## Box 1. EAC4 – Exchange Rate Arrangements and the Capital Account

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### Exchange rate arrangements and capital account openness
- Kenya
  - Exchange rate arrangement classified as free floating.
  - Central Bank of Kenya (CBK) conducts official foreign exchange market interventions to moderate the rate of change of the exchange rate:
    - Through auctions (the average rate is published after the auction closes).
    - Through direct interventions in the dealing system (market informed but amounts and rates are not published).
  - Capital account is open.
  - Kenya classified as a Frontier Market.
- Uganda
  - Classified as a floating regime.
  - Bank of Uganda (BOU) intervenes to maintain stability:
    - Since 2010, BOU conducts daily purchases for reserve buildup and engages in targeted sales as necessary.
    - BOU publishes intervention information in monthly, quarterly and annual reports, including amounts purchased or sold through the reserve buildup program and targeted transactions.
  - There are no capital controls.
- Tanzania
  - Exchange rate arrangement officially classified as a floating regime for the period under consideration.
  - Bank of Tanzania (BOT) is the predominant supplier of foreign exchange in a shallow market, sterilizing liquidity generated by government spending financed by official inflows.
  - Objectives of intervention include smoothing short-term exchange rate volatility and maintaining an adequate level of international reserves.
  - BOT announces the amount to be sold in the market through the dealing system on a monthly basis.
  - Controls on capital account transactions are widespread and the capital account is de facto quite closed.
- Rwanda
  - Exchange rate regime classified as a crawl-like arrangement.
  - National Bank of Rwanda (NBR) sells foreign exchange directly to banks at their request at a price on the upper limit of the exchange rate corridor.
  - Interbank market operates over the counter and data on NBR interventions are not disclosed.
  - Restrictions to capital account transactions are not prevalent, but the absence of capital flows is consistent with the capital account being de facto closed.

### Definition note
- Frontier market: term describing small and illiquid markets at an earlier stage of economic and financial development than emerging markets; Kenya is included in investable indexes compiled by Standard & Poor’s, MSCI and FTSE.

### Monetary policy mandates and instruments (EAC4)
- Kenya
  - Mandate: Price stability; Exchange rate stability; Financial stability; Support of Government policy
  - Instruments: Open market operations, Repo operations, FX intervention, Rediscount policy, Reserve requirements, Policy rate, Moral suasion
- Uganda
  - Mandate: Price stability; Financial stability
  - Instruments: Policy rate, FX intervention, Open market operations, Rediscount policy
- Tanzania
  - Mandate: Price stability; Financial stability; Support of Government policy
  - Instruments: Open market operations, Repo operations, Rediscount policy, Policy rate, FX intervention, Moral suasion
- Rwanda
  - Mandate: Price stability; Financial stability; Support of Government policy
  - Instruments: Open market operations, Rediscount policy, Reserve requirements, Policy rate, FX intervention

*Source: _wp13197 - Box 1. EAC4 - Exchange Rate Arrangements and the Capital Account.*

### Box 1. EAC4 – Exchange Rate Arrangements and the Capital Account ........18

### Box 1. EAC4 – Exchange Rate Arrangements and the Capital Account

### Document context (lines provided)
- Box 1. EAC4 – Exchange Rate Arrangements and the Capital Account ........18
- Box 2. EAC4 – Monetary Policy Frameworks ................................................20 
- III. The Event Study .................................................................................................................21 
- A. The Run Up .............................................................................................................21 
- B. The Event ................................................................................................................27
- Box 3. An Overview of the Transmission Mechanisms of Monetary Policy ..29 
- IV. The Outcome .....................................................................................................................31 
- V. On The Role of Global Risk Appetite and Supply Shocks .................................................42 
- VI. Conclusions........................................................................................................................46

### Available content for this unit
- The only supplied text for this content unit is the box title as listed above: "Box 1. EAC4 – Exchange Rate Arrangements and the Capital Account ........18".
- No further substantive findings, data, projections, analysis, or policy recommendations from Box 1 were provided in the supplied content.

*Source: _wp13197 - Box 1. EAC4 – Exchange Rate Arrangements and the Capital Account ........18*

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

### References

### Tables and Figures Inventory
- Tables
  - Table 1. EAC4 - Selected Economic Indicators, 2011
  - Table 2. Economic Structure Indicators, 2011
  - Table 3. Selected Financial Sector Indicators, 2011
  - Table 4. EAC4 - Summary of Policy Regimes
  - Table 5. EAC4 - Monetary Policy Mandates and Instruments
  - Table 6. EAC4 - Monetary Policy Transmission Channels
- Figures
  - Figure 1. EAC4 - Financial Depth Indicators
  - Figure 2. EAC4 - Inflation (YoY, Percent)
  - Figure 3. EAC4 - Interbank Rates (Percent)
  - Figure 4. Uganda - Selected Interest Rates (Percent)
  - Figure 5. World Commodity Prices (Index, Jan=100)
  - Figure 6. EAC4 - Selected Economic Indicators (Part I)
  - Figure 7. Kenya - Selected Interest Rates (Percent)
  - Figure 8. Tanzania - Real Money Growth and Short-Term Interest Rates
  - Figure 9. Rwanda - Real Money Growth and Short-Term Interest Rates
  - Figure 10. A Basic Diagram of the Monetary Transmission Mechanism
  - Figure 11. EAC4 - Selected Economic Indicators (Part II)
  - Figure 12. EAC4 - Money Market Interest Rates (Percent)
  - Figure 13. EAC4 - Banking Interest Rates (Percent)
  - Figure 14. EAC4 - Real Interest Rates and the Output Gap (Percent)
  - Figure 15. EAC4 - Real Import Growth (YoY, Percent)
  - Figure 16. EAC4 - Non-Food Inflation and the Output Gap (Percent)
  - Figure 17. EAC4 - Interest Rates (Percent) and Exchange Rates
  - Figure 18. EAC4 - Headline Inflation and Exchange Rate Change (YoY, Percent)
  - Figure 19. EAC4 - Interest Rates and Credit Growth (Percent)
  - Figure 20. EAC4 - Excess Reserves (Percent of Required Reserves)
  - Figure 21. Emerging and Frontier Markets Exchange Rates, (Index)
  - Figure 22. VIX (Index) and EAC4 Exchange Rates
  - Figure 23. EAC4 - Headline and Core Inflation (YoY, Percent)

