## 3. Index of Strength of Monetary Policy Framework

## Source details

**Canonical URL:** [3. Index of Strength of Monetary Policy Framework](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2011/_wp11245.pdf)

## Other formats

- [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2011/_wp11245.pdf.md)
- [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2011/_wp11245.pdf.json)

---

### Introduction and key findings
- CADR countries (except Nicaragua) had lower inflation than other Latin American countries in the 1980s and 1990s; since the early 2000s CADR inflation has been above other Latin American countries, more volatile, and more vulnerable to external shocks.
- CADR central banks tended to raise interest rates less than required to tame inflation pressures and some prioritized exchange rate stability, blurring objectives relative to price stability.
- The paper constructs an index to measure strength of monetary policy frameworks in each CADR country and finds all CADR countries lag far behind the benchmark country (Chile).
- Key areas needing improvement: ensure continued absence of fiscal dominance, enhance central bank independence, increase exchange rate flexibility, and improve effectiveness of the policy instrument (e.g., liquidity management to aid interest-rate transmission).

### Preconditions and empirical benefits of strong monetary frameworks (literature review)
- Preconditions commonly identified for adopting Inflation Targeting (IT):
  - Priority of the inflation target (price stability as main objective).
  - Absence of fiscal dominance.
  - Central bank instrument independence.
- Under IT:
  - Central bank has explicit quantitative target or target ranges for inflation; inflation forecast is the de-facto intermediate target.
  - High transparency and accountability are central features.
- Additional considerations:
  - Highly dollarized economies can implement IT while allowing some exchange rate smoothing, provided intervention does not target a level/trend of the exchange rate.
  - IT introduction and increased exchange rate flexibility associated with reduced exchange-rate pass-through to inflation.
  - Flexible frameworks that incorporate output gap responses, focus on core CPI, and use target ranges better handle supply shocks while anchoring expectations.
- Empirical benefits of IT:
  - Associated with lower inflation, lower inflation expectations, and lower inflation volatility without adverse impact on output volatility or volatility of interest rates, exchange rates, and international reserves.
  - Improved anchoring of inflation expectations, better communication, and institutional reforms reinforcing the framework.

### Monetary frameworks and reforms: Chile, Peru, Uruguay (high-level)
- Taxonomy used: (i) price stability as main objective and exchange rate flexibility; (ii) absence of fiscal dominance; (iii) central bank instrument independence; (iv) effectiveness of the policy instrument; (v) other elements (financial market depth, technical forecasting capacity, accountability and transparency).
- Chile
  - Informal IT early 1990s; fully-fledged IT in 1999; floating exchange rate since 1999; interventions infrequent and announced.
  - Current annual inflation objective: 3.0 percent +/- 1 percent.
  - Net international reserves increased by US$16.7 billion between 1988-1997 (representing 34 percent of the average GDP for the same period).
  - Operational target: daily nominal interbank rate since August 2001.
- Peru
  - Adopted IT in 2002; unified FX market in 1991 and allowed floating rate; frequent interventions due to high financial dollarization.
  - Current annual inflation objective: 2.0 percent +/- 1 percent.
  - De-dollarization: credit dollarization ~50 percent in December 2010; deposit dollarization ~47 percent in December 2010.
  - Operational target: interbank rate since 2003.
- Uruguay
  - Transitioning toward IT since late 2007; floating rate since 2002 with smoothing interventions.
  - Current inflation objective: 4-6 percent range within an 18-month horizon.
  - BCU recapitalized October 2010 via US$2.4 billion government inflation-indexed bonds.
  - Financial dollarization by end-2010: foreign-denominated credit 55 percent and deposits 72 percent.

### Monetary policy frameworks and constraints in CADR countries
- Common constraints: limited exchange rate flexibility, dollarization, underdeveloped financial sectors, reputational and credibility needs.
- Objectives and exchange rate regimes (selected):
  - Costa Rica: objective includes internal and external stability; transitioning to IT within an exchange rate band; inflation objectives end-2011: 5.0+/-1 percent; end-2012: 4.0+/-1 percent.
  - Dominican Republic: legislation establishes price stability as main objective; plan to move to IT in 2012; inflation targets end-2011: 5-6 percent; end-2012+: 4-5 percent.
  - Guatemala: monetary policy regime: inflation targeting; inflation objectives end-2011: 5.0 percent +/- 1 percent; end-2012: 4.5 percent +/- 1 percent; three-year convergence to 4 percent +/- 1 percent.
  - Honduras: BCH main objectives preserve value of currency; monetary policy regime: exchange rate anchor to the U.S. dollar.
  - Nicaragua: BCN primary objective stability of national currency; monetary policy regime: exchange rate anchor to the US dollar.
- Fiscal positions and fiscal dominance:
  - Costa Rica public sector debt reached 39 percent of GDP in 2010.
  - Dominican Republic gross public debt peaked at almost 42 percent of GDP after 2009.
  - Guatemala public sector debt 24 percent of GDP in 2010.
  - Honduras BCH can provide a 6-month overdraft up to 10 percent of preceding year’s tax revenue; BCH law overruled on three occasions in prior two years.
  - Nicaragua public sector debt was 80 percent in 2010; policy aims to reduce to 66 percent by 2014.
- Central bank independence and balance sheets:
  - De jure instrument independence established in 1990s–2000s but political autonomy needs strengthening across CADR: appointment/dismissal processes, board terms linked to political cycles, board composition.
  - Operational autonomy weakened by negative or insufficient capital and operational deficits; recapitalization mechanisms vary (Guatemala mechanism since 2003; BCN law 2010 mandates government recapitalization options in 2011; Dominican Republic implementing recapitalization plan; Costa Rica plan pending since 2007).
- Effectiveness of the policy instrument and transmission:
  - Central banks rely on reserve requirements, standing facilities, auctions of central bank securities; except Nicaragua, all have explicit policy rates.
  - Signaling of policy stance hindered by structural liquidity surplus and shallow interbank markets; liquidity forecasting needs improvement.
  - Recent operational improvements: Banguat introduced overnight rate June 2011; BCRD and BCCR use lending/deposit facilities to establish rate corridors; BCRD narrowing corridor; BCCR plans to do so.
  - Transmission to lending rates weakened by low exchange rate flexibility and dollarization; deposit dollarization ratios not substantially declined since 2008.
- Financial sector and market development:
  - Banking-dominated systems; concentration high (especially Nicaragua and Dominican Republic); NPLs typically in 2–4 percent range.
  - Capital markets dominated by government or central bank paper; limited secondary markets and few benchmark yield curves.
  - Inflation forecasting capacity varies: BCCR, BCRD, and Banguat stronger; BCN and BCH have basic models.
  - Transparency and accountability: most central banks report annually to Congress and publish audited statements; variation in minutes publication and frequency of reports.

### Index construction and methodology
- Five main criteria and weights:
  - (1) Central bank’s main policy objective (weight 0.30)
  - (2) Absence of fiscal dominance (weight 0.25)
  - (3) Central bank independence (weight 0.20)
  - (4) Control over policy instrument (weight 0.20)
  - (5) Transparency and accountability (weight 0.05)
- Twelve sub-criteria mapped to scale 0 to 1 (higher = better), assessed with legal and de facto indicators.
- Overall formula: Total index = 0.30*(1)+0.25*(2)+0.20*(3)+0.20*(4)+0.05*(5)

### Index results (exact values preserved)
- Total index (by country):
  - Costa Rica: 0.53
  - Dominican Republic: 0.53
  - Guatemala: 0.67
  - Honduras: 0.41
  - Nicaragua: 0.29
  - CADR Avg.: 0.48
  - Chile (benchmark): 0.96
- Sub-criteria scores (by criterion and country):
  - (1) Central bank main policy objective:
    - Costa Rica: 0.30
    - Dominican Republic: 0.45
    - Guatemala: 0.30
    - Honduras: 0.73
    - Nicaragua: 0.30
    - CADR Avg.: 0.35
    - Chile: 0.43
    - Benchmark: 1.00
  - (2) Absence of fiscal dominance:
    - Costa Rica: 0.25
    - Dominican Republic: 0.61
    - Guatemala: 0.80
    - Honduras: 0.80
    - Nicaragua: 0.35
    - CADR Avg.: 0.15
    - Chile: 0.54
    - Benchmark: 1.00
  - (3) Central bank independence:
    - Costa Rica: 0.20
    - Dominican Republic: 0.62
    - Guatemala: 0.47
    - Honduras: 0.54
    - Nicaragua: 0.57
    - CADR Avg.: 0.44
    - Chile: 0.53
    - Benchmark: 0.82
  - (4) Effectiveness of the policy instrument:
    - Costa Rica: 0.20
    - Dominican Republic: 0.40
    - Guatemala: 0.50
    - Honduras: 0.50
    - Nicaragua: 0.40
    - CADR Avg.: 0.15
    - Chile: 0.39
    - Benchmark: 1.00
  - (5) Transparency and accountability:
    - Costa Rica: 0.05
    - Dominican Republic: 0.71
    - Guatemala: 0.83
    - Honduras: 0.83
    - Nicaragua: 0.71
    - CADR Avg.: 0.58
    - Chile: 0.73
    - Benchmark: 1.00

