Monetary policy transparency in Sub-Saharan Africa evidence and lessons

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MONETARY POLICY TRANSPARENCY

IN SUB-SAHARAN AFRICA

EVIDENCE AND LESSONS

J. D. G. NHAVIRA

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MONETARY POLICY TRANSPARENCY

IN

SUB-SAHARAN AFRICA

EVIDENCE AND LESSONS

JOHN D. G. NHAVIRA

Thesis submitted in fulfilment of the requirements for the degree

DOCTOR OF COMMERCE (ECONOMICS) in the

Faculty of Business and Economic Sciences at the

Nelson Mandela Metropolitan University

Supervisor: Prof. M. K. Ocran Nelson Mandela Metropolitan University

Port Elizabeth

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ACKNOWLEDGEMENTS

There are many people to thank, as one should not forget those upon whose shoulders one had to stand in order to see further:

Firstly, I extend my deepest gratitude to Prof. Ocran for his sincere encouragement, inspiration and constant guidance have made this thesis possible. However, the views expressed are mine alone and not necessarily those of Prof. Ocran.

I would also like to thank Prof. Tony Hawkins of the University of Zimbabwe; Prof. M. Simatele; Prof. M.J. Ellyne of the University of Cape Town, and most of all my deepest and profound gratitude to Prof. J.J. Rossouw of the University of Wits for his insightful comments and observations. Also my thanks to Mrs. Linnette Downes-Webb for her editing. Their contributions made an immense difference to the quality of this thesis and a lasting impression on my life. However, all remaining errors of omission and Commission are my responsibility alone.

Lastly, my eternal gratitude is due to the almighty God for guiding me to these exceptional people; as well as my wife and children for their prayers and encouragement.

Port Elizabeth July 2013

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LIST OF ACRONYMS

BAC Board Audit Committee

CBA Central Bank Act

CBI - Central Bank Independence

CLE Conditional Logit Estimators

CPIX Consumer Price Index

CWN Cukierman Webb and Neyapti

EAC East African Community

EASSRR Eastern Africa Social Science Research Review

ECOWAS Economic Community of West African States

ESAP Economic Structural Adjustment Programme

GDP Gross Domestic Product

GNP Gross National Product

IS/LM Investment Savings Equilibrium and Liquidity Preference Money Supply Equilibrium

IMF International Monetary Fund

IT Inflation Targeting

MEFMI Macroeconomic and Financial Management Institute

MPC - Monetary Policy Committee

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NZRB New Zealand Reserve Bank

OECD Organisation of Economic Cooperation for Development

OSSREA Organisation for Social Science Research in Eastern and Southern Africa

RBZ - Reserve Bank of Zimbabwe

SADC - Southern Africa Development Community

SARB South Africa Reserve Bank

SSA - Sub-Saharan Africa

UDI Unilateral Declaration of Independence

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LIST OF TABLES

3.1 Five dimensions of CBI

3.2 Evidence of the weaknesses in the SADC (2008) Model Central Bank Law 4.1 Evidence of weaknesses in the Reserve Bank of Zimbabwe Act (Act 22:15

of 2010)

5.1 Weights used to aggregate the CWN Index 5.2 Legal variables based on the CWN Index

5.3 Reform of the Central Bank Act by country by year 5.4 Legal, central bank independence index

5.5 Correlation matrix

5.6 T–test results: Are the means prior to and post reform statistically different? 5.7 Descriptive statistics: Pearson Correlation prior to and post reform

5.8 Null hypothesis test: Independent samples Kruskal-Wallis test 5.9 Null hypothesis test for independent samples median test 5.10 Null hypothesis test: one sample Chi-square test

5.11 Null hypothesis test: one sample binomial test 5.12 Reliability statistics

5.13 Disaggregated, central bank independence by country by decade: 1950 – 2011

6.1 Legal, central bank independence index and ranking 7.1 Results of simulation study

7.2 Correlation matrix 7.3 The Hausman Test

7.4 SSA transparency and inflation prior to and post reform 7.5 Legal independence by country and decade 1950 – 2011 8.1 Inflation prior to and post monetary-policy transparency 8.2 Sub-Saharan-African country real GDP average growth rates 8.3 Real GDP prior to and post monetary-policy transparency 8.4 Reform of the Central Bank Act by country and by year 8.5 Parsimonious model-dependent variable inflation

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8.6 Parsimonious model-dependent variable real GDP 8.7 Correlation matrix

8.8 The Hausman specification test

8.9 The Breusch-Pagan test: Real GDP as a dependent variable 8.10 The Breusch-Pagan test: Inflation as a dependent variable

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ABSTRACT

This research deals with achieving and maintaining price stability in Sub-Saharan Africa (SSA) through the practice of monetary-policy transparency (MPT). On the one hand, MPT refers to a monetary strategy whereby the central bank is insulated from political influence and made accountable to society through disclosure of its policies, procedures, economic models, data and forecasts, operations and political practices (such as objectives, personnel independence, and the like). On the other hand, price stability refers to achieving and maintaining low and stable levels of inflation conducive for long-term planning and poverty alleviation.

The primary objective of this research was to investigate MPT in SSA as it represents a powerful means whereby economic agents’ expectations may be coordinated and managed by the central bank to achieve its societal, objective function of low inflation.

The empirical evidence shows that, first, a dependent central bank is more likely to slip into hyperinflation. Second, a SADC (2008) model central bank law is not independent enough to be used as a benchmark for any central bank or as a charter for a regional central bank. Third, the degree of central bank independence in SSA is relatively lower than that in industrialised economies. Fourth, the determinants of MPT in SSA are trade openness, and financial depth that are important factors influencing policy-makers to adopt monetary-policy transparency. Fifth, MPT is associated with a decline in the inflation rate. Sixth, MPT had no significant effect on economic output, whilst trade openness was positively associated with real GDP.