### I. Introduction — event, methodology, and core question
- Methodology
  - Applies the "narrative approach" (Romer and Romer (1989)) to identify monetary shocks using historical records and episodes of large shifts in monetary policy not driven by real developments.
  - Treats the late 2011 tightening of monetary policy in Kenya, Uganda, and Tanzania, and the different experience in Rwanda, as a "natural experiment."
- Event
  - Central bank Governors from the EAC4 met in October 2011 and decided on strong monetary policy action to stem high and rising inflation.
  - The tightening followed persistent commodity price shocks (food and energy) in 2007–2008 and again in 2010–2011.
- Core question
  - How does monetary policy transmit to activity and prices in low-income countries (LICs) in Sub-Saharan Africa?
- Key inference from the event study
  - After a large policy-induced rise in the short-term interest rate:
    - lending and other interest rates rise,
    - the exchange rate tends to appreciate,
    - output tends to fall,
    - inflation declines.
  - Clearest transmission observed in Uganda; effective transmission in Kenya after signaling reforms; weaker lending-rate transmission in Tanzania and Rwanda.

### II. Stylized facts and context
- Common characteristics of the EAC4 (Kenya, Uganda, Tanzania, Rwanda)
  - Representative of Sub-Saharan Africa LICs: low trade shares, commodity exports, high though falling aid dependence, service-sector-led growth, large agricultural sector and rural population.
  - Two major world commodity price surges: first peak food prices up 44 percent at 2008Q1; second surge in 2010-2011 more persistent.
  - Financial systems: small, concentrated, bank-dominated, large informal sector, shallow capital markets (except Kenya), short yield curves (except Kenya and more recently Uganda), substantial dollarization.
  - Rapid financial deepening in recent years (e.g., rising private credit to GDP, rising financial access).

### III. Structure of the economy and key statistics (Table 1 and Table 2)
- Table 1. EAC4 - Selected Economic Indicators, 2011
  - Kenya: Nominal GDP (USD Billions) 34; Population (Millions) 42; Real GDP Per Capita (USD, PPP) 476; Average Real GDP Growth (Percent, 2001-2011) 4.2
  - Uganda: Nominal GDP (USD Billions) 17; Population (Millions) 35; Real GDP Per Capita (USD, PPP) 374; Average Real GDP Growth (Percent, 2001-2011) 7.3
  - Tanzania: Nominal GDP (USD Billions) 24; Population (Millions) 46; Real GDP Per Capita (USD, PPP) 460; Average Real GDP Growth (Percent, 2001-2011) 6.9
  - Rwanda: Nominal GDP (USD Billions) 6; Population (Millions) 11; Real GDP Per Capita (USD, PPP) 360; Average Real GDP Growth (Percent, 2001-2011) 7.9
- Table 2. Economic Structure Indicators, 2011
  - Kenya: Exports (% of GDP) 29.1; Imports (% of GDP) 46.0; Aid (% of GDP) 9.8; Rural Population (% of Total) 76.0; Commodity Exports (% of Exports) 60.9
  - Uganda: Exports (% of GDP) 23.7; Imports (% of GDP) 34.5; Aid (% of GDP) 9.9; Rural Population (% of Total) 84.4; Commodity Exports (% of Exports) 62.6
  - Tanzania: Exports (% of GDP) 31.1; Imports (% of GDP) 50.2; Aid (% of GDP) 10.3; Rural Population (% of Total) 73.3; Commodity Exports (% of Exports) 73.3
  - Rwanda: Exports (% of GDP) 13.4; Imports (% of GDP) 32.5; Aid (% of GDP) 19.7; Rural Population (% of Total) 80.9; Commodity Exports (% of Exports) 89.0
  - Average EAC4: Exports (% of GDP) 24.3; Imports (% of GDP) 40.8; Aid (% of GDP) 12.4; Rural Population (% of Total) 78.6; Commodity Exports (% of Exports) 71.4
  - Comparators:
    - Low Income Countries: Exports 28.3; Imports 48.4; Aid 13.1; Rural Population 69.2; Commodity Exports 64.0
    - Emerging Economies: Exports 42.2; Imports 41.4; Aid 1.8; Rural Population 34.5; Commodity Exports 27.9
    - Advanced Economies: Exports 65.5; Imports 61.0; Aid 0.0; Rural Population 20.5; Commodity Exports 19.5
  - Note: 1/ Includes exports of food, agricultural raw materials and ore and minerals. Data for Kenya is for 2010.

