Abstract
Selected Issues
Monetary Policy Under Excess Liquidity1
In a context of uncertain economic developments, the financial sector in Madagascar has been maintaining ample liquidity buffers. This has undermined the ability of the central bank to influence output and price developments by lowering the effectiveness of the interest rate channel of monetary policy transmission. At the same time, the priority given to foreign reserve accumulation implies that the exchange rate channel cannot be used for domestic price stabilization objectives. Over the last few years, the central bank has embarked on a reform program aimed at fostering money and capital market development, in the context of eventually transitioning to a policy of interest rate targeting. Further to continuously improving liquidity management capacities, strengthening the monetary policy framework would require stepping up efforts to enhance communication with market operators, as well as addressing challenges relating to low financial inclusion and a large degree of informality in the economy.
A. Introduction
1. While well-capitalized and healthy, the financial sector in Madagascar is characterized by excess liquidity, which hampers the transmission of monetary policy. The banking sector is concentrated, well capitalized and healthy (See Selected Issues Paper IV) but operates in a challenging economic environment, characterized by exogenous liquidity and terms of trade shocks typically stemming from the vanilla sector. Furthermore, money markets remain under-developed, placing liquidity management under the exclusive responsibility of the central bank, Banky Foiben’i Madagasikara (BFM). In the face of these constraints and associated uncertainty, banks have been maintaining ample liquidity buffers. To the extent that these buffers are over and above the amount required for precautionary reasons, this undermines the interest rate channel of monetary policy transmission.
2. The monetary authorities have embarked on an ambitious program of reforms to transition from monetary aggregates to interest rate targeting. To strengthen the effectiveness of monetary policy and incentivize banks to contribute to economic development, the BFM has been pursuing a multipronged reform strategy, backed by Fund technical assistance, to simultaneously improve the functioning of the foreign exchange market, build an effective interbank market, and implement a risk-based approach to financial supervision. These intertwined initiatives are expected to allow for the gradual transition of the monetary policy framework from relying on reserve money aggregates to directly targeting interest rates, before eventually switching to inflation targeting.
3. This paper assesses the effectiveness of ongoing reforms and discusses accompanying measures for a successful transition towards interest rates targeting. Section B reviews the financial constraints weighing on monetary policy implementation in Madagascar. Section C takes stock of recent institutional initiatives aimed at developing the money and capital markets with a view to strengthen the interest rate channel of monetary policy transmission. Section D investigates empirically the effectiveness of alternative monetary policy instruments to influence output and inflation in recent years. Section E derives a few policy recommendations regarding possible accompanying measures for transitioning to interest rates targeting and concludes.
B. Assessing the Constraints on the Conduct of Monetary Policy
4. Monetary policy transmission to output and inflation could be expected to mostly take place through the interest and exchange rate channels in Madagascar (Figure 1). In principle, monetary policy ought to be very efficient in a country operating flexible exchange rates in a context of limited capital mobility. To counteract a slowdown in growth, a decrease in lending rates engineered by the central bank would be expected to stimulate domestic investment without triggering capital outflows. Over time, the increase in imports associated with higher domestic demand would exert pressure on the exchange rate to depreciate, hence improving the price competitiveness of exports, further boosting economic activity. Likewise, exchange rate variations possibly triggered by interventions on the foreign exchange market would be expected to directly impact trade flows in a relatively non-diversified economy, characterized by the small value added of (mostly crop) exports and limited substitutability of imports due to inelastic domestic supply. However, constraints pertaining to the financial environment can potentially affect the effectiveness of both these channels. By contrast, other transmission mechanisms such as through asset prices or inflation expectations would be expected to play a smaller role in Madagascar given the financial sector’s underdevelopment.
