Money in the Middle East and North Africa

Monetary Policy Frameworks and Strategies

David Cobham, Ghassan Dibeh

• Publisher: Routledge
• Year: 2010
• ISBN:
  9781136864155
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

Monetary policy in the Middle East and North African (MENA) countries remains an understudied area; this book fills an important gap by examining monetary policy frameworks and monetary policy strategies in the region. Building on the editors' earlier book, Monetary Policy and Central Banking in the Middle East and North Africa, which focused on central bank independence issues and on exchange rate regimes, this book emphasises monetary policy strategies. Part I contains an overview of the financial markets and institutions which condition the choice of monetary policy strategy in the countries of the region, followed by single-country studies on aspects of the monetary policy frameworks of Lebanon, Egypt, Jordan, the Palestinian Territory and Turkey. Part II includes analyses of the prospects for inflation targeting in Egypt, Morocco and Tunisia, of the monetary transmission mechanism in the Gulf Cooperation Council countries, of the relative advantages of inflation targeting and exchange rate fixity with reference to Egypt, of the problem of fiscal dominance in Egypt, and of the inflationary implications of exchange rate fixity for Saudi Arabia and Kuwait. The contributors are experts from universities inside and outside the MENA region, from central banks in the region and from outside institutions such as the European Central Bank and the International Monetary Fund.

1
Introduction

David Cobham and Ghassan Dibeh

For many years the monetary policy frameworks in the Middle East and North Africa (MENA) region were largely both unchanging and unstudied. On the one hand, most MENA countries kept their currencies pegged to the US dollar, which restricted the scope for independent monetary or macro policy. On the other hand, most research was focused elsewhere. It is striking, for example, that none of the three main general treatments of economic development in the region – Richards and Waterbury (2008), Noland and Pack (2007) and Devlin (2010) – include chapters on countries’ monetary policy frameworks or financial systems.

Over the last decade or so, however, major transformations have been under way in the financial systems of many (but not all) of these countries, and monetary policy strategies are now being accorded greater attention by policymakers and in public debate. Some of the research which is being undertaken is seeing the light of day through the revived Review of Middle East Economics and Finance, which has recently been joined by the Middle East Development Journal (which has, however, a wider economic focus). Other important references in this area include the Neaime and Colton (2005) volume and single-country studies such as Abdel-Khalek (2001) and Makdisi (2004).

There are still a number of gaps in our knowledge about both financial systems and monetary strategies, but more importantly there are significant policy issues raised by the developments that are occurring and are likely to continue. This book is intended to contribute to the rising demand for research and analysis in this area. It builds on and complements the volume which we have previously edited in this series (Monetary Policy and Central Banking in the Middle East and North Africa, eds Cobham and Dibeh, 2009). That volume had a strong emphasis on central bank independence and on exchange rate regimes, mainly through multi-country studies, and included single country studies on Lebanon (mainly pre-civil war), Algeria, Tunisia and Turkey (the central bank’s reaction function).

This volume puts the emphasis more on monetary policy frameworks and monetary policy strategies. It starts in Part I with an overview of the financial markets and institutions which condition the choice of monetary policy strategy in the countries of the region, followed by single-country studies on the monetary policy frameworks of Lebanon (post-civil war), Egypt, Jordan, the Palestinian Territory and Turkey (the nature of the banking sector and its implications for macroeconomic performance). Part II starts with an analysis of the prospects for inflation targeting in Egypt, Morocco and Tunisia. This is followed by investigations of the monetary transmission mechanism in the Gulf Cooperation Council (GCC) countries, of the relative advantages of inflation targeting and exchange rate fixity with reference to Egypt, of the problem of fiscal dominance in Egypt, and of the inflationary implications of exchange rate fixity for Saudi Arabia and Kuwait.

In Part I, David Cobham provides an overview of the ‘financial infrastructure’, that is the financial institutions and markets which condition the choice of monetary policy strategy in the various MENA countries. He emphasises in particular the potential contribution of money markets – which enable the central bank’s policy rate decisions to be passed through to the commercial banks’ own lending and deposit interest rates – and bond markets – which allow budget deficits to be financed without monetary expansion. Cobham distinguishes between three ‘polar types’ of ‘monetary architecture’ which have different requirements in terms of infrastructure and make possible different types of monetary strategy. He argues that most MENA countries lack key elements of the infrastructure necessary for a ‘modern’ monetary policy strategy such as inflation targeting. But he also suggests that for some countries the costs of establishing and operating some of the infrastructure concerned might outweigh the benefits of a more modern monetary policy strategy, if we were able to measure these costs and benefits accurately.