### IV. Financial sector indicators (Table 3, Figure 1)
- Table 3. Selected Financial Sector Indicators, 2011
  - Kenya: Credit to the Private Sector (Percent of GDP) 38.1; Bank Credit to the Private Sector (Percent of GDP) 33.6; 5-Bank Asset Concentration (Percent) 60.5; Stocks Traded, Total Value (Percent of GDP) 2.6; Dollarization 10.8; Chinn-Ito Financial Openness Index 1.1
  - Uganda: Credit to the Private Sector 17.9; Bank Credit to the Private Sector 13.8; 5-Bank Asset Concentration 73.6; Stocks Traded 0.1; Dollarization 21.8; Chinn-Ito Index 2.5
  - Tanzania: Credit to the Private Sector 17.8; Bank Credit to the Private Sector 15.8; 5-Bank Asset Concentration 67.6; Stocks Traded 0.1; Dollarization 20.3; Chinn-Ito Index -1.2
  - Rwanda: Credit to the Private Sector 16.9; Bank Credit to the Private Sector 13.2; 5-Bank Asset Concentration 100.0; Stocks Traded n.a.; Dollarization 20.0; Chinn-Ito Index -0.9
  - Average EAC4: Credit to the Private Sector 22.7; Bank Credit to the Private Sector 19.1; 5-Bank Asset Concentration 75.4; Stocks Traded 0.9; Dollarization 18.2; Chinn-Ito Index 0.4
  - Comparators:
    - Low Income Countries: Credit 19.6; Bank Credit 18.8; 5-Bank Concentration 80.0; Stocks Traded 4.9; Dollarization 12.8; Chinn-Ito Index -0.4
    - Emerging Economies: Credit 60.9; Bank Credit 49.1; 5-Bank Concentration 69.6; Stocks Traded 26.6; Dollarization 4.0; Chinn-Ito Index 0.3
    - Advanced Economies: Credit 145.3; Bank Credit 133.7; 5-Bank Concentration 84.8; Stocks Traded 70.2; Dollarization 0.5; Chinn-Ito Index 2.2
  - Notes:
    - 1/ Assets of five largest banks as a share of total commercial banking assets.
    - 2/ Foreign currency deposits as a share of total deposits in the banking system.
    - 3/ Index values are for 2010. The index takes a maximum value of 2.5 and a minimum of -1.9.
- Figure 1. Financial depth indicators show rapid recent growth in private credit to GDP, interbank borrowing (% of GDP), and percent of population accessing financial services (formal sector shares vary).

### V. Prices and inflation dynamics
- Inflation characteristics
  - Inflation in the EAC4 is volatile and highly correlated across countries.
  - CPI food-weight shares:
    - Tanzania 47 percent; Kenya 36 percent; Rwanda 35 percent; Uganda 27 percent.
  - Historical patterns:
    - Food price surge pre-2008 with peak food prices up 44 percent at 2008Q1.
    - Decline of commodity/food prices in 2008H2 moderated inflation in 2009.
    - 2010-2011 surge was more persistent and combined with strong activity and a negative balance of payments shock to de-anchor expectations and weaken exchange rates.
- Figure 2. EAC4 - Inflation (YoY, Percent) shows headline, food, and non-food inflation series and high volatility.

### VI. Policy regimes, operational frameworks, and transmission implications
- Summary of de jure arrangements (Table 4)
  - Kenya: Exchange Rate Arrangement — Free floating; Monetary Policy Framework — Flexible monetary targeting
  - Uganda: Exchange Rate Arrangement — Floating; Monetary Policy Framework — Inflation targeting lite
  - Tanzania: Exchange Rate Arrangement — Floating; Monetary Policy Framework — Monetary targeting
  - Rwanda: Exchange Rate Arrangement — Crawl-like arrangement; Monetary Policy Framework — Flexible monetary targeting
- Hybrid nature and operational consequences
  - Regimes are hybrid: multiple instruments targeting multiple objectives; central banks intervene to manage the exchange rate to varying degrees.
  - De jure monetary aggregate targeting (Rwanda, Tanzania, Kenya and Uganda until July 2011) often relaxed in practice, producing volatile short-term interest rates in the face of money demand shocks.
  - Kenya (September 2011) moved to emphasize short-term interest rate as the main policy instrument with inflation objective signaling.
  - Uganda shifted from strict money targeting to IT-lite in October 2009 and introduced the Central Bank Rate (CBR) in July 2011 to target the interbank rate.
- Effects on transmission
  - Where policy stance is clearer and short-term rates signal intentions (Uganda, post-reform Kenya), transmission to lending rates, exchange rates, output and inflation is stronger.
  - Where stance is harder to assess (Tanzania with de jure monetary targeting; Rwanda with de facto exchange rate peg and large exchange market intervention), transmission to lending rates is less evident, though exchange rate channel can be strong (Tanzania).
  - Multiplicity of instruments and central bank intervention can obscure signals and weaken interest-rate channels.
- Operational detail examples
  - Tanzania adheres most closely to de jure money targeting; this adherence contributes to volatile short-term market rates when confronted with money demand shocks.
  - Rwanda manages the nominal exchange rate closely, which can create tensions with attention to money aggregates and weakens exchange-rate-based transmission.
  - Uganda’s institutional reforms to smooth money market operations reduced interbank volatility and increased the informational content of short-term rates.

### VII. Core findings and lessons
- Findings from the October 2011 tightening event study
  - The monetary transmission mechanism operates in EAC4: higher short-term policy rates led to higher lending and other interest rates, exchange rate appreciation, lower output, and lower inflation.
  - Strongest and clearest transmission observed in:
    - Uganda: IT-lite regime with simpler, more transparent framework.
    - Kenya: effective transmission after explicit signaling via a short-term policy rate tied to inflation objectives.
  - Weaker transmission observed in:
    - Tanzania: de jure monetary targeting, multiple instruments, volatile short-term rates, but strong exchange rate response.
    - Rwanda: de facto exchange rate peg, heavy exchange rate intervention, underdeveloped interbank market limiting interest-rate signal and transmission.
- Implications
  - The nature of the policy regime and operational procedures matter critically for the effectiveness of monetary transmission in LICs, potentially more than cross-country differences in financial development.
  - Reforming policy frameworks to clarify instruments and strengthen the signaling role of short-term interest rates can improve transmission even in less-developed financial systems.
  - Heavy exchange rate management and multiple policy instruments can obscure the stance of policy and weaken typical transmission channels.