KEY WORDS: central bank independence; inflation; monetary policy

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7.3.1Theoretical framework ... 207 7.3.2Estimation technique ... 209 7.3.3Empirical model ... 212 7.3.4Variable description ... 212 7.3.4.1 Macroeconomic variables ... 213 7.3.4.2 Structural variables ... 214 7.3.4.3 Institutional variables ... 215 7.3.5Data issues ... 215 7.3.5.1 Diagnostic tests ... 216

7.3.5.2 The Hausman Specification Test ... 216

7.3.5.3 Wald Chi-squared Tests ... 217

7.4 EMPIRICAL RESULTS ... 217

7.4.1.1 Correlation test ... 219

7.4.1.2 The Hausman Specification Test ... 219

7.4.1.3 Wald Chi-squared test results ... 221

7.5 CONCLUSION ... 222

CHAPTER EIGHT ... 223

8. THE ECONOMIC EFFECT OF TRANSPARENCY ON OUTPUT AND INFLATION ... 223

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8.1.1 Descriptive statistics ... 224

8.2.1 Theoretical underpinnings of the economic effects of transparency ... 229

8.2.2 The measurement of transparency ... 230

8.3 METHODOLOGY ... 230 8.3.1 Theoretical framework ... 230 8.3.2 Estimation techniques ... 231 8.3.3 Empirical model ... 231 8.3.4 Variable description ... 232 8.3.4.1 Macroeconomic variables ... 232 8.3.4.2 Structural variables ... 233 8.3.4.3 Institutional variables ... 234 8.3.5 Diagnostic tests ... 235 8.3.5.1 Chow test ... 235

8.3.5.2 Breusch-Pagan Test for Heteroskedasticity ... 236

8.3.5.3 Hausman Test ... 236

8.3.5.4 Wald Chi-squared Test ... 236

8.3.6 Data issues... 236

8.4 EMPIRICAL RESULTS ... 237

8.4.1 Diagnostic test results ... 240

8.4.1.1 Correlation Test ... 240

8.4.1.2 Chow Test/ F-Test ... 240

8.4.1.3 Hausman Specification Test ... 241

8. 4.1.4 The Wald Chi 2 Test ... 241

8.4.1.5 Breusch-Pagan Test ... 242

8.5 CONCLUDING REMARKS ... 243

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9. CONCLUSIONS AND RECOMMENDATIONS ... 245

9.1 DETERMINANTS OF CENTRAL BANK TRANSPARENCY... 246

9.2 ECONOMIC EFFECT OF MONETARY POLICY TRANSPARENCY ... 247

9.3 MEASURING SUB-SAHARAN AFRICA CENTRAL BANK INDEPENDENCE ... 248

9.4 COMPARISON OF THE NEW ZEALAND RESERVE BANK AND THE SADC MODEL CENTRAL BANK LAW ... 249

9.5 MEASURING CENTRAL BANK INDEPENDENCE OF SADC ... 249

9.6 CRITICAL REVIEW OF RESERVE BANK OF ZIMBABWE ACT ... 249

9.7 POLICY IMPLICATIONS AND RECOMMENDATIONS EMANATING FROM THE RESEARCH ... 250

9.8 CONTRIBUTIONS OF THE RESEARCH ... 252

9.9 FUTURE RESEARCH ... 252

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CHAPTER ONE

1. INTRODUCTION

1.1 BACKGROUND AND PROBLEM STATEMENT

The primary purpose of this thesis is to investigate monetary-policy transparency in Sub-Saharan Africa (SSA). Monetary-policy transparency is a consequence of the increased independence of central banks from political influence, and has evolved to fulfil the aspirations of the public for both accountability and legitimacy, and to guide the expectations of financial market participants in particular, as well as economic agents in general.

Monetary-policy transparency aims to reduce asymmetrical information and the time-consistency problem (Akerlof, 1970; Kydland and Prescott, 1977). The focus of this study has its roots in the paradigm shift that occurred in the 1990s when New Zealand, Canada, the United Kingdom, Sweden and, more recently in the year 2000, South Africa, shifted to an inflation-targeting, monetary-policy framework coupled with an emphasis on central bank independence and transparency.

Independence for central bankers refers to the environment in which the objectives of monetary and financial policies; their legal, institutional, and policy frameworks; monetary and financial policy decisions and their rationale; dates and information related to these policies; and the terms of central bank and financial agencies’ accountability are provided to the public in a comprehensive, accessible, and timely manner (IMF, 2000).To this end, monetary policy is more effective if it is highly transparent. Transparency is also necessary for greater accountability as central banks have been given increased independence to discharge their monetary policy responsibilities (Freedman, 2002).

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Moreover, many central banks have enhanced transparency by means of the following mechanisms: (i) the announcement of inflation targets; (ii) detailed explanations of the views on the transmission mechanisms of monetary policy of the central bank; (iii) periodic forecasts of economic trends and inflation, and detailed discussions by means of Monetary Policy Statements/Reports; the use and setting of an operational target band for the overnight rate, explanations via press releases whenever this key rate changes; (iv) the use of Fixed Announcement Dates (FAD), and making an announcement, even where there is no change in monetary conditions; (vi) increased communication, frequent speeches, press conferences by the Governor and Deputy Governors, appearances before parliamentary committees, and; (vii) background briefings with journalists in advance of the release of the Monetary-Policy Committee (MPC) announcement or Minutes.

Evidence that transparency is gaining momentum as a key feature of monetary policy is evident in the growing literature on monetary-policy transparency as revealed in the 94 central banks survey (derived from Asia, Western Europe, Oceania and North America) by Fry, Mahadeva, and Sterne (2000). One possible explanation for the increased interest in transparency is the need to eliminate the time-consistency problem and asymmetric information between monetary authorities on the one hand, and economic agents on the other, thereby minimizing uncertainty.

Subsequent surveys by Eijffinger and Geraats (2006), measured the transparency of Australia, Canada, the Eurozone, Japan, New Zealand, Sweden, Switzerland, the United Kingdom, and the United States of America. Aron and Muelllbauer (2006) added South Africa, whilst Malik and Din (2008) added Pakistan to the Eijffinger and Geraats (2006) sample. Dincer and Eichengreen (2007) surveyed 17 African countries and computed a transparency index for the period 1998 to 2005, indicating that interest in transparency is spreading. Nhavira (2010) added Zimbabwe to the Eijffinger and Geraats (2006) sample. The question arises whether Africa in general and Sub-Saharan Africa in particular, are following suit and to which extent and with which success.