Ghassan Dibeh examines the political economy of stabilisation in Lebanon. Lebanon has had an exchange rate-based stabilisation (ERBS) programme since 1993, a record duration for such programmes which have typically been abandoned much earlier than this amidst the strains of real exchange rate appreciation and/or fiscal indiscipline. Lebanon experienced real appreciation up to 2002, and a striking lack of fiscal adjustment before 2001. Dibeh locates the source of the support for the ERBS in the particular nexus of relationships between the commercial banks and the central bank, upheld by official and private capital inflows linked to the commitments to Lebanese reconstruction by foreign governments and the Lebanese diaspora, and by the distributional policies of post-war governments (in terms of sect and factor shares) within Lebanon’s ‘consociational’ democratic system.

Hoda Selim surveys the evolution of Egyptian monetary policy since the late 1970s. She analyses the changes in the objectives, intermediate targets and instruments of monetary policy, examines the reasons for recurring high inflation and considers the prospects for further evolution of the monetary policy framework. Over the period studied the exchange rate has become more flexible, monetary policy operations have shifted towards indirect market instruments rather than direct credit controls and banking sector reforms have been introduced. At the same time, the central bank has acquired some independence and is undergoing significant modernisation. But the objectives of monetary policy have still not been adequately clarified, the central bank’s independence is neither complete nor secure, and fiscal dominance remains a serious danger.

Samar Maziad analyses the evolution of the monetary policy framework in Jordan, heavily influenced by the currency crisis of 1989–90, which was associated with high levels of government borrowing from abroad. Policy now involves a very hard peg of the Jordanian dinar to the US dollar, together with increased instrument independence for the central bank, which since 2001 is not allowed to lend directly to the government. Over the 1990s the central bank also shifted its monetary policy operations towards indirect monetary instruments, based on the issue by auction of its own certificates of deposit and later the introduction of standing facilities for the commercial banks. Maziad also investigates the degree of Jordan’s monetary policy independence: she finds that, despite the peg, the central bank has some limited ability to vary its policy rate in response to internal economic developments (inflation and the output gap), which presumably reflects the credibility it has acquired over the period.

Jihad K. Wazir, Mohammad Atallah and Shaker A. Sarsour analyse the development of the Palestine Monetary Authority (PMA), which is a kind of prototype central bank for the West Bank and Gaza. Its main current activity is banking supervision, since it does not issue or operate a separate currency, but it aspires to transform itself into a fully-fledged modern central bank. The authors show that the PMA’s independence would be greatly increased by the adoption of the draft law on central banking, and then discuss a number of issues involved in the transformation of the PMA. They consider different methods of estimating the size of the money supply in Palestine (which is composed of a mix of Israeli shekels, US dollars and Jordanian dinars, where data are available on bank deposits but not on currency in circulation). They discuss the idea for the PMA to issue its own certificates of deposit as a way to provide a basic instrument for interbank operations and, ultimately, for the operation of monetary policy through market interest rates. And they discuss the question of dollarisation (replacement of the shekel and the dinar by the dollar), a question which has been posed sharply by the recurring difficulties over the recent period in ensuring an adequate supply of shekel currency in Gaza.

Berksoy Bilgin and Gülçin Özkan focus on the role of the banking sector in Turkey. Here, as in many other MENA countries, it is the banks which are the main holders of government debt. They present a formal model which highlights this role, in order to identify the determinants of the cost of government borrowing, and then compare movements in that cost graphically with changes in the various determinants: the degree of competition in the banking sector, the depth of the deposit market, the cost to banks of illiquidity, reserve requirements, and the authorities’ time preference. They then explore the bank lending channel of the monetary transmission mechanism in Turkey, using data for individual banks from 2002 to 2008. These results provide clear evidence that bank lending in aggregate responds to changes in the policy interest rate and to other variables in broadly expected ways. However, they show that the response to the policy rate is lower for larger and for well-capitalised banks.

In Part II, Thierry Bracke, Michal Franta and Jan Stráský examine the changes taking place and in prospect in three southern Mediterranean countries which have shown interest in adopting formal inflation targeting: Egypt, Morocco and Tunisia. They examine the ‘preconditions’ for inflation targeting in each country: ‘economic’, e.g. exchange rate flexibility, financial market depth; ‘institutional’, e.g. central bank independence; and ‘technical’, e.g. the forecasting and modelling capacity of the central bank. They then present Bayesian estimates of a small macro model for each country along the lines of Berg et al. (2006), and compare these results with similar findings in the literature for other emerging economies. Their conclusions are that, although in each of these countries some progress has been made on the preconditions, more is required before they could move to fully fledged inflation targeting; and that the price formation and monetary transmission processes in the three countries are not incompatible with an inflation targeting strategy. They also emphasise that any move to IT needs to be supported by the whole spectrum of policymakers if it is to be successful.