Monetary Transmission in Madagascar
Citation: IMF Staff Country Reports 2020, 061; 10.5089/9781513534213.002.A003
Monetary Transmission in Madagascar
Citation: IMF Staff Country Reports 2020, 061; 10.5089/9781513534213.002.A003
Monetary Transmission in Madagascar
Citation: IMF Staff Country Reports 2020, 061; 10.5089/9781513534213.002.A003
5. Banks have been in a situation of excess liquidity for years, partly due to the impact of price fluctuations in the vanilla sector. While making up the bulk of the financial system, the banking sector is small, with total assets representing 27 percent of GDP in 2018, and heavily concentrated, with four banks, all foreign owned, holding about 80 percent of credit and deposit market shares. Despite being well capitalized and profitable, banks have been structurally maintaining excess liquidity buffers for years in the face of volatile economic conditions, not least stemming from developments on the main vanilla export market (Figure 2). In the summer of 2016, following some substantial foreign currency pre-financing of exporters in a context of spiking vanilla prices, bank reserves suddenly dried up under the effect of massive cash withdrawals to pay local producers, temporarily driving the reserve coverage ratio of banks below one and prompting the central bank to intervene to supply liquidity. Some hysteresis effects of this episode appear to have contributed to the buildup of structurally high precautionary bank liquidity buffers.
Excess Liquidity
Citation: IMF Staff Country Reports 2020, 061; 10.5089/9781513534213.002.A003
Source: BFMExcess Liquidity
Citation: IMF Staff Country Reports 2020, 061; 10.5089/9781513534213.002.A003
Source: BFMExcess Liquidity
Citation: IMF Staff Country Reports 2020, 061; 10.5089/9781513534213.002.A003
Source: BFM6. Money markets remain under-developed, reflecting the fragmentation of the banking system. The vanilla episode also exposed the absence of well-functioning money markets, leaving the central bank first in line to fend off tensions on liquidity. The fragmentation of the banking sector can be attributed to unequal holdings of reserves, with two banks responsible for excess liquidity buffers in the whole system, and reluctance of banks to lend to each other (Figure 3). In the absence of secured instruments to underpin liquidity circulation until recently, most interbank transactions have taken place on an uncollateralized basis, concluded at a price close to the fixed policy rate as per an implicit convention among the few participants. At times, some banks also resorted to the lending facility for refinancing purposes while the central bank was in parallel mopping up liquidity at much lower rates.
Breakdown on Bank Excess Reserves
(average January-August 2019, billions of ariary)
Citation: IMF Staff Country Reports 2020, 061; 10.5089/9781513534213.002.A003
Source: BFM.Breakdown on Bank Excess Reserves
(average January-August 2019, billions of ariary)
Citation: IMF Staff Country Reports 2020, 061; 10.5089/9781513534213.002.A003
Source: BFM.Breakdown on Bank Excess Reserves
(average January-August 2019, billions of ariary)
Citation: IMF Staff Country Reports 2020, 061; 10.5089/9781513534213.002.A003
Source: BFM.7. The market for government securities is too shallow for a yield curve to emerge. Banks significantly contribute to covering the financing needs of the government, holding about 2.5 percent of GDP of sovereign d ebt, 2/3 of which in the form of Treasury Bills (Bons du Trésor par Adjudication – BTA) of up to one-year maturity, and 1/3 in the form of Treasury bonds (Bons du Trésor Fihary – BTF) (Figure 4). Yet transactions on the secondary market have been scarce so far, and custodian issues on BTF holdings make it difficult for these instruments to support long-term liquidity operations, which prevents the emergence of a yield curve.
Treasury Bills Market
Citation: IMF Staff Country Reports 2020, 061; 10.5089/9781513534213.002.A003
Source: BFM.Treasury Bills Market
Citation: IMF Staff Country Reports 2020, 061; 10.5089/9781513534213.002.A003
Source: BFM.Treasury Bills Market
Citation: IMF Staff Country Reports 2020, 061; 10.5089/9781513534213.002.A003
Source: BFM.8. Foreign exchange interventions have been appropriately guided by an algorithm for intervening in the interbank market to smooth exchange rate fluctuations and meet foreign reserve targets. The foreign exchange market lacks transparency, reflecting significant volatility associated with commodity price developments and the large share of informality in the external sector. Within these constraints, the central bank has been successfully intervening on the foreign exchange market following a Fund TA-provided algorithm to steadily accumulate foreign exchange reserves, market conditions permitting, while smoothening exchange rate volatility (Figure 5).