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Sub-Saharan African countries are typically small, open economies with a total Gross Domestic Product (GDP) of only US$ 195 billion in 2004 (excluding South Africa and Nigeria) or US$ 397 327 billion (including both). Compared to Denmark with a population of only five million people, the Sub-Saharan GNP is not even double its GNP; 80% of Sub-Saharan African populations are rural based, implying a low productivity, low technological development, and a subsistence existence devoid of specialisation and division of labour. Trade amongst themselves (Sub-Saharan countries) is insignificant, with most trade made up primarily of exports of primary commodities and importation of semi-finished goods for assembly, taking place with the former colonial powers (Seidman, 1986; World Bank, 2006).

The foregoing is a legacy of Sub-Saharan African history and should be taken into account to understand its monetary history – prior to independence and post- independence. Before independence, the colonially administered economies exhibited financial stability for three reasons. First, owing to the existence of the Gold Standard; second, by using Currency Boards as a means of managing monetary policy prior to 1945, and third, as the result of the existence of the Bretton Woods system of fixed exchange rates until 1973 when this system collapsed (Seidman, 1986).

With the advent of independence, the emerging economies opted for the establishment of their own central banks and national currencies as a means of gaining control over their own monetary policies. The inherited economies in Sub-Saharan Africa exhibited a typical characteristic – the economy was a dual one, comprising a large subsistence, autarkic rural economy and a small, monetised, urban economy. In this lopsided economy, the monetised urban economy was expected to be the engine for the whole economy in terms of tax revenues. The result was that the newly independent states had a stagnant tax base from which to draw upon to meet the aspirations of the masses. The bludgeoning budget deficits became a perennial problem (Seidman, 1986). Compounding the situation was the floating exchange rates post-Bretton Woods that required a more proactive

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approach to managing the value of the local currency, as well as managing the expectations of economic agents. Many economies witnessed a reversal in the gains made prior to and immediately after independence (Mishkin, 2007).

Moreover, from the time of self-rule, monetary policy operated primarily through administrative controls (Walle, 2000). Exchange rates were fixed; there was limited scope for interest rates to shift; capital flows were controlled; exchange controls were strictly enforced; import licenses were used to further limit spending on imports; and reserve ratios were the weapon of choice as a means of limiting the funds banks had available for lending. This system provided effective monetary control without large fluctuations in either interest or exchange rates. Limiting credit by administrative fiat was a fast and technically efficient tool, but bred corruption (Walle, 2000).

The evolution of financial markets meant that it progressively became more difficult and costly to maintain a regime of direct controls. Paradoxically, the controls themselves created the incentives (loophole mining) for the rapid development of new financial institutions, instruments and markets. The 1980s heralded waves of liberalisation of financial markets. Globalisation served to further undermine administrative controls as these economies became more integrated with the global economy (Polillo and Guillen, 2005).

As widespread, direct controls on financial intermediation and foreign exchange controls were removed, monetary policy operated through the ability by the central bank to influence interest rates. Without administrative controls affecting the supply of, inter alia, credit and foreign exchange, modern monetary policy operates indirectly, relying on the ability of interest-rate changes to affect economy-wide demand. These changes left most central banks in SSA in a good position to use market-orientated, indirect tools to manage the inflation rate. This development, however, created another problem: How effective would monetary policy be in an environment of low financial depth?

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Nevertheless, the main problems causing instability have been identified as time-consistency and an inability by the central bank to resist demands for loans by the State to fund its growing budget deficit. This permissiveness on the part of the central bank meant that the fundamental issues at the root of the growing budget deficits were ignored until such time as the central bank printed itself out of a job. As is evident from the literature, inflation in SSA is persistently higher than in the trading partner countries that are typically former colonial powers (Dincer and Eichengreen, 2007).

It is in this context that this study aims to measure monetary-policy transparency and the impact thereof on inflation and output of selected Sub-Saharan countries.

The major theme of this study is that increased levels of transparency by a central bank make it a more efficient inflation-fighter that creates an environment conducive for stable growth (Geraats, 2001a; Mishkin , 2001, 2004). Nevertheless, transparency needs two other pillars to support it: independence from political interference, and accountability to society (Blinder, Goodhart, Hildebrand, Lipton, and Wyplosz, 2001; Briault, et al., 1997; Buiter, 1999; and Geraats 2002).

In conclusion, as the study of economics evolved and capitalism encouraged specialisation and exchange, the focus was on the relationship between money and prices. It was observed that monetary capital contributed to the expansion of production. The main concern was establishing what determines prices, and what influences the accumulation and reinvestment of monetary capital. The solution to those problems has evolved over time to keep pace with an ever-evolving market place and institutions that are integrated into the global economy. As a result, previous anchors of economic agent expectations, such as fixed exchange rates or the Gold Standard, have been swept away. Monetary-policy transparency is regarded as international best practice. It also provides a new anchor for economic agent expectations in a new era. At the same time, it resolves the time-consistency problem of monetary policy.

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Consequently, industrialised and developing countries around the world have adopted monetary-policy transparency (Dincer and Eichengreen, 2009). However, there is uncertainty as to the extent to which SSA central banks have adopted policy transparency. Given the background pertaining to monetary-policy transparency, the problem statement underlying this research can be phrased in terms of six broad questions, namely:

i. Is there evidence that a central bank’s charter can contribute to hyperinflation?

ii. How does the SADC (2008) Model Central Bank Law compare with the Reserve Bank of New Zealand Charter?

iii. How does one measure the statutory independence of an ideal SADC central bank?

iv. Are Sub-Saharan African central banks independent from political influence?

v. Which economic factors drive policy-makers to adopt monetary-policy transparency?

vi. What is the nature of the economic effect of monetary-policy

transparency on inflation and output?

Having raised the above problem statements, the following set of research

objectives is presented in the next sub-section.