### Interpretation: strengths and weaknesses
- Guatemala scores highest in the region; Costa Rica and Dominican Republic are above the CADR average.
- All CADR countries remain significantly below Chile (benchmark).
- Main regional weaknesses:
  - Clarify and prioritize price stability as primary mandate and increase exchange rate flexibility to avoid multiple-objective ambiguity.
  - Improve effectiveness of the policy instrument:
    - Increase signaling of the policy rate by removing structural excess liquidity through greater reliance on market-based operations.
    - Improve liquidity forecasting and management.
    - Develop interbank markets to strengthen interest-rate transmission.
  - Strengthen central bank independence:
    - Strengthen balance sheets (Costa Rica, Honduras, Nicaragua).
    - Address board composition issues (Guatemala, Nicaragua).
    - Delink governor terms from political cycle (Dominican Republic).
  - Reduce fiscal dominance by trimming public debt ratios (Costa Rica, Nicaragua) and prohibiting central bank lending to government (Honduras, Nicaragua).
  - Transparency and accountability relatively better but can be improved (e.g., publish IFRS-compliant financial statements; enhance reporting to Congress).

### Policy recommendations (consolidated)
- Increase exchange rate flexibility to reinforce price stability as the primary objective; use FX intervention to dampen volatility in stress periods (evidence from Peru and Uruguay supports this approach).
- Enhance effectiveness of the policy instrument:
  - Improve signaling of policy rate by removing structural excess liquidity via market-based operations.
  - Improve liquidity management: establish cash flow programs, introduce repos and reverse repos, fine-tune auctions, and promote interbank market development.
  - Maintain a role for rules-based instruments (e.g., reserve requirements) while expanding market operations.
  - Consider higher reserve requirements on dollar deposits to reduce dollarization (possible for Costa Rica, Guatemala, Nicaragua).
- Preserve absence of fiscal dominance and enhance central bank independence:
  - Implement fiscal consolidation to stabilize/reduce public debt-to-GDP ratios.
  - Strengthen legislation to prohibit central bank financing of government (particularly Honduras, Nicaragua).
  - Reform appointment/dismissal processes, board term overlap provisions, and board composition; strengthen central bank balance sheets (Costa Rica, Honduras, Nicaragua).
- Develop supportive conditions:
  - Strengthen central banks’ technical capacity for inflation forecasting (technical assistance needed).
  - Improve transparency and accountability: publish quarterly monetary/inflation reports, disclose minutes of monetary policy decisions; Costa Rica to publish externally audited annual financial statements regularly.
- Financial sector and market development (medium-term):
  - Enhance financial regulation and supervision to LA5 standards.
  - Standardize public debt issuance and establish benchmark government yield curves to foster corporate debt markets.
  - Deepen interbank markets (electronic book-entry systems, central securities depository) and develop domestic yield curves in local currency.
  - Consider pension system reforms to foster longer-term domestic investor base.

### Conclusions
- Strengthening monetary policy frameworks in CADR would reduce constraints to effective monetary policy and help achieve lower, more stable inflation.
- Reforms should prioritize clarifying mandates, increasing exchange rate flexibility, improving operational effectiveness (liquidity management and signaling), strengthening independence and balance sheets, and fostering market development and forecasting capacity.

*Source: IMF Staff paper, “Index of Strength of Monetary Policy Framework” (content unit: 3. Index of Strength of Monetary Policy Framework).*

### References .............................................................................................................

### _wp11245 - References ................................................................................................................................37

### References

- References ................................................................................................................................37

### Tables

- 1.   Central Bank Protts and Losses in Chile, Peru, and Uruguay .............................................8
- 2.   Index: Strength of Monetary Policy Framework ...............................................................15

### Figures

- 1.   Inflation in Central America (CADR) and Selected Latin American Countries .................3
- 2.   Average Inflation in CADR and LA5 ..................................................................................6

*Source: _wp11245 - References (PDF).*

### 3.   Index of Strength of Monetary Policy Framework ............................................................14

### 3.   Index of Strength of Monetary Policy Framework

### Introduction
- CADR countries (except Nicaragua) had lower inflation rates than other Latin American countries in the 1980s and 1990s, but since the early 2000s CADR inflation has been above other Latin American countries, more volatile, and more vulnerable to external shocks.
- CADR central banks have tended to raise interest rates less than required to tame inflation pressures and some have cared about exchange rate stability, blurring the policy objective vis-à-vis price stability.
- The paper seeks to identify reforms to strengthen monetary frameworks in CADR to reduce inflation and achieve price stability, building on prior studies and on the reform experiences of Chile, Peru, and Uruguay.
- The paper constructs an index to measure the strength of monetary policy frameworks in each CADR country and finds that all CADR countries lag far behind the benchmark country (Chile).
- Key areas needing improvement: ensure continued absence of fiscal dominance, enhance central bank independence, increase exchange rate flexibility, and improve effectiveness of the policy instrument (e.g., liquidity management to aid interest-rate transmission).

### Key Elements of a Strong Monetary Policy Framework: Literature review
- Preconditions for adopting Inflation Targeting (IT) commonly identified:
  - Priority of the inflation target (price stability as main objective).
  - Absence of fiscal dominance.
  - Central bank instrument independence.
- Under IT:
  - Central bank has explicit quantitative target or target ranges for inflation; inflation forecast is the de-facto intermediate target.
  - High transparency and accountability are central features.
- Additional considerations:
  - Highly dollarized economies can implement IT while allowing some exchange rate smoothing, provided intervention does not target a level/trend of the exchange rate.
  - IT introduction and increased exchange rate flexibility have been associated with reduced exchange-rate pass-through to inflation.
  - Flexible monetary frameworks that incorporate output gap responses (Taylor-type behavior), focus on core CPI, and use target ranges can better handle supply shocks while anchoring expectations.
- Empirical benefits of IT:
  - Associated with lower inflation, lower inflation expectations, and lower inflation volatility without adverse impact on output volatility or volatility of interest rates, exchange rates, and international reserves.
  - Improved anchoring of inflation expectations, better communication, and institutional reforms reinforcing the framework.

### Monetary frameworks and reforms in Chile, Peru, and Uruguay
- Common taxonomy used: (i) price stability as main objective and exchange rate flexibility; (ii) absence of fiscal dominance; (iii) central bank instrument independence; (iv) effectiveness of the policy instrument; (v) other elements (financial market depth, technical capacity for forecasting, accountability and transparency).
- Priority of the inflation target and exchange rate regimes:
  - Chile: informal IT early 1990s, fully-fledged IT in 1999; adopted floating exchange rate in 1999 after an exchange rate band; interventions infrequent and announced.
  - Peru: adopted IT in 2002; unified FX market in 1991 and allowed floating rate; frequent interventions due to high financial dollarization.
  - Uruguay: transitioning toward IT since late 2007; abandoned crawling band in 2002 for floating rate with frequent smoothing interventions.
- Absence of fiscal dominance:
  - Central banks forbidden to grant credit to public sector in the three countries; purchase of government securities in secondary markets allowed in Peru and Uruguay within limits; BCC can lend to government only in national emergency.
  - Fiscal positions: Chile and Peru ran surpluses up to 2008; Uruguay ran small deficits; fiscal positions deteriorated in 2009 but expected to strengthen later.
- Central bank independence and balance sheets:
  - High degree of central bank independence after legislative reforms; BCC further insulated by staggered terms.
  - Historical operational deficits in the 1980s; BCU recapitalized in October 2010 via US$2.4 billion government inflation-indexed bonds; BCC net worth remains negative despite transfers under Fiscal Responsibility Law (2006) equivalent to 0.5 percent of GDP annually in 2006–2008.
  - BCRP balance sheet strengthened after 1994 redefinition and recapitalization.
- Effectiveness of the policy instrument:
  - All three developed market-supportive operational frameworks and control over a short-term interest rate policy instrument; adopted daily interbank rate as operational target.
  - Transitioned instruments: improved auctions, longer maturities of central bank securities, standing facilities, repos and reverse repos.
  - Transmission: BCC benefits from free float and low dollarization; BCRP and BCU face some hindrance from dollarization and lower exchange rate flexibility but implemented measures to discourage dollarization (limits on net open FX positions, higher capital requirements for FX loans, higher reserve/liquidity requirements on FX deposits, tighter loan classification).
- Other supporting elements:
  - Financial system development and reforms: pension reform in Chile enabled accumulation of investable funds; Peru has growing financial market and an evolving domestic yield curve; Uruguay’s markets remain bank-dominated with limited equity and corporate bond markets.
  - Technical capacity: BCC and BCRP have advanced inflation forecasting models including DSGE models; BCU is advancing but needs more capacity.
  - Transparency and accountability: all three publish quarterly reports, financial stability reports, audited statements, and detailed policy decisions; BCC publishes minutes and voting patterns.