Interventions on the Interbank Foreign Exchange Market
Citation: IMF Staff Country Reports 2020, 061; 10.5089/9781513534213.002.A003
Source: BFM.Interventions on the Interbank Foreign Exchange Market
Citation: IMF Staff Country Reports 2020, 061; 10.5089/9781513534213.002.A003
Source: BFM.Interventions on the Interbank Foreign Exchange Market
Citation: IMF Staff Country Reports 2020, 061; 10.5089/9781513534213.002.A003
Source: BFM.9. Overall, constraints pertaining to the financial environment complicate the transmission of monetary policy impulses to the economy. Taken together, structural excess bank liquidity, the fragmentation of the banking sector, and the absence of a yield curve have been contributing factors undermining the effectiveness of the interest rate channel for both short- and long-term maturities. Moreover, the priority given to foreign reserve accumulation implies that the exchange rate channel has not been used for domestic price stabilization objectives. Rather, bank liquidity management may have been complicated at times by conflicting objectives between monetary and exchange rate policies, insofar as any purchase on the foreign exchange market following the algorithm results in a supplementary release of liquidity, adding to the surplus that the central bank is structurally seeking to mop-up.
C. Strengthening the Interest Rate Channel of Monetary Policy
10. In recent years, BFM has been playing an increasingly active role in managing bank liquidity. Up until 2014, monetary policy was not very active. Substantial liquidity buffers appear to have been self-regulated by banks in practice, with stated policy instruments or targets used at best as very imperfect signaling devices, as demonstrated by the disconnect between interbank rates and the main policy rate. Since 2015, the central bank has been increasingly intervening in the money market, mostly to mop up the surplus of bank liquidity above required reserves, thus seeking to influence bank intermediation and credit conditions at large (Figure 6).
Bank Liquidity Management
(Billions of ariary)
Citation: IMF Staff Country Reports 2020, 061; 10.5089/9781513534213.002.A003
Source: BFM.Bank Liquidity Management
(Billions of ariary)
Citation: IMF Staff Country Reports 2020, 061; 10.5089/9781513534213.002.A003
Source: BFM.Bank Liquidity Management
(Billions of ariary)
Citation: IMF Staff Country Reports 2020, 061; 10.5089/9781513534213.002.A003
Source: BFM.11. Monetary policy uses the reserve money aggregate as the intermediary target to achieve its main objective of price stability. In a context of very low financial penetration and short investment horizons associated with insufficient financial intermediation, the central bank has been mainly using deposit auctions rather than interest rates, namely volume rather than price instruments, to mop up (in the case of negative auctions – “appels d’offres négatifs”) or provide (positive auctions – “appels d’offres positifs”) bank liquidity, typically at weekly maturities (Figure 7). By contrast, the main policy rate, referring to a one-year horizon irrespective of underlying operations on the money market, has been kept flat for years, akin to the rate of required reserves.
