In recent years, the IMF has released a growing number of reports and other documents covering economic and financial developments and trends in member countries. Each report, prepared by a staff team after discussions with government officials, is published at the option of the member country.

Abstract

In recent years, the IMF has released a growing number of reports and other documents covering economic and financial developments and trends in member countries. Each report, prepared by a staff team after discussions with government officials, is published at the option of the member country.

Toward Inflation Targeting1

A. Introduction

1. The National Bank of Kazakhstan (NBK) has recently announced a medium-term commitment to adopt a formal inflation targeting regime. Over the past two decades, inflation targeting (IT) has been a popular monetary policy framework in advanced and emerging market economies. The main feature of an IT regime is the official announcement of a target (range) inflation rate and the explicit recognition that price stability is the main objective of monetary policy. NBK’s monetary policy guidelines are already explicit about the primacy of price stability as a primary goal, along with controlling short-term liquidity and smoothing volatilities within a managed exchange rate regime.

2. The literature has highlighted the need for clear monetary policy instruments, a forward-looking monetary policy, and low financial dollarization as initial preconditions for the success of an IT regime. The literature on the pre-requisites for IT is vast. Carare and others (2002) grouped these pre-conditions into four broad categories: (i) a clear mandate and accountability framework for the support of an IT regime; (ii) macroeconomic stability; (iii) developed financial system; and (iv) effective policy implementation tools. In this context, a number of studies, including Roger and Stone (2005), Freedman and Otker-Robe (2009; 2010), and Walsh (2009), have stressed the importance of an effective and clear monetary policy instrument as well as an active forward-looking monetary policy, for the success of an IT regime. Other survey studies, including IMF (2006), highlight the importance of minimizing dollarization of the domestic financial system to strengthen the efficacy of monetary policy and gradually transit towards full-fledged IT regimes.

3. This chapter conducts three empirical analyses to examine the readiness of the NBK to adopt an IT regime in the medium term. First, we examine the strength of the NBK’s policy interest rate instrument in influencing money market interest rates and inflation. Second, we test whether monetary policy in Kazakhstan has been backward- or forward-looking. And third, we examine the determinants of dollarization in Kazakhstan and discuss successful de-dollarization country experiences. The chapter concludes with a set of policy recommendations.

B. Is the Interest Rate Effective in Controlling Inflation?

Current policy framework

4. The NBK uses the refinancing rate as its main policy interest rate. Its refinance rate and deposit rate together form an interest rate corridor, with the former representing a soft ceiling and the latter a floor. Although the policy rate—the rate at which the NBK lends to the banking system in the short-term—has remained unchanged at 5½ percent since August 2012, key money market interest rates have been quite volatile. This illustrates the limited role of the NBK’s policy interest rate in anchoring money market rates, especially in the presence of tight liquidity conditions. See Epstein and Portillo (2014) for a detailed analysis of the monetary policy framework in Kazakhstan.

Figure 1.
Figure 1.

Kazakhstan: Money Market Interest Rate

(January 2010–May 2014)

Citation: IMF Staff Country Reports 2014, 243; 10.5089/9781484355671.002.A003

Sources: Bloomberg and IMF staff estimates.

Empirical model and results

5. This section estimates a multivariate vector autoregressive (VAR) model to examine the relationship (and causality) among the various interest rates and inflation. Our objective is to understand whether/how the policy refinancing rate guides other money market interest rates and achieves its ultimate goal of ensuring price stability. To this end, we specify a simple VAR model of order p for the period 2003: M1–2014: M2:

Yt=μ+Σi=1pπiΔYti+Σj=1mβjXtm+ɛt(1)

where Yt is a vector of endogenous variables: the refinance rate, deposit rate, lending rate, and inflation. Xt is a vector of exogenous variables: international food and energy prices, while εt is a vector of iid error terms. The order of lags is determined by standard lag selection criteria.

6. The results indicate that inflation does not respond to changes in any of the interest rates, while the refinance rate responds to shocks to inflation. Empirical results from the generalized impulse response functions (IRF) below deliver a few important messages.

  • First, the NBK policy (refinance) rate does not affect money market interest rates. This is shown from the statistically insignificant response of deposits or lending rates to shocks in the refinance rate.

  • Second, changes in the deposit, lending, or refinance rates do not induce any change in the inflation rate, as is evident from the statistically insignificant response of the inflation rate to generalized one standard-deviation shocks in all of these interest rates.

  • Third, IRF results also suggest that the refinance rate responds to shocks in inflation, rather than the other way round. This response is positive and statistically significant, indicating that higher inflation induces the NBK to raise its refinance interest rate. Shocks to the policy rate, however, do not affect inflation.