### Monetary policy frameworks in CADR (Central America and Dominican Republic)
- Constraints on transmission channels: limited exchange rate flexibility, dollarization, underdeveloped financial sectors, reputational and credibility needs.
- Priority of inflation target and exchange rate regimes:
  - All central banks have price stability as an objective, but often not exclusive. Dominican Republic explicitly has price stability as the fundamental objective; Guatemala has it as a secondary objective; Costa Rica, Honduras, Nicaragua define objective as preserving currency stability.
  - Exchange rate regimes and practices:
    - Only Guatemala has adopted a floating exchange rate; Costa Rica uses a crawling band; Dominican Republic has de jure managed float but de facto tightly managed; Honduras re-introduced a crawling band; Nicaragua has a crawling peg.
    - Exchange rate stability is widely emphasized, blurring priority of inflation targeting.
- Absence of fiscal dominance:
  - By law central banks not allowed to provide credit to government, though Costa Rica, Honduras, Nicaragua permit some short-term lending (BCCR can buy treasury bills; BCN can discount treasury bills; BCH can provide short-term credit).
  - Fiscal positions deteriorated since 2008 due to the global crisis; nonfinancial public sector debt around 25–30 percent of GDP in Dominican Republic, Guatemala, Honduras; about 35 percent in Costa Rica; about 80 percent in Nicaragua.
- Central bank independence and balance sheets:
  - De jure instrument independence established in 1990s–2000s but political autonomy needs strengthening: appointment/dismissal processes, terms of board linked to political cycles, board composition.
  - Executive influence common: presidents appoint governors in several countries; in Costa Rica governing council chaired by President; minister of finance sits on boards in most countries; Banguat board includes congress, banking association, and private representatives.
  - Operational autonomy weakened by central banks’ negative or insufficient capital and operational deficits; causes include quasi-fiscal activities and legacy banking crises.
  - Recapitalization mechanisms and plans vary: Guatemala has loss absorption mechanism since 2003; BCN law (2010) mandates government recapitalization during 2011; Dominican Republic implementing a recapitalization plan; Costa Rica plan pending in Congress since 2007.
- Effectiveness of the policy instrument:
  - Central banks rely on rules-based instruments and open market-type operations but money markets are underdeveloped.
  - All use reserve requirements, standing facilities, and auctions of central bank securities; except Nicaragua, all have explicit policy rates.
  - Signaling of policy stance hindered by structural liquidity surplus and shallow interbank markets.
  - Recent operational improvements: Banguat introduced an overnight rate with a one-day instrument as operational target in June 2011; BCRD and BCCR use lending/deposit facilities to establish rate corridors; BCRD narrowing corridor; BCCR plans to do so.
  - Transmission to lending rates weakened by low exchange rate flexibility and dollarization; deposit dollarization ratios have not declined substantially since 2008.
  - Need to improve liquidity forecasting to tackle excess bank liquidity.
- Other elements:
  - Financial sectors dominated by banks; concentration high (especially Nicaragua and Dominican Republic); banking sector adequately capitalized and liquid with non-performing loans in 2–4 percent range.
  - Capital markets dominated by government or central bank paper; secondary markets limited; few benchmark yield curves; Costa Rica has the most significant private securities market (but still small).
  - Inflation forecasting capacity varies: BCCR, BCRD, and Banguat stronger; BCN and BCH have only basic models.
  - Transparency and accountability: most central banks report annually to Congress and publish audited statements; Banguat publishes minutes and governor appears twice a year before Congress; Honduras publishes only one monetary policy report annually.

### Index to measure the strength of monetary policy frameworks in CADR
- Index construction:
  - Five main criteria: (1) central bank’s main policy objective; (2) absence of fiscal dominance; (3) central bank independence; (4) control over policy instrument; (5) transparency and accountability.
  - Twelve sub-criteria mapped to scale 0 to 1 (higher = better), assessed using legal and de facto indicators.
  - Overall index is a weighted average of the five criteria; detailed structure and scores in Appendix III.
  - Formula: Total index = 0.30*(1)+0.25*(2)+0.20*(3)+0.20*(4)+0.05*(5)
- Index results (Table 2 values preserved):
  - Total index (by country):
    - Costa Rica: 0.53
    - Dominican Republic: 0.53
    - Guatemala: 0.67
    - Honduras: 0.41
    - Nicaragua: 0.29
    - CADR Avg.: 0.48
    - Chile (benchmark): 0.96
  - Sub-criteria scores (by criterion and country):
    - (1) Central bank main policy objective:
      - Costa Rica: 0.30
      - Dominican Republic: 0.45
      - Guatemala: 0.30
      - Honduras: 0.73
      - Nicaragua: 0.30
      - CADR Avg.: 0.35
      - Chile: 0.43
      - Benchmark: 1.00
    - (2) Absence of fiscal dominance:
      - Costa Rica: 0.25
      - Dominican Republic: 0.61
      - Guatemala: 0.80
      - Honduras: 0.80
      - Nicaragua: 0.35
      - CADR Avg.: 0.15
      - Chile: 0.54
      - Benchmark: 1.00
    - (3) Central bank independence:
      - Costa Rica: 0.20
      - Dominican Republic: 0.62
      - Guatemala: 0.47
      - Honduras: 0.54
      - Nicaragua: 0.57
      - CADR Avg.: 0.44
      - Chile: 0.53
      - Benchmark: 0.82
    - (4) Effectiveness of the policy instrument:
      - Costa Rica: 0.20
      - Dominican Republic: 0.40
      - Guatemala: 0.50
      - Honduras: 0.50
      - Nicaragua: 0.40
      - CADR Avg.: 0.15
      - Chile: 0.39
      - Benchmark: 1.00
    - (5) Transparency and accountability:
      - Costa Rica: 0.05
      - Dominican Republic: 0.71
      - Guatemala: 0.83
      - Honduras: 0.83
      - Nicaragua: 0.71
      - CADR Avg.: 0.58
      - Chile: 0.73
      - Benchmark: 1.00
- Interpretation:
  - Guatemala scores highest in the region; Costa Rica and Dominican Republic are above the CADR average.
  - All CADR countries remain significantly below Chile.
  - Main weaknesses across CADR:
    - Establishing a clear mandate emphasizing price stability and increasing exchange rate flexibility.
    - Enhancing effectiveness of the policy instrument: increase signaling of policy rate, reduce reliance on rules-based instruments, and improve liquidity forecasting (especially Costa Rica, Honduras, Nicaragua).
    - Strengthening central bank independence: vary by country—strengthen balance sheets (Costa Rica, Honduras, Nicaragua), address board composition (Guatemala, Nicaragua), delink governor terms from political cycle (Dominican Republic).
    - Reducing fiscal dominance by trimming public debt ratios (Costa Rica, Nicaragua) and prohibiting central bank lending to government (Honduras, Nicaragua).
  - Transparency and accountability are relatively better but can be improved (e.g., publication of IFRS-compliant financial statements, enhanced reporting to Congress).