Interventions on the Money Market
Citation: IMF Staff Country Reports 2020, 061; 10.5089/9781513534213.002.A003
Source: BFMInterventions on the Money Market
Citation: IMF Staff Country Reports 2020, 061; 10.5089/9781513534213.002.A003
Source: BFMInterventions on the Money Market
Citation: IMF Staff Country Reports 2020, 061; 10.5089/9781513534213.002.A003
Source: BFM12. Since early 2019, BFM has started expanding its toolbox for liquidity management in light of an eventual transition towards interest rate targeting. Following the announcement that an overnight policy rate set at 0.9 percent would complement the existing 9.5 percent annual policy rate, the monetary authorities established in May 2019 an interest rate corridor that includes an overnight deposit facility at zero percent interest rate and an overnight lending facility at 4.40 percent interest rate. These were subsequently adjusted in November to 0.9 percent and 5.3 percent, respectively. Since then, BFM has been seeking to conduct liquidity provision (mopping-up) operations at rates close to the upper (lower) band of the corridor, further to continuously improving its liquidity forecasting capacities. To better pilot liquidity developments in response to macroeconomic developments, the authorities plan to conduct fine-tuning operations on a routine basis at the end of the reserve maintenance periods, and to eventually conduct full allotment, i.e. fixed rate/unlimited volume, deposit auctions to better anchor market expectations around the targeted policy rate. In parallel, BFM has been working towards expanding its toolkit of monetary policy instruments to include outright foreign exchange purchases and foreign exchange swaps. Some thinking is also underway to issue central bank bills in complement to T-bills as support for liquidity operations, as well as to better attune reserve requirement ratios to structural liquidity conditions, both in local and foreign currencies.
13. These improvements in the institutional changes have facilitated intensified interbank market activity over the last few months. Thanks to improved communication towards bank trading desks, BFM successfully engineered a steady decline in interest rates on the interbank market even prior to the introduction of the interest rate corridor, from about 7–8 percent in early 2019 to 3.5–4 percent recently, against the backdrop of a tripling of exchanged volumes and counterparties compared to first six months of 2018 (Figure 8). Furthermore, the duration of interbank lending operations has started lengthening, with a few transactions concluded for six months to one-year maturities at interest rates in the 7.5–9 percent range.
Effect of a Policy Rate Shock (estimation period: January 2010-December 2018
Citation: IMF Staff Country Reports 2020, 061; 10.5089/9781513534213.002.A003
Effect of a Policy Rate Shock (estimation period: January 2010-December 2018
Citation: IMF Staff Country Reports 2020, 061; 10.5089/9781513534213.002.A003
Effect of a Policy Rate Shock (estimation period: January 2010-December 2018
Citation: IMF Staff Country Reports 2020, 061; 10.5089/9781513534213.002.A003
14. The introduction of the repurchase operations (repos) regulatory framework is expected to further incentivize interbank lending at longer horizons and support the buildup of a yield curve. With the help of Fund TA, a draft law has been prepared and is awaiting submission to Parliament to introduce repurchase operations based on a strengthened collateral framework. Following some successful testing over the summer of 2019, operations could begin as of the first semester of 2020 and would represent a major step towards securing medium- to long-term interbank operations, hence allowing for the gradual buildup of a yield curve. In parallel, the clarification of custodian responsibilities on BTF holdings to make sure these securities can be effectively accessed and managed by the central bank could help foster the development of a secondary market for bonds.
D. Assessing the Effectiveness of Alternative Monetary Policy Instruments
15. We use an econometric approach to assess quantitatively the monetary policy transmission mechanism in Madagascar. The structural vector autoregression (SVAR) methodology allows for the systematic investigation of the relationship between monetary policy instruments and economic activity. For the estimation, we compile a dataset which includes the following variables, available on monthly basis over the period 2000–2018:
Exports of goods, as an indicator of economic activity, selected to get around the shortcomings of the quarterly GDP series;
Core consumer price index; 2
Broad money aggregate M3, aimed at measuring the demand for liquidity;
Central bank policy rate as the main policy variable of interest, and;
Nominal effective exchange rate.
16. The structure of the system is designed to reflect observed characteristics of the Malagasy financial environment. The reduced form of the SVAR is written as follows:
where the ordering of the variables allows for the adequate identification of shocks. Complementing standard assumptions by insights derived from Sims and Zha (1998) and Kim and Roubini (2000) to properly capture some contemporaneous responses of money developments and better characterize the monetary policy reaction function, these conditions imply that:
The activity variable contemporaneously only responds to its own shocks;
The price variable contemporaneously responds to its own shocks and to those affecting the activity variable;
The money variable contemporaneously responds to its own shocks, as well as to shocks on the policy rate, on activity and on prices;
The policy rate contemporaneously reacts to its own shocks, as well to money and exchange rate shocks, but only with a lag to activity and price shocks;
The nominal effective exchange rate reacts contemporaneously to all shocks.
