CBN can apply FX, prudential actions to ease monetary policy concerns, says IMF

BY CHARLES ABUEBE

The Central Bank of Nigeria (CBN), along with other central banks across sub-Saharan Africa, should consider foreign exchange intervention, capital flow measures, and macroprudential actions as policy tools that could ease growing short-term monetary policy trade-offs or challenges when certain shocks hit, the International Monetary Fund (IMF) has recommended.

The IMF, in a recent article on how African countries can navigate the growing monetary policy challenges, said the pandemic has dented the economic growth of some nations in the region, and even now, that the recovery is likely to leave output below the pre-crisis trend this year. It further stated that several countries in the region have also seen inflation increase, a challenge that is in some cases compounded by fiscal dominance emanating from high public debt levels.

It also asserted that for central banks considering such policies, however, the tools should not be used to maintain an over -or- undervalued exchange rate. Moreover, it added that 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.

Taking cognizance of the economic impact of the ongoing conflict in Ukraine and including the attendant sharp rise in energy and food prices, the IMF said it is likely to further intensify the challenges as many SSA economies may also face capital outflows as major central banks in advanced economies withdraw policy stimulus and raise interest rates in the period ahead.

Managing the volatile environment, the IMF pointed out that countries with managed or free-floating exchange rate regimes may generally benefit from allowing currencies to adjust while focusing monetary policy on domestic objectives, and added that countries with shallow markets (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 bids and ask prices, it noted.

On some of the vulnerabilities experienced by these economies, the IMF noted that, “In the presence of large currency mismatches on balance sheets, exchange rate depreciation can undermine the financial health of corporates and households. And weak central bank credibility can cause exchange rate changes to have a bigger effect on inflation (high passthrough). Such currency mismatches and high passthrough can cause output and inflation to move in opposite directions following shocks, thereby worsening the tradeoffs that policymakers face.

“There is also evidence that the exchange rate passthrough in low-income countries is substantially higher than it is in more advanced economies, which poses a particular problem, given the often heavy dependence on food and energy imports,” it said.

But in the near-term, while vulnerabilities remain high, the fund 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, macroprudential policy measures and capital flow measures can help enhance monetary policy autonomy, improve financial and price stability, and reduce output volatility.”

In context, it opined that, “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.”

In the meantime, the fund noted that 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. It, therefore, warned that central banks will 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.