  • These combined results suggest that the current monetary policy instruments used by the NBK are unable to signal the stance of monetary policy and are not effective in ensuring price stability.

Figure 2.
Figure 2.

Kazakhstan: Response to Generalized One S.D. Innovations

Citation: IMF Staff Country Reports 2014, 243; 10.5089/9781484355671.002.A003

7. The results hold under a number of robustness checks. We use generalized IRFs because they are not sensitive to the ordering of the endogenous variables in the VAR system. These results are also robust to using different lags, as suggested by the lag selection criteria. Further analysis suggests that inflation Granger causes the refinance rate confirming our earlier results.

C. Is Monetary Policy Forward-Looking?

8. The backward- or forward-looking nature of monetary policy is another aspect of the readiness of the NBK to move toward IT in the medium term. After studying the relationship between the NBK’s refinance rate and inflation in the previous sub-section, we turn to another important and complementary pre-requisite for IT, namely whether monetary policy is backward- or forward-looking.

Background and model specification

9. The main objective of the NBK is to achieve price stability, and keep annual inflation within a 6–8 percent range. The monetary policy guidelines of the NBK explicitly entrust the NBK with the formulation and implementation of monetary policy, with price stability being the de jure primary objective. Specifically, the NBK’s goal is to keep inflation within the range of 6–8 percent. To achieve such a target range, a set of forward-looking instruments must be in place. It is thus essential to understand how the NBK conducts monetary policy and how it adjusts its instruments in response to macroeconomic and inflationary developments.

10. We specify a Taylor rule to examine monetary policy in Kazakhstan. Building on Taylor (1993) and Clarida, Galí and Gertler (1998, 2000), among others, we aim to understand the monetary policy stance in Kazakhstan using simple backward and forward-looking Taylor rules. Taylor rules are monetary policy rules that describe how a central bank should adjust its instrument, usually its short-term interest rate, in response to inflation and macroeconomic activity. Orphanides (2007) compares the characteristics of Taylor rules with alternative monetary policy guides. Taylor (1993) first showed that the following equation can explain movements in the U.S. Federal Reserve’s federal fund rate quite well:

it=rn+πt+0.5(πtπ*t)+0.5y˜t(1)

where it is the short-term policy interest rate, rn is the natural rate of interest, πt is the inflation rate, π*t is the central bank’s inflation target, and y˜t is the output gap.

11. More recent studies have added the effect of interest rate smoothing and the exchange rate in the basic Taylor rule. Building on the above Taylor rule specification, Moura and Carvalho (2010) and Sack and Wieland (1999), among others, have argued that central banks typically smooth their interest rate changes (see Equation 2 below). Hammond, Kanbur, and Prasad (2009) and Mohanty and Klau (2004) also argued for including exchange rates in the case of small open economies (see Equation 3).

it=(1ρ)i*t+ρit1+ɛt(2)
it*=rn+πt+k+(β1)(πt+kπt*)+γy˜t+k+ηΔxt(3)

where i*t the central bank’s target interest rate is a function of rn, the natural rate of interest, the inflation target and the Δxt exchange rate. The ρ coefficient in Equation 2 above reflects the interest rate smoothing parameter. The output gap is calculated as:

y˜t=GDPtGDP¯t(4)

where y˜t is the difference between actual GDP and its long-run trend GDP¯t estimated by the Hodrick-Prescott filter.

12. This specification allows for both a backward and a forward-looking test of the NBK’s monetary policy over the 2003: Q1–2013: Q3 period. Inserting Equation 3 into 2 delivers the following equation:

it=(1ρ)α+(1ρ)βπt+k+(1ρ)γy˜t+k+(1ρ)ηΔxt+ρit1+ɛt(5)

We allow k in inflation and output gap to take a negative (backward-looking Taylor rule) or positive (forward-looking Taylor rule) value. A number of studies in the literature have argued that central banks are usually more forward-looking under IT regimes than under other monetary policy regimes (see Freedman and Otker-Robe (2009) and Roger and Stone (2005)). We, therefore, test these two versions of the Taylor rule for the case of Kazakhstan. The model to be estimated is as follows:

it=a+bπt±1+cy˜t±1+dΔxt+ρit1+ɛt(6)

Note that Equation 6 is a simple version of Equation 5 where k = -1 for the backward-looking specification and k = +1 for the forward-looking specification. A similar backward-looking Taylor rule was adopted by Moura and Carvalho (2010) in the case of seven Latin American countries and Kuzin (2006) for Germany’s Bundesbank, while Clarida, Galí and Gertler (1998, 2000), Kim and Nelson (2006), and Kishor (2012) use a similar forward-looking specification in their study of monetary policy in a number of advanced economies.