1.2 OBJECTIVES OF THE STUDY

To give effect to the main objective of the research, the following research objectives were formulated:

i. To critically review the Reserve Bank of Zimbabwe Charter and the Zimbabwe hyperinflation episode;

ii. to compare the SADC Model Central bank Law to the New Zealand Reserve Bank Law;

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iii. to measure the statutory independence of the SADC Model Central Bank Law;

iv. to measure the statutory independence of Sub-Saharan African central banks;

v. to identify the economic factors that drive policy-makers to adopt monetary-policy transparency;

vi. to investigate the nature of the economic effect of monetary-policy transparency on inflation and output; and

vii. to make policy recommendations based on the outcomes of the research.

1.3 SIGNIFICANCE OF THE STUDY

The findings of this study are intended to make an original contribution to research in this area and to provide recommendations of practical value for the design of monetary policy that sets out to optimise the welfare of society. The extent to which transparency has taken hold in Sub-Saharan Africa and with which effect, will be revealed. The central banks being studied are expected to benefit as they will have an opportunity to find out how an outsider perceives them from a framework of decision making. The outcome may even contribute to the improvement of African central banking. Employing the approach of Geraats and Eijffinger (2006) provides an opportunity to further test this method and its efficacy in Africa to determine its applicability.

1.4 STRUCTURE OF THE DISSERTATION

The rest of the dissertation comprising seven separate chapters is organised as follows: Chapter Two reviews the monetary-policy transparency literature, and discusses the theories underpinning it. Chapter Three presents a comparison of the SADC Model Central Bank Law to the New Zealand Reserve Bank Act. The fourth chapter reviews the Central Bank Charter of the Reserve Bank of Zimbabwe in a study on how a loss of independence by changing a clause in a charter culminated in hyperinflation. In the fifth chapter, the statutory independence of Sub-Saharan African Central Banks is measured and the changes from 1953 – 2011 are tracked.

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The degree of independence varies across the continent. At one end is the highly ranked Namibia as the most independent and Zimbabwe at the other end as the least. Chapter Six measures the statutory independence of the SADC Model Central Bank Law as the community’s response to the problem of time-consistency and as preparatory to monetary and economic union. Chapter Seven seeks to determine those factors that drive policy-makers to choose the adoption of monetary-policy transparency in Sub-Saharan Africa. The concept is that such an adoption could not have been random, but must have been triggered by certain factors. Chapter Eight investigates the economic effects of monetary-policy transparency on inflation and output. The underlying concept or theme is that monetary-policy transparency has an effect on the economy, else policy-makers would not be adopting it.

Finally, each chapter takes the following format: An introduction and background to the research question. This sub (introductory)-section also presents the purpose of the chapter. The second sub-section presents a cursory review of the conceptual framework pertaining to the theme. The methodology follows thereafter. Data issues are also discussed in the appropriate section, including the sources of the data used in the estimation process. Furthermore, results of the empirical estimates are presented and discussed. The final section of each chapter discusses the conclusion of the research.

Considering that this thesis is based on a collection of seven articles, of which six have been published, acknowledgement is due to the following publications as the basis of some of the chapters of this book.

- Chapter 2 is a version of Nhavira, JDG and MK, Ocran (2014). Literature Review: Monetary- Policy Transparency Journal of Strategic Studies 4 (1) - Chapter 4 is a version of Nhavira, JDG and MK, Ocran (2012). Did the Reserve

Bank of Zimbabwe Charter Contribute to Hyperinflation? A critical Review.

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- Chapter 5 is a version of Nhavira, JDG and MK Ocran (2014) Measuring the Statutory Independence of Sub-Saharan African Central Banks, EASSRR, Vol. 30 (1): 47 - -72.

- Chapter 6 is a version of Nhavira, JDG and MK, Ocran (2014). Measuring Statutory Independence of the SADC Model Central Bank Law. Journal of Strategic Studies 4 (1):

- Chapter 7 is a version of Nhavira, JDG and MK Ocran (2012) The Determinants of Monetary Policy Transparency in Sub-Saharan Africa.

Journal of Studies in Economics and Econometrics 36 (2): 79 - -107.

- Chapter 8 is a version of Nhavira, JDG and MK Ocran (2013) The Economic Effect of Transparency on output and Inflation. Research in Business and Economics Journal, Vol.7: 1 - - 22.

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CHAPTER TWO

2. LITERATURE REVIEW: MONETARY-POLICY

TRANSPARENCY

2.1 INTRODUCTION

Having described the problem statement and the purpose of the research done, this chapter gives effect to the research by conducting an extensive review of the literature to determine if any or which research paradigms, research methodologies, data-collection and data-analysis methods are the most appropriate to research the problems in question. The intention is to review the literature on transparency (including central bank independence) by focusing on the factors likely to lead to the adoption of monetary-policy transparency and on the economic effects of monetary-policy transparency on macroeconomic indicators such as growth and inflation.

Central banks have survived the passage of time because their purpose, functions, and operations have evolved over time, with the pace of reform quickening since the 1990s (Dincer and Eichengreen, 2007; Carare and Stone, 2003). These reforms have focused on three areas. First, the legal statutes governing central bank operations and its relationship to the executive branch of Government were revised to increase independence of the institution from the executive. Second, because of this separation from the executive, central banks have had to become more accountable for their actions to society through reporting to Parliament. Thus, a governor of a central bank who regularly misses his inflation targets faces dismissal, censure or both (NZRB, 2009). Third, central banks have attempted to become more transparent in their operations to complement both increased accountability, and the manner in which monetary policy would be conducted after the introduction of inflation targeting.

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Academic literature recognises, as do developed economies, that the primary role of monetary policy is price stability. Other objectives, such as promoting growth, or unemployment, have been relegated as secondary. Evidence for this assertion is reflected in the increasing independence of central banks. Amendments to their charters have seen central banks being conferred with the statutory responsibility for price stability. The thinking behind this is that the optimal way in which a central bank can promote growth and employment, is by keeping inflation low and stable (Bernanke, Laubach, Miskin and Posen, 1999; Hammond, Kanbur and Prasad, 2009).