*Source: _wp13197 - References (IMF PDF content supplied).*

### Box 1. EAC4 - Exchange Rate Arrangements and the Capital Account

### Box 1. EAC4 - Exchange Rate Arrangements and the Capital Account

### Exchange rate arrangements and capital account openness
- Kenya
  - Exchange rate arrangement classified as free floating.
  - Central Bank of Kenya (CBK) conducts official foreign exchange market interventions to moderate the rate of change of the exchange rate:
    - Through auctions (the average rate is published after the auction closes).
    - Through direct interventions in the dealing system (market informed but amounts and rates are not published).
  - Capital account is open.
  - Kenya classified as a Frontier Market.
- Uganda
  - Classified as a floating regime.
  - Bank of Uganda (BOU) intervenes to maintain stability:
    - Since 2010, BOU conducts daily purchases for reserve buildup and engages in targeted sales as necessary.
    - BOU publishes intervention information in monthly, quarterly and annual reports, including amounts purchased or sold through the reserve buildup program and targeted transactions.
  - There are no capital controls.
- Tanzania
  - Exchange rate arrangement officially classified as a floating regime for the period under consideration.
  - Bank of Tanzania (BOT) is the predominant supplier of foreign exchange in a shallow market, sterilizing liquidity generated by government spending financed by official inflows.
  - Objectives of intervention include smoothing short-term exchange rate volatility and maintaining an adequate level of international reserves.
  - BOT announces the amount to be sold in the market through the dealing system on a monthly basis.
  - Controls on capital account transactions are widespread and the capital account is de facto quite closed.
- Rwanda
  - Exchange rate regime classified as a crawl-like arrangement.
  - National Bank of Rwanda (NBR) sells foreign exchange directly to banks at their request at a price on the upper limit of the exchange rate corridor.
  - Interbank market operates over the counter and data on NBR interventions are not disclosed.
  - Restrictions to capital account transactions are not prevalent, but the absence of capital flows is consistent with the capital account being de facto closed.

### Definition note
- Frontier market: term describing small and illiquid markets at an earlier stage of economic and financial development than emerging markets; Kenya is included in investable indexes compiled by Standard & Poor’s, MSCI and FTSE.

---

### Monetary policy mandates and instruments (EAC4)
- Kenya — Mandate: Price stability; Exchange rate stability; Financial stability; Support of Government policy
  - Instruments: Open market operations, Repo operations, FX intervention, Rediscount policy, Reserve requirements, Policy rate, Moral suasion
- Uganda — Mandate: Price stability; Financial stability
  - Instruments: Policy rate, FX intervention, Open market operations, Rediscount policy
- Tanzania — Mandate: Price stability; Financial stability; Support of Government policy
  - Instruments: Open market operations, Repo operations, Rediscount policy, Policy rate, FX intervention, Moral suasion
- Rwanda — Mandate: Price stability; Financial stability; Support of Government policy
  - Instruments: Open market operations, Rediscount policy, Reserve requirements, Policy rate, FX intervention

(Source: National authorities, Christensen (2011) and Morales (2012).)

---

### Box 2. EAC4 – Monetary Policy Frameworks

### Kenya — operating framework and instruments
- Operating target: reserve money growth.
- Intermediate targets: growth in M2 and M3.
- Target horizon:
  - Initially 6-months ahead.
  - Since 2011 targets set for 3 and 6-months ahead.
- Key instruments: repo operations (repo and reverse repo), cash reserve requirements, rates on discount window operations.
- Signaling: Central Bank Rate (CBR) reviewed and announced by the Monetary Policy Committee every month.
- Operational clarifications:
  - September 2011: CBK clarified operating procedures, emphasizing CBR as the reference for overnight borrowing from its standing lending facility and for liquidity operations since November 2011.
  - In 2012 CBR used mostly as a ceiling for repo auctions and increasingly guided interbank rates.

### Tanzania — operating framework and instruments
- MPC sets and Parliament approves operational target on reserve money and intermediate targets on growth in M2 and M3.
- Annual broad money targets set at the beginning of each fiscal year and revised mid-fiscal year.
- Adherence to targets is rather strict.
- Key instrument: repo operations (central bank usually withdrawing liquidity).
- Complementary liquidity management: periodic adjustments in pricing of standby facilities (Discount facility and Lombard facility).
- Policy signaling: movements in the Bank Rate, which can potentially lead to inconsistent signaling with monetary targets.

### Rwanda — operating framework and instruments
- Despite heavily managed exchange rate, NBR sets reserve money as operational target and a floor on net foreign assets as an intermediate target.
- De facto closed capital account likely allows some independence between exchange rate management and monetary policy.
- MPC decides Key Repo Rate (KRR):
  - KRR is the maximum rate for withdrawal and the minimum rate at which liquidity will be injected for seven-day maturity operations.
  - MPC meets quarterly and on extraordinary occasions if necessary.
- Liquidity management: surplus drained through open market operations.

### Uganda — operating framework and instruments
- July 2011: BOU announced move from monetary targeting towards inflation targeting lite.
- Operating target: interest rate (Central Bank Rate (CBR)), set once a month to guide 7-day interbank interest rates.
- Corridor around CBR defined to signal allowed deviations from interbank rate; corridor width frequently adjusted.
- Rediscount policy often used to signal policy.