Empirical methodology and results

13. Estimation is done using a two-step Heckman procedure. Data comes from the IFS, and the time-series properties of the variables tested using the ADF unit root test, are taken into consideration in the estimations.

  • While estimation of the backward-looking specification is simply done using OLS, estimation of the forward-looking model is less straightforward because future values of inflation and output gap will be correlated with the error term. Mohanty and Klau (2004) and Clarida, Galí and Gertler (2000) proposed using conventional IV and GMM approaches to correct for this endogeneity problem.

  • Here, we follow a more recent approach by Kim (2006) and Kim and Nelson (2006) to correct for endogeneity and produce consistent estimates. Specifically, they suggest following a two-step Heckman (1976) procedure, where one regresses inflation and output gap on a set of instruments in the first step and obtains the residuals. Following Kim and Nelson (2006), we use four lags of inflation, output gap, global commodity prices, and interest rate as our set of instruments. These residuals are then added to the original Taylor rule specification in the second step to deliver efficient estimates. The forward-looking model can then be estimated using OLS after correcting for endogeneity.

14. Empirical results indicate that monetary policy in Kazakhstan has been backward-looking over the period under consideration. Results from the backward-looking specification suggest that the refinance rate shows a statistically significant response to past inflation and output gap. Specifically, the NBK appears to raise its refinance rate in the current period in response to higher inflation or overheating in the previous period, indicating a backward-looking monetary policy. The second specification, however, suggests that current interest rates do not respond to future changes in inflation or output gap, as the variables of interest are statistically insignificant. Both specifications show a strong interest rate smoothing effect, and suggest that the NBK does not respond to changes in the exchange rate. Note that these results are consistent with those in section B, which also indicated lack of causality from the policy rate to inflation.

Text Table 1.

Kazakhstan

article image
Robust standard errors are in parentheses.*Significant at 10 percent; **Significant at 5 percent; ***Significant at 1 percent

D. Does Dollarization Hinder the Move Toward Inflation Targeting?

15. We now study the determinants of dollarization in Kazakhstan, and discuss a few de-dollarization measures that may strengthen the efficacy of monetary policy. We have shown that a financial environment characterized by ineffective interest rate instruments and continued volatility in the money market can delay progress toward adopting a more effective monetary policy framework. Rising dollarization ratios may further complicate the conduct of domestic monetary policy. In this context, we first examine the extent of dollarization in Kazakhstan versus other emerging countries and discuss how a dollarized banking system can complicate the management of macroeconomic policy. We then show that inflation volatility and an asymmetric exchange rate policy are the main drivers of dollarization in Kazakhstan, hindering the move toward a more effective monetary policy framework. We conclude with a set of potential de-dollarization measures at the macro and micro levels.

Dollarization and macroeconomic policy

16. Financial dollarization in Kazakhstan is relatively high. The ratios of foreign currency deposits and loans to total in Kazakhstan remain high, despite a gradual fall prior to the recent devaluation. Although Kazakhstan is in a better position relative to a number of regional comparators, it still needs ambitious reforms to reach the dollarization levels of leading emerging markets.

Figure 3.
Figure 3.

Kazakhstan: Financial Dollarization in Kazakhstan

Citation: IMF Staff Country Reports 2014, 243; 10.5089/9781484355671.002.A003

Sources: Kazakhstani authorities and IMF staff calculations
Figure 4.
Figure 4.

Kazakhstan: Dollarization in Selected Countries

(latest year available)

Citation: IMF Staff Country Reports 2014, 243; 10.5089/9781484355671.002.A003

Sources: FSI, Kazakhstani authorities, and IMF staff calculations.

17. Dollarization complicates the management of macroeconomic policy and increases financial risks. It can limit the effectiveness of monetary policy, and increases the likelihood of balance sheet and liquidity risks. These effects may be exacerbated in managed exchange rate regimes.

  • Dollarization may affect the autonomy of monetary policy and weaken standard transmission mechanisms. See Ize and Yeyati (2005) for a discussion on the ineffectiveness of the interest rate channel when most intermediation is in dollars.

  • High dollarization generally calls for extra reserve cushions, and deepens the impact of the exchange rate channel on the inflation rate, particularly in managed exchange rate regimes. Ize and Yeyati (2005) argue that dollarization is associated with higher exchange rate pass-throughs, thus limiting the countercyclical capacity of domestic monetary policy and exacerbating the fear of floating in dollarized economies.

