Seychelles: Selected Issues
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International Monetary Fund. African Dept.
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Selected Issues

Abstract

Selected Issues

Assessing the Effectiveness of Monetary Transmission in Seychelles1

This note empirically assesses the effectiveness of monetary transmission mechanisms in Seychelles. Using a structural VAR model, we find that monetary transmission mechanisms are generally weak and that the results may reflect inefficiencies of the current monetary framework. This chapter is organized as follows: Section I describes the theoretical background underlying a monetary policy framework in the context of a small open-economy with flexible exchange rates. Section II presents the empirical analysis. Section III concludes and provides policy recommendations.

A. Theoretical Background

1. The Mundell-Fleming model shows that under a fixed exchange rate regime with perfect capital mobility, monetary policy is limited as a stabilization tool. In a small open economy facing perfect capital mobility with fixed exchange rates, fiscal policy is expected to be highly effective in moving aggregate demand while monetary policy is limited. Indeed, an expansionary fiscal policy translating into higher government spending would lead to higher interest rates and appreciation pressures, forcing the Central Bank to intervene by purchasing foreign currency using domestic funds, increasing money supply and ultimately resulting in higher output. In the case of an expansionary monetary policy, an increase in money supply results in a decrease in interest rate, leading to depreciation pressures, and ultimately forcing the Central Bank to intervene in the foreign exchange market in order to maintain the peg, consequently impacting neither interest rate nor output level.

2. However, under a floating exchange rate regime and perfect capital mobility, the model shows that monetary policy is the most efficient stabilization tool. In a small open economy facing perfect capital mobility with flexible exchange rates, monetary policy is expected to be more effective in moving aggregate demand while fiscal policy has limited efficacy. Indeed, an expansionary fiscal policy would lead to higher interest rates and appreciation pressures, reducing net exports which ultimately offset the initial stimulus with no resulting change in output. In the case of an expansionary monetary policy, an increase in money supply would result in a decrease in interest rate, leading to depreciation pressures which ultimately stimulate net exports and increase output.

3. As a small open economy with flexible exchange rates, Seychelles provides an interesting framework to assess the effectiveness of the monetary transmission mechanism. The Central Bank of Seychelles (CBS) has adopted a reserve money targeting framework since the inception of an IMF-supported economic reform program in November 2008. The change from exchange rate targeting was put in place in view of supporting the liberalization of the foreign exchange market and a floating exchange rate regime2, which led to the removal of administrative exchange controls and free access to foreign exchange. This framework has called for appropriate monetary policy interventions to ensure exchange rate stability 3. Seychelles is currently among the very few small states whose exchange rate regime is classified as flexible both de jure and de facto4.

B. Channels of Transmission

4. We examine Seychelles’ channels of monetary transmission mainly through four channels5: money, interest rate, exchange rate, and credit channels. Money channel. This channel assumes changes in reserve money are transmitted to broad money via the money multiplier. Because individuals hold components of broad money, currency in circulation, and various forms of deposits for transaction purposes, changes in money balances affect aggregate demand, leading to changes in prices and output.

  • Interest rate channel. This is the traditional channel of monetary transmission, where increases in money supply reduce interest rates, stimulating investment spending and output. Because monetary policy can only affect short-term nominal interest rates, the impact of monetary policy on spending decisions assumes that prices are sticky and long-run real interest rates depend on short-run real interest rates.

  • Exchange rate channel. The exchange rate channel is based on the uncovered interest rate parity condition. It assumes that differences between domestic and foreign returns drives exchange rates, affecting the country’s net exports and aggregate demand. This channel is especially important in small open economies.

  • Credit channel. The credit channel focuses on the existence of asymmetric information in financial markets which result in banks imposing an external finance premium on borrowers, affecting the supply of credit and aggregate demand. In this channel, a reduction in money supply increases the external finance premium faced by borrowers, reducing the supply of credit and output. The credit channel is composed of the bank-lending channel and the balance-sheet channel. The bank-lending channel assumes that an increase in the external finance premium arises because monetary contraction has deteriorated the quality of loans. The balance-sheet channel assumes that an increase in the external finance premium arises because monetary contraction has reduced the net worth of the private sector.

5. However, unstable money multiplier and velocity can affect the effectiveness of the monetary transmission mechanism. The monetary transmission mechanism requires that changes in reserve money affect money supply, and changes in money supply affect output and price. However, an unstable money multiplier (transmitting changes in reserve money into changes in money supply) or velocity (affecting the link between money supply and output) would make those relationships unpredictable.