### Conclusions and policy recommendations
- Overall priority:
  - Strengthening monetary policy frameworks in CADR would reduce constraints to effective monetary policy and help achieve lower, more stable inflation.
- Key recommended reforms:
  - Increase exchange rate flexibility to reinforce price stability as the primary objective and avoid multiple-objective ambiguity; evidence from Peru and Uruguay shows some dollarized economies can increase flexibility while using FX intervention to dampen volatility in stress periods.
  - Enhance effectiveness of the policy instrument:
    - Improve signaling of the policy rate by removing structural excess liquidity through greater reliance on market-based operations.
    - Improve liquidity management: establish cash flow programs, introduce repos and reverse repos, fine-tune auctions, and promote interbank market development.
    - Maintain a role for rules-based instruments (e.g., reserve requirements) while expanding market operations.
    - Consider using higher reserve requirements on dollar deposits to reduce dollarization (as in Peru and Uruguay); this could be considered for Costa Rica, Guatemala, Nicaragua.
  - Preserve absence of fiscal dominance and enhance central bank independence:
    - Implement fiscal consolidation to stabilize/reduce public debt-to-GDP ratios.
    - Strengthen legislation to prohibit central bank financing of government (particularly Honduras, Nicaragua).
    - Tackle appointment/dismissal processes, board term overlaps with political cycles, and board composition; strengthen central bank balance sheets (Costa Rica, Honduras, Nicaragua).
  - Develop other supportive conditions:
    - Strengthen central banks’ technical capacity for inflation forecasting (requires technical assistance).
    - Improve transparency and accountability: publish quarterly monetary/inflation reports, disclose minutes of monetary policy decisions; Costa Rica to publish externally audited annual financial statements regularly.
  - Financial sector and market development (medium-term):
    - Enhance financial regulation and supervision to LA5 standards.
    - Standardize public debt issuance and establish benchmark government yield curves to foster corporate debt markets.
    - Deepen interbank markets (electronic book-entry systems, central securities depository) and develop domestic yield curves in local currency.
    - Consider pension system reforms to foster longer-term domestic investor base.

*Source: IMF Staff paper, “Index of Strength of Monetary Policy Framework” (content unit: 3. Index of Strength of Monetary Policy Framework).*

### Appendix I

### Appendix I

### Goal: Price stability as the main monetary policy objective
- Steps: Set out price stability as the main objective in Central Bank (CB) legislation. Shift focus from exchange rate stability or monetary aggregate if necessary.
- Chile
  - Pre- IT: Main goals were to encourage the orderly and progressive development of the national economy through credit and monetary policy, avoiding inflationary or depressive tendencies, and thus permitting the maximum use of the productive resources of the country.
  - Current: Since 1989, main objectives of the BCC law are to safeguard the stability of the currency and ensure the normal functioning of domestic and external payments. Since September 1999, the monetary policy regime is inflation targeting. The current annual inflation objective of 3.0 percent +/- 1 percent.
- Peru
  - Pre- IT: Main goals of the BCRP were to keep monetary stability, manage credit conditions, promote output and employment growth, and foster the development of the banking sector.
  - Current: Since 1993, law establishes as the main objective of the BCRP to preserve monetary stability. The objective of price stability was established as Board resolution and is not in the legislation. Since January 2002, the monetary policy regime is inflation targeting. The current annual inflation objective is 2.0 percent +/- 1 percent.
- Uruguay
  - Pre- IT: Main goals of the BCU were to ensure currency stability, ensure the normal operation of the internal and external payment system, keep an adequate level of international reserves, and promote the solvency and adequate operations of the domestic financial system.
  - Current: Since 2008, law established that the objective of the BCU is to seek price stability that is in line with growth and employment goals, and regulation and supervision of the payment system and financial sector. Since September 2007, the monetary policy regime is inflation targeting. The current inflation objective is a 4-6 percent range within an 18-month horizon.

### Goal: Absence of fiscal dominance
- Steps: Establish legal separation between money creation and government funding. Maintain sound fiscal position.
- Chile
  - Pre- IT: For several decades monetary policy subordinated to fiscal financing. An amended BCC charter in 1979 prohibited financing to the public sector.
  - Current: BCC cannot finance directly or indirectly the government, except in case of foreign war. Since 2000 the country adopted a structural balance rule. After a sizable fiscal stimulus in 2009, consolidated public sector turned into a structural deficit of 3 percent of GDP; gross public debt remained low at almost 28 percent of GDP. Current administration aims at a structural deficit of 1 percent of GDP by 2014.
- Peru
  - Pre- IT: Prior to 1993, the BCRP could finance the public sector to offset temporary mismatches; no limits to BCRP holdings of treasury bonds or other public sector financial instruments.
  - Current: BCRP is prohibited to grant credit to the government, except for purchase of Treasury securities in the secondary market, with a limit of 5 percent of the monetary base. Fiscal and transparency law enacted in 1999. In 2009 consolidated public sector balance turned into a deficit of 2 percent of GDP; public sector debt increased slightly to 27.4 percent of GDP.
- Uruguay
  - Pre- IT: Prior to 2008, the BCU could provide 6-month advances to the government, with a limit of 10 percent of preceding year’s non-interest budgetary expenditures; could also hold public sector securities with same 10 percent limit.
  - Current: From 2008, advances to the government are prohibited. BCU can provide credit to the public sector only through purchase of public sector securities by up to 10 percent of previous year’s non-interest budgetary expenditure. In 2009 public sector deficit widened slightly to 1.7 percent of GDP; public sector debt remained practically unchanged at 61 percent of GDP.

### Goal: Central bank independence, including instrument independence
- Steps: Strengthen CB balance sheet, review CB legislation, and protect CB governor’s job security.
- Chile
  - Pre- IT: Since foundation in 1925, BCC did not have instrument independence; 1975 charter created a monetary council dependent on Executive. After banking crisis of 1982, BCC’s balance sheet expanded and net worth remains negative.
  - Current: Independence protected by the Constitution and new charter (1989). Terms of governor and board do not overlap with presidential period; board members appointed for a 10-year period. Dismissal involves a double process. 2006 Fiscal Responsibility Law established mechanism for gradual recapitalization; between 2006 and 2008 government reduced estimated capital shortfall by about 0.5 percent of GDP. Net worth continues negative due to crisis costs and reserves accumulation: gross international reserves increased by US$16.7 billion between 1988-1997, representing 34 percent of the average GDP for the same period.
- Peru
  - Pre- IT: BCRP charter provided autonomy in conduct of monetary policy but was overruled by other laws. BCRP experienced substantial operational losses in 1987-1990 (on average 1.2 percent of GDP per year).
  - Current: Independence protected by the Constitution and new charter (1993). Tenure of governor and board overlaps with executive/legislative; renewal of seven board members coincides with electoral cycle. President nominates four board members (including governor) ratified by Congress; Congress nominates three board members. Dismissal foreseen only for serious crimes with prior approval by 2/3 of Congress. BCRP balance sheet strengthened in 1994 with recapitalization; since then BCRP has not experienced losses. Charter provides for transfer by the Treasury of marketable securities to keep capital integrity.
- Uruguay
  - Pre- IT: Legal foundation and constitution did not provide for monetary policy independence. 1995 charter had weaknesses: politically driven appointments, inappropriate conflict resolution, multiplicity of objectives. Executive could suspend BCU policy decisions; tenure overlaps with executive. Since foundation BCU experienced operating losses and no statutory recapitalization requirement.
  - Current: 2008 charter redefined objectives but did not provide more autonomy; executive’s right to suspend central bank decisions maintained. De facto autonomy greater than de jure. October 2010 government recapitalized the BCU with US$2.4 billion worth of government inflation-indexed bonds (equivalent to 6 percent of GDP): US$1.9 perpetual bond bearing a real interest of 3 percent, and a US$0.46 billion 30-year bond bearing a real interest rate of 3.5 percent. Given recapitalization modality, net worth continues to be negative under internationally accepted accounting standards.

### Goal: Exchange rate flexibility
- Steps: De facto exchange regime changes to move from fixed to float. Exchange rate must be subordinated to IT.
- Chile
  - Partial adoption of IT: In 1991 BCC adopted an exchange rate band regime with multiple modifications in the 1990s; active intervention and regulations to capital inflows.
  - Current: Since September 1999 BCC adopted full-fledged inflation targeting and a free floating exchange rate. Completely opened capital account and promoted foreign exchange derivative markets. Interventions have been infrequent and when implemented through a mechanical and predetermined process.
- Peru
  - Pre- IT: Early 1991 BCRP unified foreign exchange market, allowed exchange rate to float, and eliminated foreign exchange controls.
  - Current: Since 1991 BCRP has maintained a floating exchange rate regime with frequent central bank interventions.
- Uruguay
  - Pre- IT: Until 2002 BCU pursued a crawling band regime that was abandoned during the banking crisis.
  - Current: Since 2002 the CBU has maintained a floating exchange rate regime. The exchange rate has remained broadly stable but with interventions to smooth volatility.