  • Typical financial risks include credit risks that may stem from mismatches between dollar assets and liabilities in banks’ balance sheets, solvency risks arising from potential currency mismatches in the event of large depreciations, and/or liquidity risks, which can lead to divergence between onshore and offshore interest rates on dollar deposits (see Kokenyne and others (2010) and Erasmus and others (2009) for details).

Determinants of dollarization in Kazakhstan

18. Drivers of dollarization include a number of macroeconomic and institutional factors. Dollarization typically develops when a country’s local currency performs its functions relatively poorly compared to other accessible foreign currencies. A number of macroeconomic and institutional determinants of financial dollarization have been identified in the literature.

  • Dollarization is common in countries with high and volatile inflation rates. Studies by IMF (2007) and Ize and Yeyati (2005) further argue that high variability in inflation is a more important determinant than high inflation rates per se.

  • An asymmetric exchange rate policy that allows for depreciation but resists appreciation of the local currency would encourage residents to hold foreign currency deposits as a means of preserving their purchasing power (Rennhack and Nozaki 2006).

  • Dollarization also surfaces in weak financial systems characterized by financial repression, weak intermediation, and interest rate controls.

19. We focus on the determinants of deposit dollarization in Kazakhstan. Building on the models of De Nicolo and others (2005), Neanidis and Savva (2009) and Kokenyne and others (2010), among others, we specify the following model and estimate over the 2000: Q1–2014: Q1 period:

Δdepdollarizationt=β0+β1intdifft1+β2Δexrt1+β3exrvolt1+β4inft1+β5infvolt1+β6Δcreditt1+β7exrasymmetryt+ɛt(1)

where Δdepdollarizationt the dependent variable is the percentage change in deposit dollarization at time t. Independent variables include intdifft–1 the differential between interest rates on the domestic currency versus the interest rate on dollar deposits in Kazakhstan, exrt–1 is the exchange rate, exrvolt–1 is a measure of exchange rate volatility, inft–1 is the inflation rate, infvolt–1 is inflation volatility, and Δcreditt–1 is a measure of financial development proxied by the ratio of credit to the private sector to GDP. Finally, following Rennhack and Nozaki (2006) and Neanidis and Savva (2009), we include exrasymmetryt a dummy variable that captures asymmetry in the exchange rate policy by taking a value of one in cases of depreciation and zero in appreciation.

20. Estimations are done using simple OLS. Independent variables are all lagged one period to account for possible lag effects. We include all variables in their levels or in first-difference, depending on results from the ADF unit root tests. Estimation is done using OLS with robust standard errors.

21. Empirical findings suggest that inflation volatility and asymmetry of exchange rate policy toward depreciation drive deposit dollarization in Kazakhstan. This concurs with results from the literature in confirming the importance of higher inflation volatility rather than higher inflation in higher deposit dollarization. Moreover, after controlling for other factors, our results indicate that the asymmetric nature of the exchange rate policy, which allows for depreciations but resists appreciation of the domestic currency, has been a major incentive for higher dollarization of deposits. Using estimated coefficients from our regression, we show the contribution of these two variables in explaining changes in deposit dollarization in Kazakhstan over the sample period.

Figure 5.
Figure 5.

Kazakhstan: Contributions to Deposit Dollarization

Citation: IMF Staff Country Reports 2014, 243; 10.5089/9781484355671.002.A003

De-dollarization policies

22. Successful cross-country de-dollarization experiences suggest a combination of macroeconomic stabilization policies and complementary microeconomic measures. Country experience suggests that gradual market-based de-dollarization policies, especially at the micro level, are more successful than forced de-dollarization measures which may diminish market confidence, increase short-run risks, and more generally affect the credibility of economic policy.

23. At the macro level, country experience suggests that an inflation targeting regime with flexible exchange rates and the absence of fiscal dominance provides the best monetary policy framework for market-driven financial dollarization (see Kokenyne and others (2010)). A study by IMF (2006) stipulates that dollarization is a phenomenon that is largely endogenous to the monetary policy regime, suggesting that a credible and successful macroeconomic policy of disinflation is likely to reduce dollarization over time. Suggested policies at the macro level include:

  • Widening exchange rate bands as in Poland in late 1990’s, increasing foreign exchange loan interest rates as in Croatia, and raising domestic interest rates for deposits above foreign currency interest rates as in Turkey, Egypt, Hungary, and Poland in the early 1990’s.

