significant at 10 percent level; ** denotes significant at 5 percent level; *** denotes significant at 1 percent level.

14. Compared with the results of previous studies (Table 2), this study also suggests that the reaction lags of inflation to the reserve money and exchange rate have been shortened dramatically after the secession; i.e. expansionary monetary policy has transited into higher inflation at a higher speed. This is not a surprise as the previous studies covered both high inflation and low inflation period while the period under study only relates to high inflation. As inflation is known to have downward stickiness due to rigidities in labor market, i.e., “inflation inertia,” a deflationary monetary policy is expected to take longer period to have the desired impact on reducing inflation.

Table 2.

Sudan: Estimation Results of Previous Study

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E. Policy Recommendations

15. The econometric analysis above concludes that reserve money, the exchange rate, and private sector credit are the main determinants of inflation after the secession of South Sudan and that the transmission lags have been shortened significantly compared with previous studies. These findings reinforce the need for a comprehensive package of fiscal and monetary measures that strengthens the monetary policy framework and improves its effectiveness.

16. Monetary policy should be supported by a prudent fiscal policy. The monetary policy framework in Sudan is hampered by fiscal policy dominance and reliance on central bank financing of the budget deficit. Only a comprehensive stabilization program comprising fiscal consolidation, a corresponding reduction in central bank financing of the deficit, will achieve a lasting reduction in the current high rate of inflation. In addition, due to the “inflation inertia” (inflation expectations are sticky downward) and the response lags of inflation to policy, decisive and rapid implementation of the stabilization program is necessary to anchor inflation expectation and achieve price stability.

17. Reforms of the monetary and financial system are needed to strengthen the monetary policy framework. A clear central bank mandate for operational independence and accountability needs to be established to pursue price stability. Improving transparency in the conduct and evaluation of monetary policy would make the monetary transmission mechanism more effective. Development of adequate toolkits for money market trading and central bank credit facilities are necessary to dampen inflationary pressures and improve the effectiveness of monetary policy and banks’ liquidity management.

18. The unification of the multiple exchange rates should be given priority. As the central rate no longer serves as a nominal anchor and almost all private sector foreign exchange transactions are already being executed at the parallel market rate, most prices already reflect the parallel market exchange rate and the unification of the exchange rates is unlikely to have significantly inflationary effects. Unification would discontinue the practice of direct and subsidized credits through preferential exchange rates which would further dampen inflationary pressure through the credit channel.

19. In view of the strong correlation between reserve money and inflation, the monetary policy framework can be improved by focusing on using reserve money as the nominal anchor. This study confirmed the robustness of the previous studies that reserve money remains largely determinant in times of high inflation. Focusing using reserve money would improve the effectiveness of monetary transmission mechanism.

20. Terminating participation of financial institutions by the central bank would improve the effectiveness of monetary transmission mechanism through bank lending channel. Based on the outcome of the above analysis, growth of credit to the economy is a key determinant of inflation. Participation of financial institutions by the central bank would compromise the objective of the central bank to maintain price stability by fueling inflation pressure through directly and indirectly injecting liquidity to the private sector (such as capitalization of the banks).

References

  • Abdoun, R., 2012, “Sudan’s Inflation Problem: Some Lessons from the Past 30 Years,” IMF Selected Issues (IMF Country Report 12/299).

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  • Debelle, G., Masson, P., Savastano, M., Sharma, S., 1998, “Inflation Targeting as a Framework for Monetary Policy,” IMF Economic Issues No. 15.

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  • Jabrallah, B. H., and Hasan Mohamed, M., 2008, “Determining the lag in the General Price Level’s Response to a Change in the Money Supply in Sudan, 1995-2007Khartoum, Central Bank of Sudan.

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  • Khan, M., Senhadji, S., 2000, “Threshold Effects in the Relationship Between Inflation and Growth”, IMF Working Paper, WP/00/110.

  • Mishra, P., Montiel, P., and Spilimbergo, A., 2012, “How Effective Is Monetary Transmission in Low-Income Countries? A Survey of the Empirical Evidence,” IMF Working Paper, WP/12/143.

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  • Moriyama, K., 2008, “Investigation Inflation Dynamics in Sudan,” IMF Working Paper, WP/08/189.

  • Sundararajan, V., Marston, D., and Shabsigh, G., 1998, “Monetary Operations and Government Debt Management under Islamic Banking,” IMF Working Paper, WP/98/144.

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1

Prepared by Haiyan Shi. The author would like to thank the Sudanese authorities for sharing the data, seminar participants at the Central Bank of Sudan for useful comments, and Yi Liu, Patricia Poggi and Nour Mohamad Ibrahim for excellent assistance.

3

In Sudan, the process of calculating return on most government securities depends on the audited accounts certified by the authorized bodies. The securities issued by the Central Bank of Sudan are based on ljara mode, where its return is determined in advance.

5

Khan and Senhadji (2000) have shown that high inflation would have a negative impact on growth after exceeding a threshold which is 7-11 percent for developing countries.

6

When there is a multiple exchange rate regime, the official exchange rate may not be the relevant variable but the parallel market rate.

Sudan: Selected Issues
Author: International Monetary Fund. Middle East and Central Asia Dept.
  • View in gallery

    Sudan: Central Rate, Commercial Banks Rate, and Parallel Rate, 2009–13

  • View in gallery

    Sudan: Required and Excess Reserves and Inflation, 2011–13

  • View in gallery

    Sudan: Net Credit to Central Government, 2011–13 1/

    (In billions of SDG)

  • View in gallery

    Selected MENA Importers: Seigniorage and Inflation, 2012