Since the global credit crisis of 2007, which was triggered by the sub-prime mortgage crisis in the United States of America, central banks are moreover responsible for financial stability. Even where the central banks are not responsible for prudential regulation, they remain responsible for maintaining the stability of the financial system as a whole. In fact, since the 2007 – 2009 financial crisis and, as a response to it, the objective of financial stability has become more dominant, with monetary policy crafted to restore and maintain the stability of the financial system (Borio, 2010).

Sub-Saharan African (SSA) countries are emerging market economies and, as such, their situations are complex. Financial stability is a key responsibility because, in the majority of economies of SSA countries, central banks are also responsible for prudential regulation. An additional hurdle in the context of political economy is the difficulty of insulating the central banks from other objectives, including the promotion of output and employment growth. The challenge facing SSA central bankers is that, whilst they have one instrument1_,

usually short-term interest rates, monetary policy is viewed as being responsible for promoting high growth; maintaining a low and stable inflation rate; and

1_{Monetary policy transparency utilises an inflation target to hold public attention and relies on interest rates,} rising or falling to influence economic agent expectations about future inflation rates (Mishkin, 2001)

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maintaining financial stability. This single instrument is therefore subject to constraints (Hammond et al., 2009, Borio, 2010).

2.1.1 Monetary policy constraints in SSA countries

According to Hammond et al. (2009), monetary policy constraints emanate from two sources, namely (a) the institutional setting, and (b) the technical perspective, both of which hamper monetary-policy implementation. From an institutional perspective, the key constraint is the lack of central-bank independence as it may statutorily be under the purview of the finance ministry. In some cases, the central bank may be independent, but political forces are so strong that they hold sway over the institution. Another form of limitation is where, regardless of the level of independence, the operational independence of the central bank may be circumscribed by a constraint such as an exchange-rate objective. The maintenance of the particular exchange rate can limit the room that the central bank has to maneuver in using policy instruments, such as the interest rate (Goodfriend, 2004).

Another key problem is that of fiscal dominance. In the majority of SSA economies, fiscal discipline is lacking, and monetary policy is an adjunct to fiscal policy. High levels of government budget deficits and public debt act as severe constraints on monetary policy as the central bank then has to take into account the government’s debt-management objectives in setting interest rates, making it difficult to manage inflation expectations (Sims, 2005; Hammond et al., 2009). Other challenges facing SSA economies include weak transmission mechanisms owing to underdeveloped financial systems, as the aggressive use of interest rates may devastate the balance sheets of weak banks and the weak interest-rate channel of monetary policy. Further weaknesses confronting SSA economies include a lack of market integration that results in asymmetrical responses to monetary policy; the absence of deep and liquid markets that implies limited feedback from the market about monetary policy and, most importantly, inflexible labour markets that also undermine the effectiveness of SSA monetary policy.

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The SSA countries have been undergoing structural changes flowing from Economic Structural Adjustment Programmes (ESAP), and the effects of globalisation. This has resulted in difficulties for SSA economies to isolate monetary policy from external influences owing to the increasing openness of the capital account. Capital controls seem unable to stem the tide of financial flows. Increased trade openness and increased sophistication of investors – both domestic and international – have aided in increasing the volume of financial flows across borders. Aid has not helped matters. Aid flows from the United States, European Union and the United Kingdom, although significant, can be volatile, depending on the relations of the ruling political party’s with global players and other factors (Sachs and Warner, 1997). More recently, rising worldwide food and energy prices in 2007 and the first half of 2008 created a dilemma for central bankers who were caught between a rock and a hard place. Their choice was to manage inflationary expectations by raising interest rates, or to maintain the status quo to avoid slowing growth by tightening monetary policy (Hammond, et al., 2009).

On the technical aspects, SSA central banks face challenges in implementing monetary policy, particularly inflation targeting. This framework requires the technical capacity to model the economy; understand the transmission mechanism; and forecast inflation and output. The advent of greater openness requires that modeling and forecasting techniques evolve to keep pace with the increasing number of variables required to model an economy (Hammond et al.,

2009)

However, research in this area has, in the past, been concentrated on the economic effect of inflation targeting on inflation and output. Nevertheless, inflation targeting is closely linked to high levels of transparency. Therefore, factors that influence inflation targeting are almost similar to those factors likely to drive policy-makers into adopting monetary-policy transparency (Walsh, 1998; Lippi, 1999; Sibert, 2005; Geraats, 2009).

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As regards the efficacy of inflation targeting, it is the contention that there may be factors other than inflation targeting at work that has the effect of lowering inflation. It is on this contention that an attempt is made to use a broader definition of transparency.

After decades of high and persistent inflation, the Reserve Bank of New Zealand (RBNZ) adopted a novel approach to monetary policy that is now recognised as monetary-policy transparency (Geraats, 2002; Eijffinger and Geraats, 2006; Dincer and Eichengreen, 2007). Since then industrial and developing countries alike have adopted the approach. As more central banks became more independent, transparency gained importance because it is a prerequisite of accountability for which the need was increasing. A further possible reason for transparency becoming prominent is its influence on the formulation of expectations. Success in guiding economic-agent expectations has social welfare benefits such as reduced uncertainty; lower inflation volatility; improved planning by economic agents; and a more effective monetary policy (Issing, 1999). This study, therefore, is conducted within the context of the increased interest in policy transparency as the preferred monetary-policy regime (Dincer and Eichengreen, 2009; Samimi and Motameni, 2009).

2.2 DEFINITIONS AND CONCEPTS

2.2.1 Monetary-policy transparency

The literature offers no consensus on the precise definition of transparency. Winkler (2002) defines transparency as the degree of common understanding between the central bank and the public with the objective of rendering monetary policy effective and accountable. Sibert (2005) defines it in terms of the actions of the central bank, that is, if its actions and its planned inflation are observable, the central bank is transparent. Issing (1999), on the one hand, regards transparency as the explanation of monetary-policy decisions to the public. Buiter (1999), on the other hand, regards transparency as crucial to explaining both the process of decision-making, as well as its outcomes. Geraats

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(2002; 2005) defines transparency as the absence of asymmetrical information regarding monetary policy-making. Geraats (2002) provides a taxonomy that is effective in analysing the transparency of monetary policy. Monetary-policy transparency is the disclosure of information by the central bank relevant to the conduct of monetary policy, thereby mitigating any asymmetrical information problem between the central bank and economic agents (Geraats, 2002).