  • Measures aimed at deepening the domestic financial market include introducing local currency-denominated securities with credible indexation systems as in Chile, and Mexico in the 1980’s and Bolivia, Israel, and Turkey in the early 2000’s. Egypt, Lithuania, and Poland removed administrative controls on interest rates in the early 1990’s.

  • Unbiased taxation on income earned from foreign currency deposits, bonds or other financial transactions versus local currency taxes.

24. At the micro level, supportive prudential regulations to make the local currency more attractive are necessary. Cayazzo and others (2006) and Kokenyne and others (2010) discuss a set of comprehensive prudential measures including minimum capital requirements for foreign currency-induced credit risk and requesting credit bureaus to provide currency-specific information on all debt. Rennhack and Nozaki (2006) summarize the experiences of a number of Latin American countries. Suggested policies at the micro level include:

  • Imposing higher reserve requirements on foreign currency deposits as in Armenia, Belarus, Bolivia, Croatia, Peru, Romania, Serbia, and Turkey in the 2000’s (see García-Escribano and Sosa (2011) and Kokenyne and others (2010)).

  • Remunerating the reserve requirement on local currency deposits at a higher rate than for the foreign currency deposit reserve requirement. See Kokenyne and others (2010) on the cases of Croatia, Israel, Nicaragua, and Romania in the 2000’s.

  • Holding reserve requirements for foreign currency deposits in local currency. Examples include Croatia, Haiti, and Serbia in the 2000’s.

  • Tighter provisioning requirements on foreign currency loans as in Albania, Croatia, and Mozambique in the mid 2000’s. Banks may also be required to carry routine evaluations of currency risks, or, alternatively, have to set up reserves as a percentage of foreign currency credit that has not been evaluated (see García-Escribano and Sosa (2011) on the experience of Latin American countries).

  • Raising insurance premiums on dollar deposits, see IMF (2007) and García-Escribano (2010) on the Peruvian experience.

  • Developing markets for instruments to hedge currency risks as in Peru and Israel.

  • Requiring banks to hold liquid assets of certain percentages on their short-term liabilities, with higher requirements for foreign currency than for domestic currency liabilities. See Kokenyne and others (2010) for examples from Angola, Croatia, Cyprus, Egypt, Lebanon, and Turkey in the 1990’s and 2000’s, and Rennhack and Nozaki (2006) and García-Escribano and Sosa (2011) on the experience of Latin American countries in the early 1990’s.

E. Conclusion and Policy Recommendations

25. This chapter has presented evidence that there is still ample room for improvements before the NBK is ready to adopt IT. The current nature and conduct of monetary policy in Kazakhstan, including the ineffectiveness of the policy rate, the dependence on the exchange rate as a dominant monetary policy instrument and extensive dollarization undermine the framework’s ability to ensure price stability and counteract domestic and external shocks. We have shown that the NBK’s official refinancing rate does not fully signal the stance of monetary policy, as reflected in a weak transmission from the refinance rate to money market interest rates and weak influence on inflation. Furthermore, monetary policy needs to become more forward-looking in order to contain inflationary pressures and anchor expectations. Macroeconomic stabilization policies, including a deeper domestic financial market, along with a number of micro-prudential measures are needed to arrest dollarization and increase confidence in the local currency.

26. There is no rigid or unique formula for running successful monetary policy, but a clear and effective short-term policy interest rate should be an essential element of any strategy. The results from our three empirical exercises plus successful country experiences suggest that gaining control over short-term interest rates is an essential component of any effective monetary policy regime. In doing so, it is important to recognize that sequencing of reforms is key to success, and that short-term measures can and should be taken in order to ensure a smooth transition to IT in the medium-term. In this context, suggested near-term steps could include:

  • Introducing a clear policy rate instrument supported by open market operations to help ensure that key interbank rates are anchored around the NBK’s policy rate. If current exchange rate management policies continue, large foreign exchange interventions will be required, and these will complicate and add to the operational challenge when combined with large open market operations (see Epstein and Portillo (2014)).

  • A gradual widening of the exchange rate band.

  • Introducing micro prudential measures, including certain capital and reserve requirements, to increase confidence in the domestic currency.

  • Ensuring that the multiple objectives of financial or exchange rate stability do not conflict or override its ultimate goal of price stability.

  • Enhancing open communication of the NBK’s policy intentions and operations to help anchor expectations and ensure a smooth transition to a new policy interest rate.

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Prepared by Amr Hosny.

Republic of Kazakhstan: Selected Issues
Author: International Monetary Fund. Middle East and Central Asia Dept.