### Fiscal pressures and central bank balance sheets
- Central banks are not necessarily immune to fiscal authority pressures.
- Monetary financing of Government deficit is subject to defined limits in EAC4 countries (usually set as a percent of government revenues), yet exceptional financing still occurs.
- Risk: higher interest rates can weaken fiscal position and bring government pressure on central banks.
- Aggravating factor: central banks are net debtors to the financial system, so interest rate increases can worsen central bank balance sheets and potentially require fiscal transfers from government.
- Aid inflows are high and volatile: ranging from 10 percent of GDP in Uganda and Kenya to 20 percent in Rwanda in 2011.

---

### III. The Event Study — 2011 tightening episode

### Identification and context
- Shock definition: episode where a central bank undertakes overt and unusual contractionary actions to reduce inflation (following Romer and Romer (1989)).
- Trigger: meeting of EAC Central Bank governors in October 2011 stating inflation was getting out of control and monetary policy needed to be tightened.
- Macroeconomic background (second half of 2010 through 2011):
  - International prices:
    - Food prices shot up by more than 30 percent.
    - Energy prices shot up by more than 40 percent.
  - By 2011Q3 headline inflation in Kenya, Uganda and Tanzania had surpassed the common inflation target of 5 percent.
  - Drivers of inflation: higher food and oil prices, domestic food price shocks, vigorous economic activity (output well above trend in Kenya and Uganda), pass-through from exchange rate depreciation.
  - Core inflation (excluding food and fuel) almost doubled during the course of a year in all countries and considerably overshot the common inflation target.
  - Real interest rates were strongly negative in Kenya, Uganda and Tanzania (Rwanda an exception).

### Country-specific run-up behavior
- Kenya
  - March 2011: CBK increased CBR by 25 basis points to 6 percent (reversing a 25bp cut in January 2011).
  - March–September 2011: nominal exchange rate depreciated by about 10 percent; inflation continued to increase.
  - Late June 2011: CBK increased discount rate from 6.25% to 8%, then lowered it and capped banks’ access; August 2011: stopped offering reverse repos, changed discount rate formula, stopped publishing discount rate, further restricted access to facility linked to banks’ foreign exchange trading behavior.
  - These moves produced a 2,200 bp spike in interbank rates.
  - September 2011: CBK raised CBR from 6.25 percent to 7 percent while providing liquidity through repo operations at 5.75 percent.
- Uganda
  - Interbank rates rose some 500bp in 2011 H1; lending rates remained unchanged initially.
  - July 2011: BOU switched to IT-lite and introduced CBR.
  - BOU raised CBR from 13 percent in July 2011 to 16 percent in September 2011.
  - Lending rate increased by 340 bp from July until September 2011.
- Tanzania
  - Began actions as early as 2010Q4.
  - Sharp contraction in real growth rate of money in late 2010 caused interbank rate blip.
  - As money growth reached nearly zero in mid-2011, interbank rates spiked again; limited pass-through to T-bill rates and lending rates.
- Rwanda
  - Output below trend, real interest rates positive, exchange rate stable.
  - Monetary aggregates not closely related to short-term interest rates.

### The decisive tightening event (post-October 2011)
- Kenya
  - CBK increased policy rate by 1,100 bp to 18 percent.
  - Cash reserve requirement ramped up by 75 bps to 5.25 percent.
  - Adjusted the discount window rate by more than 20 percent.
  - Ministry of Finance lowered foreign exchange exposure limit for commercial banks from 20 percent of core capital to 10 percent.
- Uganda
  - BOU raised policy interest rate by 700 bp to 23 percent.
  - Stepped up unsterilized intervention in the foreign exchange market to contain depreciating pressures on the Shilling.
- Tanzania
  - Central bank increased policy rate by 440 bp to 12 percent.
  - Augmented minimum reserve requirements on government deposits held by banks from 20 percent to 30 percent.
  - Reduced commercial banks’ limit on foreign currency net open positions from 20 percent to 10 percent of core capital.
  - Tightened capital controls and increased sales of foreign exchange in the interbank market.
- Rwanda
  - NBR increased policy rate by 50 bp to 6.5 percent, with subsequent increases by another 100 bp by mid-2012.
  - Average interbank rate climbed by 370 bp to 11.3 percent in the period between 2011Q4 and 2012Q4.

### Analytical approach and next steps
- The identified period of clear policy tightening (post-October 2011) is used to trace transmission mechanisms of monetary policy across the EAC4.
- A brief summary of transmission channels is referenced (Box 3) and further assessment follows in subsequent analysis.

*Source: _wp13197 - Box 1. EAC4 - Exchange Rate Arrangements and the Capital Account.*

### Box 3. An Overview of the Transmission Mechanisms of Monetary Policy

### Box 3. An Overview of the Transmission Mechanisms of Monetary Policy

### Overview
- The transmission mechanism of monetary policy refers to the various channels through which changes in the monetary policy stance influence aggregate demand and inflation.
- The range of channels can be grouped into five categories: (1) interest-rate channel, (2) exchange-rate channels, (3) expectations channel, (4) credit channels, (5) asset price channels and (6) the risk-taking channel.
- The asset-price and risk-taking channels operate through highly developed non-bank financial markets and institutions; given the limited nature of these in the EAC4 countries the authors do not attempt to find evidence of their existence or go into details about their functioning.