### Goal: Effectiveness of the policy instrument and transmission mechanism
- Steps: Move from reliance on rules-based instruments to open market-type operations; reduce structural liquidity surplus; develop liquidity management and forecasting; intermediate targets progress to a short-term interest rate; reduce dollarization.
- Chile
  - Pre- IT: 1985-1995 operational target was real interest rate of a 90-day indexed BCC paper; 1995-July 2001 target became daily real interbank rate. Adopted open market instruments, auctions, repos/reverse repos, standing facilities. Reserve requirements not used actively.
  - Current: Monetary policy anchored to an annual inflation target and floating exchange regime. Since August 2001 operational target is the daily nominal interbank rate. Instruments include open market operations, repurchase and reverse repurchase operations, standing facilities, and reserve requirements (not used actively). Empirical estimates: monetary policy pass-through takes from 30-days to 3 years for demand and production, and four to eight quarters for inflation. Dollarization not critical: by end-2010 foreign denominated credit and deposits at 8 percent and 11.5 percent, respectively.
- Peru
  - Pre- IT: Informal monetary target regime (1991-2000) used monetary base growth as intermediate target. From 2001-2002 operational target changed to banks’ reserves. Moved to market-based instruments in early 1990s; reserve requirements on domestic currency reduced from close to 40 percent in 1990 to 6 percent in 2000.
  - Current: In 2002 BCRP switched to formal inflation targeting. BCRP announces annual end-year inflation target defined by changes in the CPI of Lima. Since 2003 operational target is the interbank rate; mostly relies on market-based instruments but still uses reserve requirements. Some evidence that since transition to IT, inflation response to interest rates increased while response to nominal exchange rate decreased. De-dollarization: credit dollarization declined by almost 30 percentage points between 2002 and 2010 and stood at about 50 percent in December 2010; deposit dollarization declined by about 25 percentage points and stood at 47 percent of total deposits in December 2010. Prudential measures include higher reserve and liquidity requirements for foreign currency deposits, higher provisioning requirements for credit in foreign currency, and stricter limits on banks’ net open foreign position.
- Uruguay
  - Pre- IT: After 2002 crisis initially adopted quarterly monetary base targets; in 2004 moved to target a range for monetary base growth and started announcing a target for annual inflation. Late 2004 adopted M1 growth as intermediate target and monetary base as operating target (not announced). Reserve requirements and BCU notes used actively to drain excess liquidity.
  - Current: Since late 2007 BCU signals policy stance with a monetary policy rate and adopted as operational target a daily market interest rate (average of interbank rate and rates of repo and CD operations). Relies on market-based instruments including central bank letters (maturities from 30-days to 3 years), certificates of deposits (1-30 day), and repos; standing facilities established. Uses differentiated reserve requirements by maturity and currency. Understanding transmission mechanisms and enhancing effectiveness are high priorities in BCU’s strategic plan 2010-14. Financial dollarization remains high: by end-2010 foreign-denominated credit and deposits reached 55 percent and 72 percent, respectively. Regulatory steps to discourage dollarization include limits on net open foreign currency positions, higher capital requirements for foreign currency loans, higher reserve and liquidity requirements on foreign currency deposits, and tighter loan classifications for foreign currency loans.

### Goal: Reasonably well-developed and diversified financial markets; low bank concentration; stable financial system
- Steps: Expand bank credit and competition; develop payment & settlement systems; develop interbank, secondary government debt, and FX markets; strengthen surveillance; deal with insolvent banks; develop deposit insurance.
- Chile
  - Current: Comprehensive banking reform in 1986 after 1982-85 crisis: partial deposit insurance, strict loan provisioning monitoring, centralized debtor risk information, limits to related-lending, portfolio restrictions. Banking sector sound with adequate capitalization and liquidity. As of June 2011 non-performing loans 2.5 percent of total loans; capital adequacy 13.8 percent. Financial market assets accounted for about 225 percent of GDP in 2009. RTGS system established in early 2004 administered by BCC.
- Peru
  - Current: Financial system strengthened via prudential upgrades and macro stability. December 2010 non-performing loans 1.5 percent; capital adequacy ratio 13.7 percent. Financial system assets about 42 percent of GDP in 2010. Banking system concentrated by regional standards. RTGS system established in 2000. Process to merge stock exchanges of Peru, Colombia and Chile initiated in 2011.
- Uruguay
  - Current: Post-2002 crisis regulatory updates improved reporting standards, solvency, loan classification, provisioning, concentration limits, liquidity, risk management, corporate governance, and licensing. Non-performing loans 1.2 percent in September 2010; capital adequacy ratio 17 percent. Financial system dominated by banks; credit to non-financial private sector about 24 percent of GDP in 2010. BCU focused on developing fixed-rate local currency securities markets, building a yield curve up to 3 years. Laws approved: bankruptcy in 2008, capital markets in 2009, payment system in 2010.

### Goal: Reasonable methodology for inflation forecasting
- Steps: Develop technical capacity, data availability, models, surveys, and judgment.
- Chile
  - Current: BCC developed multiple models: (i) time series for short-term forecasts; (ii) structural quarterly forecasting model with five major blocks (short-term curve, aggregate demand/IS curve, monetary policy rule, yield curve, interest rate parity condition); and (iii) DSGE model with heterogeneous agents and nominal and real rigidities. BCC conducts a monthly survey of private sector expectations including inflation and discloses it on the website.
- Peru
  - Current: BCRP developed (i) semi-structural quarterly forecasting model with four blocks (Phillips curve, IS curve, exchange rate equation, monetary policy rule); (ii) a DSGE model; and (iii) VAR type models for short-run forecasts. BCRP undertakes a monthly survey of macroeconomic expectations including inflation and discloses results on its website.
- Uruguay
  - Current: BCU developed VAR type models for short-run forecasts and a quarterly macroeconomic model with four blocks (aggregate supply; aggregate demand; nominal block for prices, exchange rate, wages; block for interest rates). BCU conducts a monthly survey of macroeconomic expectations including inflation and discloses results on its website.

### Goal: Accountability and transparency of the central bank
- Steps: Publish regular CB reports, monetary data, and CB inflation forecasts.
- Chile
  - Current: BCC informs the president and appears before Congress four times a year. Publishes quarterly monetary policy report, twice a year a comprehensive financial stability report, and once a year a reserve management report. Regularly publishes extensive monetary and economic data. Discloses a communiqué following monthly Council meetings, posts policy decisions, publishes minutes of policy meetings and voting patterns. Prepares financial statements audited by an external firm; report submitted to the minister of finance and the Senate before end-April each year.
- Peru
  - Current: Constitution requires BCRP to inform the country punctually and periodically of the status of national finances. Board submits report to the minister of economy and finance. Publishes a quarterly inflation report and a financial stability report once or twice a year. Regularly publishes extensive monetary and economic data and daily information about foreign exchange intervention. After board approval publishes financial statements in the official gazette; publishes a monthly summary of its balance sheet in the official gazette. BCRP does not publish minutes of policy meetings but discloses a communiqué following monthly board meetings and posts it on the website.
- Uruguay
  - Current: BCU presents annual financial report to the executive. Publishes quarterly a monetary policy report and a financial stability report. Publishes comprehensive monetary and economic information on its website. Prepares financial statements audited by an external firm and makes them publicly available on its website. Discloses a communiqué following the quarterly meeting of the monetary policy committee and posts it on the website.

