The International Monetary Fund (IMF) has stated that Nigeria and other Sub-Saharan African countries were facing monetary policy challenges, urging them to cut down vulnerabilities, which it listed to include reducing balance sheet mismatches, develop money and foreign currency markets, and reduce exchange rate pass-through by building monetary policy credibility.
But it cautioned that central banks needed to weigh the benefits against potential negative impacts on their own transparency and credibility, especially in circumstances where policy frameworks are not yet well established.
In a blog post, the IMF observed that the COVID-19 pandemic dented economic growth, adding that even now, recovery was likely to leave output below the pre-crisis trend this year.
It noted that several countries in the region have also seen rise in inflation, a challenge it noted in some cases was compounded by fiscal dominance emanating from high public debt levels.
According to the fund, many of these economies in Sub-Saharan Africa may also face capital outflows as the major central banks in advanced economies withdraw policy stimulus and raise interest rates in the period ahead.
It stated that the economic impact of the conflict raging in Ukraine, including the attendant sharp rise in energy and food prices, was likely to further intensify the challenges.
On how to manage this sort of volatile environment, the IMF noted that sub-Saharan African countries with managed or free-floating exchange rate regimes generally benefit from allowing currencies to adjust, while focusing monetary policy on domestic objectives.
“That said, many countries in sub-Saharan Africa with floating exchange rate regimes have characteristics and vulnerabilities that can limit the benefits from fully flexible rates.
“For instance, dominant currency pricing (i.e., rigid export prices in US dollar terms) can weaken the beneficial trade adjustments associated with flexible rates.
“Moreover, shallow markets (i.e., markets with limited liquidity) can amplify exchange rate movements and yield excessive volatility.
“Foreign exchange markets tend to be shallow in many countries in the region, as evidenced by wide spreads between bid and ask prices,” the global lender said.
The IMF pointed out that high foreign currency denominated liabilities were also a key vulnerability in several economies, adding that in the presence of large currency mismatches on balance sheets, exchange rate depreciations could undermine the financial health of corporates and households.
According to the IMF, weak central bank credibility could cause exchange rate changes to have a bigger effect on inflation, stressing that such currency mismatches and high pass-through could cause output and inflation to move in opposite directions following shocks, thereby worsening the trade-offs that policymakers face.
It also stated that there was evidence that the exchange rate pass-through in low-income countries was substantially higher than in more advanced economies, which poses a particular problem given the often heavy dependence on food and energy imports.
Proffering solutions on how countries that exhibit such vulnerabilities manage their policy responses, the IMF stated that it was important to reduce the vulnerabilities over time, including reducing balance sheet mismatches; developing money and foreign currency markets; and reducing exchange rate pass-through by building monetary policy credibility.
It added that many of these were areas where the IMF technical assistance could assist.
“But in the near-term—while vulnerabilities remain high—the IMF’s work toward an Integrated Policy Framework suggests that using additional tools may help ease short-term policy trade-offs when certain shocks hit.
“In particular, where reserves are adequate and these tools are available, foreign exchange intervention, macro-prudential policy measures and capital flow measures can help enhance monetary policy autonomy, improve financial and price stability, and reduce output volatility.
“For instance, simulations with the framework’s models suggest that in response to a sharp tightening of global financial conditions or other negative external financial shock, a country exhibiting such vulnerabilities could improve immediate economic outcomes by using foreign exchange intervention to reduce exchange rate depreciation and thereby limit the inflationary impact and reduce negative balance sheet effects. “This results in higher output and lower inflation than would have been feasible without the use of the additional policy instrument,” the article said.
However, the IMF further advised that for central banks considering such policies, a few important qualifiers are in order adding that the tools should not be used to maintain an over- or undervalued exchange rate.
“Moreover, while additional tools can help alleviate short-term tradeoffs, this benefit needs to be carefully weighed against potential longer-term costs. Such costs may include, for instance, reduced incentives for market development and appropriate risk management in the private sector.
“Communicating about the joint use of multiple tools in a more complex framework can be very challenging, too, and expanding the set of policy options may subject central banks to political pressures.
“Central banks will thus need to weigh the benefits against potential negative impacts on their own transparency and credibility, especially in circumstances where policy frameworks are not yet well established,” It admonished.
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