C. Assessing the Efficiency of Monetary Transmission Mechanisms: An Empirical Analysis

6. To assess the efficiency of monetary transmission mechanisms, we follow the widely used structural VAR methodology. In order to measure the effect of monetary policy, we need to identify purely exogenous shocks to the variables of interest and see how the economy reacts to them. The advantage of a VAR is that it isolates purely exogenous shocks to monetary policy and allows tracing out the dynamics of the variables after the shocks hit the economy. For these reasons, VARs and its variant has been the most common approach adopted in the monetary transmission mechanisms (MTM) literature, both in the context of developing as well as of developed countries. Studies of MTM in developed countries have commonly used VARs and its variants (Christiano, Eichenbaum and Evans, 1999, Boivin, Kiley and Mishkin 2011 for the US; Weber, Gerke, and Worms, 2009 for the euro area). Most studies of MTM in LICS have also used VARs (Mishra, Montiel and Spilimbergo, 2010, Mishra and Montiel, 2012).

Formally, the structural VAR model is as follow:

A X t = β 0 + β n X t n + λ Y t + u t ( 1 )

Where t = 1, …,T

Xt is a vector of endogenous time series variables, contains the intercept, time trend and other deterministic terms,

Yt is a vector of contemporaneous exogenous variables

ut are independent structural shocks

We assume the following endogenous and exogenous variables6:

  • Endogenous variables: real GDP (y), price level (p), reserve money (m), policy rate (r), credit to the private sector (c), and nominal effective exchange rate (e).

  • Exogenous variables: global oil price index, global food price index, the US federal funds rate, and US industrial production. These variables are assumed to be proxies for global demand.

The structural VAR cannot be estimated directly, but its reduced form can. In order to get the reduced form, we multiply the structural model by the inverse of matrix A.

Multiplying (1) by the inverse of matrix A. we get the reduced-form VAR:

X t = G 0 + G 1 X t n + e t ( 2 )

Where vector X of endogenous variables depends on the lag of itself and forecast errors e.

In particular, the forecast errors e are now a linear combination of the structural shocks u through the inverse of matrix A:

e t = A 1. u t ( 3 )

The reduced-form VAR is estimated with OLS, allowing us to recover coefficients G and the forecast errors. However, because the number of estimated parameters in the reduced form is smaller than the number of parameters in the structural form, restrictions on matrix A are needed in order to identify the structural model. A Choleski decomposition is applied to identify the matrix A. The ordering of the variables are as follows: real GDP (y), price level (p), reserve money (m), policy rate (r), credit to the private sector (c), and nominal effective exchange rate (e). This ordering implies the following:

  • Shocks to real GDP and price level result in contemporaneous responses of reserve money.

  • Reserve money is assumed to be the main monetary policy instrument, with shocks to reserve money considered as monetary policy shocks.

  • Policy rates are assumed to be used as instruments to signal changes in monetary policy stance

  • Commercial banks react with a delay to the policy rate.

  • Exchange rates are determined by market forces.

D. Data and Specification

7. We use monthly measures of real GDP, CPI, reserve money, credit to the private sector, interest rates and nominal effective exchange rates. Because only quarterly real GDP data was available monthly estimates of real GDP were derived by interpolating quarterly GDP data using a cubic spline, and then seasonally adjusted using the X13 ARIMA method. Due to the absence of policy rate in Seychelles, the T-bill rate was used instead. Quarterly GDP data were collected from the National Bureau of Statistics of Seychelles. CPI, reserve money, credit to the private sector, and nominal effective exchange rates come from the IMF IFS database. Global oil and food indices, US federal funds rate and the US industrial production were from the IMF GAS database. Variables are in log levels, except for interest rates.

  • The stationarity of the variables was assessed. All variables were tested for stationarity using the Phillips-Perron test. The results reveal that all the variables are non-stationary in levels but the first differences are stationary.

  • Residuals were tested for serial correlation. In order for a stationary VAR to be correctly specified, residuals need to be completely random or white noise. We tested for residuals autocorrelation, and excluded the numbers of lags for which serial correlation were found.

  • The stationarity of the variables was assessed. All variables were tested for stationarity using the Phillips-Perron test. The results reveal that all the variables are non-stationary in levels but the first differences are stationary.

  • Residuals were tested for serial correlation. In order for a stationary VAR to be correctly specified, residuals need to be completely random or white noise. We tested for residuals autocorrelation, and excluded the numbers of lags for which serial correlation were found.

  • The stationarity of the variables was assessed. All variables were tested for stationarity using the Phillips-Perron test. The results reveal that all the variables are non-stationary in levels but the first differences are stationary.

  • Residuals were tested for serial correlation. In order for a stationary VAR to be correctly specified, residuals need to be completely random or white noise. We tested for residuals autocorrelation, and excluded the numbers of lags for which serial correlation were found.

  • The optimality of the lag order was tested. We investigated the lag structure of the VAR using lag length criteria. Based on the Likelihood ratio test, a lag of 3 was chosen.

  • The stability of the VAR system was assessed. We checked the stationarity of the system as whole by looking at the inverse roots of the characteristics AR polynomial, and all roots lie inside the unit circle, resulting in the VAR being stationary7.

E. Results

Table 1.

Seychelles: Variance Decomposition Results

article image
Sources: CBS and IMF staff estimates.