### Interest-rate channel
- Mechanism:
  - Changes in the monetary policy stance (reflected in short-term nominal interest rates) affect real interest rates, which feed through to aggregate demand and prices by changing firms’ and households’ investment and consumption decisions.
  - In Keynesian frameworks, deviations of aggregate demand from potential output (the output gap) result in inflationary/deflationary pressures through a standard Phillips Curve mechanism.
  - A tightening of monetary policy translates into higher interest rates, slower aggregate demand and reduced inflationary pressures.
- Interaction with exchange rates:
  - With capital mobility, changes in real interest rates affect the exchange rate: increases in local interest rates will tend to appreciate the currency.
  - Appreciation lowers the cost of imports and, by moving the real exchange rate, affects net exports and aggregate demand—contributing to lower inflation (exchange rate channel).

### Credit channels
- Encompass mechanisms that highlight asymmetric information in financial markets: the bank lending channel, the balance sheet channel and the cash-flow channel.
- Bank lending channel:
  - If banks cannot perfectly substitute deposits with other funding, changes in monetary policy alter bank reserves and deposits, changing banks’ ability and willingness to lend.
  - A tightening reduces credit availability, slowing aggregate demand and lowering inflation.
  - Credit rationing can arise: borrowers denied loans even when willing to pay higher rates due to adverse selection and moral hazard.
- Balance-sheet and cash-flow channels:
  - Monetary policy affects net worth of households and firms by altering the value of collateral pledgeable for credit.
  - Increases in interest rates translate into lower collateral values and tighter credit access, reducing aggregate demand and inflation.
- Structural factors:
  - The presence or weakness of mitigating institutions (e.g., credit reference bureaus) can amplify credit rationing effects.

### Expectations channel
- The private sector’s expectations of future policy decisions determine the strength of other channels.
- Medium and long-term interest rates that drive private sector decisions are mainly driven by expectations of future short rates.
- Expectations matter for exchange rate determination and inflation behavior.
- Monetary policy has direct control only over very short-term interest rates (usually overnight, sometimes a week); to affect longer rates policy decisions must signal the stance over the medium term.
- Communication strategy of the central bank is therefore of first-order importance.

### Empirical evidence from the EAC4 (Kenya, Uganda, Tanzania, Rwanda)
- General:
  - Authors identify a time when three of the EAC4 broke from previous behavior and executed more-or-less clearly signaled monetary policy contractions with the explicit intent of reducing inflation.
  - Clear evidence of most elements of the standard transmission mechanism is found in most countries; deviations are largely explicable by the nature of the policy adjustment and regime.
- Interest-rate channel evidence:
  - In Uganda and Kenya, pass-through from policy rates to money market interest rates was fast and complete.
  - Tanzania’s battery of measures transmitted quickly to money market rates; in Rwanda short-term interest rates responded to the announced policy tightening.
  - Banking interest rates responded swiftly to the monetary policy contraction in Kenya and Uganda.
  - Deposit rates in Kenya, Uganda and Tanzania were below policy rates during and after the policy episode.
  - In Tanzania and Rwanda banking lending rates did not respond even as deposit rates responded marginally—attributed to volatility/noise in money market rates under quantity-based monetary frameworks.
- Effects on activity and timing:
  - Negative real interest rates are associated with expansionary phases; positive and increasing real interest rates coincide with output below potential.
  - Transmission lag to activity was typically one quarter.
  - Real imports (a proxy for domestic demand) slowed after tightening measures, somewhat later in Tanzania.
- Phillips Curve evidence:
  - Support for Phillips Curve-type mechanisms in Kenya and Uganda, less so in Rwanda and Tanzania.
  - In Kenya and Uganda, positive or increasing output gaps correlate with increases in non-food inflation two to three quarters ahead.
- Exchange-rate channel evidence:
  - In Kenya, Uganda and Tanzania, increases in short-term interest rates were associated with contemporaneous appreciation of the currency—most clearly during the decisive tightening in 2011Q4.
  - Pass-through from exchange rate movements to inflation appears fast, with a lag of one month.
  - Rwanda’s case is harder to disentangle given the quasi-pegged exchange rate policy regime.
- Credit channel evidence:
  - In Kenya, Uganda and Tanzania, growth in credit to the private sector peaked soon after the policy contraction started and decelerated as tightening intensified (2011Q3 to 2012Q3).
  - Signs of credit rationing in Tanzania: lending rates did not respond, but quantity of credit extended declined meaningfully.
  - In Rwanda tighter policy does not appear to have translated into slower credit—possibly reflecting less significant tightening, less clear policy regime, and government policies promoting credit growth.

### Key empirical timings and numeric lags (preserve source phrasing)
- Transmission lag to activity: one quarter.
- Pass-through from exchange rate movements to inflation: lag of one month.
- Non-food inflation responses in Kenya and Uganda: two to three quarters ahead.
- Deceleration period for credit to the private sector in Kenya, Uganda and Tanzania: 2011Q3 to 2012Q3.
- Decisive tightening phase referenced: 2011Q4.

### Summary of findings
- Transmission was clearest in Kenya and Uganda where regimes most resembled inflation targeting: authorities prioritized inflation, emphasized the role of the policy rate, allowed the exchange rate a large degree of flexibility, and broadly avoided multiple objectives.
- In Tanzania the transmission was less clear: some interest rates, activity, the exchange rate, and inflation effects are evident, but lending rates failed to respond—possibly reflecting that the money targeting regime led to highly volatile short-term interest rates and a less clear signaling of policy stance.
- Rwanda acted as a control: the tightening was less significant, the hybrid regime did not provide a clear signal, the quasi peg and direct influence on private sector credit complicate inference from short-term interest rates, and the results of the tightening were less evident.
- Coordinated nature of the tightening could have credibility effects that bolstered transmission potency; under the assumption ex-ante credibility gains were similar across central banks involved, these effects manifested most in countries with more transparent monetary regimes (Kenya and Uganda).