The following definition of transparency may be preferred: Monetary-policy transparency is a framework that requires information disclosure, underpinned by amending the central bank charter to, inter alia, give the central bank a primary goal, and to allow the setting of a monetary-policy target. It also involves the incorporation of clauses that ensure that the central bank officials are best placed to resist direct or indirect political influence. To this end, monetary-policy transparency has its origins in an asymmetrical information problem (Akerlof, 1970), and uncertainty (Brainard, 1967).

The consequences of effective transparency manifest in two ways, namely information, and incentive effects. Information effects are the direct consequences of the removal of information asymmetries, such as a reduction in uncertainty, whilst incentive effects are the indirect influences that arise from a change in the information structure (Geraats, 2009).

2.2.2 Central bank independence

As literature would have it, most authors generally agree that a definition of central bank independence is the freedom of the central bank to formulate and implement monetary policy without political influence (Cukierman, Webb and Neyapti, 1992; Crowe and Meade, 2008).

Having defined independence, the question arose as to the appropriate and optimal level of central bank independence. This required the conceptualisation of a measure of central bank independence. A number of measures has been

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proposed in the literature by Alesina (1988); Cukierman (1992); Cukierman, Webb and Neyapti (1992); Eijffinger and Schaling (1993); Grilli, Masciandaro and Tabellini (1991a).

In analysing central bank independence, there are five legal dimensions or groups that are important for the central bank design from the perspective of political economy. The first group pertains to legal aspects of the appointment –tenure and dismissal of the Chief Executive Officer (CEO). It also includes similar rules for members of the board. A second group relates to policy formulation in particular – whether it is able to conduct monetary policy without political influence. In particular, it relates to whether it has the authority to set discount rates; supervision; and banking regulations; and in which measure the central bank is accountable to society. Third, independence is related to policy objectives. It is assumed to be high where price stability is the only, or at least the primary objective of the central bank. A fourth group pertains to limitations, or prohibition of the government to borrow from the central bank. Fifth and finally, foreign exchange is important as it impacts on monetary policy and, as such, a corollary to this is the issue of capital controls whereby the central bank is regarded as independent when it has the authority to decide on exchange rates and capital controls.

The issue of financial independence of the central bank is also crucial and impacts on independence, objectives, limitation on lending to government and financial independence (Kadek and de Haan, 2012; Cukierman, 2007; Dalton and Dziobek, 2005; Noia and Giorgio, 1999; Goodhart and Schoenmaker, 1995).

2.2.3 Inflation targeting

Green (1996) defines inflation targeting as a monetary-policy framework under which policy decisions are guided by expected future inflation relative to an announced inflation target. However, the majority of the literature seems averse to defining inflation targeting to describing what it does. The following

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definition is derived from the literature: Inflation targeting is a technique of anchoring inflation expectations (Petursson, 2004; Calderon and Schmidt-Hebbel, 2008a).

For an inflation-targeting, monetary-policy strategy to be classified as such, Mishkin (2001) suggests that it encompass the following five main elements: 1) Public announcement of a medium-term, numerical target for inflation; 2) a commitment by the monetary authority to price stability as its primary objective; 3) a policy instrument to be set on the basis of many variables and not to be limited to monetary aggregates or the exchange rate; 4) increased transparency of the monetary-policy strategy through communication with economic agents and markets regarding its plans, objectives and decisions; and 5) greater accountability of the central bank for attaining its objectives. Moreover, Mishkin (2001) cautions that an inflation target is much more than a public announcement of numerical targets for the year ahead.

With the benefit of hindsight, the “rules vs. discretion” debate would have classified inflation targeting as a rule. In fact, it is argued later in this chapter that monetary-policy transparency may be regarded as a rule. The distinction between rules and discretion rests on the concept of the power of enforcement, or a process of commitment that constrains the monetary authority from straying from a stated course. Under a monetary-policy transparency model, evaluation occurs upon the assumption of full credibility and policy commitment. In this case, the monetary authority promises to desist from inflation surprises, and commits itself to offset supply shocks in a predictable and pre-announced way so that the public knows all disturbances and their corresponding policy responses in advance. Accordingly, agents will base their inflation expectations on the policy rule alone in the belief that the monetary authority will keep to the pre-announced rule, and refrain from inflation surprises to raise output (Green (1996). In contrast, a discretionary regime is one where the monetary authority lacks the necessary credibility or ability to commit itself to convince economic agents that it will refrain from surprise inflation.

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However, Hammond et al. (2012), in his study, defined inflation targeting as a framework rather than a set of rigid rules for monetary policy. He, as in the case of Mishkin (2001), identified the same five essential elements of an inflation-targeting regime. These are first, the recognition of price stability as the primary goal of monetary policy. Second, there is a public announcement of a specific measurable inflation target. Third, monetary policy is crafted on a wide information set, including forecasts. Fourth, there is acceptance of increased transparency. Fifth, there is the implementation of a plethora of accountability mechanisms.

Hammond observes that inflation targeting has a major advantage as it combines elements of both rules and discretion in monetary policy, which he defines as “constrained discretion”. King (2005) contended that inflation targeting provided a rule-like framework upon which economic agents could anchor their expectations about future inflation. Acting within this framework, the central bank exercises discretion in reacting to shocks (Dos Santos, 1999).

This rest of this chapter is structured as follows: Section 2.3 reviews the theoretical literature on transparency; Section 2.4 examines empirical literature on central bank independence and transparency and their respective measures; and Section 2.5 presents the conclusions.

2.3 THEORETICAL LITERATURE

This is not the first review of the literature on central bank transparency. Prior surveys have discussed the subject, based on justifying the effects of transparency on the economy and on varying categories of transparency (Geraats, 2002; Hahn, 2002; Carpenter, 2004), or views of transparency (Posen, 2003). An up-to-date survey of the theoretical literature was compiled by Cruijsen (2008). This study updates the work of Cruijsen (2008), but argues, contrary to Cruijsen(2008) that expectations, coordination games, and learning are not new strands, but extensions and an elucidation of the finer workings of

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transparency that fit under the five categories of Geraats (2002). Furthermore, the literature on central bank transparency has continued to evolve since the Cruijsen (2008) study. The chronological development of the theoretical transparency literature is presented hereunder.