17. The SVAR model is estimated with variables in levels, assuming their joint co-movement over the long-run. All variables are expressed in logarithmic form and seasonally adjusted using the Census-X13 methodology except the policy rate, which is expressed in percent. The lag lengths used in the SVAR are defined by standard information criteria, and unit root tests assessed by both Augmented Dickey-Fuller and Phillips-Perron tests. All the variables are found to be integrated of order one in level, implying that they are I(0) in first difference.3
Madagascar: Unit Root Tests
Madagascar: Unit Root Tests
| Variable | Level | 1st difference | Result | ||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Augmented Dickey-Fuller1 | Phillips-Perron1 | Augmented Dickey-Fuller1 | Phillips-Perron1 | ||||||||||
| 12 | 23 | 34 | 12 | 23 | 34 | 12 | 23 | 34 | 12 | 23 | 34 | ||
| L_export_SA | 0.56 | 0.00 | 0.97 | 0.35 | 0.00 | 1.00 | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 | I(1) |
| L CPI X SA | 0.97 | 0.82 | 1.00 | 0.97 | 0.74 | 1.00 | 0.00 | 0.00 | 0.28 | 0.00 | 0.00 | 0.08 | I(1)5 |
| L_M3_SA | 1.00 | 0.95 | 1.00 | 1.00 | 0.89 | 1.00 | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 | I(1) |
| Policy Rate | 0.53 | 0.86 | 0.66 | 0.52 | 0.85 | 0.66 | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 | I(1) |
| L_NEER_SA | 0.97 | 0.18 | 0.03 | 0.95 | 0.23 | 0.02 | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 | I(1) |
Madagascar: Unit Root Tests
| Variable | Level | 1st difference | Result | ||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Augmented Dickey-Fuller1 | Phillips-Perron1 | Augmented Dickey-Fuller1 | Phillips-Perron1 | ||||||||||
| 12 | 23 | 34 | 12 | 23 | 34 | 12 | 23 | 34 | 12 | 23 | 34 | ||
| L_export_SA | 0.56 | 0.00 | 0.97 | 0.35 | 0.00 | 1.00 | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 | I(1) |
| L CPI X SA | 0.97 | 0.82 | 1.00 | 0.97 | 0.74 | 1.00 | 0.00 | 0.00 | 0.28 | 0.00 | 0.00 | 0.08 | I(1)5 |
| L_M3_SA | 1.00 | 0.95 | 1.00 | 1.00 | 0.89 | 1.00 | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 | I(1) |
| Policy Rate | 0.53 | 0.86 | 0.66 | 0.52 | 0.85 | 0.66 | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 | I(1) |
| L_NEER_SA | 0.97 | 0.18 | 0.03 | 0.95 | 0.23 | 0.02 | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 | I(1) |
Cointegration tests indicate the existence of at least two linear cointegration vectors.
Selected (0.05 level*) Number of Cointegrating Relations by Model
Critical values based on MacKinnon-Haug-Michelis (1999)
Selected (0.05 level*) Number of Cointegrating Relations by Model
| Data Trend: | None | None | Linear | Linear | Quadratic |
|---|---|---|---|---|---|
| Test Type | No Intercept No Trend | Intercept No Trend | Intercept No Trend | Intercept Trend | Intercept Trend |
| Trace | 2 | 2 | 2 | 2 | 1 |
| Max-Eig | 2 | 2 | 2 | 2 | 1 |
Critical values based on MacKinnon-Haug-Michelis (1999)
Selected (0.05 level*) Number of Cointegrating Relations by Model
| Data Trend: | None | None | Linear | Linear | Quadratic |
|---|---|---|---|---|---|
| Test Type | No Intercept No Trend | Intercept No Trend | Intercept No Trend | Intercept Trend | Intercept Trend |
| Trace | 2 | 2 | 2 | 2 | 1 |
| Max-Eig | 2 | 2 | 2 | 2 | 1 |
Critical values based on MacKinnon-Haug-Michelis (1999)
Given data limitations, above-discussed results and a short sample, this paper estimates the SVAR models with variables in level, assuming implicitly the existence of cointegration relations driving the long-run behavior of the economy.