*Sources: Websites of the Central banks of Chile, Peru and Uruguay; publications of central banks of Chile, Peru and Uruguay; and IMF country reports.*

### Appendix II

### Appendix II: The Monetary Policy Framework in CADR Countries

### Goal: Price stability as the main monetary policy objective*
- Costa Rica
  - Primary objective of the Central Bank of Costa Rica (the BCCR): maintain internal and external stability of the national currency and ensure its convertibility (Organic Law). Secondary objectives: promote orderly development of the national economy to achieve full use of productive resources, avoid inflationary or deflationary tendencies.
  - Monetary policy framework: transitioning to inflation targeting within an exchange rate band.
  - Inflation objectives: end-2011: 5.0+/-1 percent; end-2012: 4.0+/-1 percent.
- Dominican Republic
  - Legislation establishes price stability as the main objective for the Central Bank of the Dominican Republic (BCRD).
  - Monetary policy framework: no explicitly stated nominal anchor; monitors various indicators including the exchange rate. Authorities plan to move to IT in 2012.
  - Inflation targets: end-2011: 5-6 percent; end-2012 and beyond: 4-5 percent.
- Guatemala
  - Fundamental objective of Banguat: help create favorable conditions for orderly development of the economy and promote monetary, exchange, and credit conditions conducive to price stability (Organic Law).
  - Monetary policy regime: inflation targeting.
  - Inflation objectives: end-2011: 5.0 percent +/- 1 percent; end-2012: 4.5 percent +/- 1 percent; over a three-year convergence period: 4 percent +/- 1 percent.
- Honduras
  - BCH main objectives: preserve the internal and external value of the domestic currency and promote normal functioning of the payments system.
  - Monetary policy regime: exchange rate anchor to the U.S. dollar.
- Nicaragua
  - BCN primary objective: stability of the national currency and normal functioning of internal and external payments.
  - Monetary policy regime: exchange rate anchor to the US dollar.

### Goal: Absence of fiscal dominance*
- Costa Rica
  - BCCR not allowed to provide credit to the government. Allowed to buy treasury bills in the primary market at a market rate if proceeds are not used for refinancing BCCR portfolio treasury bills.
  - Balance of treasury bills in BCCR portfolio cannot exceed 1/20 of government’s expenditure.
  - Public sector debt increased with the global crisis, reaching 39 percent of GDP in 2010.
- Dominican Republic
  - Law prohibits financing the government except under emergency procedures.
  - After fiscal expansion in 2009, gross public debt peaked at almost 42 percent of GDP; gradual fiscal consolidation started in 2010 under an IMF program and is expected to continue in 2011 and 2012.
- Guatemala
  - Banguat not permitted directly or indirectly to provide credit to the government (constitutional mandate), except under emergency conditions.
  - Public sector debt reached 24 percent of GDP in 2010. Projected to increase over the medium term in absence of comprehensive tax reform.
- Honduras
  - BCH cannot provide credit directly or indirectly to the government except under emergency conditions; can buy public securities only in the secondary market.
  - BCH can provide a 6-month overdraft facility to the government to manage seasonal liquidity shortages, with a limit of 10 percent of preceding year’s tax revenue.
  - BCH law has been overruled on three occasions in the past two years.
- Nicaragua
  - BCN cannot provide credit directly or indirectly to the government; can provide short-term advances in exchange for treasury bonds of up to 10 percent of the average tax revenues recorded in the previous two fiscal years.
  - IMF staff projects public debt will continue increasing over the medium term following improvements in tax administration and adherence to tax measures.
  - Public sector debt was 80 percent in 2010; policies aim to bring public debt ratio to 66 percent by 2014.
  - Fiscal consolidation started in 2010 with goal to bring fiscal deficit to about 2 percent of GDP by 2012 (context indicates Costa Rica here; note Nicaragua: following improvements revenue performance improved and fiscal deficit started to fall in 2010).

### Goal: Central Bank (CB) independence, including instrument independence*
- Costa Rica
  - Board of Directors (BoD) formulates and conducts monetary, exchange rate, and credit policies and has instrument independence; meets weekly with no predetermined calendar for policy rate decisions.
  - BoD composition: seven members including the Governor, the minister of finance, and five others.
  - Governor appointment: by the Governing Council chaired by the President for 4 years coinciding with presidential term; 5 other members appointed for 90 months and ratified by Congress.
  - Governor can be freely removed by Governing Council; other 5 members removable only for legal reasons.
  - No legal provision requiring government to compensate BCCR losses. Negative capital position exceeded 7 percent of GDP as of end-2010. Recapitalization bill submitted in 2007 not approved.
- Dominican Republic
  - BCRD has functional and legal autonomy; governor appointed by the president for two-year terms (draft law under consideration would allow four-year non-overlapping terms).
  - Monetary Board main members: governor, minister of finance, superintendent of banks.
  - Central bank debt from 2003-2005 banking crisis: 11 percent of GDP in 2010.
  - Plan for recapitalizing BCRD involves annual transfers from the treasury to the BCRD.
- Guatemala
  - Banguat has de jure instrument independence. Monetary Board meets about eight times a year on a predetermined published calendar.
  - Governor appointed by the president for four years; term does not coincide with president. Governor removable only for legal reasons, but Congress can fire him if annual report deemed unsatisfactory.
  - Monetary Board composition undermines independence: nine members including ministers, representatives of Congress, university, banking association, and private entrepreneurs.
  - Banguat obliged to inform MoF if it incurs operational deficits; since 2003 deficits must be absorbed by general reserve account or incorporated into next year’s budget to be covered by government securities.
  - Operating deficit was 0.2 percent of GDP in 2010; half to be covered by government securities at below-market rates. Total accumulated losses were 4.6 percent of GDP as of end-2010.
- Honduras
  - BCH has de jure instrument independence. BCH board comprised of five members including its president, appointed by the President for four years; terms of two members overlap with the President.
  - Board members can be dismissed following an investigation by executive branch on legal grounds established in the BCH charter.
  - BCH charter requires government assumes central bank losses; non-market terms and conditions of bonds received have not preserved BCH capital integrity.
  - 2010 BCH losses were 0.2 percent of GDP; cumulative losses about 3.0 percent of GDP by end-2010.
- Nicaragua
  - BCN has de jure instrument independence but high quasi-fiscal losses weaken financial position and capacity for independent policy.
  - Board of Directors comprises six members including the president and the minister of finance; appointments by the president require ratification by Congress for five-year terms under the new BCN law (2010).
  - New BCN law (2010) establishes that in 2011 the government and BCN will agree on recapitalization options with market yielding government bonds.
  - Central bank deficit was 0.9 percent of GDP in 2010, down from 1.2 percent of GDP in 2009.

### Goal: Exchange rate flexibility*
- Costa Rica
  - IMF de facto exchange rate classification: other managed arrangement (crawling band with flat floor and preannounced daily devaluation rate for ceiling). Band width exceeds 30 percent of the floor value.
  - BCCR interventions: (i) buy currency at request of nonfinancial public sector, (ii) defend band, (iii) smooth fluctuations within band, (iv) accumulate international reserves.
  - September 2010: BCCR launched a 16-month US$600 million purchase program.
  - Exchange rate stands very close to the floor of the intervention band forcing BCCR to intervene. In practice, exchange rate is not subordinate to inflation targets.
- Dominican Republic
  - De jure regime: managed float; in practice exchange rate is a key anchor and tightly managed with discretionary intervention.
  - IMF de facto classification: stabilized arrangement.
  - Commitment to further exchange rate flexibility in the Fund program.
- Guatemala
  - IMF de facto classification: floating exchange rate regime.
  - Banguat intervenes to tame volatility according to a public rule: can be up to US$32 million a day if exchange rate deviates by more than 0.6 percent from its five-day moving average.
  - Discretionary intervention possible; exchange rate is subordinated to IT.
- Honduras
  - IMF de facto classification: stabilized arrangement.
  - BCH satisfies every admissible bid at a daily foreign exchange auction, pegging exchange rate at the reference rate.
  - De jure: crawling band since 1994; band width could stretch to 7 percent on either side of central parity; central parity defined by difference between domestic inflation and that of main trading partners.
  - Foreign exchange system built on general surrender requirement of foreign currency with exceptions (maquila exports and CAFTA exports).
- Nicaragua
  - De jure and IMF de facto exchange rate arrangement: crawling peg.
  - Exchange rate determined by market supply and demand; BCN may intervene.
  - Official exchange rate determined and preannounced by BCN; exchange rate against the dollar depreciates 5 percent a year.
  - BCN charges a commission of 1 percent on the sale of foreign exchange. No foreign currency surrender requirement.