2.3.1 Theoretical underpinnings of economic effects of transparency

Early researchers’ quest for the unified theory that would enable central bankers to achieve the preferred social objective of societies efficiently and effectively has been a long one. Summarised hereunder are the major milestones in that quest.

Grunberg and Modigliani (1954) set out to solve the problem of prediction in the formation of expectations. In as far as this study is concerned, a public prediction may be regarded as additional information that increases transparency regarding a particular situation. What is clear in this study, is that expectations are predictions about the future that have an effect on economic agents, either to fulfil the prophecy or to nullify it. The study solved the problem of expectations that are in the public domain, but left those of private individuals who keep their expectations quiet and unresolved. Suffice it to say that their starting point was the assumption that private expectations are capable of being fulfilled or nullified as in the case of a calamity predicted, which is then avoided or nullified. This knowledge has important implications for policy-makers who are interested in guiding economic-agent expectations by means of forecasts (predictions) of interest rate and inflation paths.

Another contribution of Grunberg and Modigliani (1954) was to lay the groundwork for the communication structure of monetary-policy transparency. To this end, communication involves a feedback of economic agents’ reaction to previous predictions, coupled with the disclosure of the model of the central bank; a forecast of alternative scenarios for inflation; and interest rates in ensuing periods subject to various caveats. The key issue that makes the study of Grunberg and Modigliani relevant to the current one is that agents’

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expectations are formed and changed as a result of new information, and at the same time they input into their models others’ expectations and react to them through their actions. Each cycle of new information and new reactions creates changes in variables, creating new information in a never-ending cycle. For the policy-maker this cycle is a source of uncertainty that must be managed. Finally, Grunberg and Modigliani (1954) did not shed light on how expectations come to be formed.

The role of prediction was extended by Muth (1961). He investigated how expectations are formed. He argued that expectations are the same as the prediction. His hypothesis was that the expectations of firms were the same as the prediction. The hypothesis asserted three issues: First, that information is scarce and that the economic system does not waste it. Second, the way in which expectations are formed, depends specifically on the structure of the relevant system describing the economy. Third, a public prediction in the sense of Grunberg and Modigliani (1954) will have no significant effect on the operation of the economic system, provided that it is not based on inside information. Muth (1961) therefore solved the puzzle left hanging in the Grunberg and Modigliani (1954) statement of the theory pertaining to the actual formation of expectations; the motivation of economic agents in making predictions; and the existence of a fail-safe device that is the prohibition of access to inside information to set aside the checks and balances inherent in an economic system. Muth’s (1961) enduring contribution was that an economic outcome would not be significantly divergent from what people expect.

The rational expectations hypothesis is one of the most common expectations or assumptions used in macroeconomics, which simply states that people’s expectations are the same as the forecast of the model being used to describe those people. It is known as the “rational expectations hypothesis”. In the 1970s, Robert Lucas (1972, 1976) was the first to incorporate the assumption of rational expectations in macroeconomic models. This led to many different schools of macroeconomic research, such as the new, classical economics school; the real

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business-cycle school; the new Keynesian economics school; the new political macroeconomics school; and the latest new, neoclassical synthesis (Goodfriend and King, 1997).

Even with the best prediction, there is always an element of uncertainty. Brainard (1967) addressed the issue of consequences for policy actions arising from structural changes for the effectiveness of policy under conditions of uncertainty. Clearly, at the time of decision-making about policy actions, the policy-maker is confronted by uncertainty about the outcome of his or her action and prediction, as well as the behaviour or reaction of economic agents to his or her policy action. Brainard’s (1967) findings were that there are two types of variables: one type over which the policy-maker has influence; and the other, exogenous variables over which no control exists. Brainard (1967) recommends that the policy-maker should only take into account his or her influence on the variable under his or her control, and rather take small steps to observe reactions. In other words, gather information, and this transformed Brainard’s (1967) study into a study of the role of information and its effect on uncertainty – how does a lack of information affect the parties to a transaction? Brainard’s (1967) work contributed immensely to the understanding of transparency.

In the relationship between the predictor and the audience, there is still an inequitable distribution of information. Consequently, Akerlof (1970) addressed the problem from the angle of the opacity of the intentions of economic agents as preventing accurate predictions being made in economic transactions at their outset. He investigated economic models in which trust or information between parties to a transaction is important. His investigation focused on transactions in the used motor-vehicle market. His findings were that, as information was scarce, transparency resolves the effects of the asymmetrical information problem that is a source of uncertainty in the mind of one of the parties, but is resolved through access to information that dispels that uncertainty. Thus far, none of the researchers linked their studies to attaining any goal in society, although there is a hint of some goal to be reached. Akerlof (1970) left a hint–

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rather than an outright prescription hints of what was required to resolve the information asymmetric problem.

Unless parties to a transaction are restrained from taking advantage of their superior position, they will. Thus, Kydland and Prescott (1977) examined the problem of policy-makers with discretion who fail to attain an agreed goal. They called this the “time-consistency problem”. Their study had far-reaching effects, not only on theoretical policy analysis, but on institutional design, such that the time-consistency problem may be mitigated. They provided a politico-economic explanation for the reason for persistent inflation in the face of repeated promises to fight it as the greatest public enemy. Clearly, the research of the 1950s up to the early 1970s emphasised that economic agents, private agents, and expectations were crucial to economic outcomes. Kydland and Prescott’s (1977), study inspired the 1990s’ wave of central bank reform aimed at creating commitment mechanisms that would lead to attaining society’s preferred social objectives, led by New Zealand (McCallum, 2004). This study contends that transparency acts as a commitment mechanism.

On the one hand, and pursuant to the rules versus discretion debate, Barro and Gordon (1983) argued that the policy-maker should be constrained from the outset either by legal means or by rules that pre-commit the course of future actions of the policy-maker with an overriding social objective that reflects the social preferences of society.