18. Based on impulse responses of macroeconomic variables to a shock on the policy rate, the effectiveness of the monetary policy transmission mechanism is assessed to be limited in Madagascar. A monetary policy shock characterized as a one-standard deviation of an exogenous, unexpected, temporary rise of the policy rate, appears to have limited impacts on the evolution of the main macroeconomic aggregates. The variance decomposition following a shock on the policy rate explains a limited proportion of 0.35 percent of the goods currently export variation and only 0.1 percent of the consumer price index variation.
19. Simulations using alternative monetary policy instruments confirm that currently, there is a limited influence of monetary policy on output and price developments. We repeat the previous estimations replacing the policy rate by the volume of offered deposit auctions (“appels d’offre négatifs”), namely the main instrument used in practice by the central bank for liquidity management purposes. With unchanged structural restrictions, results highlight the limited impact of monetary policy on macroeconomic aggregates. The variance decomposition following a one-standard deviation of an exogenous, unexpected, temporary rise of the volume of offered deposit auctions explains a limited proportion of 0.07 percent of the goods’ exports variation and 0.02 percent of the consumer price index variation.
Effect of an Auction Deposit Shock (estimation period: January 2000-December 2018)
Citation: IMF Staff Country Reports 2020, 061; 10.5089/9781513534213.002.A003
Effect of an Auction Deposit Shock (estimation period: January 2000-December 2018)
Citation: IMF Staff Country Reports 2020, 061; 10.5089/9781513534213.002.A003
Effect of an Auction Deposit Shock (estimation period: January 2000-December 2018)
Citation: IMF Staff Country Reports 2020, 061; 10.5089/9781513534213.002.A003
E. Policy Recommendations
20. The effectiveness of monetary policy transmission mechanism remains limited in Madagascar, calling for a gradual transition to the interest rate targeting framework, as currently pursued by BFM. Monetary policy transmission channels remain weak due to prevailing constraints in the economic and financial environment. The reform strategy pursued by BFM, aimed at more directly influencing credit conditions, should continue to build on ongoing efforts to improve its operational framework and liquidity management capacities and be paced by reference to observed developments in the domestic money market.
21. BFM should also enhance the dialogue with the financial market and strengthen market intelligence to anchor expectations. To this end, the monetary authorities could ensure further transparency of monetary policy operations and decisions, making more intensive use of the central bank’s website, and should seek to improve financial literacy in the financial press through dedicated technical training.
22. Broader economic and institutional constraints should be addressed to help improve the effectiveness of monetary policy. These include a large degree of informality, a low level of bank penetration, and a very uncertain legal environment.
Informal employment exceeds 90 percent of total and nonagricultural employment in Madagascar. The literature highlights the critical role of informality in reducing the effectiveness of monetary transition channels at large by mitigating shocks on wages and inflationary pressures, and by weakening the credit cost channel more specifically since the informal sector is characterized by low access to finance.
The functioning of the judicial system, and difficulties in enforcing property rights, have also been found to be major hindrances to financial deepening. Improving the effectiveness and integrity of the judicial system is crucial to the development of financial intermediation and financial stability, which is key to improve the monetary transmission mechanism.
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Prepared by Mokhtar Benlamine and Marc Gérard. The authors would like to thank the authorities for their invaluable assistance in providing data and for constructive comments received during the presentation and discussions of this work.
The correlation between inflation and core inflation reaches 92.6 percent between January 2001 and August 2019.
Using log-differenced variables would provide information on short-term relationships, which may be affected by short-term shocks. Our focus is on long-run relationships.