### Goal: Effectiveness of the policy instrument and interest-rate transmission
- Costa Rica
  - Monetary policy rate defined as center of a corridor for short-term interest rates; floor and ceiling correspond to BCCR overnight deposit and lending rates.
  - Uses discretionary auctions for liquidity injection and withdrawal for 1, 7 and 14 days.
  - Reserve requirements on deposits in domestic and foreign currency with average provisions: 15 percent regardless of currency.
  - Open market-type operations: auctions of BCCR zero-coupon bonds at 12 months maturity and coupon bonds at 3 and 5 years maturity.
  - Weaknesses: low exchange rate flexibility, financial dollarization, undeveloped financial markets undermine interest-rate transmission; crawling band makes liquidity endogenous and complicates liquidity forecasting.
  - Liquidity forecasts prepared every two weeks.
  - Dollarization: deposits pre-crisis level; credit dollarization resumed downward trend; as of December 2010 credit dollarization about 38.6 percent of banks and other depository institutions.
- Dominican Republic
  - Uses indirect instruments and an overnight policy rate with a corridor via short-term deposit and overnight lending facilities.
  - Open market-type operations using own paper: treasury bills maturities 28-308 days; bonds 1 to 5 years.
  - Reserve requirements: local currency - banks 17 percent, other financial institutions 12.5 percent; foreign currency - 20 percent for all financial institutions.
  - Dollarization of bank deposits: 28.4 percent as of December 2010.
  - Structural liquidity surplus has affected monetary policy power; liquidity management and forecasting done on a weekly scale.
- Guatemala
  - Policy rate is operational target; June 2011 adopted overnight rate with one-day instruments; two standing facilities at punitive rates for liquidity withdrawal/injection.
  - Reserve requirements: 14.6 percent on both foreign and local currency deposits.
  - Open market operations: certificates of deposit from 3 months to 8 years; medium-term plan to undertake open-market operations with Treasury bonds on secondary market.
  - Interest-rate transmission weak due to excess liquidity, undeveloped capital markets, low exchange flexibility, and dollarization.
  - Liquidity forecasting conducted daily; forecasts for at least one month will be necessary with overnight rate adoption.
  - Dollarization of deposits and credit: domestic figures indicate declines; by December 2010 dollarization of deposits 29 percent and of credit 24 percent (context indicates for BCH; for Guatemala earlier: dollarization noted as an issue).
- Honduras
  - Instruments: reserve requirements (6 percent unremunerated domestic currency, 12 percent foreign currency); 12 percent mandatory remunerated investments domestic, 10 percent foreign; weekly auctions of central bank paper (28 to 360 days zero coupon for structural liquidity; 7-day for short-term); overnight deposit and credit facilities using central bank securities as collateral.
  - Announces a monetary policy rate. Intermediate targets: net international reserves and net domestic assets.
  - Weaknesses: lack of exchange rate flexibility and structural excess liquidity undermine effectiveness.
  - Liquidity forecasting system weak; short-term forecasting model used previously was ill-suited, causing over/under allocations in weekly liquidity operations.
  - Dollarization: deposits 29 percent and credit 24 percent as of December 2010 (note: figures appear in context of regional comparisons).
- Nicaragua
  - Operations geared to support crawling peg: weekly auctions of BCN paper and dollar letras (maturities 30 days to 10 months); lending facilities: (a) overnight facility, (b) report facility for credit to banks and financial institutions, (c) financial assistance facility up to 30 days (rarely used); reserve requirements 16.25 percent on deposits in domestic and foreign currencies.
  - Under financial programming final objective is inflation; intermediate target is net international reserves.
  - Transmission channels weak due to shallow markets, low exchange rate flexibility, high dollarization, and high concentration of bank assets.
  - Deposit dollarization very high: 73 percent of total bank deposits at end-December 2010.
  - BCN carries out monthly liquidity forecasting after seasonal adjustments and plans open market operations to observe its international reserves target.
  - Nonperforming loans were 3 percent of total loans in December 2010; banking liquidity buffers adequate; recent improvements in regulation and supervision.

### Goal: Reasonably well-developed and diversified financial markets; low bank concentration; reasonably stable financial system
- Costa Rica
  - Capital markets small but relatively developed: corporate debt market, securities market, mutual fund industry present. Most trading volume from repos on government bonds.
  - Corporate issuance hampered by absence of a government benchmark yield curve due to fragmentation of sovereign debt between central bank and ministry of finance and non-standardized issuance.
  - Financial sector dominated by state-owned banks, though private financial groups growing. Banking sector sound with adequate capitalization and liquidity.
  - Nonperforming loans below 2 percent of total loans as of December 2010 and more than fully provisioned.
  - Bank concentration moderate for Central America, higher than most of LA5.
  - Supervision lags international best practices in some aspects; bills on consolidated supervision, deposit insurance, and resolution framework submitted to legislature in 2007 and 2010 not yet approved.
- Dominican Republic
  - Banking market relatively well developed but high bank concentration. Interbank money market exists but shallow. FX markets dominated by central bank intervention.
  - Local bond markets dominated by central bank bonds though treasury bonds have become important in last two years.
  - Real-time payments and clearance system recently introduced.
  - Progress in custodial arrangements: central bank began issuing dematerialized bonds in December 2010; CEVALDOM strengthening arrangements and establishing links with Clearstream.
  - Financial sector surveillance improved considerably since 2003; banking sector adequately capitalized and liquid. NPLs ratio 3.4 percent as of September 2010. Deposit insurance exists.
- Guatemala
  - Capital markets underdeveloped; mainly public debt securities and repos. Secondary government debt market small; term structure fragmented; yield curve does not reflect market conditions.
  - Need for standardization and de-materialization of public securities; new securities law being drafted to establish a single securities regulator; lack of central depository.
  - Financial depth (bank credit to private sector) compares well regionally. Financial sector generally sound: capitalization and liquidity healthy. NPLs 2.1 percent of total loans in December 2010.
  - Regulatory progress: new regulations on liquidity and foreign currency credit risk management; full provisioning of NPLs except two small banks (<2 percent of system). Amendments to banking law (submitted June 2009) not yet approved; deposit insurance scheme exists.
- Honduras
  - Bank concentration among lowest in the region and Latin America. Local capital market small and disconnected from global markets; securities mainly BCH paper and government debt.
  - High centralization of FX flows at central bank and surrender requirements prevented FX interbank market development.
  - Financial system reasonable stable. Strengthened financial safety net: replaced blanket guarantee with limited deposit insurance and strengthened bank resolution framework. Deposit insurance fund needs recapitalization.
  - Regulatory improvements: adoption of new regulations on liquidity and FX credit risk; bankruptcy framework and corporate governance need strengthening.
- Nicaragua
  - Financial system highly concentrated and dominated by regional banking groups. Banking system has adequate liquidity buffers; bank profitability recovering.
  - Nonperforming loans 4.3 percent of total loans by end-December 2010.
  - Progress in bank regulation and risk-based supervision. Need for RTGS, central security depository, improved corporate governance code, and strengthened bankruptcy framework.
  - Financial sector surveillance being strengthened towards risk-based supervision, enforcement of capital charges and provisioning, and consolidated supervision.

### Goal: Reasonable methodology for inflation forecasting
- Costa Rica
  - Technical capacity of BCCR good. Uses several models: univariate, VAR, factor, and pass-through models; forecasts linearly combined.
  - Developed a semi-structural macroeconomic model and publishes research on inflation dynamics and expectations.
  - Conducts a monthly survey of inflation expectations of private sector experts and discloses it on the website.
- Dominican Republic
  - BCRD strengthened technical capacity; portfolio of inflation forecasting models and a small-scale macroeconomic model. Received technical assistance from several central banks including Bank of Chile.
  - Monthly survey of inflation expectations exists and is shared with participants but not published on the website.
- Guatemala
  - Overall technical capacity good; received IMF technical assistance for inflation forecasting.
  - Banguat has a medium-term inflation forecasting model (semi-structural macroeconomic model) and forecasts year-end inflation including core for current and following year.
  - Uses a modified Taylor rule for interest rates.
  - Conducts and publishes a monthly survey of inflation expectations of private analysts.
- Honduras
  - BCH uses a simple econometric (VEC) model for short-term inflation forecasting.
  - Additional technical capacity needed. No survey of inflation expectations.
- Nicaragua
  - Capacity to model inflation needs strengthening. So far central bank has used ad-hoc models and received TA on modeling inflation.
  - No survey on inflation expectations. The crawling peg provides a strong anchor for inflation expectations.