An important insight from the model of Barro and Gordon (1983a; 1983b), is the acceptance that pursuing two goals simultaneously (an unemployment target and an inflation target) without prioritisation, results in the sacrifice of one of the goals, or underperformance in both. In a monetary institution setting, the likely outcome is that the policy-maker will welcome surprise inflation and fall prey to the “time-inconsistencies trap.” Barro and Gordon (1983a; 1983b) went further to warn of the spectre looming large over a discretionary monetary policy, that is, the incentive for a central bank to inflate, based on revenue from

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money creation and the benefits arising from the inverse relationship between inflation and government debt. In an extension of their earlier work, Barro and Gordon (1983b) introduced exogenous shocks and a stabilisation policy into the model without changing their earlier conclusions. In this work, they reiterated their earlier assertions for rules as a means to resolve the time-consistency problem.

On the other hand, (Backus and Driffill, 1985a; Tabellini, 1987a), relying on insights from the theory of repeated games, introduced the concept of reputation as a restraining influence on central bankers. They demonstrated that, under the right conditions, equilibria at low inflation rates were achievable under discretionary policy, provided that the policy-makers first built up a reputation by targeting inflation. In so doing, they would then be able to influence economic agents regarding the level of future inflation rates.

However, problems remained as to the nature of the rules that would constrain the central banker. Attention was therefore directed toward institutional reforms that would make discretionary policy-making better. Rogoff (1985) successfully demonstrated that by delegating monetary policy to an independent central bank, a suitable balance between credibility of low inflation and stabilisation could be attained. He contended that further benefits could accrue when a person who was more inflation averse than society was placed in charge. Moreover, this could be achieved without the dreaded unemployment cost. These findings were confirmed by Grilli, Masciandaro and Tabellini (1991a); Cukierman (1992); and Alesina and Summers (1993).

As the institutional setting of monetary policy came under increasing scrutiny, Rogoff (1986) introduced three, non-mutually exclusive devices for implementing monetary policy rules: (1) an institutional amendment; (2) using legislation to make a central bank independent; and (3) framing the time-consistency problem as a principal-agent problem. Each device has its own problems to be overcome. Economic agents would set their inflationary

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expectations based on how effective these devices are, and inflationary expectations will be lower than otherwise. However, flexibility is required. For instance, in the event of war or other peril, it may be necessary to respond appropriately to prepare for war or to meet the peril by defaulting on some of a government’s nominal debt (defaulting on paying out on its issued securities). Finally, he also suggested that central bank governors could be issued with longer terms of office as a means to increase their credibility as persons beyond the reach of political influence. Such devices were designed to increase the reputation and credibility of the central bank.

Taylor (1993) continued the quest by also investigating the role of policy rules versus discretion. He suggested a definition where policy rule was synonymous with “policy system” or “systematic policy.” The key word in his definition was “systematic”, which means “methodical; according to a plan; and not casually or at random”. He further argues that ‘… technically speaking, a policy rule is a contingency plan that lasts forever unless there is an explicit cancellation clause’. He cautions that ‘… policymakers need to make a commitment to stay within the rule if they are to gain the advantage of credibility associated with a rule’. Moreover, for analysis and prediction of how the economy will perform with the policy rule in place, it is necessary that the rule be in existence for some years.

Transparency as a rule is systematic and durable as it has been around for two decades and therefore lends itself to econometric testing and analysis. There is concern about Taylor’s position that a policy rule is a “contingency plan”. The proper wording should perhaps be that a policy rule “may be a contingency plan”. This then allows the incorporation of rules that may not be contingency plans, such as the transparency rule.

Criticism of the time-consistency literature came from Geraats (2001b) who argued that, although time-consistency literature suggested that commitment eliminated the inflationary bias of discretionary policy, it was not a sure cure.

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Under rational expectations, economic agents use the policy instrument to infer the intentions of the central bank, but the existence of economic disturbances make the instrument a noisy signal, thereby providing a covert opportunity for the central bank to expand money supply undetected. Geraats (2001b) concluded that greater openness should not be about the objectives of a central bank, but about the explanation of its policy actions. She emphatically added that central banks did not need rules, but economic transparency.

.

A review of Geraats’ (2001b) contribution indicates that she may have overlooked some issues on rules. Transparency is actually a prescription of the conduct of monetary policy and, as such, is a rule. In operation, it stipulates what and how the central bank should communicate to society. In essence, her study is an extension of the time-consistency literature because through communication, the central bank is pre-committed to following through on what it had promised to do, lest its reputation and credibility suffer. Moreover, Rogoff (1986) asserts that an institution may be a convention or a rule. In this sense, monetary-policy transparency is a convention or a rule.

Geraats (2002, 2005), in investigating transparency, defined monetary-policy transparency as the disclosure of information by the central bank relevant to the conduct of monetary policy, thereby reducing an asymmetrical information risk. The rationale is that no central bank can out-perform economic agents and, therefore, the appropriate stance is to manage agents’ expectations through transparency. Their methodology is useful in that they formulated an objective methodology for measuring transparency by using five indices that are comparable across countries. These are discussed later in this chapter.

Morris and Shin (2002) were the first to demonstrate that transparency influences economic outcomes through its effect on the formation of inflation expectations in what is known as “coordination games”. In turn, by being transparent, that is, by informing the public of its intentions and by giving feedback to economic agents about their effect on macro variables, the central

Monetary policy transparency in Sub-Saharan Africa evidence and lessons

MONETARY POLICY TRANSPARENCY

IN SUB-SAHARAN AFRICA

EVIDENCE AND LESSONS

MONETARY POLICY TRANSPARENCY

IN

SUB-SAHARAN AFRICA

EVIDENCE AND LESSONS

JOHN D. G. NHAVIRA

ACKNOWLEDGEMENTS

LIST OF ACRONYMS

LIST OF TABLES

ABSTRACT

CONTENTS

CHAPTER ONE

1. INTRODUCTION

CHAPTER TWO

2.

LITERATURE REVIEW: MONETARY-POLICY

TRANSPARENCY