How Africa Can Navigate Growing Monetary Policy Challenges

IMF Blog, April 4, 2022

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Sub-Saharan African countries face important monetary policy challenges following the pandemic: "the pandemic dented economic growth, and even now the recovery is likely to leave output below the pre-crisis trend this year."
Several countries in the region have seen inflation increase, sometimes compounded by "fiscal dominance emanating from high public debt levels."
Many economies may face capital outflows as "the major central banks in advanced economies withdraw policy stimulus and raise interest rates in the period ahead."
The conflict in Ukraine and the associated "sharp rise in energy and food prices" are likely to intensify these challenges.

Countries with managed or free-floating exchange rate regimes generally benefit from allowing currencies to adjust while focusing monetary policy on domestic objectives.
Factors that can limit the benefits of fully flexible rates in many sub-Saharan African countries:
- Dominant currency pricing (i.e., "rigid export prices in US dollar terms") can weaken trade adjustments from flexible rates.
- Shallow markets (i.e., "markets with limited liquidity") can amplify exchange rate movements and yield excessive volatility; evidence includes "wide spreads between bid and ask prices."
- High foreign-currency denominated liabilities lead to currency mismatches on balance sheets; exchange rate depreciations can "undermine the financial health of corporates and households."
- Weak central bank credibility can cause exchange rate changes to have a bigger effect on inflation ("high passthrough").
Consequences of these vulnerabilities:
- Currency mismatches and high passthrough can cause "output and inflation to move in opposite directions following shocks," worsening policy tradeoffs.
- There is evidence that "the exchange rate passthrough in low-income countries is substantially higher than it is in more advanced economies," problematic given heavy dependence on food and energy imports.

Reducing vulnerabilities over time is important and includes:
- Reducing balance sheet mismatches.
- Developing money and foreign currency markets.
- Reducing exchange rate passthrough by building monetary policy credibility.
- "Many of these are areas where IMF technical assistance can help."
While vulnerabilities remain high, the IMF’s work toward an "Integrated Policy Framework" suggests additional tools can ease short-term policy trade-offs when certain shocks hit. When reserves are adequate and tools are available, the following can help:
- Foreign exchange intervention.
- Macroprudential policy measures.
- Capital flow measures.
Expected short-term benefits from using these additional tools:
- Enhance monetary policy autonomy.
- Improve financial and price stability.
- Reduce output volatility.
Model simulations cited suggest that in response to a "sharp tightening of global financial conditions or other negative external financial shock," a vulnerable country could improve immediate outcomes by using foreign exchange intervention to reduce exchange rate depreciation, thereby:
- Limiting the inflationary impact.
- Reducing negative balance sheet effects.
- Resulting in "higher output and lower inflation than would have been feasible without the use of the additional policy instrument."

Important qualifiers for central banks considering these policies:
- Tools "should not be used to maintain an over- or undervalued exchange rate."
- Benefits of additional tools must be weighed against potential longer-term costs, which may include "reduced incentives for market development and appropriate risk management in the private sector."
- Communicating about the joint use of multiple tools "can be very challenging," and expanding policy options may expose central banks to political pressures.
- Central banks need to consider potential negative impacts on "their own transparency and credibility, especially in circumstances where policy frameworks are not yet well established."

Near-term: Consider limited, conditional use of foreign exchange intervention, macroprudential measures, and capital flow measures when reserves are adequate and vulnerabilities justify their use, to ease immediate trade-offs between output and inflation.
Medium- to long-term: Prioritize structural measures to reduce vulnerabilities:
- Reduce currency and balance sheet mismatches.
- Deepen money and foreign exchange markets.
- Build central bank credibility to reduce exchange rate passthrough.
- Leverage IMF technical assistance where relevant.
Ensure clear communication strategies and safeguard central bank transparency and independence when expanding the policy toolkit.

Tobias Adrian, Gaston Gelos, David Hofman — April 4, 2022