### Goal: Accountability and transparency of the Central Bank
- Costa Rica
  - BCCR publishes externally audited financial statements.
  - January: publishes annual macroeconomic program with inflation forecast and monetary policy objectives.
  - Within 30 calendar days of each semester: publishes a report on program implementation and modifications.
  - Publishes a monthly statistical summary and twice-yearly inflation report. Website contains detailed monetary, financial, real, and external sector data.
  - Board of Directors decisions on exchange rate regime, interest rates, and minimum reserve requirements published; minutes not published. No legal provision for Governor to appear in Congress regularly, though Governor must inform Congress about BCCR operations with treasury bills in primary market and use of nonconventional monetary instruments.
- Dominican Republic
  - Publishes annual financial statements audited internally and externally.
  - BCRD publishes a monthly statement explaining policy meeting decisions; does not publish minutes or details of inflation forecasts.
  - Publishes yearly monetary program with inflation forecast, quarterly updates, quarterly economic reports, and extensive monetary and economic data on its website.
  - BCRD governor must report annually to Congress.
- Guatemala
  - Banguat publishes annual financial statements audited internally and externally.
  - Extensive data and information on website including monthly monetary and economic data.
  - Annual report published in December and two other reports during the year, all containing inflation forecast and describing monetary policy objectives.
  - Minutes of policy rate meetings published 30 days after meetings. Meetings convened with press and academia following policy rate meeting; press statement and power point released.
  - Head of central bank must appear twice a year in Congress to report on implemented policies and objectives.
- Honduras
  - BCH publishes externally audited financial statements annually on its website.
  - BCH publishes an annual monetary program with macroeconomic projections including inflation for current and following year.
  - Publishes extensive monthly monetary and economic data; information on monetary policy more limited.
  - Publishes press release following policy rate decisions but not minutes; does not prepare an inflation report.
  - Law stipulates the board will report to Congress once a year and twice to the executive branch (minister of finance).
- Nicaragua
  - Central bank publishes externally audited annual financial statements.
  - BCN releases a report quarterly with a six- to eight-week lag monitoring the monetary program. Does not publish an inflation forecast.
  - BCN publishes decisions on monetary policy but not minutes of discussions. Governor reports annually to the president; no legal provision for appearance before Congress.
  - High-frequency data (daily, weekly, monthly, annual) published on central bank website covering economic, fiscal, debt, balance of payments, monetary and financial statistics.

* A survey of studies on the adoption of IT frameworks reveals the first three conditions (in bold above) should be met prior to the adoption of IT in emerging markets. Some degree of exchange rate flexibility is also needed at the outset of IT; most other conditions can be developed afterwards.

*Sources: IMF desk economists, central bank websites, and Jácome and Parrado (2007).*

### Appendix III

### Appendix III — Strength of Monetary Policy Index

### Central bank main policy objective (weight 0.30)
- Country value vector (CR I, DOM, GTM, HND, NIC, CHL): 0.45, 0.30, 0.73, 0.30, 0.35, 1.00

Subcriteria (weights in brackets where shown)
- 1. Clear mandate on price stability (0.5)
  - Price stability primary objective, average inflation < 5%: 1.00, 1.00
  - Price stability primary objective, average inflation < 10%: 0.75, 0.75
  - Price stability and other objectives, average inflation < 10%: 0.50, 0.50, 0.50, 0.50
  - Price stability and other objectives, avg. inflation between (10-20%): 0.40, 0.40
  - Objectives do not include price stability, average inflation > 20%: 0.00

- 2. Exchange rate flexibility (0.5)
  - Free floating: 1.00, 1.00
  - Floating: 0.70, 0.70
  - Other managed arrangement: 0.50, 0.50
  - Crawling peg: 0.20, 0.20
  - Stabilized arrangements: 0.10, 0.10, 0.10

Notes
- Footnote 1/: Average inflation during 2005-10.
- Footnote 2/: IMF de facto classification of exchange rate arrangements, 2010.

### Absence of fiscal dominance (weight 0.25)
- Country value vector (CR I, DOM, GTM, HND, NIC, CHL): 0.61, 0.80, 0.80, 0.35, 0.15, 1.00

Subcriteria (weights in brackets where shown)
- 3. Central bank lending or advances to the government (0.6)
  - Advances, direct or indirect lending prohibited, except in secondary markets for monetary policy purposes: 1.00, 1.00, 1.00, 1.00
  - Permitted to buy government securities in primary market, but effectively not done: 0.85, 0.85
  - Permitted to buy government securities in primary market: 0.50
  - Permitted to provide government advance within limits: 0.25, 0.25, 0.25
  - Allowed without limits: 0.00

- 4. Public debt to GDP ratios (0.4)
  - Less than 10 percent: 1.00, 1.00
  - Less than 20 percent: 0.75
  - Less than 30 percent: 0.50, 0.50, 0.50, 0.50
  - Less than 40 percent: 0.25, 0.25
  - More than 40 percent: 0.00, 0.00

### Central bank independence (weight 0.20)
- Country value vector (CR I, DOM, GTM, HND, NIC, CHL): 0.62, 0.47, 0.54, 0.57, 0.44, 0.82

Subcriteria (weights in brackets where shown)
- 5. Who appoints/dismiss the Governor/Board (0.30)
  - Double process (Executive/Legislative): 1.00, 1.00, 1.00
  - The Executive branch appoints: 0.50, 0.50, 0.50, 0.50, 0.50

- 6. Term of office of Governor (0.20)
  - Do not overlap with presidential period: 1.00, 1.00, 1.00
  - Overlap with the presidential term: 0.66, 0.66, 0.66, 0.66
  - Less than the presidential period: 0.33, 0.33

- 7. Composition of the Board (0.20)
  - Independent professionals: 1.00, 1.00, 1.00
  - Includes members of the executive branch: 0.66, 0.66, 0.66
  - Includes members of the executive branch and private interest groups: 0.33, 0.33, 0.33

- 8. Central bank capital (0.30)
  - Government should maintain capital integrity, legal provisions in place, and balance sheet healthy: 1.00
  - Government should maintain capital integrity, legal provisions in place, but still weak balance sheet: 0.40, 0.40, 0.40, 0.40
  - Government should maintain capital integrity, legal provisions in place but not effective, and weak balance sheet: 0.30, 0.30, 0.30
  - No legal provisions in place, and weak balance sheet: 0.20, 0.20

### Effectiveness of the policy instrument (weight 0.20)
- Country value vector (CR I, DOM, GTM, HND, NIC, CHL): 0.40, 0.50, 0.50, 0.50, 0.40, 0.15, 1.00

Subcriteria (weights in brackets where shown)
- 9. Signaling effect of monetary policy rate (0.50)
  - High transmission of changes in policy rate over other rates: 1.00, 1.00
  - Low transmission due to excess liquidity, inoperative interbank market, high dollarization, etc.: 0.50, 0.50, 0.50, 0.50, 0.50
  - No policy rate in place: 0.00, 0.00

- 10. Degree of monetary instrument development (0.50)
  - Full reliance on money market-type instruments to regulate liquidity: 1.00, 1.00
  - Good liquidity forecasting and partial reliance on rules-based instruments and reliance on open market-type operations: 0.50, 0.50, 0.50
  - Deficient liquidity forecasting, reliance on rules-based instruments and partial reliance on open market-type operations: 0.30, 0.30, 0.30
  - Full reliance on rules-based instruments and deficient liquidity forecasting: 0.00

### Transparency and accountability (weight 0.05)
- Country value vector (CR I, DOM, GTM, HND, NIC, CHL): 0.71, 0.83, 0.83, 0.71, 0.58, 1.00

Subcriteria (weights in brackets where shown)
- 11. Publication of central bank financial statements (0.50)
  - Publishes detailed financial statements externally audited once a year, following International Financial Reporting Standards (IFRS): 1.00, 1.00
  - Publishes detailed financial statements externally audited once a year: 0.66, 0.66, 0.66, 0.66, 0.66, 0.66
  - Publishes detailed financial statements internally audited once a year: 0.33
  - Does not publish detailed financial statements: 0.00

- 12. Central bank reporting (0.50)
  - The central bank governor must appear in Congress to report on monetary policy, at least once a year: 1.00, 1.00, 1.00, 1.00
  - The central bank governor must report to the executive and congress, at least once a year: 0.75, 0.75, 0.75
  - Annual report to the executive: 0.50, 0.50
  - Issues annual report at specific time: 0.25

### Index of strength of monetary policy framework
- Country index values (CR I, DOM, GTM, HND, NIC, CHL): 0.53, 0.53, 0.67, 0.41, 0.29, 0.96

*Source: Information to assess the main criteria in Appendix II, The Monetary Policy Framework in CADR Countries.*

---


_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2011/_wp11245.pdf_