8. Results from the variance decomposition show that contribution of monetary shocks to the variability of GDP and inflation is very small. While the exchange rate and interest rate explain most of the variation in GDP due to monetary shocks, credit and exchange explain most of the variation in CPI. Shocks to the exchange rate and interest rate account respectively for 5.3 percent and 3.5 percent of the variation in GDP, and shocks to credit and exchange rate account for respectively for 4.9 percent and 2.6 percent of the variation in CPI.

9. Money and interest rate channels appear to be weak (figure 1). Impulse responses show that neither output nor price react to a one standard deviation shock of reserve money and T-bill rate.

Figure 1.
Figure 1.

Seychelles: No Output and Price Responses to (i) Reserve Money and to (ii) T-bill Rate

Citation: IMF Staff Country Reports 2017, 161; 10.5089/9781484304792.002.A007

Sources: CBS and IMF staff estimates.

10. Credit and exchange rate channels seem to be only weakly present (figure 2). A one standard deviation positive shock to credit has some brief impact on CPI. However, reserve money and interest rate were not found to have an impact on credit. Moreover, a one standard deviation positive shock to the exchange rate result in a weak increase in GDP. But NEER was not found to be responsive to either reserve money nor interest rate.

Figure 2.
Figure 2.

Seychelles: Some Partial Response to Credit and Exchange Rate

Citation: IMF Staff Country Reports 2017, 161; 10.5089/9781484304792.002.A007

Sources: CBS and IMF staff estimates.

F. Conclusion and Policy Recommendations

11. This note aimed at empirically assessing the efficiency of monetary transmission mechanism in Seychelles and found that transmission is generally weak. Results show that the impact of the money and interest rate channels are statistically insignificant while there are only partial evidence of a credit channel and exchange rate channel.

12. In fact, the broader trend of velocity and money multiplier for Seychelles indicates that both velocity and money multiplier have not been stable over time, which may indicate some ineffectiveness in the monetary transmission (Figure 3). The monetary transmission requires stable money multiplier and velocity, i.e. that changes in reserve money affect money supply, and changes in money supply affect output and price. However, an unstable money multiplier (transmitting changes in reserve money into changes in money supply) or velocity (affecting the link between money supply and output) would make those relationships unpredictable. In Seychelles, velocity has tended to decline over time, especially between 2013 and 2015. Fluctuations in velocity were mainly driven by volatility in broad money rather than GDP. While money multiplier was broadly stable from 2011 to 2013, it increased slightly from 2013 to 2014 before declining in the months during 2015.

Figure 3.
Figure 3.

Seychelles: Velocity and Money

Citation: IMF Staff Country Reports 2017, 161; 10.5089/9781484304792.002.A007

Source: CBS.

13. The limited transmission could reflect inefficiencies of the current monetary framework. Existing inefficiencies include (i) structural excess liquidity in the banking system, which could significantly affect the monetary transmission through the money channel, (ii) limited interest rate corridor that does not allow a clear signaling of the monetary stance and guidance to the market short-term interest rates, which is likely to hamper the interest rate channel, and (iii) underdeveloped money markets including interbank markets, which would probably limit the effectiveness of the credit channel.

14. The on-going transition to an interest rate based framework should provide a step towards a more effective monetary transmission8. To strengthen the interest rate impact, the CBS is currently switching to an interest rate based framework from its reserve money based framework. Currently, short-term rates do not seem to respond to fluctuations of the T-bill rate (figure 4). The reintroduction of the interest rate corridor should therefore allow a better signaling and transmission of the monetary stance. While the specifics of the new monetary framework are still under discussion, the introduction of a monetary policy rate, currently scheduled to be approved by June 2017 and implemented by July 2017, should help reduce short-term interest rate volatility and at the same time, provide guidance short-term interest rates.

Figure 4.
Figure 4.

Seychelles: Short-Term Interest, 2012–2017

Citation: IMF Staff Country Reports 2017, 161; 10.5089/9781484304792.002.A007

Sources: Seychelles authorities and IMF staff estimates.
1.

By Wendell Samuel and Arina Viseth. This note is part of a chapter of a forthcoming book on monetary transmission in small states.

2.

The float of the exchange rate and elimination of exchange controls follow the restructuring of external debt.

3.

For example, in the last quarter of 2008 so as to stimulate capital inflows and support the exchange rate. Weekly auctions for a liquidity deposit facility at the Central Bank were introduced and weekly T-bill auctions were open to all. The sales of T-bills contributed to liquidity sterilization and exchange rate stability.

4.

Classification based on AREAER 2016.

5.

Two more channels exist – the asset price and expectation channels – but due to data availability, they are not discussed here.

6.

Our variables follow Davoodi, Dixit and Pinter (2013).

7.

Had a solution of the characteristic polynomial had a root equal to one, then this would have revealed that there is cointegration between the variables, and a VECM model rather than an unrestricted VAR would have been more appropriate to estimate.

8.

For more details on the reforms under discussion, see Annex x on Modernizing Seychelles Monetary Policy Framework.

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Seychelles: Selected Issues
Author:
International Monetary Fund. African Dept.