*Source: Box 3, _wp13197 - Box 3. An Overview of the Transmission Mechanisms of Monetary Policy*

### introduction of new operating frameworks (Kenya and Uganda), movements in reserve

### introduction of new operating frameworks (Kenya and Uganda), movements in reserve

### Evidence on the transmission mechanism (EAC4)
- Broad finding: "after a large policy-induced rise in the short-term interest rate, lending and other interest rates rise, the exchange rate tends to appreciate, output growth tends to fall, and inflation declines."
- Strength of transmission across countries:
  - Kenya and Uganda: standard transmission features most evident.
  - Tanzania: exchange rate responds to monetary policy adjustments; some signs of effects on output (possibly through credit rationing).
  - Rwanda: evidence is less suggestive.
- Empirical channel lags and evidence (by country):
  - Interest Rate Channel: Money market rates — Kenya: Yes 1 quarter; Uganda: Yes 1 quarter; Tanzania: Yes 1 quarter; Rwanda: Yes 1 quarter.
  - Interest Rate Channel: Deposit rates — Kenya: Yes 1 quarter; Uganda: Yes 1 quarter; Tanzania: Yes 1 quarter; Rwanda: Yes 2 quarter.
  - Interest Rate Channel: Lending rates — Kenya: Yes 2 quarter; Uganda: Yes 2 quarter; Tanzania: Non.a.; Rwanda: Non.a.
  - Interest Rate Channel: Activity — Kenya: Yes 3 quarters; Uganda: Yes 3 quarters; Tanzania: Yes 1 quarter; Rwanda: Yes 1 quarter.
  - Exchange Rate Channel: Arbitrage — Kenya: Yes 1 quarter; Uganda: Yes 1 quarter; Tanzania: Yes 1 quarter; Rwanda: n.a.
  - Exchange Rate Channel: Pass-through — Kenya: Yes 1 quarter; Uganda: Yes 1 quarter; Tanzania: Yes 1 quarter; Rwanda: Inconclusive 6 quarters.
  - Credit Channel — Kenya: Yes 1 quarter; Uganda: Yes 1 quarter; Tanzania: Yes 1 quarter; Rwanda: n.a.
  - Phillips Curve — Kenya: Yes 2-3 quarters; Uganda: Yes 2 quarters; Tanzania: Inconclusive n.a.; Rwanda: Inconclusive n.a.

### Excess reserves and their role
- Observed pattern: "substantial reserves in excess of required levels in all four countries, with large variations across time and countries."
- Country-specific movements during the episode:
  - Kenya: excess reserves fell during 2011.
  - Uganda: excess reserves rose during 2011 and "varied around 30 percent of required reserves during the peak of the tightening phase, higher than they had been since 2007."
- Interpretation: available data suggest excess reserves did not prevent monetary transmission in the period under study; these "excess" reserves may reflect equilibrium phenomena (risk aversion, structural interbank market deficiencies) and, while addressing them is important for financial development, they are "not necessary for the transmission of monetary policy."

### Role of global risk appetite and supply shocks — alternative interpretations and rebuttals
- Global risk and capital flows:
  - 2011 saw increased global risk aversion (Arab Spring, sovereign debt crisis in Europe, rating downgrades).
  - EAC currencies started weakening in 2010, before the 2011 coordinated tightening; they were among the most depreciated in emerging and frontier markets during 2010–2011.
  - Specific timing notes:
    - Exchange rate pressures exacerbated in March 2011 in Kenya and in June 2011 in Uganda and Tanzania around major international events.
    - Real interest rates in these countries remained in negative territory throughout, amplifying exchange rate pressure.
  - Reaction to coordinated tightening:
    - Kenyan shilling reached its lowest level in seventeen years on October 2011, but rallied after the October 12 announcement, with "the shilling strengthening by 20% through year-end."
    - Ugandan shilling started to appreciate after the October 12 announcement.
    - Tanzanian shilling continued to weaken after the announcement, only interrupting its slide after measures announced the week of October 24.
    - Rwanda: reserve dynamics do not show a substantial outflow in H2 2011 (aid volatility may obscure picture).
- Supply shock (commodity prices) argument:
  - Alternative view: inflationary pressures driven predominantly by higher food and fuel prices, with inflation falling after the supply shock unwound rather than due to tighter monetary policy.
  - Counter-evidence:
    - Core inflation nearly doubled over the course of a year and overshot targets; after coordinated tightening, core inflation fell significantly (less so in Tanzania).
    - Core inflation dynamics, together with output and exchange rate paths, support the primacy of monetary policy in these events.
    - Structural model evidence (Andrle et al (2013)) applied to Kenya finds monetary policy accounts for much of inflation dynamics, including domestic food prices.
- Conclusion on alternatives: global risk swings and supply shocks contributed and compounded vulnerabilities, but cannot by themselves provide a coherent account of the documented events; monetary policy played a central role.