Wassim Shahin uses an analysis of the monetary transmission mechanism in the GCC countries to derive implications for the type of monetary policy appropriate for them. He starts by reviewing the array of different transmission mechanisms in the literature, with an emphasis on the environment in terms of the financial markets and institutions of different kinds required for these mechanisms to function. He then examines the environment which actually exists in developing and transition countries in general and the GCC countries in particular, arguing that for the latter the effective transmission mechanisms are through liquidity effects (via interest rates), the credit channel and the exchange rate. He reviews recent macro performance and the current monetary framework in the GCC countries, and recommends that they should move away from the hard exchange rate pegs which dominate the current framework towards greater exchange rate flexibility, with the interest rate as an implicit policy anchor and a credit aggregate as a possible intermediate target.

Rania A. Al-Mashat examines the role of the exchange rate under inflation targeting, in the light of the emphasis often placed on exchange rate variability and the pass-through from the exchange rate to the domestic economy for open and emerging economies. She sets up a New Keynesian macro model in which uncovered interest parity (UIP) is modified so that the exchange rate is a weighted average of an exchange rate target and the standard UIP equilibrium level, while the central bank’s reaction function is modified so that the interest rate is a weighted average of a rate set by the central bank along Taylor-rule lines and the rate determined by foreign rates through the UIP condition. This model is then calibrated for Egypt, and simulated under alternative values of the two sets of weights. This generates predictions of inflation and output variability and the central bank’s loss under different assumptions about exchange rate flexibility and inflation targeting. The key result is that inflation and output variability and the welfare loss are higher under a pure fixed exchange rate regime, but lowest at a point close to (but not quite at) pure inflation targeting plus full exchange rate flexibility.

Hoda Abdel Ghaffar Youssef investigates the extent of fiscal dominance in Egypt. After exploring the existing analytical and empirical literature on fiscal dominance, and the structure of government expenditure and revenues in Egypt, she uses cointegration tests and an error correction model to assess the short run and long run impact of claims on the government (i.e. government borrowing) on the price level in Egypt. She finds clear evidence of long run effects of government borrowing (together with broad money and real GDP) on the price level, but no significant evidence of short run effects. Granger causality tests suggest claims on the government ‘cause’ prices, and not vice versa, while a range of tests indicate there is no structural break in the relationship, for example around recent announcements of changes in the monetary policy framework. She concludes that changes to the fiscal policy framework, so that fiscal policy no longer dominates monetary policy, are an essential precondition for any move to inflation targeting.

Maher Hasan and Hesham Alogeel set out to identify the nature of the inflationary process in Saudi Arabia and Kuwait, as representative GCC countries, in the light of the recent rise in inflation in those countries and the debate it has provoked. They estimate an error correction model in which the change in prices is related to foreign prices, the nominal effective exchange rate and the oil price, together with a domestic excess demand variable and domestic money supply shocks. For both countries they find that external factors play a dominant role in inflation, with a strong relationship in the long run between domestic prices and trading partners’ prices, and a less strong relationship with the exchange rate (but no significant role for the oil price). In the short run, domestic prices respond also to excess money supply and, in the Kuwaiti case, excess demand. They suggest that prices respond more strongly to trading partners’ inflation than to exchange rate movements because the former are typically permanent but the latter are often reversed. They also note that the similarity between the two countries bodes well for the planned GCC monetary union.

References

Abdel-Khalek, G. (2001), Stabilisation and Adjustment in Egypt: Reform or De-Industrialisation. Cheltenham: Edward Elgar.

Berg, A., Karam, P., and Laxton, D. (2006), ‘A practical model-based approach to monetary policy analysis – Overview’, IMF working paper no. 06/80.

Cobham, D., and Dibeh, G. (eds) (2009), Monetary Policy and Central Banking in the Middle East and North Africa, London: Routledge.

Devlin, J. (2010), Challenges of Economic Development in the Middle East and Nor...

Table of contents

• The Routledge Political Economy of the Middle East and North Africa Series
• Contents
• Figures
• Tables
• Contributors
• Preface
• 1 Introduction
• Part I Monetary policy frameworks
• Part II Monetary policy strategies
• Index