### Conclusions and policy lessons
- Key conclusions:
  - There is clear evidence of a working monetary transmission mechanism in the EAC4 episode studied.
  - The policy framework matters: where countries target money (Tanzania, Rwanda), short rates are less informative and less likely to move long rates.
  - Policy tightenings without good communication or a coherent framework have less clear effects.
  - Imperfect asset substitution and multiple instruments complicate interpretation of policy measures and can reduce the capacity of interest rates to clear markets and signal policy.
- Fiscal and other considerations:
  - Fiscal pressures or "fiscal dominance" were not central to tracing the transmission mechanism in this episode, though fiscal policy can create challenges (e.g., desire to keep treasury bill rates low led to occasional inconsistencies in central bank operations).
  - A belief that "monetary policy may not matter" may have influenced authorities’ earlier responses when policy rates were clearly negative.
- Policy recommendations and implications:
  - Moving towards forward-looking monetary policy frameworks such as inflation targeting is encouraging: "The transmission mechanism appears to be working, but it functions best when signals are clear and the regime simple and coherent."
  - Improve communication and coherence of the policy regime to strengthen transmission.
  - Address structural deficiencies in the interbank market that contribute to excess liquidity, to promote financial development (though not a prerequisite for transmission in this episode).
  - Use standard analytic tools such as small semi-structural inflation forecasting models to guide policy, avoid "go-stop" policies, and calibrate responses to supply shocks.
  - Further exploration needed on the management of capital account shocks and the role and place of sterilized intervention in the policy mix.
- Open research and policy questions:
  - The roles of supply shocks, food prices, the banking system and limited financial participation, fiscal policy, limited capital account openness, and other features require further study.
  - More complex situations than the late-2011 events do not always admit simple explanations.
  - The reduction of policy rates (in Kenya and Uganda) later in 2012 did not produce as clear a transmission to lending rates or real activity, leaving major open policy questions.

*Source: IMF staff analysis in the content unit titled "introduction of new operating frameworks (Kenya and Uganda), movements in reserve".*

### REFERENCES

### REFERENCES (_wp13197)

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- Montiel, P., Adam, C., Mbowe, W., & O’Connell, S. (2012). Financial Architecture and the Monetary Transmission Mechanism in Tanzania. Working Paper, International Growth Center.
- O'Connell, S. (2012). Inflation Targeting in Africa. In E. Aryeetey, S. Devarajan, R. Kanbur, & L. Kasekende (Eds.), The Oxford Companion to the Economics of Africa (pp. 360-364). Oxford: Oxford University Press.
- Saxegaard, M. (2006). Excess Liquidity and Efectiveness of Monetary Policy: Evidence from Sub-Saharan Africa. Working Paper, International Monetary Fund.

### Country-specific central bank statements, reports, and regional EAC analysis
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- Bank of Tanzania. (2012). Monetary Policy Statement - The Mid Year Review. February.
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- Bank of Uganda. (2011). Economic and Financial Indicators. February.
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- Central Bank of Kenya. (2011). MPC Press Release. March.
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- National Bank of Rwanda. (2011). Current Economic Developments and Monetary Policy Orientation.
- National Bank of Rwanda. (2011a). The BNR Key Repo Rate Increased From 6% to 6.5%.

### IMF, regional outlooks, country reviews, and policy support instruments
- International Monetary Fund. (2008). Regional Economic Outlook: Sub-Saharan Africa. Washington D.C. April.
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- International Monetary Fund. (2011d). Uganda-Third Review Under the Policy Support Instrument, Request for Waiver of Nonobservance of an Assessment Criterion, and Request for Modification of Assessment Criteria. Washington, D.C. December 21.
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- International Monetary Fund. (2013). United Republic of Tanzania-Sixth Review Under the Policy Support Instrument, Second Review Under the Standy Credit Facility Arrangement and Request for Modification of Performance Criteria – Staff Report. Washington, D.C. May 17.

### Regional integration, growth, savings, and financial systems
- Adam, C., Maturu, B., Ndung'u, N., & O'Connell, S. (2010). Building a Monetary Regime for the 21st Century. In C. Adam, P. Collier, & N. Ndung'u (Eds.), Kenya: Policies for Prosperity. Oxford: Oxford University Press.
- MacAuliffe, C., Saxena, S., & Yabara, M. (2012). Sustaining Growth in the East African Community. In H. Davoodi (Ed.), The East African Community After Ten Years. Deepening Integration. Washington, D.C.: International Monetary Fund.
- Morales, R. (2012). Monetary Policy Harmonization in the East African Community. In H. Davoodi (Ed.), The East African Community After Ten Years. Deepening Integration. International Monetary Fund.
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- Kessy, P. (2011). Dollarization in Tanzania: Empirical Evidence and Cross Country Experience. Working Paper, International Growth Center.
- Murinde, V. (2012). Banks and Credit Markets. In E. Aryeetey, S. Devarajan, R. Kanbur, & L. Kasekende (Eds.), The Oxford Companion to the Economics of Africa (pp. 374-379). Oxford: Oxford University Press.
- Murgosova, Z., Gorbanyov, M., Saenz, M. & Sobolev, Y. (2008). Impact of Rising International Food and Fuel Price on Inflation in EAC Countries. Selected Issues Paper, International Monetary Fund, Washington D.C.
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### Empirical methods, fiscal and macroeconomic analysis, and financial openness
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### Banking sector, interbank markets, competition, and financial system reviews
- Allen, F. I. (Forthcoming). African Financial Systems: A Review. Review of Development Finance.
- MacAuliffe, C., Saxena, S., & Yabara, M. (2012). Sustaining Growth in the East African Community. In H. Davoodi (Ed.), The East African Community After Ten Years. Deepening Integration. Washington, D.C.: International Monetary Fund.
- Muse, M., Kiplang'at, S., & Shimba, C. (2012). Segmentation and Efficiency of the Interbank Market in Kenya. Working Paper, Kenya Bankers Association, Center for Research on Financial Markets and Policy.
- Sanya, S., & Gaertner, M. (2012). Assessing Bank Competition Within the East African Community. Working Paper, International Monetary Fund, Washington, D.C.
- Selassi, A. (2008). Beyond Macroeconomic Stability: The Quest for Industrialization in Uganda. Working Paper, International Monetary Fund, Washington, D.C.

*References list as provided in document _wp13197 - REFERENCES*

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